10-Q: Quarterly report pursuant to Section 13 or 15(d)
Published on November 16, 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 September 30, 1998
Commission file number 1-12672
AVALONBAY COMMUNITIES, INC.
(Exact name of registrant as specified in its charter)
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Maryland 77-0404318
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
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)
Avalon Bay Communities, Inc.
(Former name, if changed since last report)
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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:
63,843,927 shares outstanding as of November 3, 1998
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AVALONBAY COMMUNITIES, INC.
FORM 10-Q
INDEX
PAGE
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PART I - FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements (Unaudited):
Condensed Consolidated Balance Sheets as of September 30,
1998 and December 31, 1997..................................... 2
Condensed Consolidated Statements of Operations for the
three months and nine months ended September 30, 1998
and 1997....................................................... 3
Condensed Consolidated Statements of Cash Flows for the
nine months ended September 30, 1998 and 1997.................. 4-5
Notes to Condensed Consolidated Financial Statements........... 6-13
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations...................................... 14-35
PART II - OTHER INFORMATION
Item 1. Legal Proceedings.............................................. 36
Item 2. Changes in Securities.......................................... 36
Item 3. Defaults Upon Senior Securities................................ 36
Item 4. Submission of Matters to a Vote of Security Holders............ 36
Item 5. Other Information.............................................. 36
Item 6. Exhibits and Reports on Form 8-K............................... 36-37
Signatures.............................................................. 38
1
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
AVALONBAY COMMUNITIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share data)
The accompanying notes are an integral part of these condensed consolidated
financial statements.
2
AVALONBAY COMMUNITIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(Dollars in thousands, except share data)
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
AVALONBAY COMMUNITIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(Dollars in thousands)
4
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
$25,603 during the nine months ended September 30, 1998 and 1997, respectively.
The Company issued $3,851 in operating partnership units for acquisitions during
1998.
During the nine months ended September 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 September 30, 1998 and 1997 totaled
$41,040 and $11,878, respectively.
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
AVALONBAY COMMUNITIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Organization and Recent Developments
AvalonBay Communities, Inc. (in conjunction with its partnerships and
subsidiaries, 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. On October 2, 1998, the Company changed its name from Avalon
Bay Communities, Inc. to AvalonBay Communities, Inc.
At September 30, 1998, the Company owned or held an ownership interest in 130
operating apartment communities containing 38,132 apartment homes in sixteen
states and the District of Columbia. The Company also owned 16 communities with
an estimated 4,432 apartment homes under construction and rights to develop an
additional 23 communities that will contain an estimated 6,377 apartment homes.
Of the operating apartment communities, there were 13 communities containing
4,855 apartment homes under reconstruction.
During the third quarter of 1998, the Company's acquisition investments totaled
$154,000 comprised principally of the acquisition of the Prudential Center
Apartments for $130,000. The remaining $24,000 related to the acquisition of a
participating mortgage note secured by Fairlane Woods, a 288 apartment home
community located in Dearborn, Michigan. Management is pursuing the purchase of
a 100% equity interest in Fairlane Woods, but no assurance can be provided that
such an equity interest can be acquired. The Company also acquired land on which
development of two new communities with 505 new apartment homes will begin in
the fourth quarter of 1998. The total budgeted construction cost for these
communities is approximately $60,400.
Dispositions during the third quarter of 1998 consisted of the sale of three
communities, two in suburban Detroit, Michigan and one in suburban Los Angeles,
California. Proceeds from the sale of the Michigan communities, which contained
a total of 758 apartment homes, were approximately $44,000. Proceeds from the
sale of the California community, which contained 260 apartment homes, were
approximately $12,500. The net proceeds were used to repay amounts outstanding
under the Company's unsecured credit facility and to acquire the participating
mortgage note secured by Fairlane Woods.
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 Reports on Form 10-K for the year ended
December 31, 1997. The results of operations for the three and nine months ended
September 30, 1998 are not necessarily indicative of the operating results for
the full year. Management believes 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.
6
Principles of Consolidation
The accompanying condensed 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.
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, redevelopment and acquisition. Expenditures
for maintenance and repairs are charged to operations as incurred.
The capitalization of costs during the development of assets (including interest
and related loan fees, property taxes and other direct and indirect costs)
begins when active development commences and ends when the asset is delivered
and a final certificate of occupancy is issued. Cost capitalization during
redevelopment of 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 redevelopment and ends when the apartment home
redevelopment is completed and the apartment home is placed-in-service. The
accompanying condensed consolidated financial statements include a charge to
expense for unrecoverable deferred development costs related to pre-development
communities that are unlikely to be developed.
Depreciation is calculated on buildings and improvements using the straight-line
method over their estimated useful lives, which range from 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 one year or less. Rental income
and operating costs incurred during the initial lease-up or post-redevelopment
lease-up period are fully recognized as they accrue.
Income Taxes
The Company elected to be taxed as a REIT under the Internal Revenue Code of
1986, as amended, 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 stockholders), the payment of federal and state
income taxes at the corporate level is avoided or reduced. Management believes
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
financing 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.
7
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 nine months ended September 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 share on a diluted basis.
The Company's basic and diluted weighted average shares outstanding for the
three and nine months ended September 30, 1998 and 1997 are as follows:
Use of Estimates
The preparation of financial statements in conformity with GAAP requires
management to make certain estimates and assumptions. These estimates and
assumptions affect the reported amounts of assets and liabilities and disclosure
of contingent assets and liabilities at the dates of the financial statements
and the reported amounts of revenue and expenses during the reporting periods.
Actual results could differ from those estimates.
Reclassifications
Certain reclassifications have been made to amounts in prior years' financial
statements to conform with current year presentations.
Newly Issued Accounting Standards
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130
"Reporting Comprehensive Income" and SFAS 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 September 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 material
impact on the Company's consolidated financial statements.
8
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. This ruling does not have a material effect on the Company's
condensed consolidated financial statements.
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities." This
pronouncement 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. SFAS No. 133 requires that changes in
the derivative's fair value be recognized currently in earnings unless specific
hedge accounting criteria are met. SFAS No. 133 is effective for fiscal years
beginning after June 15, 1999 and cannot be applied retroactively. The Company
currently plans to adopt this pronouncement 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, respectively.
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 nor does it
purport to represent the results of operations for future periods had the Merger
been consummated on January 1, 1997.
9
3. INTEREST CAPITALIZED
Capitalized interest associated with projects under development or redevelopment
totaled $4,847 and $2,009 for the three months ended September 30, 1998 and
1997, respectively, and $11,372 and $4,430 for the nine months ended September
30, 1998 and 1997, respectively.
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 4.5% at September 30,
1998. The weighted average interest rate of fixed rate notes (conventional and
tax-exempt) was 6.6% and 6.4% at September 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 .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 September 30, 1998 was 6.1%.
The Company is subject to certain customary covenants under the Unsecured
Facility, including, but not limited to, maintaining certain maximum leverage
ratios, a 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 therein. The Unsecured
Facility matures in July 2001 and has two, one-year extension options.
The Company's unsecured senior notes consist of the following:
Interest Maturity
Principal Rate Date
--------- -------- --------
$100,000 7.375% 2002
$ 50,000 6.25% 2003
$100,000 6.5% 2003
$100,000 6.625% 2005
$ 50,000 6.5% 2005
$150,000 6.8% 2006
$110,000 6.875% 2007
$ 50,000 6.625% 2008
10
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 nine months
ended September 30, 1998:
6. INVESTMENTS IN UNCONSOLIDATED JOINT VENTURES
At September 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:
9-30-98 12-31-97
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Assets:
Real estate, net $ 96,676 $ 97,964
Other assets 4,694 10,790
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Total assets $101,370 $108,754
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Liabilities and partners' equity:
Mortgage notes payable $ 26,000 $ 26,000
Other liabilities 4,752 4,164
Partners' equity 70,618 78,590
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Total liabilities and partners' equity $101,370 $108,754
======== ========
11
The following is a combined summary of the operating results of these joint
ventures for the periods presented:
7. COMMUNITIES HELD FOR SALE
During the third quarter of 1998, the Company determined that it would pursue a
disposition strategy for certain assets in markets that were in primarily
outlying locations. In connection with this decision, the Company's Board of
Directors authorized management to pursue the disposition of select communities
within specific markets. The Company will solicit competing bids from unrelated
parties for these individual assets, and will consider the sales price and tax
ramifications of each proposal. Management anticipates these assets will be sold
during the upcoming twelve months. One of these communities authorized for sale,
Arbor Park, was disposed during September 1998, resulting in a net gain of $40.
The assets to be disposed include land, buildings and improvements and
furniture, fixtures and equipment, and are recorded at the lower of carrying
amount or fair value less selling costs. At September 30, 1998, total real
estate, net of accumulated depreciation, subject to sale totaled $128,978.
Certain individual assets are secured by mortgage indebtedness which may be
assumed by the purchaser or repaid by the Company from the net sales proceeds.
The Company's condensed consolidated statements of operations includes net
income of the communities held for sale of $1,463 and $546 for the three months
ended September 30, 1998 and 1997, respectively and $2,994 and $1,558 for the
nine months ended September 30, 1998 and 1997, respectively.
8. SUBSEQUENT EVENTS
On October 2, 1998, the Company held a Special Meeting of Stockholders at which
stockholders approved (i) amendments to the charter reducing the number of
authorized shares of the Company's Common Stock from 300,000,000 to 140,000,000,
and (ii) an amendment to the charter changing the Company's name from "Avalon
Bay Communities, Inc." to "AvalonBay Communities, Inc."
On October 15, 1998, the Company completed the sale of 4,000,000 shares of 8.7%
Series H Cumulative Redeemable Preferred Stock at a public price of $25 per
share (the "Offering"). The net proceeds from the Offering of approximately
$96,600 were used to reduce borrowings under the Company's Unsecured Facility.
12
As disclosed in Footnote 7 of these financial statements, during the third
quarter of 1998 the Company's Board of Directors authorized management to pursue
the disposition of select communities within specific markets. During October
1998, the Board of Directors authorized additional communities to be disposed.
The additional assets to be disposed include land, buildings and improvements
and furniture, fixtures and equipment and are recorded at the lower of carrying
amount or fair value less selling costs. At September 30, 1998, total real
estate, net of accumulated depreciation, subject to sale totaled $105,444 for
these assets. Certain individual assets are secured by mortgage indebtedness
which may be assumed by the purchaser or repaid by the Company from the net
sales proceeds.
The Company's condensed consolidated statements of operations include net income
of the communities held for sale of $762 and $249 for the three months ended
September 30, 1998 and 1997, respectively and $1,347 and $703 for the nine
months ended September 30, 1998 and 1997, respectively.
13
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 each term is hereinafter defined) and related cost and
EBITDA estimates, as well as the cost, timing and effectiveness of Year 2000
compliance, 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; 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; and the Company
and its suppliers may experience unanticipated delays or expenses in achieving
Year 2000 compliance.
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. On
October 2, 1998, the Company changed its name from Avalon Bay Communities, Inc.
to AvalonBay 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
14
pursue opportunities to develop and acquire upscale apartment homes in its
target markets.
The Company's real estate investments as of November 6, 1998 consist primarily
of apartment communities in various stages of the development cycle and land or
land options held for development and can be divided into three categories:
Number of Number of
Communities Apartment Homes
----------- ---------------
Current Communities 130 38,132
Development Communities 16 4,432(*)
Development Rights 23 6,377(*)
(*) 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 as of 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 13 Redevelopment Communities containing 4,855
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
112 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 partnership interest in partnerships structured as DownREITs, which own
13 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 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 communities and new developments) where constraints to new
supply exist and where new household formations have out-paced multifamily
permit activity in recent years.
15
At September 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 96.5% and achieved an
average economic occupancy of 96.7% and 96.5% for the three and nine months
ended September 30, 1998, respectively. Average economic occupancy for the
portfolio for the three and nine months ended September 30, 1997 was 95.8% and
95.6%, respectively. 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 total rental revenue could lead to lower occupancy levels. Given the
high occupancy level of the portfolio, Management anticipates that any rental
revenue and net income gains from the Company's Established Communities would be
achieved primarily through higher rental rates and enhanced operating cost
leverage provided by high occupancy.
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; New York, New York; Newport Beach, California;
Princeton, New Jersey; Richmond, Virginia; and Seattle, Washington.
RECENT DEVELOPMENTS
Acquisitions of Existing Communities. Since June 30, 1998, the Company has
acquired the following community and land held for development communities
(dollars in millions):
(1) 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.
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.
16
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, located 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 used to acquire the participating mortgage note secured by
the Fairlane Woods community in Dearborn, Michigan, with the balance used to
repay amounts outstanding under the Company's $600 million variable rate
unsecured credit facility (the "Unsecured Facility"). The Company also sold
Arbor Park, a 260 apartment home community located in suburban Los Angeles,
California. The gross proceeds of approximately $12.5 million were used to repay
amounts outstanding under the Unsecured Facility.
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 nine months ended September 30, 1998 and 1997.
Net income increased $20,887,000 (196.1%) to $31,540,000 for the three months
ended September 30, 1998 compared to $10,653,000 for the comparable period of
the preceding year. Net income increased $35,859,000 (133.3%) to $62,761,000 for
the nine months ended September 30, 1998 compared to $26,902,000 for the
comparable period of the preceding year. The primary reasons for these increases
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 $84,529,000 (254.9%) to $117,693,000 for the three
months ended September 30, 1998 compared to $33,164,000 for the comparable
period of the preceding year. Rental income increased $143,989,000 (160.3%) to
$233,794,000 for the nine months ended September 30, 1998 compared to
$89,805,000 for the comparable period of the preceding year. Of the increase for
the nine month period, $4,118,000 relates to rental revenue increases from
Established Communities, $86,046,000 relates to rental revenue attributable to
the former Avalon communities, and $53,825,000 is attributable to the addition
of newly completed or acquired apartment homes.
Overall Portfolio - The $143,989,000 increase in rental income for the nine
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 9,535 apartment homes for
the nine months ended September 30, 1997 to 24,034 apartment homes for the
nine months ended September 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 September 30,
1998, the weighted average monthly revenue per occupied apartment home
increased $46 (4.4%) to $1,100 compared to $1,054 for the comparable period
of the preceding year. For the nine months ended September 30, 1998, the
weighted average monthly revenue per occupied apartment home increased $34
(3.3%) to $1,070 compared to $1,036 for the comparable period of the
preceding year.
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Established Communities - Rental revenue increased $1,107,000 and
$4,118,000 for the three and nine months ended September 30, 1998,
respectively, compared to the comparable periods of the preceding year due
to market conditions that allowed for higher average rents at relatively
stable occupancy. For the three months ended September 30, 1998, weighted
average monthly revenue per occupied apartment home increased $67 (6.3%) to
$1,131 compared to $1,064 for the comparable period of the preceding year.
The average economic occupancy decreased 0.7% from 98.0% for the three
months ended September 30, 1997 to 97.3% for the three months ended
September 30, 1998. For the nine months ended September 30, 1998, weighted
average monthly revenue per occupied apartment home increased $73 (7.0%) to
$1,111 compared to $1,038 for the comparable period of the preceding year.
The average economic occupancy increased 0.1% from 97.6% for the nine
months ended September 30, 1997 to 97.7% for the nine months ended
September 30, 1998.
The Company's Established Communities consist entirely of communities
located within the Northern California market. Compared to the prior year,
most of the sub-markets within Northern California have maintained a strong
economic environment that has allowed for high occupancy levels and rent
growth. However, Management has seen in recent periods that certain
Northern California sub-markets, that are dependent on Silicon Valley
employment markets are being negatively impacted by tightening employment
conditions caused by recent Asian economic difficulties. These impacted
sub-markets have not experienced the same rent growth or occupancy levels
that are prevalent in other Northern California sub-markets.
Management fees totaling $342,000 and $457,000 for the three and nine months
ended September 30, 1998, respectively, represent revenue from certain
third-party contracts obtained from the Merger with Avalon.
Operating expenses increased $24,445,000 (290.9%) to $32,848,000 for the three
months ended September 30, 1998 compared to $8,403,000 for the comparable period
of the preceding year. These expenses increased $40,459,000 (175.2%) to
$63,554,000 for the nine months ended September 30, 1998 compared to $23,095,000
for the comparable period of the preceding year.
Overall Portfolio - The increases for the three and nine months ended
September 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 for which 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 $41,000 (0.9%) to
$4,428,000 for the three months ended September 30, 1998 compared to
$4,387,000 for the comparable period of the preceding year. These expenses
decreased $69,000 (0.5%) to $12,948,000 for the nine months ended September
30, 1998 compared to $13,017,000 for the comparable period of the preceding
year. The net changes are the result of higher maintenance costs, offset
by lower insurance costs.
Property taxes increased $7,677,000 (306.3%) to $10,183,000 for the three months
ended September 30, 1998 compared to $2,506,000 for the comparable period of the
preceding year. Property taxes increased $12,911,000 (193.7%) to $19,576,000 for
the nine months ended September 30, 1998 compared to $6,665,000 for the
comparable period of the preceding year.
Overall Portfolio - The increases for the three and nine months ended
September 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 for which 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 $42,000 (3.1%) to
$1,395,000 for the three months ended September 30, 1998 compared to
$1,353,000 for the comparable period of the preceding year. Property taxes
increased $163,000 (4.1%) to $4,132,000 for the nine months ended September
30, 1998 compared to $3,969,000 for the comparable period of the preceding
year. These increases are primarily the result of increased assessments of
property values.
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Interest expense increased $15,142,000 (466.9%) to $18,385,000 for the three
months ended September 30, 1998 compared to $3,243,000 for the comparable period
of the preceding year. Interest expense increased $25,388,000 (245.1%) to
$35,748,000 for the nine months ended September 30, 1998 compared to $10,360,000
for the comparable period of the preceding year. These increases are primarily
attributable to $643,410,000 of debt assumed in connection with the Merger as
well as increased borrowings under the Unsecured Facility offset in part by
higher capitalization of interest from increased development, redevelopment,
construction and reconstruction activity.
Depreciation and amortization increased $16,652,000 (240.4%) to $23,579,000 for
the three months ended September 30, 1998 compared to $6,927,000 for the
comparable period of the preceding year. Depreciation and amortization increased
$29,029,000 (152.4%) to $48,082,000 for the nine months ended September 30, 1998
compared to $19,053,000 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 $1,314,000 (103.9%) to $2,579,000
for the three months ended September 30, 1998 compared to $1,265,000 for the
comparable period of the preceding year. General and administrative expenses
increased $2,592,000 (88.4%) to $5,525,000 for the nine months ended September
30, 1998 compared to $2,933,000 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 increased $210,000
(150.0%) to $350,000 for the three months ended September 30, 1998 compared to
$140,000 for the comparable period of the preceding year. These costs increased
$80,000 (11.9%) to $750,000 for the nine months ended September 30, 1998
compared to $670,000 for the comparable period of the preceding year. These
increases are the result of higher provisions related to abandoned projects in
the current year, offset by a significant one time charge in the prior year
related to a large west coast portfolio acquisition that was not completed.
Equity in income of unconsolidated joint ventures of $608,000 and $846,000 for
the three and nine months ended September 30, 1998, respectively, represents the
Company's share of income of certain joint ventures that were acquired in
conjunction with the Merger.
Interest income increased $1,170,000 to $1,222,000 for the three months ended
September 30, 1998 compared to $52,000 for the comparable period of the
preceding year. Interest income increased $1,527,000 to $1,690,000 for the nine
months ended September 30, 1998 compared to $163,000 for the comparable period
of the preceding year. These increases are primarily due to the interest on the
Avalon Arbor note that was obtained from the Merger and the Fairlane Woods note
acquired during August 1998.
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 condensed 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
19
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 September 30, 1998, FFO increased to $47,492,000 from
$16,178,000 for the comparable period in the preceding year. This increase is
primarily due to the delivery of high yielding new development and redevelopment
communities 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.
FFO for the three months ended September 30, 1998 and the preceding four
quarters are summarized as follows (dollars in thousands):
(1) Represents the amortization of pre-1986 bond issuance costs carried forward
to the Company 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 nine months ended September 30, 1998 resulted in
non-revenue generating capitalized expenditures for Stabilized Communities of
approximately $3,373,000 or $100 per apartment home on a pro forma basis. For
the nine months ended September 30, 1998, the Company charged to maintenance
expense, including carpet and appliance replacements, a total of approximately
$20,666,000 for Stabilized Communities or $745 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.
20
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 $3,829,000 at September 30, 1997 to
$9,458,000 at September 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 $87,625,000 from
$33,259,000 for the nine months ended September 30, 1997 to $120,884,000
for the nine months ended September 30, 1998 primarily due to an increase
in operating income from newly developed and acquired communities and
Established Communities.
Cash used in investing activities increased by $189,046,000 from
$299,653,000 for the nine months ended September 30, 1997 to $488,699,000.
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 $104,782,000 from
$269,303,000 for the nine months ended September 30, 1997 to $374,085,000
for the nine months ended September 30, 1998 primarily due to the proceeds
from the sale of unsecured senior notes and a net increase in borrowings
under the Unsecured Facilities compared to the comparable period in the
prior year, offset by a reduction in proceeds raised through the sale of
common stock and an increase in dividends paid.
The Company regularly reviews its short-term liquidity needs and the adequacy of
FFO 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 Internal
Revenue Code of 1986, as amended. 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 may 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 or, if available, that they will be on terms satisfactory to the
Company.
Capital Resources. To sustain the Company's active development 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;
21
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 whereby current ratings levels can
be maintained;
5. Accounting practices that provide a high level of quality to reported
earnings; and
6. Timely, accurate and detailed disclosures to the investment community.
Management believes that these strategies provide a disciplined approach to
capital access to help position the Company to fund portfolio growth.
Recent volatility in the capital markets has resulted in a shortage of
liquidity for most companies. See "Future Financing Needs" for a discussion of
Management's response to the current capital markets environment.
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 July 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 plus 0.47% for balances most recently placed under the
competitive bid option. At September 30, 1998, $327,600,000 was outstanding,
$15,891,000 was used to provide letters of credit and $256,509,000 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 senior unsecured notes. On July 7, 1998, the Company issued $250 million
of senior unsecured notes, of which $100 million of the notes bear interest at
6.5% and will mature in July 2003 and $150 million of the notes 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.
22
Preferred offering. In October 1998, the Company completed an underwritten
public offering of 4,000,000 shares of 8.7% Series H Cumulative Redeemable
Preferred Stock at a public price of $25 per share (the "Offering"). The net
proceeds from the Offering of approximately $96.6 million 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 FFO 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 FFO 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 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. If necessary, the Company will 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.
A shortage of liquidity for corporate borrowers emerged during the third quarter
of 1998. Management estimates that a significant portion of the Company's
liquidity needs will be met from retained operating cash and borrowings under
the Company's Unsecured Facility during the next 18 to 24 months. To meet the
balance of the Company's liquidity needs, it will be necessary to arrange
additional capacity under the Company's existing Unsecured Facility, complete
the sale of existing communities or issue additional debt or equity securities.
While Management believes the Company has the financial position to expand its
short term credit capacity and support such capital markets activity, no
assurance can be provided that the Company will be successful in completing
these arrangements, offerings or sales. If these transactions cannot be
completed, the liquidity shortage described herein could have a material and
adverse impact on the operating results and financial condition of the Company.
During the third quarter of 1998, the Company determined that it would pursue a
disposition strategy for certain assets in markets that were in outlying
locations. In connection with this decision, the Company's Board of Directors
authorized Management to pursue the disposition of select communities within
specific markets. During October 1998, the Board of Directors authorized
additional communities to be disposed. The Company will solicit competing bids
from unrelated parties for these individual assets, and will consider the sales
price and tax ramifications of each proposal. Management anticipates these
assets will be sold during the upcoming twelve months. One of these communities
authorized for sale, Arbor Park, was disposed during September 1998, resulting
in a net gain of $40,000.
The assets to be disposed include land, buildings and improvements and
furniture, fixtures and equipment. At September 30, 1998, total real estate, net
of accumulated depreciation, of all communities currently subject to sale
totaled $234,422,000. Certain individual assets are secured by mortgage
indebtedness which may be assumed by the purchaser or repaid by the Company from
the net sales proceeds. The net income of the communities held for sale of
$4,341,000 and $2,261,000 for the nine months ended September 30, 1998 and 1997,
respectively, are included in the Company's condensed consolidated statements of
operations.
The table on the following page summarizes debt maturities for the next five
years (excluding the Unsecured Facility):
23
AVALONBAY COMMUNITIES, INC.
DEBT MATURITY SCHEDULE
(Dollars in thousands)
24
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 these leases generally 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 statements in the following section include "Year 2000 readiness disclosure"
within the meaning of the Year 2000 Information and Readiness Disclosure Act of
1998.
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 causing disruptions of operations or create erroneous results.
The Year 2000 issue affects virtually all companies and organizations.
Management has been taking the necessary steps to understand the nature and
extent of the work required to make its information computer systems and
non-information embedded systems Year 2000 compliant. Management has identified
certain phases necessary to become Year 2000 compliant and has established an
estimated timetable for completion of those phases, as shown in the table on the
following page:
25
26
The Task Force has completed the Inventory System Phase for computerized IT
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 IT 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 accounting software has a compliant version of
its product, but growth in the Company's operations is expected to require a
general ledger system with scope and functionality that is not present in either
the system currently in use or the Year 2000 compliant version of that system.
Accordingly, the Company is replacing the current general ledger system with an
enhanced system that, in addition to increased functionality, is Year 2000
compliant. The new general ledger system has been selected and is expected to be
implemented by the third quarter of 1999. The Company is not treating the cost
of this new system as a Year 2000 expense because the implementation date has
not been accelerated due to Year 2000 compliance concerns. 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 Task Force has also completed the Inventory System Phase of the Company's
Non-IT Systems (e.g., security, heating and cooling, fire and elevator systems)
at each community that may not be Year 2000 compliant, and has identified areas
of risks for non-compliance by community type. The high-rises, mid-rises and
newer garden communities represent the greatest risk of non-compliant systems as
they have the most systems per community. The Task Force is currently conducting
an assessment of these systems at all communities to identify and evaluate the
changes and modifications necessary to make these systems compliant for Year
2000 processing. The Company's Task Force is currently in the process of
contacting all system vendors to obtain information regarding the system's Year
2000 compliance, and this process is expected to be completed by December 15,
1998. Upon receipt of the vendors' responses, the Task Force will prioritize the
non-compliant systems, if any, and proceed according to the phases described
above. No assurance, however, can be given that the responses received will
identify all non-compliant systems.
Upon completion of each of the above described upgrades and replacements of the
Company's IT and Non-IT Systems, the Company will commence testing to ensure
Year 2000 compliance. The Company currently expects its testing to be completed
during the third quarter of 1999. While the Company anticipates such tests will
be successful in all material respects, the Task Force intends to closely
monitor the Company's Year 2000 compliance and will develop contingency plans by
January 31, 1999, and continue to review both compliance and contingency plans,
in the event certain systems are not compliant on time.
The Company continues to evaluate the estimated costs associated with these
compliance efforts and, therefore, the total cost of bringing all Non-IT Systems
into Year 2000 compliance has not been determined. Management anticipates that
the costs of becoming Year 2000 compliant for all impacted Non-IT Systems will
be reasonably measurable upon completion of the Prioritize and Budget Phase,
currently scheduled to be completed by January 31, 1998. 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 all the Company's Non-IT Systems will be
Year 2000 compliant by December 31, 1999 or that the Company will not incur
significant costs pursuing Year 2000 compliance for Non-IT Systems.
The third parties with which the Company has material relationships include the
Company's utility providers and the vendor that will provide the Company's new
accounting software system. The Company is communicating with these, and other,
third party providers and vendors with which it does business to determine the
efforts being made on their part for compliance. The Company is currently
requesting compliance certificates from all third parties that have an impact on
the Company's operations,
27
but no assurance can be given that such certifications will be received by the
Company or that they will prove to be accurate. As described above, the Company
expects that its accounting software will be Year 2000 compliant.
The Company is not aware of third parties other than its residents to which it
could have potential material liabilities should its IT or Non-IT Systems be
non-compliant on January 1, 2000. The inability of the Company to achieve Year
2000 compliance on its Non-IT Systems by January 1, 2000 may cause disruption in
services that could potentially lead to declining occupancy rates, rental
concessions, or higher operating expenses, and other material adverse effects,
which are not quantifiable at this time. These disruptions may include, but are
not limited to, disabled fire control systems, lighting controls, utilities,
telephone and elevator operations.
Currently, the Company has not delayed any information technology or
non-information technology projects due to the Year 2000 compliance efforts.
However, the Company can neither provide assurance that future delays in such
projects will not occur as a result of Year 2000 compliance efforts, nor
anticipate the effects of such delays on the Company's operations.
The Company has not yet begun development of contingency plans for use in the
event certain systems are not compliant on time. However, as previously shown,
the Company does intend to develop contingency plans, and the development of
such plans are scheduled to be completed by January 31, 1999.
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 West Coast communities that the Company owned at that
time and for each of the five West Coast 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 West Coast 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
28
materially and adversely affect the business of the Company and its financial
condition and results of operations.
DEVELOPMENT COMMUNITIES
Currently 16 Development Communities are under construction. The total
capitalized cost of these Development Communities, when completed, is expected
to be approximately $694.7 million. There can be no assurance that the Company
will complete the Development 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 developments will
realize comparable returns.
The following page presents a summary of Development Communities:
29
AVALONBAY COMMUNITIES, INC.
DEVELOPMENT COMMUNITIES SUMMARY
(1) 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. EBITDA is
relevant to an understanding of the economics of the Company because it
indicates cash flow available from Company operations to service fixed
obligations. EBITDA should not be considered as an alternative to operating
income, as determined in accordance with GAAP, as an indicator of the
Company's operating performance, or to cash flows from operating activities
(as determined in accordance with GAAP) as a measure of liquidity. EBITDA as
disclosed by other REITs may not be comparable to the Company's calculation
of EBITDA.
(4) Represents a combined yield for Avalon Valley and Avalon Lake.
(5) Financed with tax-exempt bonds.
30
REDEVELOPMENT COMMUNITIES
There are 13 Redevelopment Communities. The total capitalized cost of these
Redevelopment Communities, when completed, is expected to be approximately
$462.5 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:
31
AVALONBAY 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) 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.
(5) Formerly named "The Park."
(6) Formerly named "Westwood Club."
(7) Formerly named "Mission Bay."
32
DEVELOPMENT RIGHTS
The Company is considering the development of 23 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 6,377 institutional-quality apartment homes
to the Company's portfolio. At September 30, 1998, the cumulative capitalized
costs incurred in pursuit of the 23 Development Rights was approximately $35.5
million. Many of these apartment homes will offer features like those offered by
the communities currently owned by the Company. The 23 Development Rights that
the Company is currently pursuing are summarized on the following table.
33
AVALONBAY 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.
34
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
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 for the three
months ended September 30, 1998 and 1997 totaled $4,847,000 and $2,009,000,
respectively, and for the nine months ended September 30, 1998 and 1997 totaled
$11,372,000 and $4,430,000, respectively.
35
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings
The Company is involved in certain ordinary routine litigation
incidental to the conduct of its business. While the outcome
of such litigation cannot be predicted with certainty,
management does not expect any current litigation to have a
material effect on the business or financial condition of the
Company.
ITEM 2. Changes in Securities
None
ITEM 3. Defaults Upon Senior Securities
None
ITEM 4. Submission of Matters to a Vote of Security Holders
None
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
(Incorporated by reference to Exhibit 3(i).1 to Form 10-Q of
the Company for the quarter ended June 30, 1998).
3(i).2 Articles of Amendment, dated as of October 2, 1998
(Incorporated by reference to Exhibit 3.1(ii) to Form 8-K of
the Company filed on October 6, 1998).
3(i).3 Articles Supplementary, dated as of October 13, 1998, relating
to the 8.70% Series H Cumulative Redeemable Preferred Stock
(Incorporated by reference to Exhibit 1 to Form 8-A of the
Company filed October 14, 1998).
3(ii).1 Bylaws of the Company, as amended and restated, on July 24,
1998 (Incorporated by reference to Exhibit 3(ii).1 to
Form 10-Q of the Company).
4.1 Indenture, dated as of January 16, 1998, between the Company
and State Street Bank and Trust Company, as Trustee
(Incorporated by reference to Exhibit 4.1 to Form 8-K of the
Company filed on January 21, 1998).
4.2 First Supplemental Indenture, dated as of January 20, 1998,
between the Company and the Trustee (Incorporated by reference
to Exhibit 4.2 to Form 8-K of the Company filed on January 21,
1998).
4.3 Second Supplemental Indenture, dated as of July 7, 1998,
between the Company and the Trustee (Incorporated by reference
to Exhibit 4.2 to Form 8-K of the Company filed on July 9,
1998).
4.4 The Company's 6.50% Senior Note due 2003 (Incorporated by
reference to Exhibit 4.3 to Form 8-K of the Company filed on
July 9, 1998).
36
4.5 The Company's 6.80% Senior Note due 2006 (Incorporated by
reference to Exhibit 4.4 to Form 8-K of the Company filed on
July 9, 1998).
10.1 1994 Stock Incentive Plan, as amended and restated on April
13, 1998 and subsequently amended on July 24, 1998.
12.1 Statements re: Computation of ratios.
27.1 Financial Data Schedule.
(b) Reports on Form 8-K
1. Form 8-K of the Company, filed July 9, 1998, announcing the completion
of an underwritten public offering of the Company's Senior Notes.
2. Form 8-K of the Company, filed August 5, 1998, relating to the
Company's acquisition of the Prudential Center Apartments on July 16, 1998.
37
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
AVALONBAY COMMUNITIES, INC.
Date: November 16, 1998 /s/ Richard L. Michaux
-------------------------------------
Richard L. Michaux
Chief Executive Officer and Director
Date: November 16, 1998 /s/ Thomas J. Sargeant
-------------------------------------
Thomas J. Sargeant
Chief Financial Officer and Treasurer
38