10-Q: Quarterly report pursuant to Section 13 or 15(d)
Published on August 14, 1998
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UNITED STATES
SECURITIES 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, 1998
Commission File Number 1-12672
AVALON BAY COMMUNITIES, INC.
(Exact name of Registrant as specified in its Charter)
-------------------------
Maryland 77-0404318
(State or other juristiction of (I.R.S. Employer Identification No.)
Incorporation or organization)
2900 Eisenhower Avenue, Third Floor, Alexandria, Virginia 22314
(Address of principal executive offices, including zip code)
(703) 329-6300
(Registrant's telephone number, including area code)
Bay Apartment Communities, Inc.
4340 Stevens Creek Boulevard, #275, San Jose, California 95129
(Former name, former address and former fiscal year,
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:
Yes [X] No
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.
63,574,010 shares outstanding as of August 3, 1998
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AVALON BAY COMMUNITIES, INC.
FORM 10-Q
INDEX
1
PART I - FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
AVALON BAY COMMUNITIES, INC.
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share data)
The accompanying notes are an integral part of these consolidated
financial statements.
2
AVALON BAY COMMUNITIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(Dollars in thousands, except share data)
The accompanying notes are an integral part of these consolidated
financial statements.
3
AVALON BAY COMMUNITIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Dollars in thousands, except share data)
4
AVALON BAY COMMUNITIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(CONTINUED)
Supplemental disclosures of non-cash investing and financing activities:
In connection with the merger of Avalon Properties, Inc. with and into the
Company (the "Merger") in June 1998, the Company issued Common and Preferred
Shares valued at $1,433,513 in exchange for the net real estate assets of Avalon
Properties, Inc. The Company also assumed $643,410 in debt, $6,221 in deferred
compensation expense, $25,866 in net other assets, $1,013 in cash and cash
equivalents and minority interest of $19,409.
The Company assumed debt in connection with acquisitions totaling $10,400 and
$12,870 during the six months ended June 30, 1998 and 1997, respectively. The
Company issued $3,851 in operating partnership units for acquisitions during
1998.
During the six months ended June 30, 1998, 2,308,800 shares of Series A
Preferred Stock and 405,022 shares of Series B Preferred Stock totaling $28
were converted into an aggregate of 2,713,822 shares of common stock.
Dividends declared but not paid as of June 30, 1998 and 1997 totaled $40,978 and
$10,428, respectively.
5
AVALON BAY COMMUNITIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(Dollars in thousands, except per share data)
1. Organization and Significant Accounting Policies:
Organization and Recent Developments
Avalon Bay Communities, Inc. (in conjunction with its wholly-owned partnerships
and subsidiaries referred to as the "Company"), is a real estate investment
trust ("REIT") that is focused exclusively on the ownership of
institutional-quality apartment communities in high barrier-to-entry markets of
the United States. These markets include Northern and Southern California and
selected states in the Mid-Atlantic, Northeast, Midwest and Pacific Northwest
regions of the country. The Company is the surviving corporation from the merger
(the "Merger") of Avalon Properties, Inc. ("Avalon") with and into the Company
(sometimes hereinafter referred to as "Bay" before the Merger) on June 4, 1998.
The Merger was accounted for as a purchase of Avalon by Bay. Concurrently with
the Merger, the Company changed its name from Bay Apartment Communities, Inc. to
Avalon Bay Communities, Inc.
At June 30, 1998, the Company owned or held an ownership interest in 130
stabilized apartment communities containing 37,768 apartment homes in sixteen
states and the District of Columbia. The Company also owned 15 communities with
4,332 apartment homes under construction and rights to develop an additional 23
communities that will contain an estimated 6,707 apartment homes. Of the
stabilized apartment communities, there were 12 communities containing 3,954
apartment homes under reconstruction.
During the second quarter of 1998, Avalon, Bay or the Company purchased four
communities with a total of 1,362 apartment homes for a total purchase price of
approximately $107,200. One community is located in the Minneapolis area, one
community is located in the St. Louis area and two communities are located in
the Seattle metropolitan area. The community acquired in the St. Louis area and
one of the communities acquired in the Seattle metropolitan area were purchased
pursuant to presale agreements. Also, the Company has acquired a parcel of land
on which the Company intends to begin development, by the end of 1999 of a 288
apartment home community located in California. The total budgeted construction
cost for this community is approximately $53,800.
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 Company's and Avalon's Annual Report on Form 10-K for the
year ended December 31, 1997. The results of operations for the three and six
months ended June 30, 1998 are not necessarily indicative of the operating
results for the full year. Management believes that the disclosures are
adequate to make the information presented 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 consolidated financial statements include the accounts of the
Company and its wholly-owned partnerships and subsidiaries and the operating
partnerships structured as DownREITs. All significant intercompany balances and
transactions have been eliminated in consolidation.
6
Real Estate
Significant expenditures, which improve or extend the life of the 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 development or redevelopment and construction or
reconstruction and acquisition. Expenditures for maintenance and repairs are
charged to operations as incurred.
The capitalization of costs during the development and construction 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 and reconstruction of assets (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 reconstruction
and ends when the apartment home reconstruction is completed and the apartment
home is placed-in-service. The accompanying consolidated financial statements
include a charge to expense for unrecoverable deferred development costs
related to pre-development communities that may not proceed to development.
Depreciation is calculated on buildings and improvements using the
straight-line method over their estimated useful lives, which range from ten to
thirty years. Furniture, fixtures and equipment are generally depreciated using
the straight-line method over their estimated useful lives, which range from
three to seven years.
Lease terms for apartment homes are generally for one year or less. Rental
income and operating costs incurred during the initial lease-up or
post-reconstruction lease-up period are fully recognized as they accrue.
Income Taxes
The Company elected to be taxed as a REIT under the Internal Revenue Code of
1986, as amended (the "Code"), for the year ended December 31, 1994 and has not
revoked such election. A corporate REIT is a legal entity which holds real
estate interests and, if certain conditions are met (including but not limited
to the payment of a minimum level of dividends to shareholders), the payment of
federal and state income taxes at the corporate level is avoided or reduced.
Management estimates that all such conditions for the avoidance of taxes have
been met for the periods presented. Accordingly, no provision for federal and
state income taxes has been made.
Deferred Financing Costs
Deferred financing costs include fees and costs incurred to obtain debt
financings and are amortized on a straight-line basis over the shorter of the
term of the loan or the related credit enhancement facility, if applicable.
Unamortized financing costs are written-off when debt is retired before the
maturity date.
Cash and Cash Equivalents
Cash and cash equivalents include all cash and liquid investments with an
original maturity of three months or less from the date acquired. The majority
of the Company's cash, cash equivalents, and cash in escrows is held at major
commercial banks.
Earnings per Common Share
The Company has adopted Statement of Financial Accounting Standards ("SFAS")
No. 128, "Earnings per Share". In accordance with the provisions of SFAS No.
128, basic earnings per share for the three and six months ended June 30, 1998
and 1997 is computed by dividing earnings available to common shares (net
income less preferred stock dividends) by the weighted average number of shares
outstanding during the period. Additionally, other potentially dilutive common
shares are considered when calculating earnings per
7
share on a diluted basis. The Company's basic and diluted weighted average
shares outstanding for three and six months ended June 30, 1998 and 1997 are as
follows:
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that 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.
Newly Issued Accounting Standards
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130
"Reporting Comprehensive Income" and No. 131 "Disclosure of Segment
Information." SFAS No. 130 establishes the disclosure requirements for
reporting comprehensive income in an entity's annual and interim financial
statements and becomes effective for the Company for the fiscal year ending
December 31, 1998. Comprehensive income includes unrealized gains and losses on
securities currently reported by the Company as a component of stockholders'
equity which the Company would be required to include in a financial statement
and display the accumulated balance of other comprehensive income separately in
the equity section of the consolidated balance sheet. At June 30, 1998 this
pronouncement has no material effect on the Company's results of operations.
SFAS No. 131 establishes standards for determining an entity's operating
segments and the type and level of financial information to be disclosed. SFAS
No. 131 becomes effective for the Company for the fiscal year ending December
31, 1998. The Company does not believe this pronouncement will have a
significant impact on the Company's consolidated financial statements.
In March 1998, the Emerging Issues Task Force of the Financial Accounting
Standards Board issued Ruling 97-11 entitled "Accounting for Internal Costs
Relating to Real Estate Property Acquisitions," which requires that internal
costs of identifying and acquiring operating property be expensed as incurred.
Costs associated with the acquisition of non-operating property may still be
capitalized. The ruling is effective for acquisitions completed subsequent to
March 19, 1998. The Company estimates that this ruling will not have a material
effect on the Company's consolidated financial statements.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities". Statement 133 is
8
effective for fiscal years beginning after June 15, 1999 and cannot be applied
retroactively. The Statement establishes accounting and reporting standards
requiring that every derivative instrument be recorded in the balance sheet as
either an asset or liability measured at its fair value. The Statement requires
that changes in the derivative's fair value be recognized currently in earnings
unless specific hedge accounting criteria are met. The Company currently plans
to adopt Statement 133 effective January 1, 2000, and will determine both the
method and impact of adoption prior to that date.
2. Merger between Bay and Avalon
In June 1998, the Company completed its merger with Avalon. The Merger and
related transactions were accounted for using the purchase method of accounting
in accordance with GAAP. Accordingly, the assets and liabilities of Avalon were
adjusted to fair value for financial accounting purposes and the results of
operations of Avalon are included in the results of operations of the Company
beginning June 4, 1998.
In connection with the Merger, the following related transactions occurred:
The Company issued .7683 of a share of common stock for each outstanding
share of Avalon common stock;
The Company issued one share of Series F and G Preferred Stock for each
outstanding share of Avalon Series A and B Preferred Stock;
The following unaudited pro forma information has been prepared as if the
Merger and related transactions had occurred on January 1, 1997. The pro forma
financial information is presented for informational purposes only and is not
necessarily indicative of what actual results would have been if the Merger had
been consummated on January 1, 1997 nor does it purport to represent the
results of operations for future periods (in thousands, except per share data).
3. Interest Capitalized
Capitalized interest associated with projects under development and
construction or redevelopment and reconstruction totaled $3,561 and $1,396
for the three months ended June 30, 1998 and 1997, respectively, and $6,525 and
$2,421 for the six months ended June 30, 1998 and 1997, respectively.
9
4. Notes Payable, Unsecured Senior Notes and Credit Facility
The Company's notes payable, unsecured senior notes and credit facility are
summarized as follows:
Notes payable are collateralized by certain apartment communities and mature at
various dates from July 1999 through December 2036. The weighted average
interest rate of variable rate notes (tax-exempt) was 4.8% at June 30, 1998. The
weighted average interest rate of fixed rate notes (conventional and tax-exempt)
was 6.6% and 6.4% at June 30, 1998 and December 31, 1997, respectively.
The Company has a $600,000 variable rate unsecured credit facility (the
"Unsecured Facility") with Morgan Guaranty Trust Company of New York, Union Bank
of Switzerland and Fleet National Bank, serving as co-agents for a syndicate of
commercial banks. The Unsecured Facility bears interest at the London Interbank
Offered Rate ("LIBOR") based on rating levels achieved on the Company's senior
unsecured notes and on a maturity selected by the Company. The current pricing
is LIBOR plus 0.60% per annum. The Unsecured Facility, which was put into place
during June 1998, replaced three separate credit facilities previously available
to the separate companies prior to the merger. The terms of the retired
facilities were similar to the Unsecured Facility. In addition, the Unsecured
Facility includes a competitive bid option for up to $400,000. The interest rate
for borrowings under the Unsecured Facility as of June 30, 1998 was 6.4%. The
Company, among other things, is subject to certain customary covenants under the
credit facility including maintaining certain maximum leverage ratios, minimum
fixed charge 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("FFO"), as defined. The Unsecured Facility matures in
June 2001 and has two, one-year extension options.
The Company's unsecured senior notes are in the form of $100,000 of 7.375%
notes due in 2002, $50,000 of 6.25% notes due in 2003, $100,000 of 6.625% notes
due in 2005, $50,000 of 6.5% notes due in 2005, $110,000 of 6.875% notes due in
2007, and $50,000 of 6.625% notes due in 2008. The Company's unsecured senior
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.
5. Stockholders' Equity
The following summarizes the changes in stockholders' equity for the six months
ended June 30, 1998:
10
6. Investments in Unconsolidated Joint Ventures
At June 30, 1998, investments in unconsolidated joint ventures consist of a 50%
general partnership interest in Falkland Partners, a 49% equity interest in
Avalon Run and a 50% general partnership interest in Avalon Grove. The
unconsolidated joint venture interests were obtained in connection with the
Merger. The following is a combined summary of the financial position of these
joint ventures for the periods presented:
The following is a combined summary of the operating results of these joint
ventures for the periods presented:
7. Subsequent Events
On July 7, 1998, the Company issued $250,000 of senior unsecured notes of which
$100,000 of the notes will bear interest at 6.5% and will mature in July 2003
and $150,000 of the notes will bear interest at 6.8% and will mature in July
2006. The net proceeds of $247,600 to the Company were used to reduce
borrowings under the Company's Unsecured Facility.
In July 1998, the Company acquired the Prudential Center Apartments, a 781
apartment home community located in downtown Boston, Massachusetts. This
community, comprising the residential portion of the Prudential Center and
related underground parking, was purchased from the Prudential Insurance
Company of America for approximately $130,000.
The Company disposed of two communities, Village Park of Troy and Aspen Meadows,
in suburban Detroit, Michigan, in connection with an agreement which provided
for the buyout of certain limited partners in DownREIT V Limited Partnership.
Proceeds from the sale of the two communities, containing 758 apartment homes
combined, were approximately $44,000. The proceeds were re-invested in a
participating mortgage note for $24,000 and an expected yield of 10.1% in the
first stabilized year secured by Fairlane Woods, a 288 apartment home community
located in Dearborn, Michigan, with the balance used to repay amounts
outstanding under the Unsecured Facility. Management is pursuing the purchase of
a 100% equity interest in the community secured by the participating mortgage
note, but no assurance can be provided that such an equity interest can be
acquired.
The Company exercised it's option to acquire a 3.2 acre site in Stamford,
Connecticut for approximately $6,200. The Company plans to develop an apartment
home community on the Stamford, Connecticut site with up to 195 apartment homes.
11
PART I. FINANCIAL INFORMATION (CONTINUED)
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Forward-Looking Statements
Certain statements in this Form 10-Q constitute "forward-looking statements" as
that term is defined under the Private Securities Litigation Reform Act of 1995
(the "Reform Act"). The words "believe," "expect," "anticipate," "intend,"
"estimate," "assume" and other similar expressions which are predictions of or
indicate future events and trends and which do not relate to historical matters
identify forward-looking statements. In addition, information concerning
construction, occupancy and completion of Development Communities and
Development Rights (as hereinafter defined) and related cost and EBITDA
estimates, are forward-looking statements. Reliance should not be placed on
forward-looking statements as they involve known and unknown risks,
uncertainties and other factors, which are in some cases beyond the control of
the Company and may cause the actual results, performance or achievements of
the Company to differ materially from anticipated future results, performance
or achievements expressed or implied by such forward-looking statements.
Certain factors that might cause such differences include, but are not limited
to, the following: the Company may not be successful in managing its current
growth in the number of apartment communities and the related growth of its
business operations; the Company's expansion into new geographic market areas
may not produce financial results that are consistent with its historical
performance; acquisitions of portfolios of apartment communities may result in
the Company acquiring communities that are more expensive to manage and
portfolio acquisitions may not be successfully completed, resulting in charges
to earnings; the Company may fail to secure or may abandon development
opportunities; construction costs of a community may exceed original estimates;
construction and lease-up may not be completed on schedule, resulting in
increased debt service expense and construction costs and reduced rental
revenues; occupancy rates and market rents may be adversely affected by local
economic and market conditions which are beyond management's control; financing
may not be available on favorable terms; the Company's cash flow may be
insufficient to meet required payments of principal and interest; and existing
indebtedness may not be able to be refinanced or the terms of such refinancing
may not be as favorable as the terms of existing indebtedness.
The following discussion should be read in conjunction with the consolidated
financial statements and notes included in this report.
General
The Company is a real estate investment trust ("REIT") that is focused
exclusively on the ownership of institutional-quality apartment communities in
high barrier-to-entry markets of the United States. These markets include
Northern and Southern California and selected states in the Mid-Atlantic,
Northeast, Midwest and Pacific Northwest regions of the country. The Company is
the surviving corporation from the merger (the "Merger") of Avalon Properties,
Inc. ("Avalon") with and into the Company (sometimes hereinafter referred to as
"Bay" before the Merger) on June 4, 1998. The Merger was accounted for as a
purchase of Avalon by Bay. Concurrently with the Merger, the Company changed
its name from Bay Apartment Communities, Inc. to Avalon Bay Communities, Inc.
The Company is a fully-integrated real estate organization with in-house
acquisition, development, redevelopment, construction, reconstruction,
financing, marketing, leasing and management expertise. With its experience and
in-house capabilities, the Company believes it is well-positioned to continue
to pursue opportunities to develop and acquire upscale apartment homes in its
target markets.
12
The Company's real estate holdings as of August 10, 1998 consist exclusively of
apartment communities in various stages of the development cycle and can be
divided into three categories:
(*) Represents an estimate
"Current Communities" are apartment communities where construction is
complete and the community has either reached stabilized occupancy or
is in the initial lease-up process. A "Stabilized Community" is a
Current Community that has completed its initial lease-up and has
attained a physical occupancy level of at least 95% or has been
completed for one year, whichever occurs earlier. An "Established
Community" is a Current Community that has been a Stabilized Community
with stabilized operating costs during the current and the beginning
of the previous calendar year such that its year-to-date operating
results are comparable between periods. Included in the Current
Communities are "Redevelopment Communities", which are communities for
which substantial redevelopment has either begun or is scheduled to
begin. Redevelopment is considered substantial when additional capital
invested during the reconstruction effort exceeds the lesser of $5
million or 10% of the community's acquisition cost. There are currently
12 Redevelopment Communities containing 3,954 apartment homes.
"Development Communities" are communities that are under construction
and may be partially complete and operating and for which a final
certificate of occupancy has not been received.
"Development Rights" are development opportunities in the very
earliest phase of the development process for which the Company has an
option to acquire land or owns land to develop a new community and
where related pre-development costs have been incurred and capitalized
in pursuit of these new developments.
Of the Current Communities, the Company held a fee simple ownership interest in
113 operating communities (one of which is on land subject to a 149 year land
lease), a general partnership interest in four other operating communities, a
general partner interest in partnerships structured as DownREITs, which own 11
communities, and a 100% interest in a senior participating mortgage note
secured by another operating community. The Company holds a fee simple
ownership interest in each of the Development Communities except for two
communities for which the Company holds a general partnership interest. The
existing DownREITs have been structured so that substantially all of the
economic interests of these partnerships accrue to the benefit of the Company.
The Company believes that it is unlikely that the limited partners in these
partnerships will receive any financial return on their limited partnership
interests other than the stated distributions on their units of the operating
partnerships ("Units") or as a result of the possible future conversion of
their Units into shares of common stock. The DownREIT partnerships are
consolidated for financial reporting purposes.
Management believes that apartment communities present an attractive investment
opportunity compared to other real estate investments because a broad potential
resident base results in relatively stable demand during all phases of a real
estate cycle. The Company intends to pursue appropriate new investments (both
acquisitions of new communities and new developments) where constraints to new
supply exist and where new household formations have out-paced multifamily
permit activity in recent years.
13
At June 30, 1998, the Company's management ("Management") had positioned the
Company's portfolio of Stabilized Communities, excluding communities owned by
joint ventures, to a physical occupancy level of 97.5% and achieved an average
economic occupancy of 96.7% and 96.6% for the three and six months ended June
30, 1998, respectively. Average economic occupancy for the portfolio for the
three and six months ended June 30, 1997 was 95.4% and 95.5%. This continued
high occupancy was achieved through aggressive marketing efforts combined with
limited and targeted pricing adjustments. This positioning has resulted in
overall growth in rental revenue from Established Communities between periods.
It is Management's strategy to maximize total rental revenue through management
of rental rates and occupancy levels. If market and economic conditions change,
Management's strategy of maximizing rental rates could lead to lower occupancy
levels. Given the currently high occupancy level of the portfolio, Management
anticipates that, for the foreseeable future, any rental revenue and net income
gains from currently owned and Established Communities would be achieved
primarily through higher rental rates and enhanced operating cost leverage
provided by high occupancy, rather than through continued occupancy gains.
The Company elected to be taxed as a REIT for federal income tax purposes for
the year ended December 31, 1994 and has not revoked that election. The Company
was incorporated under the laws of the State of California in 1978 and was
reincorporated in the State of Maryland in July 1995. Its principal executive
offices are located at 2900 Eisenhower Avenue, Suite 300, Alexandria, Virginia
22314, and its telephone number at that location is (703) 329-6300. The Company
also maintains super-regional offices in San Jose, California and Wilton,
Connecticut and acquisition, development, redevelopment, construction,
reconstruction or administrative offices in Boston, Massachusetts; Chicago,
Illinois; Minneapolis, Minnesota; Newport Beach, California; New York, New
York; Princeton, New Jersey; Richmond, Virginia; and Seattle, Washington.
Recent Developments
Merger of Bay and Avalon. On June 4, 1998, the stockholders of Bay Apartment
Communities, Inc. and Avalon Properties, Inc. approved the merger of Avalon
with and into Bay. Bay Apartment Communities, Inc., the surviving corporation,
was renamed Avalon Bay Communities, Inc.
Pursuant to the merger agreement between Avalon and Bay, each Avalon common
stockholder received .7683 of a share of common stock of Avalon Bay. In
addition, the Company assumed outstanding liabilities of Avalon of approximately
$646 million. Avalon's preferred stockholders received one share of the Company
preferred stock for each share of Avalon preferred stock, with the same rights,
preferences and privileges provided by the Avalon preferred stock. The
liquidation value of the preferred stock issued in connection with the Merger is
approximately $219 million. The Merger was accounted for as a purchase of Avalon
by Bay.
14
Acquisitions of Existing Communities. Since March 31, 1998, Avalon, Bay or the
Company has acquired the following communities and development rights (dollars
in millions):
(a) Acquired by Avalon.
(b) Acquired by Bay. Community consists of Avalon Ridge (356 apartment
homes, purchase price of $21.3 million) and Sunpointe (64 apartment
homes, purchase price of $3.8 million).
(c) Acquired by Avalon Bay.
Acquisitions entail risks that investments will fail to perform in accordance
with expectations and that judgments with respect to the cost of improvements
to bring an acquired community up to standards established for the market
position intended for that community will prove inaccurate, as well as general
investment risks associated with any new real estate investment. Although the
Company undertakes an evaluation of the physical condition of each new
community before it is acquired, certain defects or necessary repairs may not
be detected until after the community is acquired, which could significantly
increase the Company's total acquisition costs and decrease the Company's
percentage return on that investment.
Historically, construction costs and the costs to reposition communities that
have been acquired have, in some cases, exceeded management's original
estimates. Management believes that it may experience similar increases in the
future. There can be no assurance that the Company will be able to charge rents
upon completing either the development or redevelopment of the communities that
will be sufficient to offset the effects of increases in construction costs in
order to achieve the original projected yield on the investment.
Sale of Existing Communities and Re-investment of Proceeds. In connection with
an agreement executed by Avalon in March 1998 which provided for the buyout of
certain limited partners in DownREIT V Limited Partnership, the Company sold
two communities, Village Park of Troy and Aspen Meadows, in suburban Detroit,
Michigan in July 1998. Gross proceeds from the sale of the two communities,
containing an aggregate of 758 apartment homes, were approximately $44 million
and were re-invested in the participating mortgage note secured by the Fairlane
Woods community in Dearborn, Michigan, with the balance used to repay amounts
outstanding under the variable rate unsecured credit facility ("Unsecured
Facility").
15
Results of Operations
The changes in operating results from period-to-period are primarily the result
of increases in the number of apartment homes owned due to the Merger as well
as the development and acquisition of additional communities. Where
appropriate, comparisons are made on a weighted average basis for the number of
occupied apartment homes in order to adjust for such changes in the number of
apartment homes. For Stabilized Communities (excluding communities owned by
joint ventures), all occupied apartment homes are included in the calculation
of weighted average occupied apartment homes for each reporting period. For
communities in the initial lease-up phase, only apartment homes of communities
that are completed and occupied are included in the weighted average number of
occupied apartment homes calculation for each reporting period.
The analysis that follows compares the operating results of the Company for the
three and six months ended June 30, 1998 and 1997.
Net income increased $9,763,000 (115.1%) to $18,242,000 for the three months
ended June 30, 1998 compared to $8,479,000 for the comparable period of the
preceding year. Net income increased $14,970,000 (92.1%) to $31,221,000 for the
six months ended June 30, 1998 compared to $16,251,000 for the comparable
period of the preceding year. The primary reasons for this increase are
additional operating income from the former Avalon communities, communities
developed or acquired during 1998 and 1997, as well as growth in operating
income from Established Communities.
Rental income increased $40,247,000 (133.5%) to $70,399,000 for the three
months ended June 30, 1998 compared to $30,152,000 for the comparable period of
the preceding year. Rental income increased $59,460,000 (105.0%) to
$116,101,000 for the six months ended June 30, 1998 compared to $56,641,000 for
the comparable period of the preceding year. Of the increase for the six month
period, $3,011,000 relates to rental revenue increases from Established
Communities, $20,880,000 relates to rental revenue attributable to the former
Avalon communities, and $35,569,000 is attributable to the addition of newly
completed or acquired apartment homes.
Overall Portfolio - The $59,460,000 increase in rental income for the six
month period is primarily due to increases in the weighted average number
of occupied apartment homes as well as an increase in the weighted average
monthly rental income per occupied apartment home. The weighted average
number of occupied apartment homes increased from 9,182 apartment homes
for the six months ended June 30, 1997 to 18,433 apartment homes for the
six months ended June 30, 1998 as a result of additional apartment homes
from the former Avalon communities, and the development and acquisition of
new communities. For the three months ended June 30, 1998, the weighted
average monthly revenue per occupied apartment home increased $63 (6.0%)
to $1,110 compared to $1,047 for the comparable period of the preceding
year. For the six months ended June 30, 1998, the weighted average monthly
revenue per occupied apartment home increased $21 (2.0%) to $1,048
compared to $1,027 for the comparable period of the preceding year.
Established Communities - Rental revenue increased $1,403,000 and
$3,011,000 for the three and six months ended June 30, 1998, respectively,
compared to the comparable periods of the preceding year due to
strengthening market conditions and the resulting impact on rents and
occupancy. For the three months ended June 30, 1998, weighted average
monthly revenue per occupied apartment home increased $73 (7.0%) to $1,110
compared to $1,037 for the comparable period of the preceding year. The
average economic occupancy increased .3% from 97.6% for the three months
ended June 30, 1997 to 97.9% for the three months ended June 30, 1998. For
the six months ended June 30, 1998, weighted average monthly revenue per
occupied apartment home increased $76 (7.4%) to $1,100 compared to $1,024
for the comparable period of the preceding year. The average economic
occupancy increased .5% from 97.3% for the six months ended June 30, 1997
to 97.8% for the six months ended June 30, 1998.
16
Management fees totaling $115,000 for both the three and six months ended
June 30, 1998, represents revenue from certain third-party contracts
obtained from the merger with Avalon.
Operating expenses increased $11,423,000 (146.5%) to $19,220,000 for the three
months ended June 30, 1998 compared to $7,797,000 for the comparable period of
the preceding year. These expenses increased $16,013,000 (109.0%) to
$30,705,000 for the six months ended June 30, 1998 compared to $14,692,000 for
the comparable period of the preceding year.
Overall Portfolio - The increases for the three and six months ended June
30, 1998 are primarily due to additional expense from the former Avalon
communities, the acquisition of new communities as well as the completion
of Development Communities whereby maintenance, insurance and other costs
are expensed as communities move from the initial construction and
lease-up phase to the stabilized operating phase.
Established Communities - Operating expenses increased $22,000 (0.5%) to
$4,362,000 for the three months ended June 30, 1998 compared to $4,340,000
for the comparable period of the preceding year. These expenses decreased
$109,000 (1.3%) to $8,520,000 for the six months ended June 30, 1998
compared to $8,629,000 for the comparable period of the preceding year.
Property taxes increased $3,388,000 (150.8%) to $5,635,000 for the three months
ended June 30, 1998 compared to $2,247,000 for the comparable period of the
preceding year. Property taxes increased $5,237,000 (126.0%) to $9,394,000 for
the six months ended June 30, 1998 compared to $4,157,000 for the comparable
period of the preceding year.
Overall Portfolio - The increases for the three and six months ended June
30, 1998 are primarily due to additional expense from the former Avalon
communities, the acquisition of new communities as well as the completion
of Development Communities whereby property taxes are expensed as
communities move from the initial construction and lease-up phase to the
stabilized operating phase.
Established Communities - Property taxes increased $9,000 (0.7%) to
$1,358,000 for the three months ended June 30, 1998 compared to $1,349,000
for the comparable period of the preceding year. Property taxes increased
$120,000 (4.6%) to $2,737,000 for the six months ended June 30, 1998
compared to $2,617,000 for the comparable period of the preceding year.
Interest expense increased $7,352,000 (193.5%) to $11,152,000 for the three
months ended June 30, 1998 compared to $3,800,000 for the comparable period of
the preceding year. Interest expense increased $10,246,000 (144.0%) to
$17,363,000 for the six months ended June 30, 1998 compared to $7,117,000 for
the comparable period of the preceding year. These increases are primarily
attributable to $643,410,000 debt assumed in connection with the Merger as well
as increased borrowings under the variable rate unsecured credit facility
("Unsecured Facility") offset in part by higher capitalization of interest from
increased development, redevelopment, construction and reconstruction activity.
Depreciation and amortization increased $8,171,000 (127.2%) to $14,597,000 for
the three months ended June 30, 1998 compared to $6,426,000 for the comparable
period of the preceding year. Depreciation and amortization increased
$12,378,000 (102.1%) to $24,503,000 for the six months ended June 30, 1998
compared to $12,125,000 for the comparable period of the preceding year. These
increases reflect additional expense from the former Avalon communities, as
well as acquisitions and development of communities in 1998 and 1997.
General and administrative expenses increased $857,000 (93.1%) to $1,778,000
for the three months ended June 30, 1998 compared to $921,000 for the
comparable period of the preceding year. General
17
and administrative expenses increased $1,277,000 (76.5%) to $2,946,000 for the
six months ended June 30, 1998 compared to $1,669,000 for the comparable period
of the preceding year. These increases are primarily due to the Merger and
staff additions related to the growth of the Company's portfolio.
Provision for unrecoverable deferred development costs decreased $200,000
(44.4%) to $250,000 for the three months ended June 30, 1998 compared to
$450,000 for the comparable period of the preceding year. Abandoned project
costs decreased $130,000 (24.5%) to $400,000 for the six months ended June 30,
1998 compared to $530,000 for the comparable period of the preceding year.
These decreases are primarily due to the absence in 1998 of a one time charge
present in 1997 related to the abandoned pursuit of a large west coast
portfolio acquisition.
Equity in income of unconsolidated joint ventures of $238,000 for both the
three and six months ended June 30, 1998 represents the Company's share of
income of certain joint ventures that were acquired in conjunction with the
Merger.
Interest income increased $317,000 (704.4%) to $362,000 for the three months
ended June 30, 1998 compared to $45,000 for the comparable period of the
preceding year. Interest income increased $357,000 (321.6%) to $468,000 for the
six months ended June 30, 1998 compared to $111,000 for the comparable period
of the preceding year. These increases are primarily due to the interest earned
on the Avalon Arbor note that was obtained from the Merger.
Management generally considers Funds from Operations ("FFO") to be an
appropriate measure of the operating performance of the Company because it
provides investors an understanding of the ability of the Company to incur and
service debt and to make capital expenditures. The Company believes that in
order to facilitate a clear understanding of the operating results of the
Company, FFO should be examined in conjunction with the net income as presented
in the consolidated financial statements included elsewhere in this report. FFO
is determined in accordance with a resolution adopted by the Board of Governors
of the National Association of Real Estate Investment Trusts(R), and is defined
as net income (loss) (computed in accordance with generally accepted accounting
principles ("GAAP"), excluding gains (or losses) from debt restructuring and
sales of property, plus depreciation of real estate assets and after
adjustments for unconsolidated partnerships and joint ventures). FFO does not
represent cash generated from operating activities in accordance with GAAP and
therefore should not be considered an alternative to net income as an
indication of the Company's performance or to net cash flows from operating
activities as determined by GAAP as a measure of liquidity and is not
necessarily indicative of cash available to fund cash needs. Further, FFO as
calculated by other REITs may not be comparable to the Company's calculation of
FFO.
For the three months ended June 30, 1998, FFO increased to $28,314,000 from
$14,591,000 for the comparable period in the preceding year. This increase is
primarily due to the delivery of high yielding new development and redevelopment
communities (11%+) from the Merger with Avalon as well as the Company's existing
redevelopment programs. Growth in earnings from Established Communities also
contributed to the increase. Acquisition activity in 1998 and 1997 was also an
important component of FFO growth between years.
18
FFO for the three months ended June 30, 1998, March 31, 1998, December 31,
1997, September 30, 1997, and June 30, 1997 are summarized as follows (dollars
in thousands):
(1) Represents the amortization of pre-1986 bond issuance costs carried
forward to the Company, under the pooling of interest method of
accounting, and costs associated with the reissuance of tax-exempt bonds
incurred prior to the initial public offering of Bay in March 1994 (the
"Initial Offering") in order to preserve the tax-exempt status of the
bonds at the Initial Offering.
Capitalization of Fixed Assets and Community Improvements
The Company maintains a policy with respect to capital expenditures that
generally provides that only non-recurring expenditures are capitalized.
Improvements and upgrades are capitalized only if the item exceeds $15,000,
extends the useful life of the asset and is not related to making an apartment
home ready for the next resident. Under this policy, virtually all capitalized
costs are non-recurring, as recurring make ready costs are expensed as
incurred, including costs of carpet and appliance replacements, floor
coverings, interior painting and other redecorating costs. Purchases of
personal property (such as computers and furniture) are capitalized only if the
item is a new addition (i.e., not a replacement) and only if the item exceeds
$2,500. The application of these policies for the six months ended June 30,
1998 resulted in non-revenue generating capitalized expenditures for Stabilized
Communities of approximately $2,457,000 or $70 per apartment home on a pro
forma basis. For the six months ended June 30, 1998, the Company charged to
maintenance expense, including carpet and appliance replacements, a total of
approximately $13,725,000 for Stabilized Communities or $363 per apartment home
on a pro forma basis. Management anticipates that capitalized costs per
apartment home will gradually rise as the Company's portfolio of communities
matures.
Liquidity and Capital Resources
Liquidity. A primary source of liquidity to the Company is cash flows from
operations. Operating cash flows have historically been determined by the
number of apartment homes, rental rates, occupancy levels and the Company's
expenses with respect to such apartment homes. The cash flows used in investing
activities and provided by financing activities have historically been
dependent on the number of apartment homes under active development and
construction or that were acquired during any given period.
Cash and cash equivalents increased from $1,846,000 at June 30, 1997 to
$15,060,000 at June 30, 1998 due to the excess of cash provided by financing
and operating activities over cash flow used in investing activities.
Net cash provided by operating activities increased by $45,075,000 from
$28,005,000 for the six months ended June 30, 1997 to $73,080,000 for the
six months ended June 30, 1998 primarily
19
due to an increase in operating income from newly developed and acquired
communities and Established Communities.
Cash used in investing activities increased by $109,575,000 from
$163,601,000 for the six months ended June 30, 1997 to $273,176,000. This
increase reflects the expenditures for the 1998 and 1997 communities
acquired, and the amounts used to acquire, develop, and construct the
Development and Redevelopment Communities.
Net cash provided by financing activities increased by $75,446,000 from
$136,522,000 for the six months ended June 30, 1997 to $211,968,000 for
the six months ended June 30, 1998 primarily due to the proceeds from the
sale of unsecured senior notes, a net increase in borrowings under the
unsecured facilities compared to the comparable period in the prior year,
and a reduction in proceeds raised through the sale of common stock.
The Company regularly reviews its short-term liquidity needs and the adequacy
of Funds from Operations and other expected liquidity sources to meet these
needs. The Company believes that its principal short-term liquidity needs are
to fund normal recurring operating expenses, debt service payments and the
minimum dividend payment required to maintain the Company's REIT qualification
under the Code. Management anticipates that these needs will be fully funded
from cash flows provided by operating activities. Any short-term liquidity
needs not provided by current operating cash flows would be funded from the
Company's Unsecured Facility.
Management anticipates that no significant portion of the principal of any
indebtedness will be repaid prior to maturity and if the Company does not have
funds on hand sufficient to repay such indebtedness, it will be necessary for
the Company to refinance this debt. Such refinancing could be accomplished
through additional debt financing, which may be collateralized by mortgages on
individual communities or groups of communities, by uncollateralized private or
public debt offerings or by additional equity offerings. There can be no
assurance that such additional debt financing or debt offerings will be
available on terms satisfactory to the Company.
Capital Resources. To sustain the Company's active development and acquisitions
program, continuous access to the capital markets is required. Management
intends to match the long-term nature of its real estate assets with long-term
cost effective capital. Management follows a focused strategy to help
facilitate uninterrupted access to capital. This strategy includes:
1. Hire, train and retain associates with a strong resident service focus,
which should lead to higher rents, lower turnover and reduced operating
costs;
2. Manage, acquire and develop institutional quality communities with in-fill
locations that should provide consistent, sustained earnings growth;
3. Operate in markets with growing demand (as measured by household formation
and job growth) and high barriers-to-entry. These characteristics combine to
provide a favorable demand-supply balance, which the Company believes will
create a favorable environment for future rental rate growth while
protecting existing and new communities from new supply. This strategy is
expected to result in a high level of quality to the revenue stream;
4. Maintain a conservative capital structure largely comprised of equity and
with modest, cost-effective leverage. Secured debt will generally be
avoided and used primarily to obtain low cost, tax-exempt debt. Such a
structure should promote an environment for ratings upgrades that can lead
to a lower cost of capital and increased financial flexibility;
5. Accounting practices that provide a high level of quality to reported
earnings; and
6. Timely, accurate and detailed disclosures to the investment community.
20
Management believes that these strategies provide a disciplined approach to
capital access that is expected to ensure that capital resources are available
to fund portfolio growth.
The following is a discussion of specific capital transactions, arrangements
and agreements that are important to the capital resources of the Company.
Unsecured Facility
The Company's Unsecured Facility is provided by a consortium of banks that
provides for $600,000,000 in short-term credit and is subject to an annual
facility fee of $900,000. The Unsecured Facility bears interest at the London
Interbank Offered Rate ("LIBOR") based on rating levels achieved on the
Company's senior unsecured notes and on a maturity selected by the Company. The
current pricing is LIBOR plus 0.60% per annum and matures in June 2001. The
Unsecured Facility, which was put into place during June 1998, replaced three
separate credit facilities previously available to the separate companies prior
to the Merger, with terms similar to the Unsecured Facility. A competitive bid
option is available for up to $400,000,000 which may result in lower pricing if
market conditions allow. Pricing under the competitive bid option resulted in
average pricing of LIBOR + .42% for balances most recently placed under the
competitive bid option. At June 30, 1998, $374,000,000 was outstanding,
$15,567,245 was used to provide letters of credit and $210,432,755 was
available for borrowing under the Unsecured Facility. The Company will use
borrowings under the Unsecured Facility for capital expenditures, acquisitions
of developed or undeveloped communities, construction, development and
renovation costs, credit enhancement for tax-exempt bonds and for working
capital purposes.
Interest Rate Protection Agreements
The Company is not a party to any long-term interest rate agreements, other
than interest rate protection and swap agreements on certain tax-exempt
indebtedness. The Company intends, however, to evaluate the need for long-term
interest rate protection agreements as interest rate market conditions dictate
and has engaged a consultant to assist in managing the Company's interest rate
risks and exposure.
Financing Commitments/Transactions Completed
Sale of Common Stock. On April 29, 1998, Bay sold 1,244,147 shares of common
stock for aggregate net proceeds of approximately $44 million. Bay used the
net proceeds from the offering to reduce its borrowings under its then-existing
unsecured revolving credit facility.
Sale of senior unsecured notes. On July 7, 1998, the Company issued $250
million of senior unsecured notes, of which $100 million of the notes will bear
interest at 6.5% and will mature in July 2003 and $150 million of the notes
will bear interest at 6.8% and will mature in July 2006. The net proceeds of
$247.6 million to the Company were used to reduce borrowings under the
Company's Unsecured Facility.
Future Financing Needs
Substantially all of the capital expenditures to complete the communities
currently under construction and reconstruction will be funded from the
Unsecured Facility and/or issuance of debt or equity securities. Management
expects to continue to fund deferred development costs related to future
developments from Funds from Operations and advances under the Unsecured
Facility. The Company believes that these sources of capital are adequate to
take each of the proposed communities to the point in the development cycle
where construction can commence.
Management anticipates that available borrowing capacity under the Unsecured
Facility and Funds from Operations will be adequate to meet future expenditures
required to commence construction of each of the Development Rights. In
addition, the Company currently anticipates funding construction of some (but
not all) of the Development Rights under the expected remaining capacity of the
Unsecured Facility. However, before the construction of a Development Right
commences, the Company intends, if
21
necessary, to issue additional equity or debt securities, arrange additional
capacity under the Unsecured Facility or future credit facilities or obtain
additional construction loan commitments not currently in place to ensure that
adequate liquidity sources are in place to fund the construction of a
Development Right, although no assurance can be given in this regard.
The table on the following page summarizes debt maturities for the next five
years (excluding the Unsecured Facility):
22
AVALON BAY COMMUNITIES, INC.
DEBT MATURITY SCHEDULE
(Dollars in thousands)
23
Inflation
Substantially all of the leases at the Current Communities are for a
term of one year or less, which may enable the Company to realize increased
rents upon renewal of existing leases or commencement of new leases. Such
short-term leases generally minimize the risk to the Company of the adverse
effects of inflation, although as a general rule these leases permit residents
to leave at the end of the lease term without penalty. Short-term leases
combined with relatively consistent demand allow rents, and therefore cash flow
from the Company's portfolio of apartments, to provide an attractive inflation
hedge.
Year 2000 Compliance
The Year 2000 compliance issue concerns the inability of computer systems to
accurately calculate, store or use a date after 1999. This could result in a
system failure or miscalculations causing disruptions of operations. The Year
2000 issue affects virtually all companies and organizations.
The Company has been taking the necessary steps to understand the nature and
extent of the work required to make its core information computer systems and
non-information embedded systems Year 2000 compliant. The Company has
established a Year 2000 project team which has completed the assessment phase
for computerized management information systems. The assessment determined that
it will be necessary to modify, update or replace limited portions of the
Company's computer hardware and software applications.
The Company anticipates that replacing and upgrading its existing management
information systems (both hardware and software) in the normal course of
business will result in Year 2000 compliance by the end of the second quarter of
1999. The vendor that provides the Company's existing general ledger software
expects to release a compliant version of its product by the end of 1998. Growth
in the Company's operations is expected to require a general ledger system with
scope and functionality that is not present in the current, non-compliant system
in use, and the scope and functionality required by the Company is not expected
to be provided by the Year 2000 compliant version of that system. Accordingly,
the Company expects to replace the current general ledger system with an
enhanced system that, in addition to increased functionality, is Year 2000
compliant. The cost of the new general ledger system, after considering
anticipated efficiencies provided by the new system, is not currently expected
to have a material effect (either beneficial or adverse) on the Company's
financial condition or results of operations. The new general ledger system is
expected to be selected by the end of the third quarter of 1998 and implemented
by the second quarter of 1999. The Company believes its computerized information
systems will be Year 2000 compliant by the beginning of the third quarter of
1999.
The Company is also reviewing each community for embedded systems (e.g.,
security, HVAC, fire and elevator systems) that may not be Year 2000 compliant.
The Company is currently conducting an assessment of these systems to identify
and evaluate the changes and modifications necessary to make these systems
compliant for Year 2000 processing and this assessment is expected to be
completed by December 31, 1998. The Company continues to evaluate the estimated
costs associated with these compliance efforts and, therefore, the total cost of
bringing all embedded systems into Year 2000 compliance has not been quantified.
Based on available information, the Company believes that these costs will not
have a material adverse effect on its business, financial condition or results
of operations. However, no assurance can be given that the Company's embedded
systems will be Year 2000 compliant by December 31, 1999 or that the Company
will not incur significant costs pursuing Year 2000 compliance.
24
Upon completion of each of the above described upgrades and replacements of the
Company's information computer systems and non-information embedded systems, the
Company will commence testing to ensure Year 2000 compliance. The Company
currently expects its testing to be completed in the third quarter of 1999.
While the Company anticipates that such tests will be successful in all material
respects, the Company's Year 2000 project team intends to closely monitor the
Company's Year 2000 compliance and will develop contingency plans if necessary.
The Company is communicating with third-party service providers and vendors
with which it does business to determine the efforts being made on their part
for compliance. The Company is attempting to receive compliance certificates
from all third parties that have a material impact on the Company's operations,
but no assurance can be given with respect to the cost or timing of such
efforts or the potential effects of any failure to comply.
Natural Disasters
Many of the Company's West Coast communities are located in the general
vicinity of active earthquake faults. In July 1998, the Company obtained a
seismic risk analysis from an engineering firm which estimated the probable
maximum damage ("PMD") for each of the 60 communities that the Company owned at
that time and for each of the five communities under development, individually
and for all of those communities combined. To establish a PMD, the engineers
first define a severe earthquake event for the applicable geographic area,
which is an earthquake that has only a 10% likelihood of occurring over a
50-year period. The PMD is determined as the structural and architectural
damage and business interruption loss that has a 10% probability of being
exceeded in the event of such an earthquake. Because a significant number of
the Company's communities are located in the San Francisco Bay Area, the
engineers' analysis defined an earthquake on the Hayward Fault with a Richter
Scale magnitude of 7.1 as a severe earthquake with a 10% probability of
occurring within a 50-year period. The engineers then established an aggregate
PMD at that time of $113 million for the 60 west coast communities that the
Company owned at that time and the five communities under development. The $113
million PMD for those communities was a PMD level that the engineers expected
to be exceeded only 10% of the time in the event of such a severe earthquake.
The actual aggregate PMD could be higher or lower as a result of variations in
soil classifications and structural vulnerabilities. For each community, the
engineers' analysis calculated an individual PMD as a percentage of the
community's replacement cost and projected revenues. No assurance can be given
that an earthquake would not cause damage or losses greater than the PMD
assessments indicate, that future PMD levels will not be higher than the
current PMD levels for the Company's communities located on the West Coast, or
that future acquisitions or developments will not have PMD assessments
indicating the possibility of greater damage or losses than currently
indicated.
In August 1998, the Company renewed its earthquake insurance, both for physical
damage and lost revenue, with respect to all communities it owned at that time
and all of the communities under development. For any single occurrence, the
Company self-insures the first $25 million of loss, and has in place $75
million of coverage above this amount. In addition, the Company's general
liability and property casualty insurance provides coverage for personal
liability and fire damage. In the event that an uninsured disaster or a loss in
excess of insured limits were to occur, the Company could lose its capital
invested in the affected community, as well as anticipated future revenue from
that community, and would continue to be obligated to repay any mortgage
indebtedness or other obligations related to the community. Any such loss could
materially and adversely affect the business of the Company and its financial
condition and results of operations.
Development Communities
Currently sixteen Development Communities are under construction. The total
capitalized cost of these Development Communities, when completed, is expected
to be approximately $685.5 million. There can be no assurance that the Company
will complete the Development Communities, that the Company's
25
budgeted costs, leasing, start dates, completion dates, occupancy or estimates
of "EBITDA as % of Total Budgeted Cost" will be realized or that future
developments will realize comparable returns.
The following page presents a summary of Development Communities:
26
AVALON BAY COMMUNITIES, INC.
DEVELOPMENT COMMUNITIES SUMMARY
(1) Total budgeted cost includes all capitalized costs projected to be
incurred to develop the respective Development Community, including land
acquisition costs, construction costs, real estate taxes, capitalized
interest and loan fees, permits, professional fees, allocated
development overhead and other regulatory fees determined in accordance
with GAAP.
(2) Stabilized operations is defined as the first full quarter of 95% or
greater occupancy after completion of construction.
(3) Projected EBITDA represents gross potential earnings projected to be
achieved at completion of construction before interest, income taxes,
depreciation, amortization and extraordinary items, minus (a) projected
economic vacancy and (b) projected stabilized operating expenses.
(4) Represents a combined yield for Avalon Valley and Avalon Lake.
(5) Financed with tax-exempt bonds.
27
Redevelopment Communities
There are currently twelve Redevelopment Communities. The total capitalized
cost of these Redevelopment Communities, when completed, is expected to be
approximately $379.7 million. There can be no assurance that the Company will
complete the Redevelopment Communities, that the Company's budgeted costs,
leasing, start dates, completion dates, occupancy or estimates of "EBITDA as %
of Total Budgeted Cost" will be realized or that future redevelopments will
realize comparable returns.
In accordance with GAAP, cost capitalization during redevelopment and
reconstruction of assets (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 reconstruction and ends when the apartment home
reconstruction is completed and the apartment home is placed-in-service.
The following page presents a summary of Redevelopment Communities:
28
AVALON BAY COMMUNITIES, INC.
REDEVELOPMENT COMMUNITIES SUMMARY (1)
(1) Redevelopment Communities are communities acquired for which redevelopment
costs are expected to exceed the lesser of 10% of the original acquisition
cost or $5,000,000.
(2) Total budgeted cost includes all capitalized costs projected to be
incurred to redevelop the respective Redevelopment Community, including
costs to acquire the community, reconstruction costs, real estate taxes,
capitalized interest and loan fees, permits, professional fees, allocated
redevelopment overhead and other regulatory fees determined in accordance
with GAAP.
(3) Restabilized operations is defined as the first full quarter of 95% or
greater occupancy after completion of redevelopment.
(4) Projected EBITDA represents gross potential earnings projected to be
achieved at completion of redevelopment before interest, income taxes,
depreciation, amortization and extraordinary items, minus (a) projected
economic vacancy and (b) projected stabilized operating expenses.
29
Development Rights
The Company is considering the development of 22 new apartment communities. The
status of these Development Rights range from land owned or under contract for
which design and architectural planning has just commenced to land under
contract or owned by the Company with completed site plans and drawings where
construction can commence almost immediately. There can be no assurance that the
Company will succeed in obtaining zoning and other necessary governmental
approvals or the financing required to develop these communities, or that the
Company will decide to develop any particular community. Further, there can be
no assurance that construction of any particular community will be undertaken
or, if undertaken, will begin at the expected times assumed in the financial
projections or be completed at the total budgeted cost. Although there can be no
assurance that all or any of these communities will proceed to development,
management estimates that the successful completion of all of these communities
would ultimately add approximately 6,512 institutional-quality apartment homes
to the Company's portfolio. At June 30, 1998, the cumulative capitalized costs
incurred in pursuit of the 22 Development Rights was approximately $32.7
million. Many of these apartment homes will offer features like those offered by
the communities currently owned by the Company. The 22 Development Rights that
the Company is currently pursuing are summarized on the following table.
30
AVALON BAY COMMUNITIES, INC.
DEVELOPMENT RIGHTS SUMMARY
(1) Company owns land, but construction has not yet begun.
(2) Currently anticipated that the land seller will retain a minority limited
partner interest.
31
Risks of Development and Redevelopment
The Company intends to continue to pursue the development and construction of
apartment home communities in accordance with the Company's development and
underwriting policies. Risks associated with the Company's development and
construction activities may include: the abandonment of development and
acquisition opportunities explored by the Company; construction costs of a
community may exceed original estimates due to increased materials, labor or
other expenses, which could make completion of the community uneconomical;
occupancy rates and rents at a newly completed community are dependent on a
number of factors, including market and general economic conditions, and may
not be sufficient to make the community profitable; financing may not be
available on favorable terms for the development of a community; and
construction and lease-up may not be completed on schedule, resulting in
increased debt service expense and construction costs. Development activities
are also subject to risks relating to the inability to obtain, or delays in
obtaining, all necessary zoning, land-use, building, occupancy, and other
required governmental permits and authorizations. The occurrence of any of the
events described above could adversely affect the Company's ability to achieve
its projected yields on communities under development or reconstruction and
could prevent the Company from paying distributions to its stockholders.
For each new development community, the Company establishes a target for
projected EBITDA as a percentage of total budgeted cost. Projected EBITDA as a
percentage of total budgeted cost represents gross potential earnings projected
to be achieved at completion of development or redevelopment before interest,
income taxes, depreciation, amortization and extraordinary items, minus (a)
projected economic vacancy and (b) projected stabilized operating expenses.
Total budgeted cost includes all capitalized costs projected to be incurred to
develop the respective Development or Redevelopment Community, including land,
acquisition costs, construction costs, real estate taxes, capitalized interest
and loan fees, permits, professional fees, allocated development overhead and
other regulatory fees determined in accordance with GAAP. Gross potential
earnings and construction costs reflect those prevailing in the community's
market at the time the Company's development budgets are prepared taking into
consideration certain changes to those market conditions anticipated by the
Company at the time. Although the Company attempts to anticipate changes in
market conditions, the Company cannot predict with certainty what those changes
will be. Construction costs have been increasing and, for certain of the
Company's development communities, the total construction costs have been or
are expected to be higher than the original budget. Nonetheless, because of
increases in prevailing market rents management believes that, in the
aggregate, the Company will still achieve its targeted projected EBITDA as a
percentage of total budgeted cost for those communities experiencing costs in
excess of the original budget. Management believes that it could experience
similar increases in construction costs and market rents with respect to other
development communities resulting in total construction costs that exceed
original budgets. Likewise, costs to redevelop communities that have been
acquired have, in some cases, exceeded management's original estimates and
similar increases in costs may be experienced in the future. There can be no
assurances that market rents in effect at the time new development communities
or repositioned communities complete lease-up will be sufficient to fully
offset the effects of any increased construction costs.
Capitalized Interest
In accordance with GAAP, the Company capitalizes interest expense during
construction until each building obtains a final certificate of occupancy.
Thereafter, interest for each completed building is expensed. Capitalized
interest for all communities under construction or reconstruction the three
months ended June 30, 1998 and 1997 totaled $3,561,000 and $1,396,000,
respectively and for the six months ended June 30, 1998 and 1997 totaled
$6,525,000 and $2,421,000, respectively.
32
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None
Item 2. Changes in Securities
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
The Company held its Annual Meeting of Stockholders on June
4, 1998. The stockholders voted to elect Gilbert M. Meyer,
Bruce A. Choate, John J. Healy, Jr., Brenda J. Mixson, Thomas
H. Nielsen and Lance R. Primis to serve as directors of the
Company until the 1999 Annual Meeting of Stockholders and
until their successors are duly elected and qualified.
22,295,769 votes were cast for, and 2,134,974 votes were
withheld from the election of Mr. Meyer.
22,295,989 votes were cast for, and 2,134,755 votes were
withheld from the election of Mr. Choate.
22,295,989 votes were cast for, and 2,134,755 votes were
withheld from the election of Mr. Healy.
22,295,989 votes were cast for, and 2,134,755 votes were
withheld from the election of Ms. Mixson.
22,295,989 votes were cast for, and 2,134,755 votes were
withheld from the election of Mr. Nielsen.
22,295,989 votes were cast for, and 2,134,755 votes were
withheld from the election of Mr. Primis.
The stockholders voted to ratify certain amendments to the
Company's charter relating to the rights, preferences and
privileges of the Series A Preferred Stock. Of the shares of
common stock voted on this proposal, 19,692,750 votes were
cast in favor of this proposal, 688,092 were cast against,
71,560 votes abstained and 3,978,342 broker non-votes were
recorded. Of the shares of Series A Preferred Stock voted on
this proposal, 2,308,800 votes were cast in favor of this
proposal.
The stockholders voted to ratify the 1994 Stock Incentive
Plan, as amended and restated. Of the shares of common stock
voted on this proposal, 18,304,106 votes were cast in favor
of this proposal, 2,304,946 were cast against, 113,345 votes
abstained and 3,978,347 broker non-votes were recorded.
The stockholders voted to approve the Agreement and Plan of
Merger, dated as of March 9, 1998 (the "Merger Agreement"),
by and between Bay and Avalon, the merger of Avalon with and
into the Company (the "Merger"), with the Company as the
surviving corporation (the "Surviving Corporation"), and all
of the matters and transactions contemplated by the Merger
Agreement, including the amendment and restatement of the
charter of the Company. Of the shares of common stock voted
on this proposal,
33
19,126,147 votes were cast in favor of this proposal,
1,288,540 votes were cast against, 37,719 votes abstained and
3,978,388 broker non-votes were recorded.
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
EXHIBIT NO. DESCRIPTION
- ----------- -----------
3(i).1 Articles of Amendment and Restatement of Articles of
Incorporation of the Company, dated as of June 4, 1998.
3(ii).1 Bylaws of the Company, as amended and restated on July 24,
1998.
10.1 Employment Agreement, dated as of March 9, 1998, between the
Company and Richard L. Michaux.
10.2 Employment Agreement, dated as of March 9, 1998, between the
Company and Charles H. Berman.
10.3 Employment Agreement, dated as of March 9, 1998, between the
Company and Robert H. Slater.
10.4 Employment Agreement, dated as of March 9, 1998, between the
Company and Thomas J. Sargeant.
10.5 Employment Agreement, dated as of March 9, 1998, between the
Company and Bryce Blair.
10.6 Revolving Loan Agreement, dated as of June 23, 1998, between
the Company and Fleet National bank, Morgan Guaranty Trust
Company of New York and Union Bank of Switzerland, each as
co-agents.
27.1 Financial Data Schedule.
(b) REPORTS ON FORM 8-K
1. Form 8-K of the Company, filed April 16, 1998, relating to the filing
of unaudited pro forma condensed financial statements giving effect to the
Merger of the Company and Avalon Properties, Inc.
2. Form 8-K of the Company, filed April 22, 1998, relating to the
announcement of the Company's results of operations for fiscal quarter ended
March 31, 1998.
3. Form 8-K of the Company, filed June 19, 1998, announcing the completion
of the Merger by and between the Company and Avalon Properties, Inc., in which
the Company was the surviving corporation. This Form 8-K contains unaudited pro
forma condensed financial statements.
4. Form 8-K/A of the Company, filed June 26, 1998, incorporating by
reference certain agreements related to Avalon Properties, Inc.
34
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.
AVALON BAY COMMUNITIES, INC.
Date: August 14, 1998 /s/ Richard L. Michaux
-------------------------------------
Richard L. Michaux
Chief Executive Officer and Director
Date: August 14, 1998 /s/ Thomas J. Sargeant
-------------------------------------
Thomas J. Sargeant
Chief Financial Officer and Treasurer
35