UNITED STATESSECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
Commission file number 1-12672
AVALONBAY COMMUNITIES, INC.(Exact name of registrant as specified in its charter)
2900 Eisenhower Avenue, Suite 300Alexandria, Virginia 22314(Address of principal executive offices, including zip code)
(703) 329-6300(Registrant’s telephone number, including area code)
(Former name, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve (12) months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past ninety (90) days.
APPLICABLE ONLY TO CORPORATE ISSUERS
Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:
69,380,910 shares outstanding as of August 1, 2002
AVALONBAY COMMUNITIES, INC.FORM 10-QINDEX
PART I — FINANCIAL INFORMATION
AVALONBAY COMMUNITIES, INC.CONDENSED CONSOLIDATED BALANCE SHEETS(Dollars in thousands, except per share data)
See accompanying notes to Condensed Consolidated Financial Statements.
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AVALONBAY COMMUNITIES, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONSAND COMPREHENSIVE INCOME(Unaudited)(Dollars in thousands, except per share data)
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AVALONBAY COMMUNITIES, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(Dollars in thousands)
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)
Supplemental disclosures of non-cash investing and financing activities (dollars in thousands):
During the six months ended June 30, 2002:
During the six months ended June 30, 2001:
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AVALONBAY COMMUNITIES, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)(Dollars in thousands, except per share data)
1. Organization and Significant Accounting Policies
Organization
AvalonBay Communities, Inc. (the “Company,” which term, unless the context otherwise requires, refers to AvalonBay Communities, Inc. together with its subsidiaries) is a Maryland corporation that has elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended. The Company focuses on the ownership and operation of upscale apartment communities in high barrier-to-entry markets of the United States. These markets are located in the Northeast, Mid-Atlantic, Midwest, Pacific Northwest, and Northern and Southern California regions of the country.
At June 30, 2002, the Company owned or held a direct or indirect ownership interest in 133 operating apartment communities containing 39,126 apartment homes in eleven states and the District of Columbia, of which one community containing 781 apartment homes was under reconstruction. In addition, the Company owned 13 communities with 3,788 apartment homes under construction and rights to develop an additional 33 communities that, if developed in the manner expected, will contain an estimated 9,533 apartment homes.
During the three months ended June 30, 2002:
The interim unaudited financial statements have been prepared in accordance with generally accepted accounting principles (“GAAP”) for interim financial information and in conjunction with the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements required by GAAP have been condensed or omitted pursuant to such rules and regulations. These unaudited financial statements should be read in conjunction with the financial statements and notes included in the
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Company’s Annual Report on Form 10-K for the year ended December 31, 2001. The results of operations for the six months ended June 30, 2002 are not necessarily indicative of the operating results for the full year. Management believes the disclosures are adequate to ensure the information presented is not misleading. In the opinion of management, all adjustments and eliminations, consisting only of normal, recurring adjustments necessary for a fair presentation of the financial statements for the interim periods, have been included.
Principles of Consolidation
The accompanying Condensed Consolidated Financial Statements include the accounts of the Company and its wholly-owned partnerships and certain joint venture partnerships in addition to subsidiary partnerships structured as DownREITs. All significant intercompany balances and transactions have been eliminated in consolidation.
In each of the partnerships structured as DownREITs, either the Company or one of the Company’s wholly-owned subsidiaries is the general partner, and there are one or more limited partners whose interest in the partnership is represented by units of limited partnership interest. For each DownREIT partnership, limited partners are entitled to receive distributions before any distribution is made to the general partner. Although the partnership agreements for each of the DownREITs are different, generally the distributions per unit paid to the holders of units of limited partnership interests have approximated the Company’s current common stock dividend per share. Each DownREIT partnership has been structured so that it is unlikely the limited partners will be entitled to a distribution greater than the initial distribution provided for in the partnership agreement. The holders of units of limited partnership interest have the right to present each unit of limited partnership interest for redemption for cash equal to the fair market value of a share of the Company’s common stock on the date of redemption. In lieu of a cash redemption of a limited partner’s unit, the Company may elect to acquire any unit presented for redemption for one share of common stock.
The Company has minority interest investments in four technology companies. The Company accounts for these unconsolidated entities in accordance with Accounting Principles Board (“APB”) Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” The Company applies the equity method of accounting to its investment in Realeum, Inc., a company involved in the development and deployment of a property management and leasing automation system. The remaining investments are accounted for under the cost method of accounting. As of June 30, 2002, the aggregate carrying value of our investment in these four companies was $3,946. If there is an event or change in circumstance that indicates a loss in the value of an investment, the Company’s policy is to record the loss and reduce the value of the investment to its fair value. A loss in value would be indicated if the Company could not recover the carrying value of the investment or if the investee could not sustain an earnings capacity that would justify the carrying amount of the investment.
Revenue Recognition
Rental income related to leases is recognized on an accrual basis when due from residents in accordance with SEC Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements.” In accordance with the Company’s standard lease terms, rental payments are generally due on a monthly basis. Any cash concessions given at the inception of the lease are amortized over the approximate life of the lease – generally one year.
The following reconciles total revenue in conformity with GAAP to total revenue adjusted to state concessions on a cash basis for the three and six months ended June 30, 2002, and 2001.
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Real Estate
Significant expenditures which improve or extend the life of an asset are capitalized. The operating real estate assets are stated at cost and consist of land, buildings and improvements, furniture, fixtures and equipment, and other costs incurred during their development, redevelopment and acquisition. Expenditures for maintenance and repairs are charged to operations as incurred.
The Company’s policy with respect to capital expenditures is generally to capitalize only non-recurring expenditures. Improvements and upgrades are capitalized only if the item exceeds $15, extends the useful life of the asset and is not related to making an apartment home ready for the next resident. Purchases of personal property, such as computers and furniture, are capitalized only if the item is a new addition. The Company generally expenses purchases of personal property made for replacement purposes.
The capitalization of costs during the development of assets (including interest and related loan fees, property taxes and other direct and indirect costs) begins when active development commences and ends when the asset is delivered and a final certificate of occupancy is issued. Cost capitalization during redevelopment of apartment homes (including interest and related loan fees, property taxes and other direct and indirect costs) begins when an apartment home is taken out-of-service for redevelopment and ends when the apartment home redevelopment is completed and the apartment home is placed in-service.
In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 67, “Accounting for Costs and Initial Rental Operations of Real Estate Projects,” the Company capitalizes pre-development costs incurred in pursuit of new development opportunities for which the Company currently believes future development is probable. Future development of these communities is dependent upon various factors, including zoning and regulatory approval, rental market conditions, construction costs and availability of capital. The accompanying Condensed Consolidated Financial Statements include a charge to expense to provide an allowance for unrecoverable deferred development costs related to pre-development communities that are unlikely to be developed.
Depreciation is calculated on buildings and improvements using the straight-line method over their estimated useful lives, which range from seven to thirty years. Furniture, fixtures and equipment are generally depreciated using the straight-line method over their estimated useful lives, which range from three years (primarily computer related equipment) to seven years.
Lease terms for apartment homes are generally one year or less. Rental income and operating costs incurred during the initial lease-up or post-redevelopment lease-up period are fully recognized as they accrue.
If there is an event or change in circumstance that indicates an impairment in the value of a community, the Company’s policy is to assess any impairment in value by making a comparison of the current and projected operating cash flows of the community over its remaining useful life, on an undiscounted basis, to the carrying amount of the community. If such carrying amounts are in excess of the estimated projected operating cash flows of the community, the Company would recognize an impairment loss equivalent to an amount required to adjust the carrying amount to its estimated fair market value. The Company has not recognized an impairment loss in 2002 or 2001 on any of its real estate.
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Earnings per Common Share
In accordance with the provisions of SFAS No. 128, “Earnings per Share,” basic earnings per share is computed by dividing earnings available to common shareholders by the weighted average number of shares outstanding during the period. Other potentially dilutive common shares, and the related impact to earnings, are considered when calculating earnings per share on a diluted basis. The Company’s earnings per common share are determined as follows:
Certain options to purchase shares of common stock in the amounts of 8,602 and 13,935 were outstanding during the three and six months ended June 30, 2002, respectively, and 877,043 and 14,500 were outstanding during the three and six months ended June 30, 2001, respectively, but were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common shares for the period.
Executive Separation Costs
In February 2001, the Company announced certain management changes including the departure of a senior executive who became entitled to severance benefits in accordance with the terms of his employment agreement with the Company. The Company recorded a charge of approximately $2,500 in the first quarter of 2001 related to the costs associated with such departure.
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Recently Issued Accounting Standards
In August 2001, the Financial Accounting Standards Board issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” This pronouncement establishes accounting and reporting standards requiring that long-lived assets held for sale be classified as discontinued operations. These assets will continue to be measured at the lower of the carrying amount or the fair value less the cost to sell. Operations, including the gain or loss on sale, for both the current and prior periods shall be reported in discontinued operations. The statement is effective for fiscal years beginning after December 15, 2001. The Company adopted this pronouncement on January 1, 2002, as required, and the adoption did not have a material effect on the Company’s Condensed Consolidated Financial Statements.
In May 2002, SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections” was issued. SFAS No. 145, among other items, rescinds SFAS No. 4, “Reporting Gains and Losses from Extinguishments of Debt,” which provided that gains and losses from early debt retirements be treated as extraordinary items. Under SFAS No. 145, gains and losses from early debt retirements will only be treated as extraordinary items if they meet the criteria for extraordinary items under APB No. 30. This statement is effective for fiscal years beginning after May 15, 2002. The Company will adopt this pronouncement effective January 1, 2003, but does not expect it to have a material impact on its financial condition and results of operations.
In June 2002, SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” was issued. This statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity.” Under SFAS No. 146, a liability for costs associated with exit or disposal activities is only to be recognized when the liability is incurred and the definition of a liability under Concepts Statement No. 6 is met, rather than at the date of an entity’s commitment to an exit or disposal plan. This statement is effective for exit or disposal activities that are initiated after December 31, 2002. The Company will adopt this pronouncement effective January 1, 2003, but does not expect it to have a material impact on its financial condition and results of operations.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates.
Reclassifications
Certain reclassifications have been made to amounts in prior years’ financial statements to conform with current year presentations.
2. Interest Capitalized
Capitalized interest associated with communities under development or redevelopment totaled $8,020 and $6,522 for the three months ended June 30, 2002 and 2001, respectively, and $16,671 and $12,119 for the six months ended June 30, 2002 and 2001, respectively.
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3. Notes Payable, Unsecured Notes and Credit Facility
Mortgage notes payable are collateralized by certain apartment communities. Mortgage notes payable, excluding a short-term construction loan, mature at various dates from May 2004 through February 2041. The weighted average interest rate of the Company’s variable rate notes and unsecured credit facility, including the effect of certain financing related fees, was 3.4% at June 30, 2002. The weighted average interest rate of the Company’s fixed rate mortgage notes (conventional and tax-exempt) was 6.7% at June 30, 2002. The Company’s notes payable, unsecured notes payable and credit facility are summarized as follows:
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Scheduled payments and maturities of notes payable and unsecured notes are as follows:
The Company’s unsecured notes contain a number of financial and other covenants with which the Company must comply, including, but not limited to, limits on the aggregate amount of total and secured indebtedness the Company may have on a consolidated basis and limits on the Company’s required debt service payments.
The Company has a $500,000 variable rate unsecured credit facility with J.P. Morgan Chase and Fleet National Bank serving as co-agents for a syndicate of commercial banks, which had $179,700 outstanding on June 30, 2002. Under the terms of the unsecured credit facility, if the Company elects to increase the facility up to $650,000, the syndicate of banks cannot prohibit such an increase of the facility and the increased lending commitment could be provided by one or more banks (from the syndicate or otherwise) at their election; such an increase in the facility will only be effective to the extent banks (from the syndicate or otherwise) choose to commit to lend additional funds. The unsecured credit facility bears interest at a spread over the London Interbank Offered Rate (“LIBOR”) based on rating levels achieved on the Company’s unsecured notes and on a maturity schedule selected by the Company. The current stated pricing is LIBOR plus 0.60% per annum (2.44% on June 30, 2002). In addition, the unsecured credit facility includes a competitive bid option, which allows banks that are part of the lender consortium to bid to make loans to the Company at a rate that is lower than the stated rate provided by the unsecured credit facility for up to $400,000. The Company is subject to certain customary covenants under the unsecured credit facility, including, but not limited to, maintaining certain maximum leverage ratios, a minimum fixed charges coverage ratio, minimum unencumbered assets and equity levels and restrictions on paying dividends in amounts that exceed 95% of the Company’s Funds from Operations, as defined therein. The existing facility matures in May 2005 assuming exercise of a one-year renewal option by the Company.
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4. Stockholders’ Equity
The following summarizes the changes in stockholders’ equity for the six months ended June 30, 2002:
During the six months ended June 30, 2002, the Company issued (i) 535,696 shares of common stock in connection with stock options exercised and (ii) 141,718 shares in connection with stock grants to employees of which 80% are restricted, (iii) had forfeitures of 5,534 shares, and (iv) withheld 10,374 shares to satisfy the employees’ tax withholding liabilities related to the vesting of restricted stock in the six months ended June 30, 2002.
Dividends per common share for the six months ended June 30, 2002 and 2001 were $1.40 and $1.28, respectively. In the six months ended June 30, 2002 and 2001, average dividends per all non-redeemed preferred shares were $1.05 and $1.07, respectively. For the six months ended June 30, 2001, dividends for preferred shares redeemed were $1.00 per share.
5. Derivative Instruments and Hedging Activities
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 133, as amended by SFAS No. 137, “Accounting for Derivative Instruments and Hedging Activities – Deferral of the Effective Date of SFAS No. 133,” and SFAS No. 138, “Accounting for Certain Instruments and Certain Hedging Activities, an amendment of Statement 133,” was adopted by the Company on January 1, 2001. SFAS No. 133, as amended, establishes accounting and reporting standards requiring that every derivative instrument be recorded on the balance sheet as either an asset or liability measured at its fair value. SFAS No. 133 also requires that a change in the derivative’s fair value be recognized currently in earnings unless specific hedge accounting criteria are met. For fair value hedge transactions, changes in the fair value of the derivative instrument and changes in the fair value of the hedged item due to the risk being hedged are recorded through the income statement. For cash flow hedge transactions, changes in the fair value of the derivative instrument are reported in other comprehensive income. For hedges where the changes in the fair value of the derivative exceeds the change in fair value of the hedged item, the ineffective portion is recognized in current period earnings. Derivatives which are not part of a hedge relationship are recorded at fair value through earnings.
The Company has historically used interest rate swap agreements (the “Swap Agreements”) to reduce the impact of interest rate fluctuations on its variable rate tax-exempt bonds. The Company has not entered into any interest rate hedge agreements or treasury locks for its conventional unsecured debt. The Swap Agreements are not held for trading or other speculative purposes. As of June 30, 2002, the effect of these Swap Agreements is to fix $166,624 of the Company’s tax-exempt debt at a weighted average interest rate of 6.0% with an average maturity of 4.0 years. By using derivative financial instruments to hedge exposures to changes in interest rates, the Company exposes itself to credit risk and market risk.
The credit risk is the risk of a counterparty not performing under the terms of the Swap Agreement. The counterparties to these Swap Agreements are major financial institutions which have an A+ or better credit rating by the Standard & Poor’s Ratings Group. The Company monitors the credit ratings of counterparties and the amount of the Company’s
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debt subject to Swap Agreements with any one party. Therefore, the Company believes the likelihood of realizing material losses from counterparty non-performance is remote.
Market risk is the adverse effect of the value of financial instruments that results from a change in interest rates. The market risk associated with interest-rate contracts is managed by the establishment and monitoring of parameters that limit the types and degree of market risk that may be undertaken. These risks are managed by the Company’s Chief Financial Officer and Vice President of Finance.
The Company has determined that its Swap Agreements qualify as effective cash-flow hedges under SFAS No. 133. When entering into hedging transactions, the Company documents the relationships between hedging instruments and hedged items, as well as the risk management objective and strategy. The Company assesses, both at inception and on an on-going basis, the effectiveness of all hedges in offsetting cash flows of hedged items. In accordance with SFAS No. 133, the Company records all changes in the fair value of the Swap Agreements in other comprehensive income. Amounts recorded in other comprehensive income will be reclassified into earnings in the period in which earnings are affected by the hedged cash flows. For example, the reduction in fair value on a cash flow hedge due to the periodic payment of interest under the Swap Agreements is recorded in earnings each period. The combination of this expense with the lower interest expense the Company expects to pay on the underlying floating rate debt should result in overall interest expense equal to the contractually fixed amount resulting from the fixed rate swaps. In all situations where hedge accounting is discontinued, the derivative will be carried at fair value with changes in its fair value recognized in income. Upon the termination of a hedging relationship, the amount in other comprehensive income will be amortized over the remaining life of the hedged cash flows.
At January 1, 2001, in accordance with the transition provisions of SFAS No. 133, the Company recorded a cumulative effect adjustment of $6,412 to other comprehensive loss to recognize at fair value all of the derivatives that are designated as cash flow hedging instruments. Through June 30, 2001, the Company recorded additional unrealized losses to other comprehensive loss of $632 to adjust the Swap Agreements to their fair value. In connection with the sale of a community during the first quarter of 2001, a Swap Agreement with a fair value of $528 was transferred to the new owner. Through June 30, 2002, the Company recorded unrealized losses to other comprehensive loss of $1,674 to adjust the Swap Agreements to their fair value. Hedge ineffectiveness did not have a material impact on earnings and the Company does not anticipate that it will have a material effect in the future. The fair value of the obligations under the Swap Agreements are included in accrued expenses and other liabilities on the accompanying Condensed Consolidated Balance Sheets.
6. Investments in Unconsolidated Real Estate Entities
The Company accounts for investments in unconsolidated real estate entities in accordance with Statement of Position (“SOP”) 78-9, “Accounting for Investments in Real Estate Ventures” and APB Opinion No. 18. The Company applies the equity method of accounting to an investment in an entity if it owns greater than 20% of the equity value and has significant and disproportionate influence over that entity. At June 30, 2002, the Company’s investments in unconsolidated real estate entities accounted for under the equity method of accounting consisted of:
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The following is a combined summary of the financial position of these entities as of the dates presented:
The following is a combined summary of the operating results of these entities for the periods presented:
The Company also holds a 25% limited liability company membership interest in the limited liability company that owns Avalon on the Sound, which is presented on a consolidated basis in the financial statements in accordance with GAAP due to the Company’s control over that entity. The financial position and operating results in the tables above for the three and six months ended June 30, 2002 reflect reclassifications made to amounts in prior periods’ financial statements to conform with current period presentations.
7. Communities Held for Sale
The Company has a policy of disposing of assets that are not consistent with its long-term investment criteria when market conditions are favorable. In connection with this strategy, the Company solicits competing bids from unrelated parties for individual assets, and considers the sales price and tax ramifications of each proposal. During the six months ended June 30, 2002, the Company did not sell any communities. The Company sold one community containing 226 homes for net proceeds of $14,500 during the six months ended June 30, 2001.
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The Company’s Condensed Consolidated Statements of Operations and Comprehensive Income include net income of the communities held for sale at June 30, 2001 of $4,969 and $9,013 for the three and six months ended June 30, 2001, respectively. There were no communities held for sale as of June 30, 2002, however, the Company will continue to evaluate market conditions and may dispose of communities in an effort to optimize its concentration of assets when conditions are favorable.
8. Segment Reporting
The Company’s reportable operating segments include Established Communities, Other Stabilized Communities, and Development/Redevelopment Communities. Annually on January 1st, the Company determines which of its communities fall into each of these categories and maintains that classification throughout the year for the purpose of reporting segment operations.
The primary financial measure for Established and Other Stabilized Communities is Net Operating Income (“NOI”), which represents total revenue less operating expenses and property taxes. The primary performance measure for communities under development or redevelopment depends on the stage of completion. While under development, management monitors actual construction costs against budgeted costs as well as lease-up pace and rent levels compared to budget.
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[Additional columns below]
[Continued from above table, first column(s) repeated]
The segments are classified based on the individual community’s status as of the beginning of the given calendar year. Therefore, each year the composition of communities within each business segment is adjusted. Accordingly, the amounts between years are not directly comparable. The accounting policies applicable to the operating segments described above are the same as those described in the summary of significant accounting policies.
Operating expenses as reflected on the Condensed Consolidated Statements of Operations and Comprehensive Income include $7,462 and $7,898 for the three months ended June 30, 2002 and 2001, respectively, and $16,283 and $17,945 for the six months ended June 30, 2002 and 2001, respectively, of property management overhead costs that are not allocated to individual communities. These costs are not reflected in NOI as shown in the above tables.
9. Related Party Arrangements
Purchase of Mortgage Loan
The Company’s Chairman and CEO, and the Company’s former Chairman and CEO are partners of an entity that is the general partner of Arbor Commons Associates Limited Partnership (“Arbor Commons Associates”). Arbor Commons Associates owns Avalon Arbor, a 302 apartment home community in Shrewsbury, Massachusetts. Concurrently with the initial public offering in November 1993 of Avalon Properties, Inc. (“Avalon”), a predecessor entity, Avalon purchased an existing participating mortgage loan made to Arbor Commons Associates that was originated by CIGNA Investments, Inc. The mortgage loan is secured by Arbor Common Associates’ interest in Avalon Arbor. This loan accrues interest at a fixed rate of 10.2% per annum, payable at 9.0% per annum. The balance of the note receivable at both June 30, 2002 and December 31, 2001 was $21,483. The balance of accrued interest on the note receivable as of June 30, 2002 and December 31, 2001, respectively, was $4,570 and $5,231. Related interest income of $1,546 and $1,525 was recorded for the six months ended June 30, 2002, and 2001, respectively. Under the terms of the loan, the Company (as successor to Avalon) receives (as contingent interest) 50% of the cash flow after the 10.2% accrual rate is paid and 50% of the residual profits upon the sale of the community.
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Sublease of San Jose Office Space to Greenbriar Homes
From September 1, 1999 to August 31, 2001, the Company subleased approximately 8,500 square feet of space in its San Jose office to Greenbriar Homes, for approximately $21 per month. A director of the Company holds a controlling interest in Greenbriar Homes. The lease has expired and Greenbriar no longer subleases office space from the Company.
Unconsolidated entities
The Company manages several unconsolidated real estate joint venture entities for which it receives management fee revenue. From these entities the Company received management fee revenue of $516 and $497 in the six months ended June 30, 2002 and 2001, respectively.
Indebtedness of Management
The Company has adopted a recourse loan program under which the Company lends amounts to or on behalf of employees (“Stock Loans”) equivalent to the estimated employees’ tax withholding liabilities related to the vesting of restricted stock under the 1994 Plan. The principal balance outstanding under the Stock Loans to employees was $1,705 and $1,133 as of June 30, 2002 and December 31, 2001, respectively. The balance of accrued interest on the notes receivable was $22 and $100 as of June 30, 2002 and December 31, 2001, respectively. Interest income on the notes of $16 and $31 was recorded for the three months ended June 30, 2002 and 2001, respectively, and $39 and $49 was recorded for the six months ended June 30, 2002 and 2001, respectively. Each Stock Loan is made for a one-year term, is a full personal recourse obligation of the borrower and is secured by a pledge to the Company of the stock that vested and gave rise to the tax withholding liability for which the loan was made. In addition, dividends on the pledged stock are automatically remitted to the Company and applied toward repayment of the Stock Loan.
Pursuant to a Promissory Note and Pledge and Security Agreement dated June 15, 2000, the Company advanced a senior officer $457. The loan, which bears interest at the rate of 6.39%, until June 15, 2005, at which time the rate may be adjusted, must be repaid upon demand on the earlier of June 15, 2002 or sixty days after termination of the officer’s employment. This is a full recourse loan, and is secured by Common Stock (with the dividends thereon applied toward repayment of the loan) and rights to employee stock options owned by the officer. The outstanding balance of the loan, including accrued interest, was $414 and $428 as of June 30, 2002 and December 31, 2001, respectively. Interest income of $7 relating to the loan was recorded for both the three months ended June 30, 2002 and 2001, and $13 and $14 was recorded for the six months ended June 30, 2002 and 2001, respectively. If this loan is not repaid in full by June 15, 2005, then at any time thereafter the Company in its sole discretion may demand repayment. In addition, the officer will be required to repay the loan in full within sixty days following his termination of employment with the Company for any reason.
Consulting Agreement with Mr. Meyer
In March 2000, the Company and Gilbert M. Meyer announced that Mr. Meyer would retire as Executive Chairman of the Company in May 2000. Although Mr. Meyer ceased his day-to-day involvement with the Company as an executive officer, he continues to serve as a director. In addition, pursuant to a consulting agreement which terminates in May 2003, Mr. Meyer agreed to serve as a consultant to the Company for three years following his retirement for an annual fee of $1,395. In such capacity he responds to requests for assistance or information concerning business matters with which he became familiar while employed, and he provides business advice and counsel to the Company with respect to business strategies and acquisitions, dispositions, development and redevelopment of multifamily rental properties.
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Director Compensation
The Company’s Stock Incentive Plan provides that directors of the Company who are also employees receive no additional compensation for their services as a director. Under the Stock Incentive Plan, on the fifth business day following each annual meeting of stockholders, each of the Company’s non-employee directors automatically receives options to purchase 7,000 shares of Common Stock at the last reported sale price of the Common Stock on the NYSE on such date, and a restricted stock (or deferred stock award) grant of 2,500 shares of Common Stock. Subject to accelerated vesting under certain limited circumstances, all of such stock options will become exercisable one year after the date of grant and will expire ten years after the date of grant, and such shares of restricted stock (or deferred stock awards) granted to non-employee directors will vest at the rate of 20% on the date of issuance and on each of the first four anniversaries of the date of issuance. If a director elects to receive a deferred stock award in lieu of restricted stock, then at the time of such election, the director also elects at what time in the future he or she will receive shares of stock in respect of the vested portion of the deferred stock award. The Company recorded compensation expense relating to these deferred stock awards in the amount of $412 and $277 in the six months ended June 30, 2002 and 2001, respectively. Deferred compensation relating to the these deferred stock awards was $883 and $688 on June 30, 2002 and December 31, 2001, respectively.
10. Subsequent Events
On July 12, 2002, the Company redeemed all 2,300,000 outstanding shares of its 8.50% Series C Cumulative Redeemable Preferred Stock at a price of $25.00 per share, plus $0.1417 in accrued and unpaid dividends, for an aggregate redemption price of $25.1417 per share. The redemption price was funded in part by the sale on July 11, 2002 of 592,000 shares of Series I Cumulative Redeemable Preferred Stock through a private placement to an institutional investor for a purchase price of $25.00 per share. The dividend rate on such shares is initially equal to 3.36% per annum (three month LIBOR plus 1.5%) of the liquidation preference. As permitted under the terms of such preferred, the Company has notified the holder of the Series I Preferred Shares that it will redeem all of the shares on August 29, 2002 for an aggregate redemption price of $14,606.
The Company announced in July 2002 that its Board of Directors had authorized a common stock repurchase program. Under this program, the Company may acquire shares of its common stock in open market or negotiated transactions up to an aggregate purchase price of $100,000. Actual purchases of stock will vary with market conditions. The size of the stock repurchase program was designed so that retained cash flow, as well as the proceeds from sales of existing apartment communities and a reduction in planned acquisitions, will provide the source of funding for the program, with the Company’s line of credit providing temporary funding as needed.
In July 2002, the Company finalized the settlement of its insurance claim related to the fire that occurred in 2000 at Avalon at Edgewater. Accordingly, the Company recorded $2,100 of additional business interruption income in the second quarter related to the final settlement. The income recognized in the second quarter combined with the $6,200 in prior quarters brings the total and final amount of business interruption proceeds to $8,300. In addition, the total insurance reimbursement related to capitalized costs was $21,980. The Company has received written confirmation from all participating carriers as to the final settlement amount and expects no further income or adjustments pertaining to this claim.
On August 8, 2002 the Company issued $150,000 in unsecured notes at an effective interest rate of 5.03% which matures in August 2007.
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Forward-Looking Statements
This Form 10-Q, including the footnotes to our Condensed Consolidated Financial Statements, contains “forward-looking statements” as that term is defined under the Private Securities Litigation Reform Act of 1995. You can identify forward-looking statements by our use of the words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “assume,” “project,” and other similar expressions in this Form 10-Q, that predict or indicate future events and trends or that do not report historical matters. In addition, information concerning the following are forward-looking statements:
We cannot assure the future results or outcome of the matters described in these statements; rather, these statements merely reflect our current expectations of the approximate outcomes of the matters discussed. You should not rely on forward-looking statements because they involve known and unknown risks, uncertainties and other factors, some of which are beyond our control. These risks, uncertainties and other factors may cause our actual results, performance or achievements to differ materially from the anticipated future results, performance or achievements expressed or implied by these forward-looking statements. Some of the factors that could cause our actual results, performance or achievements to differ materially from those expressed or implied by these forward-looking statements include, but are not limited to, the following:
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You should read our Condensed Consolidated Financial Statements and notes included in this report in conjunction with the following discussion. These forward-looking statements represent our estimates and assumptions only as of the date of this report. We do not undertake to update these forward-looking statements, and you should not rely upon them after the date of this report.
Business Description and Community Information
AvalonBay is a Maryland corporation that has elected to be treated as a real estate investment trust, or REIT, for federal income tax purposes. We focus on the ownership and operation of upscale apartment communities (which generally command among the highest rents in their submarkets) in high barrier-to-entry markets of the United States. This is because we believe that, long term, the limited new supply of upscale apartment homes in these markets will result in larger increases in cash flows relative to other markets. These barriers-to-entry generally include a difficult and lengthy entitlement process with local jurisdictions and dense in-fill locations where zoned and entitled land is in limited supply. These markets are located in the Northeast, Mid-Atlantic, Midwest, Pacific Northwest, and Northern and Southern California regions of the United States.
We are a fully-integrated real estate organization with in-house expertise in the following areas:
We believe apartment communities present an attractive long-term investment opportunity compared to other real estate investments because a broad potential resident base results in relatively stable demand over a real estate cycle. We intend to pursue real estate investments in markets where constraints to new supply exist and where new household formations have out-paced multifamily permit activity in recent years. Short-term supply-demand imbalances do occur, however, especially during a cyclical downturn. A number of our markets are experiencing economic contraction due to significant job losses. We do not expect conditions to improve materially until 2003.
With our in-house capabilities and expertise, we believe we are well-positioned to continue to pursue opportunities to develop and acquire upscale apartment homes in our target markets. Our ability to identify or pursue attractive opportunities, however, is affected by capital market conditions, including prevailing interest rates, and by the availability of attractively priced opportunities. Given current capital market and real estate market conditions, we are carefully considering the appropriate allocation of capital investment among development and redevelopment communities, the acquisition of existing communities, and stock redemptions/repurchases. See “Liquidity and Capital Resources” and “Future Financing and Capital Needs.”
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Our real estate investments consist primarily of current operating apartment communities, communities in various stages of development, and land or land options held for development. The following is a description of each category:
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On June 30, 2002, we owned or had an ownership interest in these categories as follows:
We did not acquire or dispose of any communities between June 30, 2002 and August 1, 2002. As of August 1, 2002, our 133 apartment home communities consisted of 39,126 apartment homes. Of those communities, we owned:
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We also hold a fee simple ownership interest in nine of the Development Communities, a general partnership interest in a limited partnership and a membership interest in a limited liability company that each hold a fee simple interest in a Development Community and a general partnership interest in two partnerships structured as “DownREITs” that each own one community.
In each of the six partnerships structured as DownREITs, either AvalonBay or one of our wholly-owned subsidiaries is the general partner, and there are one or more limited partners whose interest in the partnership is represented by units of limited partnership interest. For each DownREIT partnership, limited partners are entitled to receive distributions before any distribution is made to the general partner. Although the partnership agreements for each of the DownREITs are different, generally the distributions per unit paid to the holders of units of limited partnership interests have approximated the current AvalonBay common stock dividend amount. Each DownREIT partnership has been structured so that it is unlikely the limited partners will be entitled to a distribution greater than the initial distribution provided for in the partnership agreement. The holders of units of limited partnership interest have the right to present each unit of limited partnership interest for redemption for cash equal to the fair market value of a share of AvalonBay common stock on the date of redemption. In lieu of cash, we may elect to acquire any unit presented for redemption for one share of our common stock. As of June 30, 2002, there were 1,008,701 units outstanding. The DownREIT partnerships are consolidated for financial reporting purposes.
We elected to be taxed as a REIT for federal income tax purposes for the year ended December 31, 1994 and we have not revoked that election. We were incorporated under the laws of the State of California in 1978, and we were reincorporated in the State of Maryland in July 1995. Our principal executive offices are located at 2900 Eisenhower Avenue, Suite 300, Alexandria, Virginia, 22314, and our telephone number at that location is (703) 329-6300. We also maintain regional offices and administrative or specialty offices in or near the following cities:
Recent Developments
Acquisition, Development and Redevelopment Activities. During the three months ended June 30, 2002, we acquired two communities. The Promenade, located in Burbank, California, contains 400 apartment homes and was acquired for a total price of $70,300,000, which includes the assumption of $33,900,000 of floating rate, tax exempt financing. Avalon Greyrock, located in Stamford, Connecticut, contains 306 apartment homes and was acquired pursuant to a forward purchase contract agreed to in 1997 with an unaffiliated third party for a total acquisition cost of approximately $69,900,000.
We acquired land through the issuance of 102,756 DownREIT partnership units valued at $5,000,000 and cash of $4,781,000. The land parcel, located in Newton, Massachusetts, is the site for the development of Avalon at Newton Highlands which commenced construction during the second quarter. The community is expected to contain 294 apartment homes with a projected total investment of approximately $58,700,000. We also purchased land for a total of $9,663,000 in Saugus, Massachusetts in connection with a development right. We expect to build a community containing 326 apartment homes for a total investment of $59,000,000 on this parcel.
During the three months ended June 30, 2002, we completed the development of four communities, Avalon at Edgewater, (located in Edgewater, New Jersey), Avalon at Freehold (located in Freehold, New
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Jersey), Avalon Towers on the Peninsula (located in Mountain View, California) and Avalon Orchards (located in Marlborough, Massachusetts). Avalon at Edgewater contains 408 apartment homes and was completed for a total construction cost of $75,000,000, which reflects the net capitalized cost after consideration of insurance reimbursement related to capitalized costs that totaled $21,980,000. Avalon at Freehold, a 296 apartment home community, was completed for a total investment of $34,400,000. Avalon Towers on the Peninsula contains 211 apartment homes and was completed for a total investment of $66,100,000. Avalon Orchards, a 156 apartment home community, was completed for a total investment of $21,300,000. We also completed the redevelopment of Avalon Bedford (formerly known as Avalon Terrace), located in Stamford, Connecticut. This community, containing 368 apartment homes, was completed for a total investment in redevelopment of $60,900,000 (including $37,500,000 of acquisition cost). We own a 25% equity interest in this community through a joint venture with an institutional investor.
The development and redevelopment of communities involves risks that the investment will fail to perform in accordance with our expectations. See “Risks of Development and Redevelopment” for our discussion of these and other risks inherent in developing or redeveloping communities.
Results of Operations and Funds From Operations
A comparison of our operating results for the three and six months ended June 30, 2002 and June 30, 2001 follows (dollars in thousands):
Net income available to common stockholders decreased $6,816,000 (17.4%) to $32,315,000 for the three months ended June 30, 2002 and decreased by $12,780,000 (15.8%) to $68,005,000 for the six months ended June 30, 2002 compared to the same periods in 2001. These decreases in net income are primarily attributable to a decline in revenue due to deteriorating market conditions in several of our principal markets as well as increases in interest and depreciation expenses and the absence of asset sales in the first half of 2002.
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Net operating income (“NOI”) decreases of $4,781,000 and $3,296,000 for the three and six months ended June 30, 2002 , respectively, as compared to the same periods of 2001 consist of changes in the following categories:
The net operating income decreases in Established Communities were largely due to the effects of the national recession and to the relatively high occupancy and market rents experienced in certain of our submarkets in 2001. Uncharacteristically strong single family home sales during this recession, partially fueled by a low mortgage rate environment, have aggravated a weak demand environment. We expect to continue to experience weak demand during the next few quarters with modest improvement in demand in the middle of 2003, although no assurances regarding this projection can be given.
Rental income decreased due to a decline in overall occupancies as well as rental rates for Established Communities.
Although most of our markets have been affected by the national recession, we have observed the most significant declines in market rents and occupancy in certain Northern California and Northeast sub-markets. The Northern California and Northeast regions account for approximately 32.5% and 31.9% of current Established Community rental revenue, respectively. The declines in rents and occupancy in
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Northern California is partially related to volatility in the technology sector that comprises a significant portion of the area’s economy. The decline in the Northeast is primarily the result of job losses in the financial services sector and, with respect to our communities in Northern New Jersey, the disruption of certain transportation nodes adjacent to or located at the former World Trade Center.
Economic occupancy decreased in the Northern California region, from 95.6% for the six months ended June 30, 2001 to 93.4% for the same period of 2002. Economic occupancy decreased in the Northeast region, from 97.8% for the six months ended June 30, 2001 to 92.5% for the same period of 2002. Our largest declines in average occupancy from the first quarter of 2002 to the second quarter of 2002 were also in the Northeast.
Other income increased in the second quarter of 2002 primarily due to the recognition of an additional $2,100,000 in business interruption insurance related to the Edgewater insurance claim which represents the final settlement. For the six months ended 2002, other income increased primarily due to the recognition of $5,800,000 in business interruption insurance related to the Edgewater insurance claim. In addition, we recognized $711,000 in the first quarter of 2002 in construction management fees in connection with the redevelopment of a community owned by a limited liability company in which we have a membership interest.
Operating expenses, excluding property taxes increased primarily due to increases in insurance and abandoned pursuits, offset by a decline in executive separation costs. Insurance expense has increased over the past two years, particularly during 2001 as the insurance and reinsurance markets deteriorated, resulting in higher insurance costs for the entire real estate sector. Our insurance costs increased significantly upon the renewal of our general liability policy on August 1, 2001 and our property coverage on November 1, 2001. In addition, abandoned pursuit costs increased $200,000 compared to the same period of 2001 related to development rights which may not be developed as planned. A decrease in executive separation costs recognized in the second quarter of 2001 due to the departure of a senior executive partially offset the overall increase in operating expenses.
Property taxes increased due to higher assessments and the addition of newly developed and redeveloped apartment homes. Property taxes on Development and Redevelopment Communities are capitalized while the community is under construction. We begin to expense these costs as homes within the community receive a certificate of occupancy.
Interest expense increased primarily due to the issuance of $300,000,000 of unsecured notes in September 2001. After consideration of the issuance of $150,000,000 of unsecured notes in August 2002, we expect to issue additional unsecured debt later this year, of which a portion may be used to refinance maturing unsecured debt.
Depreciation expense increased primarily related to acquisitions and completion of development or redevelopment activities. We expect depreciation expense to continue to increase during 2002 as we complete additional development communities.
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General and administrative decreased primarily due to a decrease in consulting expense and a reduction in compensation expense due to the retirement of a senior executive in the fourth quarter of 2001, as well as targeted staff reductions and unfilled positions.
Equity in income of unconsolidated entities increased primarily due to the absence in 2002 of a $934,000 valuation allowance recorded in the first half of 2001 for an investment in a technology company accounted for under the cost method.
Interest income decreased due to lower average cash balances invested.
Gain on sale of communities decreased $4,901,000 or 100.0% for the six months ended June 30, 2002 compared to the same period of 2001 due to the lack of asset sales in 2002. Gains on the sale of communities are the result of our strategy to sell communities that do not meet our long-term strategic objectives and redeploy the proceeds to current Development and Redevelopment Communities. The amount of gains realized depend on many factors, including the number of communities sold, the size and carrying value of those communities, and the market conditions in the local area.
Funds from Operations
We consider Funds from Operations (“FFO”) to be an appropriate supplemental measure of our operating performance because it helps investors understand our ability to incur and service debt and to make capital expenditures. We believe that to understand our operating results, FFO should be examined with net income as presented in the Condensed Consolidated Statements of Operations and Comprehensive Income included elsewhere in this report. FFO is determined in accordance with a definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts®, and is defined as:
FFO does not represent cash generated from operating activities in accordance with GAAP. Therefore it should not be considered an alternative to net income as an indication of our performance. FFO should also not be considered an alternative to net cash flows from operating activities, as determined by GAAP, as a measure of liquidity. Additionally, it is not necessarily indicative of cash available to fund cash needs. Further, FFO as calculated by other REITs may not be comparable to our calculation of FFO. The following is a reconciliation of net income to FFO and a presentation of GAAP based cash flow metrics:
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Capitalization of Fixed Assets and Community Improvements
Our policy with respect to capital expenditures is generally to capitalize only non-recurring expenditures. We capitalize improvements and upgrades only if the item:
Under this policy, virtually all capitalized costs are non-recurring, as recurring make-ready costs are expensed as incurred. Recurring make-ready costs include the following:
We capitalize purchases of personal property, such as computers and furniture, only if the item is a new addition and the item exceeds $2,500. We generally expense purchases of personal property made for replacement purposes. For Established and Other Stabilized Communities, we recorded non-revenue generating capitalized expenditures of approximately $132 per apartment home in the six months ended June 30, 2002. The average maintenance expense, including carpet and appliance replacements, related to these communities was $579 per apartment home for the six months ended June 30, 2002 and $597 for the same period in 2001. We anticipate that capitalized costs per apartment home will gradually increase as the average age of our communities increases.
We have expanded our Condensed Consolidated Statement of Cash Flows to include additional information on capital expenditures. For the year ended December 31, 2001, the amounts capitalized (excluding land costs) related to (i) acquisitions, construction and redevelopment, net of dispositions were $243,419,000 (ii) revenue generating expenditures, such as water sub-metering equipment and cable installations were $1,675,000 and (iii) non-revenue generating expenditures were $12,234,000.
Liquidity and Capital Resources
Liquidity. The primary source of liquidity is our cash flows from operations. Operating cash flows have historically been determined by:
The timing, source and amount of cash flows provided by financing activities and used in investing activities are sensitive to the capital markets environment, particularly to changes in interest rates. Changes in the capital markets environment affect our plans for undertaking construction and development as well as acquisition activity.
Cash and cash equivalents totaled $9,492,000 at June 30, 2002, a decrease of $63,494,000 from $72,986,000 at December 31, 2001. The following discussion relates to changes in cash due to operating, investing and financing activities, which are presented in our Condensed Consolidated Statements of Cash Flows included in this report.
Operating Activities – Net cash provided by operating activities of $152,710,000 was primarily due to operating income from our portfolio of communities.
Investing Activities – Net cash used in investing activities of $337,869,000 in the six months ended June 30, 2002 related to investments in assets through development, redevelopment and acquisition of apartment communities.
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Financing Activities – Net cash provided by financing activities totaled $121,665,000 for the six months ended June 30, 2002, primarily due to the increase in borrowings under our unsecured credit facility.
We regularly review our short and long-term liquidity needs, the adequacy of Funds from Operations, as defined above, and other expected liquidity sources to meet these needs. We believe our principal short-term liquidity needs are to fund:
We anticipate that we can fully satisfy these needs from a combination of cash flows provided by operating activities and capacity under the unsecured credit facility.
One of our principal long-term liquidity needs is the repayment of medium and long-term debt at the time at which such debt matures. For unsecured notes, we anticipate that no significant portion of the principal of these notes will be repaid prior to maturity. If we do not have funds on hand sufficient to repay our indebtedness, it will be necessary for us to refinance this debt. This refinancing may be accomplished by additional debt financing that is collateralized by mortgages on individual communities or groups of communities, by uncollateralized private or public debt offerings or by additional equity offerings. We also anticipate having significant retained cash flow in each year so that when a debt obligation matures, some or all of each maturity can be satisfied from this retained cash. Although we believe we will have the capacity to meet our long-term liquidity needs, we cannot assure you that additional debt financing or debt or equity offerings will be available or, if available, that they will be on terms we consider satisfactory.
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Capital Resources. We intend to match the long-term nature of our real estate assets with long-term cost- effective capital to the extent permitted by prevailing market conditions. Since January 1, 2000, external sources of debt capital used to fund investment activities totaled $800,000,000, representing public sales of unsecured debt. We expect this source of capital to remain available to meet our capital needs, in addition to cash flow from operating activities, for the foreseeable future, although no assurance can be provided that the debt capital markets will remain available or that such debt will be available on attractive terms.
Variable Rate Unsecured Credit Facility
Our unsecured revolving credit facility is furnished by a syndicate of banks and provides up to $500,000,000 in short-term credit. Under the terms of the credit facility, if we elect to increase the facility up to $650,000,000, and one or more banks (from the syndicate or otherwise) voluntarily agree to provide the additional commitment, then we will be able to increase the facility up to $650,000,000, and no member of the syndicate of banks can prohibit such increase; such an increase in the facility will only be effective to the extent banks (from the syndicate or otherwise) choose to commit to lend additional funds. We pay participating banks an annual facility fee of $750,000 in equal quarterly installments. The unsecured credit facility bears interest at varying levels tied to the London Interbank Offered Rate (“LIBOR”) based on ratings levels achieved on our unsecured notes and on a maturity schedule selected by us. The current stated pricing is LIBOR plus 0.60% per annum (2.44% on August 1, 2002). A competitive bid option is available for borrowings of up to $400,000,000. This option allows banks that are part of the lender consortium to bid to provide us loans at a rate that is lower than the stated pricing provided by the unsecured credit facility. The competitive bid option may result in lower pricing if market conditions allow. Pricing under the competitive bid option resulted in average pricing of LIBOR plus 0.34% for amounts most recently borrowed under the competitive bid option. At August 1, 2002, $297,700,000 was outstanding, $80,352,000 was used to provide letters of credit and $121,948,000 was available for borrowing under the unsecured credit facility. On August 8, 2002, we settled on the issuance of $150,000,000 of 5 year unsecured notes with an effective rate of 5.03%. The net proceeds of $149,000,000 will be used to repay amounts outstanding on the unsecured facility. The balances at August 1, 2002 do not reflect the application of proceeds from these unsecured notes. We intend to use borrowings under the unsecured credit facility for:
Interest Rate Protection Agreements
We are not a party to any long-term interest rate agreements, other than interest rate protection and swap agreements on approximately $167,000,000 of our variable rate tax-exempt indebtedness. We intend, however, to evaluate the need for long-term interest rate protection agreements as interest rate market conditions dictate, and we have engaged a consultant to assist in managing our interest rate risks and exposure.
Future Financing and Capital Needs
As of June 30, 2002, we had 13 new communities under construction. As of June 30, 2002, a total estimated cost of $275,295,000 remained to be invested in these communities. In addition, we had one other community under reconstruction, for which an estimated $5,083,000 remained to be invested.
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Substantially all of the capital expenditures necessary to complete the communities currently under construction and reconstruction will be funded from:
We expect to continue to fund development costs related to pursuing Development Rights from retained operating cash and borrowings under the unsecured credit facility. We believe these sources of capital will be adequate to take the proposed communities to the point in the development cycle where construction can begin. Before planned reconstruction activity or the construction of a Development Right begins, we intend to arrange adequate financing to complete these undertakings, although we cannot assure you that we will be able to obtain such financing. In the event that financing cannot be obtained, we may have to abandon Development Rights, write-off associated pursuit costs that were capitalized and/or forego reconstruction activity. In such instances, we will not realize the increased revenues and earnings that we expected from such pursuits, and the related write-off of costs could increase current period expenses.
Our liquidity could be adversely impacted by expanding development and acquisition activities and/or reduced capital (as compared to prior years) available from asset sales. To meet the balance of our liquidity needs under such conditions, we would need to arrange additional capacity under our existing unsecured credit facility, sell additional existing communities and/or issue additional debt or equity securities. While we believe we have the financial position to expand our short-term credit capacity and support our capital markets activity, we cannot assure you that we will be successful in completing these arrangements, sales or offerings. The failure to complete these transactions on a cost-effective basis could have a material adverse impact on our operating results and financial condition, including the abandonment of development pursuits and a resulting charge to earnings.
It is our policy to sell assets that do not meet our long-term investment criteria when market conditions are favorable, and to redeploy the proceeds. Under our disposition program, we solicit competing bids from unrelated parties for these individual assets and consider the sales price and tax ramifications of each proposal. We intend to actively seek buyers for communities that we determine to hold for sale. However, we cannot assure you that the assets can be sold on terms that we consider satisfactory. We expect to significantly curtail our disposition program this year in response to anticipated real estate and capital markets conditions.
We have minority interest investments in four technology companies, including Constellation Real Technologies LLC, an entity formed by a number of real estate investment trusts and real estate operating companies for the purpose of investing in multi-sector real estate technology opportunities. Our original commitment to Constellation was $4,000,000. Constellation has proposed a reduction in the aggregate amount of capital commitments from its members. If that proposal is accepted, our revised commitment would fall to $2,600,000. As of August 1, 2002, we have contributed approximately $959,000. In January 2002, we invested an additional $2,300,000 in Realeum, Inc., a company involved in the development and deployment of a property management and leasing automation system. Pursuant to an agreement with Realeum, Inc., we will utilize the property management and leasing automation system in exchange for payments under a licensing arrangement. Realeum, Inc. is negotiating licensing arrangements with other real estate companies unaffiliated with AvalonBay. As of August 1, 2002, the total remaining carrying value of our investments in the four technology companies was $3,748,000. We have no obligation to contribute additional funds, other than the commitment to Constellation described above.
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Debt Maturities
The following table details debt maturities for the next five years, excluding the unsecured credit facility (dollars in thousands):
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Stock Repurchase Program
In July 2002 we announced that our Board of Directors had authorized a common stock repurchase program. Under this program, we may acquire shares of our common stock in open market or negotiated transactions up to an aggregate purchase price of $100,000,000. Actual purchases of stock will vary with market conditions. The size of the stock repurchase program was designed so that retained cash flow, as well as the proceeds from sales of existing apartment communities and a reduction in planned acquisitions, will provide the source of funding for the program, with our line of credit providing temporary funding as needed. We have acquired 23,600 shares under this program through August 1, 2002.
Redemption of Preferred Stock
In July 2002, we redeemed all 2,300,000 outstanding shares of our 8.50% Series C Cumulative Redeemable Preferred Stock at a price of $25.00 per share, plus $0.1417 in accrued and unpaid dividends, for an aggregate redemption price of $25.1417 per share. The redemption price was funded in part by the sale on July 11, 2002 of 592,000 shares of Series I Cumulative Redeemable Preferred Stock through a private placement to an institutional investor for a purchase price of $25.00 per share. The dividend rate on such shares is initially equal to 3.36% per annum (three month LIBOR plus 1.5%) of the liquidation preference. As permitted under the terms of such preferred, we have notified the holder of the Series I Preferred Shares that we will redeem all of the shares on August 29, 2002 for an aggregate redemption price of $14,606,000.
In addition to the Series I Preferred Stock, we currently have the following two other series of redeemable preferred stock outstanding at an aggregate stated value of $181,692,500. As these series become redeemable, we will evaluate the requirements necessary for such redemptions as well as the cost-effectiveness based on the existing market conditions.
Inflation
Substantially all of our leases are for a term of one year or less. In the event of significant inflation, this may enable us to realize increased rents upon renewal of existing leases or the beginning of new leases. Short-term leases generally minimize our risk from the adverse effects of inflation, although these leases generally permit residents to leave at the end of the lease term without penalty and therefore expose us to the effect of a decline in market rents. In a deflationary rent environment, as is currently being experienced, we are exposed to declining rents more quickly under these shorter term leases.
Natural Disasters
Many of our West Coast communities are located in the general vicinity of active earthquake faults. A large concentration of AvalonBay communities lies near, and thus is susceptible to, the major fault lines in the San Francisco Bay Area, including the San Andreas fault and Hayward fault. We cannot assure you that an earthquake would not cause damage or losses greater than insured levels.
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In November 2001, we renewed our earthquake insurance. For any single occurrence, and in the aggregate, we have in place with respect to communities located in California, $67,000,000 of coverage with a deductible per building equal to five percent of the value of that building. The five percent deductible is subject to a minimum of $100,000 per occurrence. Earthquake coverage outside of California, with the exception of Washington State, is subject to a $100,000,000 limit and a $100,000 deductible per location. In addition, up to an aggregate of $2,000,000, the next $400,000 of loss per occurrence will be treated as an additional deductible. Coverage in Washington State is subject to a $65,000,000 limit, with the same deductible. Our general liability and property insurance program provides coverage for public liability and fire damage. In the event an uninsured disaster or a loss in excess of insured limits were to occur, we could lose our capital invested in the affected community, as well as anticipated future revenue from that community. We would also continue to be obligated to repay any mortgage indebtedness or other obligations related to the community. Any such loss could materially and adversely affect our business and our financial condition and results of operations.
Insurance
We have noted that the insurance and reinsurance markets have worsened as compared to the prior year, which we believe will result in higher insurance costs for the entire real estate sector. The impact of the terrorist attacks on the World Trade Center and the Pentagon on September 11, 2001, have further deteriorated these markets.
Our annual general liability policy and workman’s compensation coverage was renewed on August 1, 2002. Although the insurance coverage provided for in the renewal policies did not materially change from the preceding year, the level of our deductible and premiums costs has increased. We expect a 30% increase in the cost related to these insurance categories for the policy period from August 1, 2002 to July 31, 2003.
Our property coverage will be renewed on November 1, 2002. We expect that our property insurance premium will increase approximately 25% to 50% over last year’s renewal.
Critical Accounting Policies
Our accounting policies are in conformity with GAAP. The preparation of financial statements in conformity with GAAP requires management to use judgment in the application of accounting policies, including making estimates and assumptions. These judgments affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. If our judgment or interpretation of the facts and circumstances relating to various transactions had been different, it is possible that different accounting policies would have been applied resulting in a different presentation of our financial statements. Below is a discussion of accounting policies which we consider critical in that they may require complex judgment in their application or require estimates about matters which are inherently uncertain. Additional discussion of accounting policies which we consider significant, including further discussion of the critical accounting policies described below, can be found in the Notes to our Condensed Consolidated Financial Statements.
Real Estate Development Rights
With few exceptions, we capitalize pre-development costs incurred in pursuit of new development opportunities. These costs include legal fees, design fees and related overhead costs. The accompanying Condensed Consolidated Financial Statements include a charge to expense to provide an allowance for unrecoverable capitalized pre-development costs that may be written off if we determine that a pre-development community is unlikely to be developed.
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Rental income related to leases is recognized on an accrual basis when due from residents in accordance with SEC Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements.” In accordance with our standard lease terms, rental payments are generally due on a monthly basis. Any cash concessions given at the inception of the lease are amortized over the approximate life of the lease – generally one year.
If there is an event or change in circumstance that indicates an impairment in the value of a community, our policy is to assess the impairment by making a comparison of the current and projected operating cash flows of the community over its remaining useful life, on an undiscounted basis, to the carrying amount of the community. If the carrying amount is in excess of the estimated projected operating cash flows of the community, we would recognize an impairment loss equivalent to an amount required to adjust the carrying amount to its estimated fair market value. We have not recognized an impairment loss in 2002 or 2001 on any real estate.
Investments in Technology Companies
We account for our investments in technology companies in accordance with Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” If there is an event or change in circumstance that indicates a loss in the value of an investment, our policy is to record the loss and reduce the value of the investment to its fair value. A loss in value would be indicated if we could not recover the carrying value of the investment or if the investee could not sustain an earnings capacity that would justify the carrying amount of the investment. Due to the nature of these investments, an impairment in value can be difficult to determine.
Legal Contingencies
We are subject to various legal proceedings and claims that arise in the ordinary course of business. These matters are frequently covered by insurance. While the resolution of these matters cannot be predicted with certainty, we believe the final outcome of such matters will not have a material adverse effect on our financial position or the results of operations. Once it has been determined that a loss is probable to occur, the estimated amount of the loss is recorded in the financial statements. Both the amount of the loss and the point at which its occurrence is considered probable can be difficult to determine.
Development Communities
As of June 30, 2002, we had 13 Development Communities under construction. We expect these Development Communities, when completed, to add a total of 3,788 apartment homes to our portfolio for a total capitalized cost, including land acquisition costs, of approximately $712,700,000. Statements regarding the future development or performance of the Development Communities are forward-looking statements. We cannot assure you that:
You should carefully review the discussion under “Risks of Development and Redevelopment” included elsewhere in this report.
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The following table presents a summary of the Development Communities. We hold a direct or indirect fee simple ownership interest in these communities except where noted.
During the period between June 30, 2002 and August 1, 2002, construction began on two Development Rights, one in Saugus, Massachusetts and one in Glen Cove, New York. When completed, we expect these communities to add 582 apartment homes to our portfolio at a total investment of $130,000,000.
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Redevelopment Communities
As of June 30, 2002, we had one community under redevelopment. We expect the total budgeted cost to complete this community, including the cost of acquisition and redevelopment, to be approximately $154,500,000, of which approximately $20,600,000 is the additional capital invested or expected to be invested above the original purchase cost. Statements regarding the future redevelopment or performance of the Redevelopment Communities are forward-looking statements. We have found that the cost to redevelop an existing apartment community is more difficult to budget and estimate than the cost to develop a new community. Accordingly, we expect that actual costs may vary from our budget by a wider range than for a new development community. We cannot assure you that we will meet our schedules for reconstruction completion, or that we will meet our budgeted costs, either individually or in the aggregate. See the discussion under “Risks of Development and Redevelopment” included elsewhere in this report.
The following presents a summary of this Redevelopment Community:
Development Rights
As of June 30, 2002, we are considering the development of 33 new apartment communities on land that is either owned by us, under contract, subject to a leasehold interest, or for which we hold a purchase option. We generally hold Development Rights through options to acquire land, although for nine of the Development Rights we currently own the land on which a community would be built if we proceeded with development. The Development Rights range from those beginning design and architectural planning to those that have completed site plans and drawings and can begin construction almost immediately. We estimate that the successful completion of all of these communities would ultimately add 9,533 upscale apartment homes to our portfolio. Substantially all of these apartment homes will offer features like those offered by the communities we currently own.
The properties comprising the Development Rights are in different stages of the due diligence and regulatory approval process. The decisions as to which of the Development Rights to pursue, if any, or to continue to pursue once an investment in a Development Right is made, are business judgments that we make after we perform financial, demographic and other analyses. In the event that we do not proceed with a Development Right, we generally would not recover capitalized costs incurred in the pursuit of those communities, unless we were to recover amounts in connection with the sale of land; however we cannot guarantee a recovery. To recognize the possibility of such loss, we recognize a charge to expense to provide an allowance for unrecoverable capitalized pre-development costs that may be written off if we determine that a pre-development community is unlikely to be developed. The determination of a charge to expense relative to pursuits involves management judgment regarding the probability that a pursuit will not proceed to development. The amount charged to expense and reflected in the accompanying Condensed Consolidated Financial Statements related to possible abandoned pursuits was $1,400,000 and $1,200,000 for the six months ended June 30, 2002 and 2001, respectively. At August 1, 2002 there were cumulative capitalized costs (including legal fees, design fees and related overhead costs) of $29,214,000 and land costs (consisting of original cost and additional carrying costs) of $64,875,000, related to the pursuit of Development Rights.
We currently intend to limit the percentage of debt used to finance new developments in order to maintain our general historical practice with respect to the proportion of debt in our capital structure. Therefore, other financing alternatives may be required to finance the development of those Development Rights scheduled to start construction after January 1, 2002.
Although the development of any particular Development Right cannot be assured, we believe that the Development Rights, in the aggregate, present attractive potential opportunities for future development and growth of our long-term stockholder value. Statements regarding the future development of the Development Rights are forward-looking statements.
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We cannot assure you that:
The following presents a summary of the 33 Development Rights at June 30, 2002:
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Risks of Development and Redevelopment
We intend to continue to pursue the development and redevelopment of apartment home communities. Our development and redevelopment activities may be exposed to the following:
The occurrence of any of the events described above could adversely affect our ability to achieve our projected yields on communities under development or redevelopment and could affect results of operations and our payment of distributions to our stockholders.
Construction costs are projected by us based on market conditions prevailing in the community’s market at the time our budgets are prepared and reflect changes to those market conditions that we anticipated at that time. Although we attempt to anticipate changes in market conditions, we cannot predict with certainty what those changes will be. Construction costs have been increasing and, for some of our Development Communities, the total construction costs have been or are expected to be higher than the original budget. Total budgeted cost includes all capitalized costs projected to be incurred to develop the respective Development or Redevelopment Community, determined in accordance with GAAP, including:
Costs to redevelop communities that have been acquired have, in some cases, exceeded our original estimates and similar increases in costs may be experienced in the future. We cannot assure you that market rents in effect at the time new development communities or redevelopment communities complete lease-up will be sufficient to fully offset the effects of any increased construction or reconstruction costs.
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Capitalized Interest
In accordance with GAAP, we capitalize interest expense during construction or reconstruction until a building obtains a certificate of occupancy. Interest that is incurred thereafter and allocated to a completed apartment home within the community is expensed. Capitalized interest totaled $8,020,000 for the three months ended June 30, 2002 and $16,671,000 for the six months ended June 30, 2002. Capitalized interest totaled $6,522,000 for the three months ended June 30, 2001 and $12,119,000 for the six months ended June 30, 2001.
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Part I. FINANCIAL INFORMATION (continued)
Part II. OTHER INFORMATION
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† filed herewith
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
AVALONBAY COMMUNITIES, INC.
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