AvalonBay Communities - 10-Q quarterly report FY

 

2900 Eisenhower Avenue, Suite 300
Alexandria, Virginia 22314
(Address of principal executive offices, including zip code)

(703) 329-6300
(Registrant’s telephone number, including area code)

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.

Yes þ     No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes þ     No o

Indicate by check mark whether the Exchange registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).

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Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date:

81,433,377 shares of common stock, par value $0.01 per share, were outstanding as of October 30, 2009

AVALONBAY COMMUNITIES, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

See accompanying notes to Condensed Consolidated Financial Statements.

AVALONBAY COMMUNITIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

AND OTHER COMPREHENSIVE INCOME

(Unaudited)

(Dollars in thousands, except per share data)

See accompanying notes to Condensed Consolidated Financial Statements.

AVALONBAY COMMUNITIES, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Dollars in thousands)

See accompanying notes to Condensed Consolidated Financial Statements.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

Supplemental disclosures of non-cash investing and financing activities (dollars in thousands):

During the nine months ended September 30, 2009:

During the nine months ended September 30, 2008:

1. Organization and Basis of Presentation

AvalonBay Communities, Inc. (the “Company,” which term, unless the context otherwise requires, refers to AvalonBay Communities, Inc. together with its consolidated 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 (“the Code”), as amended. The Company focuses on the development, acquisition, ownership and operation of apartment communities in high barrier to entry markets of the United States. These markets are located in the New England, Metro New York/New Jersey, Mid-Atlantic, Midwest, Pacific Northwest, and Northern and Southern California regions of the country.

At September 30, 2009, the Company owned or held a direct or indirect ownership interest in 163 operating apartment communities containing 46,693 apartment homes in ten states and the District of Columbia, of which six communities containing 2,380 apartment homes were under reconstruction. In addition, the Company owned or held a direct or indirect ownership interest in nine communities under construction that are expected to contain an aggregate of 3,421 apartment homes when completed. The Company also owned or held a direct or indirect ownership interest in rights to develop an additional 27 communities that, if developed as expected, will contain an estimated 6,788 apartment homes.

The interim unaudited financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”) for interim financial information and in conjunction with the rules and regulations of the Securities and Exchange Commission (“SEC”). 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 Company’s 2008 Annual Report on Form 10-K. The results of operations for the three and nine months ended September 30, 2009 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.

Basic earnings per share is computed by dividing net income attributable to common stockholders by the weighted average number of shares outstanding during the period. All outstanding unvested restricted share awards, which contain rights to non-forfeitable dividends, participate in undistributed earnings with common shareholders and, accordingly, are considered participating securities that are included in the two-class method of computing basic earnings per share (“EPS”). All historical periods presented have been restated to reflect the impact of including participating securities in the basic earnings per share calculation. Both the unvested restricted shares and 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 2,023,878 and 1,489,780 were outstanding at September 30, 2009 and 2008, respectively, but were not included in the computation of diluted earnings per share because such options are anti-dilutive.

The Company is required to estimate the forfeiture of stock options and recognize compensation cost net of the estimated forfeitures. The estimated forfeitures included in compensation cost are adjusted to reflect actual forfeitures at the end of the vesting period. The forfeiture rate at September 30, 2009 was 1.7%. The application of estimated forfeitures did not materially impact compensation expense for the three and nine months ended September 30, 2009 or 2008.

The Company capitalizes pre-development costs incurred in pursuit of new development opportunities for which the Company currently believes future development is probable (“Development Rights”). Future development of these Development Rights is dependent upon various factors, including zoning and regulatory approval, rental market conditions, construction costs and the availability of capital. Pre- development costs incurred in the pursuit of Development Rights for which future development is not yet considered probable are expensed as incurred. In addition, if the status of a Development Right changes, making future development by the Company no longer probable, any capitalized pre-development costs are written off with a charge to expense. The Company expensed costs related to abandoned pursuits, which includes the abandonment of Development Rights, acquisition pursuits and disposition pursuits, in the amounts of $1,721 and $715 for the three months ended September 30, 2009 and 2008, respectively and $5,096 and $3,044 for the nine months ended September 30, 2009 and 2008, respectively. These costs are included in operating expenses, excluding property taxes on the accompanying Condensed Consolidated Statements of Operations and Other Comprehensive Income. Abandoned pursuit costs can vary greatly, and the costs incurred in any given period may be significantly different in future years.

In addition, during the second quarter of 2009, the Company concluded that the continued economic downturn and the related decline in employment levels did not support the development and construction of certain new apartment communities that were previously in planning. This resulted in the recognition of an impairment charge of $20,302 related to the impairment of two land parcels for which the Company no longer intends to pursue development. The Company looked to third-party pricing estimates to determine the fair values of the land parcels considered to be impaired. Given the heterogeneous nature of multifamily real estate, the third party values incorporated significant other unobservable inputs and are therefore considered to be Level 3 prices in the fair value hierarchy.

At September 30, 2009, the Company was involved in litigation alleging that communities constructed by the Company violate the accessibility requirements of the Fair Housing Act (“FHA”) and the Americans with Disabilities Act. The Equal Rights Center (“ERC”) filed a complaint against the Company on September 23, 2005 in the U.S. District Court, District of Maryland with respect to 100 properties. On October 30, 2009, the Company entered into a proposed consent decree with the ERC to settle this matter and on November 2, 2009, the court approved the consent decree. See Note 12, “Subsequent Events”, for further discussion.

In a separate matter related to FHA accessibility matters, on August 13, 2008 the U.S. Attorney’s Office for the Southern District of New York filed a civil lawsuit against the Company and the joint venture in which it has an interest that owns Avalon Chrystie Place. The lawsuit alleges that Avalon Chrystie Place was not designed and constructed in accordance with the accessibility requirements of the FHA. The Company designed and constructed the community to address compliance with New York City’s Local Law 58, which for more than 20 years has been New York City’s code regulating the accessible design and construction of apartments. As there are uncertainties relating to the Avalon Chrystie Place lawsuit, (such as the legal requirements to meet and demonstrate accessibility under the applicable statutes, the cost to remediate, if necessary and whether the scope of this lawsuit will be extended to other properties) the Company cannot predict or determine the outcome of this lawsuit, nor is it reasonably possible at this time to estimate the amount of loss, if any, that would be associated with an adverse decision or settlement.

In addition, the Company is subject to various other legal proceedings and claims that arise in the ordinary course of business. These matters are frequently covered by insurance. If it has been determined that a loss is probable to

occur and can be reasonably estimated, the estimated amount of the loss is recorded in the financial statements. While the resolution of these other matters cannot be predicted with certainty, management currently believes the final outcome of such matters will not have a material adverse effect on the financial position or results of operations of the Company. In instances where the Company has a gain contingency associated with legal proceedings, the Company records a gain in the financial statements when it is deemed probable to occur, can be reasonably estimated and is considered to be collectible.

Redeemable noncontrolling interests are comprised of potential future obligations of the Company, which allow the investors holding the noncontrolling interest to require the Company to purchase their interest. The Company classifies obligations under the redeemable noncontrolling interests at fair value, with a corresponding offset for changes in the fair value recorded in accumulated earnings less dividends. Reductions in fair value are recorded only to the extent that the Company has previously recorded increases in fair value above the redeemable noncontrolling interest’s initial basis. The redeemable noncontrolling interests are presented outside of permanent equity as settlement in the Company’s common shares, where permitted, may not be within the Company’s control. The nature and valuation of the Company’s redeemable noncontrolling interests are discussed further in Note 11, “Fair Value.”

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.

Certain reclassifications have been made to amounts in prior years’ financial statements to conform to current year presentations.

In June 2009, the FASB issued FASB Accounting Standards Codification (“ASC”) 105, “Generally Accepted Accounting Principles”, (the “Codification”) which established the FASB ASC as the sole source of authoritative GAAP. The adoption of FASB ASC 105 did not impact the Company’s financial position or results of operations.

In June 2009, the FASB issued Statement No. 167, “Amendments to FASB Interpretation No. 46(R)” (“SFAS No. 167”), which is not yet included in the Codification. SFAS No. 167 significantly amends the consolidation guidance applicable to variable interest entities (“VIEs”). SFAS No. 167 modifies the consolidation model to one based on control and economics, and replaces the current quantitative primary beneficiary analysis with a qualitative analysis. The primary beneficiary of a VIE will be the entity that has (1) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (2) the obligation to absorb losses or receive benefits that could potentially be significant to the VIE. If multiple unrelated parties share such power, as defined, no party will be required to consolidate the VIE. Further, SFAS No. 167 requires continual reconsideration of the primary beneficiary of a VIE and adds an additional reconsideration event for determination of whether an entity is a VIE. SFAS No. 167 also requires expanded disclosures related to VIEs which are largely consistent with the disclosure framework currently applied by the Company. SFAS No. 167 is effective January 1, 2010 for the Company. The Company is currently evaluating the impact that adoption of SFAS No. 167 will have on its financial statements.

In August 2009, the FASB issued Accounting Standards Update (“ASU”) 2009-05, “Measuring Liabilities at Fair Value”. ASU 2009-05 provides additional guidance clarifying the measurement of liabilities at fair value. When a quoted price in an active market for the identical liability is not available, ASU 2009-05 requires that the fair value of a liability be measured using one or more of the listed valuation techniques that should maximize the use of relevant observable inputs and minimize the use of unobservable inputs. In addition, the amendments in ASU 2009-05 clarify that when estimating the fair value of a liability, an entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability, and clarify how the price of a traded debt security should be considered in estimating the fair value of a liability. ASU 2009-05 is effective for the Company beginning in the fourth quarter of 2009, and will not materially impact the Company’s financial position or results of operations.

2. Interest Capitalized

The Company capitalizes interest during the development and redevelopment of real estate assets. Capitalized interest associated with communities under development or redevelopment totaled $11,878 and $18,803 for the three months ended September 30, 2009 and 2008, respectively and $37,923 and $57,625 for the nine months ended September 30, 2009 and 2008, respectively.

3. Notes Payable, Unsecured Notes and Credit Facility

The Company’s mortgage notes payable, unsecured notes and Credit Facility, as defined below, as of September 30, 2009 and December 31, 2008, are summarized below.

The following debt activity occurred during the nine months ended September 30, 2009:

In October 2009, the Company repurchased $310,100 principal amount of its unsecured notes. See Note 12, “Subsequent Events” for further discussion.

In the aggregate, secured notes payable mature at various dates from December 2009 through July 2066 and are secured by certain apartment communities and improved land parcels (with a net carrying value of $1,891,995 as of September 30, 2009). As of September 30, 2009, the Company has guaranteed approximately $385,269 of mortgage notes payable held by wholly owned subsidiaries; all such mortgage notes payable are consolidated for financial reporting purposes. The weighted average interest rate of the Company’s fixed rate mortgage notes payable (conventional and tax-exempt) was 5.9% and 5.7% at September 30, 2009 and December 31, 2008, respectively. The weighted average interest rate of the Company’s variable rate mortgage notes payable, Term Loan and its unsecured credit facility, including the effect of certain financing related fees, was 2.1% at September 30, 2009 and 2.9% at December 31, 2008.

Scheduled payments and maturities of mortgage notes payable and unsecured notes outstanding at September 30, 2009 are as follows:

The Company has a variable rate unsecured credit facility (the “Credit Facility”) in the amount of $1,000,000 with a syndicate of commercial banks, to whom the Company pays, in the aggregate, an annual facility fee of approximately $1,250. The Company did not have any amounts outstanding under the Credit Facility and had $38,684 outstanding in letters of credit as of September 30, 2009. At December 31, 2008, there was $124,000 outstanding under the Credit Facility and $45,976 outstanding in letters of credit. The Credit Facility bears interest at varying levels based on the London Interbank Offered Rate (“LIBOR”), 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 0.40% per annum (0.65% at September 30, 2009). The Company did not have any amounts outstanding under the Credit Facility’s competitive bid option as of September 30, 2009. The Credit Facility matures in November 2011, assuming exercise of a one-year renewal option by the Company.

The Company was in compliance at September 30, 2009 with applicable financial and other covenants contained in the Credit Facility, the Term Loan and the Company’s unsecured notes.

4. Stockholders’ Equity

The following summarizes the changes in stockholders’ equity for the nine months ended September 30, 2009:

During the nine months ended September 30, 2009, the Company:

The Company granted 344,801 options for common stock to employees. Deferred compensation related to the Company’s stock option and restricted stock grants during the nine months ended September 30, 2009 is not reflected on the Company’s Condensed Consolidated Balance Sheet as of September 30, 2009, and will not be reflected until earned as compensation cost.

In August 2009, the Company commenced a continuous equity offering program (the “Offering Program”), under which the Company may sell up to an aggregate amount of $400 million of its common stock until August 2012. The Company may sell common stock in amounts and at times to be determined by the Company. Actual sales will depend on a variety of factors to be determined by the Company, including market conditions, the trading price of the Company’s common stock and determinations by the Company of the appropriate sources of funding for the Company. In conjunction with the Offering Program, the Company engaged sales agents who received compensation of 1.5% of the gross sales price per share for the common stock sold in the quarter ended September 30, 2009. During the quarter ended September 30, 2009, the Company sold 1,467,001 shares under this program at an average sales price of $69.44 per share resulting in net proceeds of $100,334.

5. Derivative Instruments and Hedging Activities

The Company enters into interest rate swap and interest rate cap agreements (collectively, the “Hedging Derivatives”) to reduce the impact of interest rate fluctuations on its variable rate, tax-exempt bonds and its variable rate conventional secured debt (collectively, the “Hedged Debt”). The Company has not entered into any interest rate hedge agreements for its conventional unsecured debt and does not enter into derivative transactions for trading or other speculative purposes. The following table summarizes the consolidated Hedging Derivatives at September 30, 2009, excluding derivatives executed to hedge debt on communities classified as held for sale:

Excluding derivatives executed to hedge debt on communities classified as held for sale, the Company had three derivatives designated as cash flow hedges and six derivatives not designated as hedges at September 30, 2009. Fair value changes for derivatives that are not in qualifying hedge relationships are reported as a component of general and administrative expenses on the accompanying Condensed Consolidated Statements of Operations and Other Comprehensive Income. Fair value changes for derivatives not in qualifying hedge relationships for the three and nine month periods ended September 30, 2009, were not material. For the derivative positions that the Company has determined qualify as effective cash flow hedges, the Company has recorded the effective portion of cumulative changes in the fair value of the Hedging Derivatives in other comprehensive income. Amounts recorded in other comprehensive income will be reclassified into earnings in the periods in which earnings are affected by the hedged cash flow. To adjust the Hedging Derivatives to their fair value and recognize the impact of hedge accounting, the Company recorded an increase in other comprehensive income of $1,318 during the nine months ended September 30, 2009 and an increase of $1,044 during the nine months ended September 30, 2008. Amounts in other comprehensive income will be reclassified into earnings in conjunction with the periodic adjustment of the floating rates on the Hedged Debt, in interest expense, net. The amount reclassified into earnings for the nine months ended September 30, 2009, as well as the estimated amount included in accumulated other comprehensive loss as of September 30, 2009, expected to be reclassified into earnings within the next twelve months to offset the variability of cash flows of the hedged items during this period are not material.

The Company assesses, both at inception and on an on-going basis, the effectiveness of qualifying cash flow hedges. Hedge ineffectiveness, reported as a component of general and administrative expenses, did not have a material impact on earnings of the Company for any period presented, and the Company does not anticipate that it will have a material effect in the future. The fair values of the Hedging Derivatives are included in accrued expenses and other liabilities on the accompanying Condensed Consolidated Balance Sheets. Refer to Note 11, “Fair Value,” for further discussion of fair value measurements including the Company’s incorporation of credit valuation adjustments.

6. Investments in Real Estate Entities

As of September 30, 2009, the Company had investments in six unconsolidated real estate entities with ownership interest percentages ranging from 15.2% to 50%. In the second quarter of 2009, in conjunction with the second closing of the AvalonBay Value Added Fund II, LP (“Fund II”), the Company’s equity ownership interest decreased to 31% from 45%. There were no other changes in the Company’s ownership interest in, or presentation of, its investments in unconsolidated real estate entities during the nine months ended September 30, 2009.

The following is a combined summary of the financial position of the entities accounted for using the equity method, as of the dates presented:

The following is a combined summary of the operating results of the entities accounted for using the equity method, for the periods presented:

In conjunction with the acquisition and development of the investments in unconsolidated entities, the Company incurred costs in excess of its equity in the underlying net assets of the respective investments. These costs represent $11,148 at September 30, 2009 and $4,817 at December 31, 2008 of the respective investment balances.

As part of the formation of the AvalonBay Value Added Fund, LP (the “Fund”) and Fund II, the Company provided separate and distinct guarantees to one of the limited partners in each of the ventures. These guarantees are specific to the respective fund and any impacts or obligation of the Company to perform under one of the guarantees has no impact on the Company’s obligations with respect to the other guarantee. The guarantees provide that, if, upon final liquidation of the Fund or Fund II, the total amount of all distributions to the guaranteed partner during the life of the respective fund (whether from operating cash flow or property sales) does not equal the total capital contributions made by that partner, then the Company will pay the guaranteed partner an amount equal to the shortfall, but in no event more than 10% of the total capital contributions made by the guaranteed partner (maximum of approximately $7,192 for the Fund and approximately $413 for Fund II as of September 30, 2009). As of September 30, 2009, the expected realizable value of the real estate assets owned by the Fund and Fund II is considered adequate to cover such potential payments under a liquidation scenario. The estimated fair value of and the Company’s obligation under these guarantees, both at inception and as of September 30, 2009, was not significant and therefore the Company has not recorded any obligation for either of these guarantees as of September 30, 2009.

7. Real Estate Disposition Activities

During the nine months ended September 30, 2009, the Company sold two communities, Avalon at River Oaks, located in San Jose, California and Avalon at Faxon Park, located in Quincy, Massachusetts. These two communities contain an aggregate of 397 apartment homes and were sold for an aggregate sales price of $69,500. These dispositions resulted in a gain in accordance with GAAP of approximately $26,670. As of September 30, 2009, the Company had one community that qualified as discontinued operations and held for sale.

The operations for any real estate assets sold from January 1, 2008 through September 30, 2009 and the real estate assets that qualified as discontinued operations and held for sale as of September 30, 2009 have been presented as such in the accompanying Condensed Consolidated Financial Statements. Accordingly, certain reclassifications have been made in prior periods to reflect discontinued operations consistent with current period presentation.

The following is a summary of income from discontinued operations for the periods presented:

8. Segment Reporting

The Company’s reportable operating segments include Established Communities, Other Stabilized Communities, and Development/Redevelopment Communities. Annually as of January 1^st, the Company determines which of its communities fall into each of these categories and maintains that classification, unless disposition plans regarding a community change, throughout the year for the purpose of reporting segment operations.

In addition, the Company owns land for future development and has other corporate assets that are not allocated to an operating segment.

The Company’s segment disclosures present the measure(s) used by the chief operating decision maker for purposes of assessing such segments’ performance. The Company’s chief operating decision maker is comprised of several members of its executive management team who use net operating income (“NOI”) as the primary financial measure for Established Communities and Other Stabilized Communities. NOI is defined by the Company as total revenue less direct property operating expenses. Although the Company considers NOI a useful measure of a community’s or communities’ operating performance, NOI should not be considered an alternative to net income or net cash flow from operating activities, as determined in accordance with GAAP. NOI excludes a number of income and expense categories as detailed in the reconciliation of NOI to net income.

A reconciliation of NOI to net income for the three and nine months ended September 30, 2009 and 2008 is as follows:

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.

The following table provides details of the Company’s segment information as of the dates specified. 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. Segment information for the three and nine months ended September 30, 2009 and 2008 have been adjusted for the communities that were sold from January 1, 2008 through September 30, 2009, or otherwise qualify as discontinued operations as of September 30, 2009, as described in Note 7, “Real Estate Disposition Activities.”

9. Stock-Based Compensation Plans

On May 21, 2009, the stockholders of the Company, upon the recommendation of the Board of Directors, approved the AvalonBay Communities, Inc. 2009 Stock Option and Incentive Plan (the “2009 Plan”). The 2009 Plan includes an authorization to issue up to 4,199,822 shares of the Company’s common stock, par value $0.01 per share, (2,930,000 newly authorized shares plus 1,269,822 shares that were available for grant as of May 21, 2009 under the Company’s 1994 Stock Option and Incentive Plan (the “1994 Plan”)), pursuant to awards under the 2009 Plan. The 2009 Plan provides for various types of equity awards to employees, officers, non-employee directors and agents of the Company and its subsidiaries. The types of awards that may be granted under the 2009 Plan include restricted and deferred stock, stock options that qualify as incentive stock options (“ISOs”) under Section 422 of the Internal Revenue Code, non-qualified options, and stock appreciation rights. The 2009 Plan will expire on May 21, 2019.

Effective as of the close of business on May 21, 2009, and as part of the proposal to approve the 2009 Plan described above, the Board of Directors terminated the 1994 Plan with respect to new awards. The 1994 Plan provided for the same types of equity awards as the 2009 Plan, and would have expired by its terms on May 8, 2011. Outstanding awards previously granted under the 1994 Plan will not be affected by termination of the 1994 Plan, the terms of which shall continue to govern such previously granted awards. In addition to the 4,199,822 shares available for awards under the 2009 Plan as described above, any awards that were outstanding under the 1994 Plan on May 21, 2009 that are subsequently forfeited, canceled, surrendered or terminated (other than by exercise) will become available for awards under the 2009 Plan.

     Information with respect to stock options granted under the 1994 Plan is as follows:

The weighted average fair value of the options granted during the nine months ended September 30, 2009 is estimated at $6.53 per share on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: dividend yield of 8.5% over the expected life of the option, volatility of 36.57%, risk-free interest rate of 2.17% and an expected life of approximately seven years.

At September 30, 2009, the Company had 246,309 outstanding unvested shares granted under restricted stock awards. The Company issued 169,851 shares of restricted stock valued at $8,360 as part of its stock-based compensation plan during the nine months ended September 30, 2009. Restricted stock vesting during the nine months ended September 30, 2009 totaled 130,418 shares and had fair values ranging from $48.60 to $147.75 per share. The total fair value of shares vested was $10,687 and $10,554 for the nine months ended September 30, 2009 and 2008, respectively.

Total employee stock-based compensation cost recognized in income was $10,056 and $14,148 for the nine months ended September 30, 2009 and 2008, respectively, and total capitalized stock-based compensation cost was $5,193 and $5,203 for the nine months ended September 30, 2009 and 2008, respectively. At September 30, 2009, there was a total of $2,726 and $8,070 in unrecognized compensation cost for unvested stock options and unvested restricted stock, respectively, which does not include estimated forfeitures. The unrecognized compensation cost for unvested stock options and restricted stock is expected to vest over a weighted average period of 1.56 years and 2.38 years, respectively.

10. Related Party Arrangements

The Company manages unconsolidated real estate entities for which it receives asset management, property management, development and redevelopment fee revenue. From these entities, the Company received fees of $1,878 and $1,622 in the three months ended September 30, 2009 and 2008, respectively and $5,423 and $4,805 for the nine months ended September 30, 2009 and 2008, respectively. These fees are included in management, development and other fees on the accompanying Condensed Consolidated Statements of Operations and Other Comprehensive Income.

The Company recorded non-employee director compensation expense relating to restricted stock grants and deferred stock awards in the amount of $219 and $637 for the three and nine months ended September 30, 2009 as a component of general and administrative expense. Deferred compensation relating to these restricted stock grants and deferred stock awards was $583 and $137 on September 30, 2009 and December 31, 2008, respectively.

11. Fair Value

As a basis for applying a market-based approach in fair value measurements, GAAP establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity and the reporting entity’s own assumptions about market participant assumptions. The valuation of financial instruments can be determined using widely accepted valuation techniques.

The Company applies widely accepted valuation models such as discounted cash flow analysis on the expected cash flows of each instrument which considers the contractual terms of the instruments, including the period to maturity, and uses observable market-based inputs, including interest rate curves and market prices, as available and applicable. In addition, the Company incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements as discussed below. When market-based inputs are not available in valuing the Company’s financial instruments, such as for valuing redeemable noncontrolling interests, the Company uses unobservable inputs considering the assumptions that market participants would make in deriving the fair value. The use of different market assumptions and/or estimation methodologies may have a material effect on the Company’s estimates of fair value.

Currently, the Company uses interest rate swap and interest rate cap agreements to manage its interest rate risk. These instruments are carried at fair value in the Company’s financial statements. See Note 5, “Derivative Instruments and Hedging Activities,” for derivative values at September 30, 2009 and a description of where these amounts are recorded in the financial statements. In adjusting the fair value of its derivative contracts for the effect of counterparty nonperformance risk, the Company has considered the impact of its net position with a given counterparty, as well as any applicable credit enhancements, such as collateral postings, thresholds, mutual puts, and guarantees. Although the Company has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives use Level 3 inputs, such as estimates of current credit spreads, to evaluate the likelihood of default by itself and its counterparties. As of September 30, 2009, the Company assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined it is not significant. As a result, the Company has determined that its derivative valuations are classified in Level 2 of the fair value hierarchy.

Redeemable noncontrolling interests are reported at fair value, with reductions in fair value recorded only to the extent that the Company has previously recorded increases in fair value above the redeemable noncontrolling interests’ initial basis.

Cash and cash equivalent balances are held with various financial institutions within principal protected accounts. The Company monitors credit ratings of these financial institutions and the concentration of cash and cash equivalent balances with any one financial institution and believes the likelihood of realizing material losses related to cash and cash equivalent balances is remote. Cash and cash equivalents are carried at their face amounts, which reasonably approximate their fair values.

Rents receivable, accounts and construction payable and accrued expenses and other liabilities are carried at their face amounts, which reasonably approximate their fair values.

The Company values its bond indebtedness, notes payable and outstanding amounts under the Credit Facility using a discounted cash flow analysis on the expected cash flows of each instrument. This analysis reflects the contractual terms of the instrument, including the period to maturity, and uses observable market-based inputs, including interest rate curves. The process also considers credit valuation adjustments to appropriately reflect the Company’s nonperformance risk. The Company has concluded that the value of its bond indebtedness and notes payable are Level 2 prices as the majority of the inputs used to value its positions fall within Level 2 of the fair value hierarchy. Bond indebtedness, notes payable and outstanding amounts under the Company’s Credit Facility (as applicable) with an aggregate outstanding par amount of approximately $4,435,000 and $3,676,000 had an estimated aggregate fair value of $4,503,621 and $3,612,130 at September 30, 2009 and December 31, 2008, respectively.

12. Subsequent Events

The Company has evaluated subsequent events through the date this quarterly report in Form 10-Q was filed, the date these financial statements were issued, identifying the items below for disclosure.

In October 2009, the Company settled a cash tender offer, purchasing the following unsecured notes:

In addition, in October 2009, the Company repurchased $10,100 principal amount of the Company’s 6.625% unsecured notes due September 2011 at a weighted average price of 107.0% of par.

The Company will record a charge for the purchase premium as well as certain deferred issuance costs related to the above repurchase activity of approximately $26,000, in the fourth quarter of 2009. All of the notes purchased were cancelled upon settlement.

In October 2009, the Company sold one community, Avalon at Parkside, located in Sunnyvale, California. Avalon at Parkside contains 192 apartment homes and was sold for $43,800. The Company estimates that it will record a gain of approximately $17,000 related to this disposition.

In October 2009, the Company sold a parcel of land in Virginia for $13,250. This land parcel was included in the assets impaired by the Company in the fourth quarter of 2008, as an asset which the Company did not intend to proceed with development. The Company estimates that it will record a gain of approximately $4,500 related to this disposition.

In October 2009, the Company repaid the final $112,200 tranche of its Term Loan, in advance of its scheduled maturity of January 2011.

In October 2009, the Company executed $300,000 notional of interest rate swaps to convert $300,000 principal amount of the Company’s fixed-rate unsecured notes with a weighted average maturity of approximately two years to effective floating rate instruments at a weighted average rate of three month LIBOR plus 5.42%. The Company designated the interest rate swaps as fair value hedges of the unsecured notes.

Also in October 2009, the Company entered into a proposed consent decree with the ERC, which was approved by the court in November 2009, settling the Company’s previously reported accessibility litigation with ERC without admitting liability. Under the consent decree, AvalonBay (i) will make a payment to ERC to compensate it for the attorneys’ fees and other costs incurred by it related to the litigation, and (ii) will inspect and, if necessary, remediate up to 8,250 apartment units and related public and common areas at the Company’s communities. The payment to be made to ERC is not material to the Company’s financial condition or results of operations. The Company expects the remediation resulting from the inspections, which should occur over an approximate four year period, will enhance and/or extend the useful life of the assets at the applicable communities and will therefore be capitalized. The Company does not expect that the remediation costs will be material to the Company.

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help provide an understanding of our business and results of operations. This MD&A should be read in conjunction with our Condensed Consolidated Financial Statements and the accompanying Notes to Condensed Consolidated Financial Statements included elsewhere in this report. This report, including the following MD&A, contains forward-looking statements regarding future events or trends as described more fully under “Forward-Looking Statements” included in this report. Actual results or developments could differ materially from those projected in such statements as a result of the factors described under “Forward-Looking Statements” below and the risk factors described in Item 1a, “Risk Factors,” of our Form 10-K for the year ended December 31, 2008 (our “Form 10-K”).

We are primarily engaged in developing, acquiring, owning and operating apartment communities in high barrier to entry markets of the United States. Barriers to entry in our markets generally include a difficult and lengthy entitlement process with local jurisdictions and dense urban or suburban areas where zoned and entitled land is in limited supply. We believe that apartment communities are an attractive long-term investment opportunity compared to other real estate investments because a broad potential resident base should help reduce demand volatility over a real estate cycle. However, throughout the real estate cycle, apartment market fundamentals, and therefore operating cash flows, are affected by overall economic conditions, such as the current economic downturn. We seek to create long-term shareholder value by accessing capital on cost effective terms; deploying that capital to develop, redevelop and acquire apartment communities in high barrier to entry markets; operating apartment communities; and selling communities when they no longer meet our long-term investment strategy or when pricing is attractive.

We regularly evaluate the allocation of our investments by the amount of invested capital and by product type within our individual markets, which are located in New England, the New York/New Jersey metro area, the Mid-Atlantic, the Midwest, the Pacific Northwest, and the Northern and Southern California regions of the United States. Our strategy is to penetrate these markets with a broad range of products and services and an intense focus on our customer. Our communities are predominately upscale, which generally command among the highest rents in their markets. However, we also pursue the ownership and operation of apartment communities that target a variety of customer segments and price points, consistent with our goal of offering a broad range of products and services.

The contraction in the U.S. economy and high unemployment levels during the first nine months of 2009 have adversely impacted apartment fundamentals across all markets. A composite of several economic forecasts suggest

that the U.S. unemployment rate will increase from the current levels of 9.8% to over 10% before it is expected to level off and eventually decline in 2010. Changes in employment conditions have a significant impact on overall demand for rental housing and are highly correlated to changes in our revenue growth. As a result, we expect the current economic and employment conditions will continue to put downward pressure on rental rates for the balance of 2009 and into 2010.

Longer-term, we expect apartment fundamentals to strengthen from a reduction in new supply, favorable demographic trends, limited home sales activity and an economic recovery that we expect will eventually produce employment growth. Changes in any of the above factors, including a more prolonged decline in economic conditions than we currently expect, could materially change our expectations for the remainder of 2009 and future periods.

While market fundamentals remain challenging, we continue to benefit from a strong balance sheet that provides significant financial flexibility. During 2009, we accessed capital, through a variety of sources at cost effective levels. Through the end of October 2009, we have raised over $1,500,000,000 through secured financings, unsecured debt, equity raised in the public markets, capital commitments for Fund II and asset dispositions. We have used these proceeds to fund our development and redevelopment activities, to repay higher cost secured and unsecured debt, and to repay floating rate debt, while retaining substantial cash balances for other general corporate purposes. Our focus on raising capital includes consideration for managing the maturity risk associated with our secured and unsecured debt obligations. Our year to date 2009 activity includes the issuance of $500,000,000 of unsecured notes in September 2009 in two $250,000,000 tranches, one maturing in 2017 and the second maturing in 2020. A portion of the proceeds was used to repurchase $310,100,000 principal amount of some or all of the amounts outstanding on unsecured notes maturing over the next three years, effectively extending the duration of debt maturities while reducing interest costs. We believe that our relatively modest level of secured and unsecured debt will continue to provide financial flexibility to access capital on attractive terms.

We remain focused on investing in development and redevelopment opportunities, including increased expenditures on redevelopment to ensure our existing assets are competitively positioned in the market. In addition we will invest in new communities through acquisitions, which we expect will occur primarily through Fund II, our private discretionary investment vehicle that was originally formed in August of 2008. Fund II will acquire, operate and sometimes redevelop (but not develop) multifamily apartment communities primarily in our current markets with the objective of creating value through redevelopment, enhanced operations and/or improving market fundamentals. Fund II has a term that expires in August 2018, plus two one-year extension options. Fund II will serve as the exclusive vehicle through which we will acquire investment interests in apartment communities until August 2011 or, if earlier, until 90% of the committed capital of Fund II is invested, subject to limited exceptions. Fund II can employ leverage of up to 65%, allowing for an investment capacity of approximately $1,100,000,000. As of October 31, 2009, Fund II has invested $33,139,000.

Our development activity has declined from prior periods as a result of reduced development starts, completion of development underway and our increased return requirements. We currently have nine communities under construction with a total projected capitalized cost of approximately $1,218,900,000. As of September 30, 2009, approximately $930,944,000 of this development has been invested, with approximately $287,956,000 remaining to be invested. We have arranged $79,200,000 of this required funding through financing from third-party, tax-exempt and taxable debt. We started no new construction during the nine months ended September 30, 2009. We expect to start modest development activity in the fourth quarter of 2009, however we do not expect it will have a significant impact on our liquidity, corporate cash flows or earnings. In addition to our current development activity, at September 30, 2009, there were six communities under redevelopment, with an expected incremental capital investment of approximately $112,100,000, of which approximately $54,489,000 remains to be invested. We expect to maintain our current level of redevelopment activity through the end of 2009. We believe that we currently have sufficient committed capital to complete the development and redevelopment activities underway and meet other liquidity uses. See the discussion under Liquidity and Capital Resources.

Our real estate investments consist primarily of current operating apartment communities, Development Communities and Development Rights both as defined below. Our current operating communities are further

distinguished as Established Communities, Other Stabilized Communities, Lease-Up Communities and Redevelopment Communities. The following is a description of each category:

In addition, we currently own approximately 60,000 square feet of office space in Alexandria, Virginia, for our corporate office, with all other regional and administrative offices leased under operating leases.

As of September 30, 2009, communities that we owned or held a direct or indirect interest in were classified as follows: