AvalonBay Communities, Inc. (AVB) Q1 2021 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the AvalonBay Communities First Quarter 2021 Earnings Conference Call. . Your host for today's conference call is Mr. Jason Reilley, Vice President of Investor Relations. Mr. Reilley, you may begin your conference.

Okay, great. Thanks, Jason, and welcome to our Q1 call. With me today are Ben Schall, Kevin O'Shea, Matt Birenbaum and Sean Breslin. Ben, Sean and I will provide comments on the slides that we posted last night, and all of us will be available for Q&A afterward. For our prepared comments today, I'll start by providing an overview of Q1 results. Sean will elaborate on operating trends in the portfolio. Our fundamentals have improved materially since beginning of the year, and we'll also review our Q2 outlook. And then Ben will provide some thoughts as to why we believe we are positioned for outsized growth as the recovery and expansion take hold. Now let's turn to results for the quarter, starting on Slide 4. In terms of operating results, it was another tough quarter. Core FFO growth was down by over 18% in Q1. Same-store revenue declined by 9.1% on a year-over-year basis. Given the timing of the pandemic, which began towards the end of Q1 '20, this past quarter will be the toughest year-over-year comp we'll face this year. On a sequential basis, the decline in same-store revenue leveled off at 1.5% from Q4, which compares to a sequential decline of 1.6% in Q4 of '20. And Sean will touch more on the sequential trends in his comments. And then lastly, we completed almost $600 million of development in Q1 at a projected initial yield of 5.6%, well above prevailing cap rates we're seeing in the transaction markets, where cap rates are drifting down to or below 4%. Given the improvement we've seen in fundamentals, we're ramping up the development pipeline and expect to start $650 million this quarter in Q2, with much of that to be match funded with expected dispositions of approximately $500 million in the second quarter.

All right. Thanks, Tim. Moving to Slide 9. We've seen an acceleration in the trends we spoke about on our last call with physical occupancy continuing to increase during the quarter, now approaching 96%, and average move-in rent value growing steadily over the last 4 months. For April, our month-to-date average move-in rent is roughly 5% above what we experienced in January of this year and approximately 8% below the pre-COVID peak rent we achieved in March of 2020.

Thank you, Sean. Supported by this backdrop of improving operating fundamentals, we believe that we are well positioned to generate outsized growth as the economy recharges. As we look to the composition of our existing portfolio, each of the subsegments highlighted on Slide 15 have been impacted in varying degrees during the pandemic, and each have their distinct growth opportunities as we look forward. Our largest segment at 40% of revenue is in what we've called out as other suburban to differentiate it from more densely populated job center suburban markets. This 40% of our portfolio was the least impacted by the pandemic, and our current asking -- our current average asking rent is 6% above the pre-pandemic peak rent we achieved in March of last year. We continue to push asking rents in these submarkets, and concessions have largely been eliminated. Our next largest segment at 28% of the portfolio represents communities and job center suburban markets, including our transit-oriented development. This is like Redmond, Washington; Tysons Corner in Virginia; and Assembly Row in Massachusetts. Operating fundamentals in many of these suburban locations have been more significantly impacted with asking rents still 3% to 4% below pre-pandemic levels and with the continued use of concessions in certain markets. Our expectation is that as people increasingly return to the office and nearby restaurants and as other amenities start to reopen more fully, we will increasingly see prospects that seek out these environments for walkability, ease of transportation and the array of services provided. For our communities and urban environments, we have a mix of core urban, effectively central business districts, and secondary urban, locations like Jersey City, New Jersey; and the Rosslyn-Ballston Corridor in Northern Virginia, which make up 19% and 13% of our portfolio, respectively. As Sean noted, occupancy in our urban portfolio has climbed more than 500 basis points, and rents are trending upward in pretty much all of the urban environments. And this has occurred with urban office usage still at very low levels of less than 20%. As a return to offices starts to gain real momentum this summer and leading up to Labor Day, we do expect a significant rebound in our urban portfolio as in prior cycles. This is a theme that we expect to be true across much of our portfolio. And as shown on Chart 1 of Slide 16, Class A communities, which represent approximately 70% of our portfolio, have historically outperformed early in cycles. We expect similar trends in this recovery, particularly as the traditional higher-income AVB resident is poised to benefit financially as the economy heats up. And while our residents stand to benefit from the recovery, it is also becoming more challenging for those interested in buying a home to afford one, given the acceleration in home prices in many of our coastal markets. Chart 2 on Slide 16 shows this long-term affordability trend and the growing attractiveness of renting versus owning a home in our markets.

Great. Thanks, Ben. And just turning to the last slide and to summarize some key points for the quarter, Slide 20. Q1 was a challenging quarter in terms of results. But as I mentioned before, it is expected to be the toughest year-over-year revenue comp we see this year. In addition, the recovery in fundamentals is taking hold in our markets as Sean discussed. And many suburban submarkets are now at or above pre-COVID levels, while the early improvement we're seeing in urban submarkets should gain strength midyear and into the fall as workers return back to the office. And lastly, as Ben mentioned in his remarks, we believe we are very well positioned over the next few years due to a number of factors, including our coastal market footprint, a portfolio that is heavily concentrated in urban and job center urban -- job center infill urban -- infill suburban markets, excuse me, the rising cost of homeownership, healthy performance and a ramp in our development pipeline, margin improvement in our stabilized portfolio due to innovation in the operating model and then lastly, a leadership position in ESG, where the investment we've made over the last several years is paying off in terms of OpEx savings and stakeholder engagement. So with that, operator, Anna, we'd be happy to open the call for questions.

. And we'll now take a question from Nick Joseph with Citi.

Maybe just starting off with guidance. I was wondering if you can talk through the decision to not issue full year guidance at this point. Just given that we already have 1Q results and the operating trends that you've walked through, what held back that decision to institute 2021 guidance?

Nick, this is Kevin. Yes. I mean as we've indicated before, providing quarterly guidance, which is what we've done this week -- this quarter, is consistent with how we have been managing the business as we move through a pretty dynamic environment and in an uncertain period of time. But given the stability and the growth that we're seeing in April and as we head into May, as Sean pointed out, we do expect to be able to provide guidance for the balance of the year in connection with our second quarter call after we've had a chance to complete our customary midyear reforecast, which is a lot more fulsome than the Q1 reforecast process that we do for this call.

That's helpful. And then for the $650 million of starts this quarter, what's the expected initial yield on those? And then is that on in-place rents or trended rents?

Nick, it's Matt. Yes, those deals, the yield is kind of very consistent with where our current development under way is. It's kind of high 5s, and that's pretty much in every case. When we quote yields, we're quoting based on today's rents, today's cost. We don't trend it. So -- and in fact, on our development attachment, we don't mark those rents to current market until we get at least about 20% leased. So that's why we see most of the rents in the attachment are still what we were carrying when we started the job. So my guess is, given where we are today and given the ones we haven't started at today's market, there's probably a pretty good chance that we'll exceed the underwriting on those by the time they stabilize.

We'll take our next question from Rich Hightower with Evercore.

I think Nick took two of my questions, so let me fire a different one at you. But just to follow up on the development question. We could -- we probably said the same thing for the last 5 or 10 years, but market cap rates can't go any lower than they are. And so if -- tell us how you think about the possibility of market cap rates expanding from here and perhaps that yield differential narrowing as you think about that high 5s development yield target? How much cushion do you sort of bake into the way you think about that?

Rich, Tim here. I mean as Kevin has mentioned plenty of times in the past, I mean, we -- it is something we take into consideration. It informs how we think about match funding the development book. And I think we showed this quarter, it's largely matched funded, and we expect as -- if there -- if we believe that there's capital market risk, that we're going to be closer to 100% match-funded, which means, essentially, at the time we start construction is making the big capital commitment, the permanent capital has already been raised either in the form of equity, debt or dispositions.

Okay. That's fine. And then just on the expense guidance, I know that we are lapping a tough comp in 2Q, and there's a little bit of detail in the slide deck on this. But maybe just break down some of the categories where you expect the biggest year-over-year growth in expenses.

Yes, Rich, this is Sean. I mean, I hate to say it, but it's pretty broad-based. I mean, if you think about what happened in Q2 last year, things really shut down. So turnover decline, we draw back to strictly essential maintenance only for our resident customers. We pulled back on marketing, given sort of the demand shock. We had talked to the hiring freeze. So if you think about all the various sort of maintenance activities, payroll, et cetera, we're expecting all of those to look more normal as compared to the depressed levels that we experienced in Q2 of 2020. So it's relatively broad-based. Most of it is on the sort of what I would call the controllable side of things, and it's a more modest increase in taxes and insurance. But all the activity kind of base costs and payroll really are coming up pretty materially on a year-over-year basis.

We'll now take a question from Rich Hill with Morgan Stanley.

I want to spend maybe a little bit more time talking about your suburban versus urban portfolio. We're right there with you on the urban portfolio and the inflections that we're seeing, and we think they're very real. But as you think about the urban portfolio, you and your peers have noted that rents are above, in many cases, pre-COVID levels. How are we supposed to think about those suburban markets going forward? Is there any chance that they begin to normalize, while urban markets are inflecting? Or do you think that there's more than sufficient demand coming from a younger generation that can support that?

Yes, Rich, Sean. I'm happy to start and anyone else can jump in. I think you said that rents in our urban portfolio are above the pre-COVID peak. That's actually not the case.

Yes, I maybe misheard. Yes.

Yes. In other words, asking rents in the urban portfolio down about 8% from the pre-COVID peak. But in the suburban portfolio, we're up a little more than 2%. And I'd say, certainly, we'll see a snapback, and we've already started to see that in the urban submarkets. But the suburbs are pretty healthy. I mean if you keep in mind the slide that Ben showed, there's still a number of these sort of job center suburban submarkets that have probably another leg to come because people have not been called back to the office. If you think of just sort of maybe even the kind of the headline FANG stock, as an example, they -- people have gotten called back to Google and Facebook and Apple and Amazon and Microsoft over at Redmond. So there's some pretty good embedded demand that should be coming back to those environments that should support the suburban portfolio. And then additionally, also as Ben pointed out, if you look at sort of the single-family side, it's a very tight market. Prices, if you go look at kind of home price inflation on a year-over-year basis, it's up kind of double digits. So the ability to exit into that product is more constrained. It's just not as available. So I think there's a number of factors when you look at the suburban portfolio that give it a fairly high tailwind. You may not see the same sort of percentage gain over the next couple of quarters as people come back to these urban environments just because it's so concentrated, but there's still some very good sort of demand tailwinds in the suburban -- for the suburban portfolio over the next quarter -- couple of quarters as well. So Tim, do you want to add on to that?

Yes. Yes, Richard, I think the other aspect to your question is just the notion that we would expect as the economy reopens and these urban markets reopen, we're going to just see convergence in performance. So there's going to be some normalization. I think Sean is right. It doesn't mean we're going to see suburban rents fall while urban rents rise because there's some -- there's still some pretty compelling supply-demand dynamics going on in the suburbs. But as I mentioned on the last call, I do think as you sort of think out, you look out over the next few years, supply, I think, in the urban markets is frankly to be quite a bit lower than what we see in the suburbs. And in some ways, you may see the relationship between urban and suburban flip this coming cycle relative to what we saw in the last cycle where urban demand was stronger, but urban demand -- urban supply have more than offset that. So the suburbs actually outperformed. You get out 3 or 4 years from now, so I think I mentioned this in the last call, 2024, '25, I would not be surprised if you see urban more than -- urban outperforming the suburban markets. When you look long term at our markets, that's one of the reasons why we've been somewhat agnostic, and we want to have a diversified portfolio. Really, the winners and losers are really kind of at the MSA level, and the performance tends to normalize over time between the urban, suburban markets. It's a dynamic market both on the demand and the supply side. But I think we are at a moment in time, obviously, right now, where urban is massively underperforming suburban. But we think we're kind of on the precipice where those lines are going to start to converge.

Yes. And the reason I focus on it is I look at your weekly asking rent chart that looks like we're back to -- pretty close to back to pre-COVID levels. But it just strikes me, given this dynamic that you're talking about, if you're looking at that one singular chart and suburban is above COVID and we're inflecting on urban, isn't there a really good chance that asking rents could completely overshoot on a weighted average basis as this recovery continues?

No. Absolutely. You think about the reopening combined with the amount of fiscal and monetary stimulus being injected in the economy, I think we could see it really much closer to a V-shape recovery than I think any of us were thinking about 3, 6 months ago. I think maybe with -- inside of a K-shape recovery because it's going to be an uneven -- I think it's likely to be an uneven recovery, still favoring the educated and knowledge-based jobs. But that one slide that Ben showed that actually broke down the portfolio into the 4 buckets is pretty telling, right? I mean you had the other suburban at 6% asking rent growth and the job center suburban a little over -- down about 3%, secondary urban down 6% and core urban down 8%. That's -- those are pretty big disparities from just a year ago, right, that, yes, as the economy reopens, we would just expect things to start leveling off a bit.

Our next question will come from John Kim with BMO Capital Markets.

You've been a very consistent seller of assets at attractive returns and economic gains over the last -- throughout your history. But right now, with cap rates compressing and 1031 on the table for potentially being repealed, do you think about expediting sales at all?

So John, your question is because 1031 may come off the table, I mean it's -- we've used 1031s, but we haven't had to use them extensively. We typically have a couple hundred million -- $200 million, $300 million sort of gains capacity in a typical year that we can absorb on the sales side. So really -- it's really a function of how much portfolio recycling we really need to do. We've been pretty aggressive about it over the last few years. And we've used the 1031s on a limited basis to help kind of manage the tax impact. But for the most part, we basically have just absorbed the gains capacity that we have embedded in our earnings.

So it's not just the 1031 but just the cap rates compressing so much, and is this a better time today to sell assets that are maybe a little bit older in your portfolio than it would be the last few years?

Yes. No, I think that's a fair point. It's something we debate when we look at asset sales, we look at equity, we look at debt. Debt is still the most compelling source of capital today for us. But asset sales are creeping closer for sure just in terms of what we're seeing, the additional compression in cap rates and asset values. And a lot of the submarkets, particularly the suburban submarkets, are actually up from pre-COVID level. So it's a fair point. It does inform some of our capital allocation decisions at the margin, for sure.

Okay. And then you've had notably stronger rental growth in April in Southeast Florida and Denver. Do you see that outperformance continuing for the rest of the year? And also, how important is it for you to either expedite your exposure in those markets or potentially enter new markets, given this validated your strategy to enter them?

Yes. John, this is Sean. I'll take the first one, and then I'll let Tim talk about sort of the expansion market strategy a bit. But the first one, one thing to recognize is that at present, those 2 expansion markets represent a very small basket of assets. So noise from one asset to another can create some volatility here. So the kind of growth that we've seen on a year-over-year basis in Q1, I would not expect that to be same level moving forward for the balance of the year. There's just some unique factors with 1 or 2 of those assets. And when you only have 3 or 4 in the basket, it can move the needle quite a bit within 1 quarter. So I wouldn't count on that as sort of the run rate for the balance of the year.

Yes. John, this is Matt. I guess to the second question about kind of what our appetite is, I mean we said we are looking to grow both of those markets to be roughly at least 5% of our portfolio. And so I think right now, including nonsame-store, they're probably about 2% each. So we still have a ways to go. We do have starts planned in both of those regions in the next quarter or 2. So we are continuing to move forward with development there. We have additional pipeline starts that are probably '22 starts in each of those regions, and we're out looking for more. And we're actively pursuing acquisitions in both of those markets as well. And we'll continue to do what we've done in the past, which is we find acquisitions, rotate capital out of some of our legacy markets to fund that. As it relates to other markets beyond those, I mean, I think we've said before that we are looking at other markets. We don't have anything to announce at this time. But we are looking for markets that are going to be over-indexed to the knowledge economy and over-indexed to kind of the higher-income jobs, the higher education jobs, which we think will drive outsized performance for our portfolio. And we do think Denver and Florida are 2 of those markets, and there are others as well that probably fit that description over time.

Your next question will be from Rich Anderson with SMBC.

So I heard you sort of adjusting maybe at the margin some of the product that you're planning to deliver. You mentioned townhomes and direct-entry-type product. And I'm curious if a hybrid office environment is sort of the first landing point for the office business, is that actually a good thing for multifamily in your property, in particular? Because they need to be close to the office, but they're also going to spend more time at home, so more attention spent on having usable space where they live, too. Do you kind of see hybrid office is a good thing for your business?

Rich, I think, as I mentioned before, kind of agnostic between urban and suburban and that we're generally looking at where we think there's -- we're going to tilt towards where we think there's more -- there's better value. And I think it argues that there's just -- that suburban household formation should be a little stronger this cycle than last cycle as people don't have to commute as many days. And it just ought to spread the workforce out within an MSA and maybe across broader geography as well as people -- there'll be some folks who could be able to telecommute 100% of the time. But for those that are more in a hybrid situation, absolutely. We think there's going to be some people at the margin that are going to be willing to live 10, 15 miles further out than they otherwise would because they only have to be in the office 2 or 3 days a week versus 5 days a week. And we're in a position to capture them in either case. So...

Right, right. And the second question is, any other sort of post-pandemic changes that you're seeing in terms of how the business -- the cadence of the business? Is there any silver lines such as perhaps more likelihood to live alone, that kind of thing? Are you seeing anything like that? Or is it just too soon to tell at this point?

Yes. Rich, it's Sean. I'd say it's probably a little too early to tell. I think when we get up to the sort of other side of the pandemic, things stabilize, we'll have a better sense of has resident profile really changed in terms of suburban or urban assets. And as we continue to communicate with our residents, maybe kind of touching on the last question that you had, that may inform our product choices in some of those suburban markets in terms of some of the larger floor plans, what we provide in the way of workspace or work lounges in the building and program in more townhomes in some cases or things like that. It's probably just a little too early to peg that just yet.

We will now take a question from John Pawlowski with Green Street.

Matt, curious if you can give us some sense of the compression in development yields, not on starts that you're about -- or projects you're about to start, but if these construction cost pressures prove more persistent a year from now, what kind of development yield compression will we be looking at?

I wish I knew, John. I do think that cost pressures are definitely rising. But on the other hand, there's also the numerator, right? And we're underwriting deals still with rents that are, for the most part, less than maybe they were in the prior peak because a lot of our suburban development is job center suburban. Maybe in some of the other suburban category from Ben's slide, maybe some of that rents are higher than the prior peak in terms of what we're underwriting. So I do think there's still some list to come on the numerator. And I guess what I would say is on the denominator, what we've seen so far, the deals that we're lining up now in many cases, our total capital cost for those deals isn't any higher than it was a year ago. Maybe it's higher than it was 6 months ago as lumber has come up some, but there were some other trades costs which came down a little bit. Soft costs may have softened a bit. So certainly, there's going to be some cost pressures going forward. And we're mindful of that. If anything, the margin right now is wider than it was on deals we started a year or 2 ago just because of what's happened to asset values and cap rates on the other side. So there's probably a little bit of room there.

Yes. John, I guess I'd say, I think the market, if I had a guess, would be betting on NOIs outpacing total development costs over the next 12 months. There's clearly some inflation pressures because of supply chain issues, I think, as your question implies, and a real question in how transitory versus sort of permanent those cost pressures will be. But there's some pretty good pressures building on the rent side, too. And so I think that's -- I know you all have written a lot about the supply side and sort of stay in sort of stubbornly in that 350,000 to 400,000 range. I expect it's going to continue because I think as people are looking at economics, and the people that do trends, things are probably looking better today than they were maybe even a year ago.

Okay. That makes sense. Understood. Last one for me. Sean, in markets where you've had to pull the concession lever harder, as we anniversary the vintage and leases signed with concession, do you expect occupancy to decline in the next few months due to just lower retention?

Yes. No, good question, John. I mean, I think it speaks to sort of the, I guess, you want to call it sort of the durability of the customers that have allowed us to build occupancy. I mean we'll see. The -- I mean if you look at sort of our portfolio income levels for our residents are down about 6% on a year-over-year basis. So there's -- based on what we've seen, I'd say there's some embedded capacity there to pay. Whether people want to pay or not will be a question that we'll have to come across here. So I mean, in Q1, we started to see pretty good lift. Turnover was up but not for really financial reasons, just for other reasons in terms of people wanting to move for whether it's roommate situations or all the other sort of typical stuff. So it doesn't seem to be, based on what we're realizing from our customers today, much in the way of financial pressure. As we move through the second and third quarter, particularly in the urban environments, we'll have a much better sense for that. So could there be a little bit of pressure there? Yes. I mean the other thing that I think we're going to see is right now, Tim talked about the bad debt kind of lapping the bad debt side of it. At some point, as we get it on the other side of the eviction moratoria, some of that bad debt is going to convert to just physical vacancy. So you'll see a little bit of that start to trickle in, in the back half of the year, just depending on what happens in the overall regulatory environment. So maybe a little noisy in terms of physical occupancy as it relates to that one issue alone in a couple of markets, particularly places like L.A., as an example.

We'll now take a question from Austin Wurschmidt with KeyBanc.

Just a question on development, given the positive outlook that you have in your markets and some of the benefits you spoke to from the stimulus entering the system, how are you guys thinking about just sizing up the development pipeline overall in the next couple of years?

Yes. I can start, and maybe Ben or Matt wants to jump in. As Ben had mentioned, we are kind of up in our outlook here of -- to over $1 billion this year. And as we've talked about sort of years past, middle of last cycle, development pipeline was probably about $1.4 billion, $1.5 billion in terms of kind of how it was scaled. And we kind of rescaled it as we got into later part of the cycle in a downturn to something that's more in the $800 million to $900 million range. We think we can flex that up pretty easily to $1.2 billion without too much trouble and probably to $1.5 billion. So I think kind of -- those are the kind of ranges we're looking at right now, absent potentially entering some new markets and expanding the footprint.

Got it. And then as far as some of the initiatives you guys outlined, the $10 million from some of the things you've already deployed on the technology side and then you outlined another $25 million to $30 million, what's the total investment that goes into generating that incremental NOI?

Yes, Austin, good question. So the way I'd lay it out for you is that the technology initiatives around the digital platform, the AI that Ben described and things like that, that will be roughly around $30 million. And then beyond that, the smart access and smart home component is the piece that's up in air. It's a little bit of a TBD based on customer adoption, what they're willing to pay, what features they want. Is it just the smart access component for guests? Or is it more along the lines of thermostat control, lighting, various sort of things. So that's a little bit of a TBD on the investment. But the foundational elements to have the infrastructure, the digital platforms and all that is around $30 million.

Our next question will be from Brad Heffern with RBC Capital Markets.

Just circling back to the development question. I'm curious, last cycle and typically at the beginning of a cycle, you've seen a big trough in supply. And that's part of the reason that you ramp development at the beginning of the cycle. Certainly, we haven't seen as much of that this time around. So I'm curious, does that moderate your expectations as to how big the program could go versus how large it got in kind of 2013, '14, '15, that time frame?

Yes. It became awfully profitable, right, last cycle, particularly for the first 3 years. It's -- we're developing a value creation margins that we hadn't seen really before, probably in the 40%, 45% range in some cases. So I think the range I talked about is right, the kind of the $1 billion to $1.5 billion range. It's probably a little less as it relates to enterprise value to maybe what you're driving at. But no, I think it's about $1 billion, $1.5 billion seems about right just in terms of the opportunity set within our markets and kind of where the platform has scaled and what the balance sheet can kind of handle without sort of over-relying on the equity markets being continuously open.

Okay. Got it. And then you touched on bad debt a little bit, but I was just curious, it's hung out in the 3% range for several quarters now. Has there been any movement on that in April? And have you seen any impact from the federal funds at this point?

Yes, Brad. This is Sean. Happy to chat about that, and then Kevin could jump in if he'd like. But yes, I mean, I think, for us, we're not expecting a meaningful shift in bad debt until we get beyond kind of the moratoria that's in place today, which is likely in the second half of the year. There's a number of orders that are right now set to expire in June, I think June 30. Some may be extended. Some may not. It's a little too early to tell. So we're not seeing a lot of movement right now sort of month-to-month in terms of a significant shift one way or another in bad debt. I suspect as customers see the light at the end of the tunnel in terms of the eviction option becoming available to us, we're going to see some greater movement. And then on the stimulus side, yes, we're heavily involved in that. In some places, we can apply sort of in bulk on behalf of our customers. In other locations, we prompt them with e-mails where they have to sign up, and then we ultimately receive the fund. So we receive some funds, but I would tell you, it's been very slow and it's been sort of trickling as opposed to a big avalanche of funds So I just don't think the agencies that are within these states and counties are set up to administer the funds. They just weren't set up for that. And therefore, it's taken quite a bit of time for them to figure out how to develop a process to make it work at resident certifications, how do we get the funds to the landlord, to validate it's the right owner, all that kind of stuff. It's just been painfully slow.

We'll now take a question from Alexander Goldfarb with Piper Sandler.

Just going back to the development, I saw that you guys -- the yields on the stuff that you have in the pipeline now are only 20 basis points lower. But just help me walk through. I mean 2x4 lumber, I mean anything mechanical, anything involving construction or -- is just through the roof. I mean double-digit increases, substantial increases. Rents haven't kept pace. I understand the wider margin given the cap rate compression. So just help me understand why development yields really seem unaffected, given that rents are softer, construction costs are through the roof, labor is still a challenge. What's the offset? Just help me understand.

Alex, it's Matt. So on the stuff that's currently under way, that's all bought out. So that part is...

That part, I get. That part, I get.

Yes. In some cases, there are actually savings there because there was some sense that there was pretty strong momentum in construction cost inflation in many of our markets pre-pandemic. So a lot of it has to do with what Tim was saying, is it going to be kind of transitory based on supply chain bottlenecks or not. But I think there's a little bit of an underappreciation about how our cost breakdown actually works. I mean if you think of a typical development deal and you say, for every dollar that's in a total development budget, $0.15 to $0.20 is land. So that -- and everything that's in our pipeline, for the most part, is land that we contracted before the pandemic. In some cases, there was an opportunity to recut some of those land deals in some situations based on the slowdown we saw last year. Then you probably have anywhere from $0.15 to $0.20 that is soft cost, whether that's architectural engineering fees, permits, capitalized interest, which has come down. So there's a little bit of an offset there. And then you have maybe $0.60 to $0.65 that's the actual hard cost. And then when you drill down on that piece, probably 2/3 of that is labor, and 1/3 of that is materials. And actually, even on the materials, when you peel it back further, a lot of those materials, it's not an appliance that you're buying. It's a roof truss, which is lumber, but it's also labor to put the roof truss together. So probably the key is the pressure on labor cost. That's what would really move the equation more. I mean we can see lumbers double, then it probably increases the total capital budget of a job by 3%, for example, 2% or 3%, which is something. But probably, that's the thing I would keep an eye on would be labor cost because if that starts to really move, that would start to .

Yes. And Alex, maybe explaining this real quick. I think in reality, we underwrite on a current basis, as Matt mentioned before, current cost, current rents, current OpEx. I think in reality, the yields have deteriorated a little bit. So the deals that Matt talked about were going to start in the high 5s. When we first put those in a contract, went through due diligence, they're probably low 6s in reality. So if you think about it over the last 2 years, rents, maybe they're flattish overall, particularly in the suburban markets, given that's where the focus of the development pipeline is. And costs are up, the denominator is up a little bit. And so I think you probably have seen some deterioration of -- I don't know where to bracket, but somewhere between 25 and 50 basis points of yield erosion. But you've seen cap rate compression that more or less offset that.

Okay. That's helpful. And then the second question, as you guys think about the new markets that you want to enter, there's obviously a cost and efficiency, critical mass, get a platform. How do you guys weigh straight-up acquisitions? I'm not saying that you guys go out and sort of bulk purchase a bunch of communities. But how do you weigh pushing on just buying some existing deals even if the yields are a little skinnier than you'd want versus using your development partnership with like local landowners to get better yields, but understanding that it's going to take a longer time to establish that critical mass as you enter new markets. How do you balance those two?

Alex, this is Matt. I mean, basically, what we've been taking the approach is all of the above. So we're looking to buy existing assets. What we found in the expansion market so far has been it's been an opportunity to buy, in general, brand-new or very young assets and not necessarily pay a premium on a cap rate basis versus older assets. So that's where we've tended to buy so far just because of relative value. But ultimately, we'd like to own some older communities in those regions as well just for price point diversification. So we're looking to buy. We're looking to build. And we're also looking to capitalize third-party developers, which we've done successfully. In fact, the deal we just completed last quarter in Doral in the Miami area was a partnership with a local merchant builder there, where we funded it. And we work together on the deal. So that's kind of an expansion of our model a bit that we've -- I think we're leaning on in these expansion markets. So that gives us another way we can get capital into these markets and grow our portfolio more quickly. So I don't think we view it as an either/or. We view it as an all of the above.

Yes. And Alex, the only other thing I would add to that, it also gives us an opportunity to allocate capital over a period of time because they don't -- they're not all on the same time horizon, right? So you buy assets today, if you're funding a third-party developer that may be capital that goes out over the next 1 to 3 years. If you're developing for your own account where you're having to go through the entitlement process yourself, that's maybe more of a 3- to 5-year time horizon. So it allows us to diversify across time as well as sort of buy product in a market.

And we'll now take our next question from Alua Askarbek with Bank of America.

I'll just be really quick. I want to ask a little bit more about Park Loggia. So it seems like you guys had some good traction on the commercial leasing this quarter. Can you tell us who the tenants are and what box sizes are left that you guys have to lease? And then I think a while ago, you guys mentioned that it would be about $10 million in NOI annually once it's stabilized. Are you still on track for that?

Sure. This is Matt. I -- just to give you an update on the retail, as we mentioned in the earnings release, we did lease the remainder of the second space -- second-floor space last quarter. So we're now about 87% leased on the retail, and these are about 8,500 square feet remaining on the ground floor with Broadway bunch. And our sense is for that remaining space, we're going to be patient to find -- wait for kind of activity to restart in New York, which hopefully, we'll start to see pick up in a more meaningful way in the next couple of quarters. That is high dollar space. But the second-floor space that we leased was leased to a medical user. So on the second floor, we have them. We have Fidelity, which is open and operating with a financial services office. And on the ground floor, we have spectrum for a small portion of the ground floor. We have Target with their entrance, and then they have below-grade space there. And then we have kind of the remaining available space on the ground floor. So we'll see where it settles out in terms of long term, does it generate the amount of NOI that we had talked about before. Obviously, street retail in New York is softer than it was, but a lot of it is going to depend on what we wind up getting for that remaining ground floor space.

. We'll now take a question from Brent Dilts with UBS.

Given the return to office is expected to extend through the fall, how do you think that might impact the usual seasonal leasing trends as this year plays out?

Yes. Brent, it's Sean. Good question. Not sure we know the answer just yet in terms of how it's going to play out other than I would say, based on the data that we're seeing from prospects and new leases in certain markets, we are seeing some people come back to some of these urban environments from more distant locations than normal. So like in New York City in the past quarter, when you look at the distribution of the leases that we signed and where they came from, more people from locations that are, let's just say, greater than 50 miles away. So we're starting to see some percentage come back. How it plays out, it's hard to tell. Obviously, as companies further announce what's happening with their return-to-office dates and the trend for universities in terms of on-campus learning in the fall has been pretty positive so far, I think, for our business, where most universities are planning for full on-campus learning, which should be a benefit to these major urban markets for their universities. And even if we -- as Ben pointed out, office occupancy is less than 20%. So it doesn't take a lot to start to move the needle. Even if we get to 50%, 60%, 70% of what it was previously, that's a pretty good movement from where we are today. So I think it's going to be a pretty positive trend between now and Labor Day. It's hard to say exactly how it's going to play out in terms of getting back to what we would think of as sort of pre-pandemic normal levels, and we really won't know that until we get past Labor Day.

Yes. Makes sense. Okay. And then just one other. On new leases in urban markets, what trends are you seeing in terms of demand by unit type or price point?

Yes. The only thing I'd say is in the urban pockets that we're still seeing some difficulty with studio units in terms of single households. So if you look at overall occupancy, they're trailing the portfolio average a couple of hundred basis points. It's most acute in the places you would expect, New York City, DC, San Francisco, urban Boston, places like that. That's really the difference we're seeing in terms of sort of bedroom type at this point in time. There's just not as much demand for single occupancy yet.

We'll now move to Dennis McGill with Zelman & Associates.

First question just goes back to the margin potential from some of the technology investments. How should we think about the baseline for that 200 basis point improvement. If we look pre-COVID kind of in the 71%, 72% range, that sort of more peakish cycle how would you think about maybe a normalized margin? And then what this savings would do on top of that?

Yes. No. Good question, Dennis. And what we look at is kind of our stabilized base years, what we call it. And so for the most part, it's kind of a blend. But if you use 2019 as kind of a proxy for controllable NOI margins, excluding taxes and insurance. That's how we think of where the base year is. And the movement from there, obviously, things have distorted during the pandemic, given what's happened, but that would be kind of the way we're looking at it at least.

So essentially just controlling for property taxes versus pre-COVID?

Exactly. With insurance, yes, which pushes those margins. If you look at it carefully and go back there, for example, like '18, '19, those extra margins, excluding that, we're kind of in the 80% range, 80%-plus, if you map out each one in terms of what you've got up there in terms of '18 and '19, but '19 is really kind of a base year.

Okay. That's helpful. And then this is probably tougher, but just wondering how you think about it. With the economies reopening in some of these urban environments, in particular, and you have a lot of young adults that are moving back in who were back home or doubled up in some fashion, there's probably a pent-up demand element that the markets are experiencing right now. How do you get comfort around what that next leg of demand might look like, whether there's a continuation of pent-up demand or whether there's going to be an air pocket at some point once you get through sort of satisfying that first level of pent-up demand?

Yes. Good question. I'm not sure exactly how to answer the air pocket question. I mean we certainly expect people that left these urban environments to come back, not 100%, but people come back. What percent is sort of pure speculation. That would be hard for us or anyone else to say what the number is. In terms of air pocket beyond that, it really just is a function of sort of the macroeconomy, what's happening with jobs and income growth and sort of more the normal factors that drive the business in terms of demand characteristics. On the supply side, we talked about that a little bit. We expect that to be relatively constant. Probably have a little bit of a tailwind from the single-family market, as Ben pointed out, just given the affordability issues in our legacy markets. So I think really, I would just sort of pause and look at it as what's the macro environment looks like from a demand and supply standpoint? And how does that support the business going forward once we get to the other side of the pandemic.

And it appears there are no further telephone questions. I'd like to turn the conference back over to Mr. Naughton for any additional or closing remarks.

Great. Thank you, Anna. Thanks, everyone, for being on the call today. I know it's a busy day and a busy week. We look forward to catching up with you in early June, at least virtually, I think, in NAREIT. So enjoy the rest of your day. Thanks.

And once again, that does conclude today's conference. We thank you all for your participation. You may now disconnect.