AvalonBay Communities, Inc. (AVB) Q3 2022 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to the AvalonBay Communities Third Quarter 2022 Earnings Conference Call. At this time, all participants are in a listen-only mode. Following remarks by the Company, we will conduct a question-and-answer session. [Operator Instructions] Your host for today’s conference call is Mr. Jason Reilley, Vice President of Investor Relations. Mr. Reilley, you may begin your conference.

Thank you, Doug, and welcome to AvalonBay Communities Third Quarter 2022 Earnings Conference Call. Before we begin, please note that forward-looking statements may be made during this discussion. There are a variety of risks and uncertainties associated with forward-looking statements, and actual results may differ materially. There is a discussion of these risks and uncertainties in yesterday afternoon’s press release as well as in the Company’s Form 10-K and Form 10-Q filed with the SEC. As usual, this press release does include an attachment with definitions and reconciliations of non-GAAP financial measures and other terms, which may be used in today’s discussion. The attachment is also available on our website at www.avalonbay.com/earnings, and we encourage you to refer to this information during the review of our operating results and financial performance. And with that, I will turn the call over to Ben Schall, CEO and President of AvalonBay Communities, for his remarks. Ben?

Thank you, Jason, and thank you everyone for joining us today, here with Kevin, Matt, Sean, and after our opening comments, we will open the lineup for questions. In many ways, Q3 continued our strong momentum from the first half of the year with significant year-over-year increases in our earnings and operating metrics. As referenced on slide 4 of our quarterly investor presentation, core FFO for the quarter increased 21% as compared to a year ago. Same-store revenue increased almost 12% from last year, and 2.2% sequentially compared to our strong Q2 figure. Before progressing further into the presentation, I wanted to emphasize a number of AvalonBay specific drivers of future earnings growth. First up and as Sean will describe more fully, we expect to head into 2023 with an earn-in above traditional levels. In short, just a simple roll through of our existing rent roll creates positive earnings momentum, which can then be further enhanced by our underlying loss-to-lease. There are then three other drivers of earnings growth, which we estimate should generate in the range of $200 million of incremental NOI over the next several years. The most significant of these drivers is the development projects we have underway, which we refer to as projects with yesterday’s costs and today’s rents. Our current lease-ups continue to outperform, currently yielding nearly 7%, and we expect our current development activity to deliver $130 million of incremental NOI upon stabilization, which Matt will cover further. The other two significant drivers are further margin improvement from our operating model initiatives, which we’ve targeted for $50 million of NOI uplift and expect to have delivered about 40% or $20 million of this NOI uplift to our bottom line by year-end and the return on our structured investment program as we build that book of business up to $300 million to $500 million. In a potentially recessionary environment, the $200 million of incremental earnings generated from these activities collectively serve as a ballast for our future earnings. Turning to slide 5. While our Q3 performance was strong, it was short of guidance. Q3 core FFO per share was $0.02 below guidance, and we reduced our full year core FFO per share figure by $0.07, updating our estimate of full year core FFO growth to 18.5%. For the full year, on the revenue side, while we contemplated the return of rent seasonality, the seasonal trend line has been slightly greater than historical norms. On the expense side, turnover has been slightly higher than we forecasted, leading to higher repairs and maintenance costs to turn apartments, and utility costs are projected to be higher. Slide 6 highlights how we’ve been actively adjusting our balance sheet and [Technical Difficulty] strategy during the year based on the changing capital markets environment. Based on the steps taken by Kevin and Joanne Lockridge and our Capital Markets team, our balance sheet is stronger than ever. Recently, we increased our line of credit by $500 million to $2.25 billion and extended the maturity date out to 2026. Additionally, we have an interest rate swap in place for our next $150 million of debt borrowings and our $500 million equity forward proactively addressed the bulk of development funding through the end of 2023. On the transaction front, we shifted our strategy earlier this year to a posture of selling assets first and locking in the cost of that capital before selectively deploying capital into acquisitions in our expansion markets, which given cap rate movements has worked to our benefit. As part of this shift, we also pivoted during the year from expecting to be a net buyer of approximately $275 million to being a net seller of $400 million or nearly $700 million total swing. In an environment where profit margins on new development are likely to come down and the costs associated with that incremental capital has increased, we’ve also reduced new development starts. For 2022, we reduced our starts from $1.15 billion to a projected $850 million. In 2023, while we haven’t provided guidance regarding new starts, our expected start figure is trending lower than we previously anticipated as we use the flexibility we have with our development rights pipeline to manage our land contracts and the timing of potential starts. We will continue to make adjustments based on trends in rent and construction costs, the spread between potential development yields and underlying market cap rates with a continued target of 100 to 150 basis to spread and our cost of incremental capital with a laser focus on making the appropriate long-term value-creation decisions. And with that, I’ll turn it to Sean to more fully discuss the operating environment and our approach.

All right. Thank you, Ben. Before I start, I’d like to give a big shout out to all the AvalonBay associates who are out there working hard to provide our customers with a high-quality apartment home and service experience. I’d like to thank you for your efforts with our customers and the performance you deliver for our shareholders. Moving to slide 7. Our strong Q3 revenue growth of 11.8% was primarily driven by higher lease rates, which increased 9.5% year-over-year, the reduced impact of concessions, which contributed 240 basis points and other more modest contributions from other rental revenue and underlying bad debt trends. As noted on the chart, rent relief was 140 basis-point headwind for the quarter as we recognized $5.7 million versus the $12.7 million from Q3 2021. Turning to slide 8. Same-store trends during the quarter remained quite strong relative to historical norms. Starting with chart 1, turnover increased a little more than we anticipated as we pushed through healthy rent increases, but was still well below pre-pandemic levels. As a result of the increased turnover, physical occupancy ticked down to 96%, but remained roughly 20 basis points above our typical experience during the quarter. Additionally, as noted in the 2 charts at the bottom of the slide, while our availability increased relative to the last few quarters, we realized a double-digit rent increase on the unit inventory we leased and occupied during the quarter, a very favorable outcome that sets us up well for 2023. Moving to slide 9. I thought I’d provide an overview of some of the key revenue drivers for our portfolio as we think ahead to 2023. Beginning with chart 1, given the very strong rent change we’ve experienced this year, we’ll likely start in 2023 with built-in revenue growth of roughly 4%, the second highest level in our history, and more than 100 basis points stronger than our starting point of roughly 2.5% entering 2022. In addition to the baked-in revenue growth outlined in chart 1, our loss-to-lease is currently running at roughly 6% and is depicted in chart 2, providing plenty of opportunity to benefit from renewal rent increases as leases expire throughout 2023. Shifting to the bottom of the slide, chart 3, our collection rate from residence continues to improve. At the beginning of the year, bad debt was trending in the high 4% range but has declined by roughly 200 basis points as the years progressed. As eviction moratoria has expired and the courts are continuing to make progress processing new cases, we expect the overall downward trend to continue as we move into 2023, providing a tailwind for revenue growth. Of course, as indicated in chart 4, we’ll likely experience immaterial amounts of rent relief in 2023 as compared to the $35 million we’ve recognized in 2022, presenting a headwind for ‘23 revenue growth. Now, I’ll turn it over to Matt to address development. Matt?

Great. Thanks, Sean. Turning to slide 10. [Technical Difficulty] development communities currently in lease-up, all of which are in suburban locations that have seen very limited new supply and strong demand over the past few years. These developments are benefiting from today’s higher rents while having a basis based on yesterday’s lower construction costs, resulting in an exceptional yield on cost, as Ben mentioned earlier, of nearly 7%. As these communities reach stabilization, they will contribute strong growth to both NAV and core FFO. As shown on slide 11, the vast majority of our development NOI is still to come. The $2.6 billion in development currently underway is mostly still in the earlier stages of construction and generated only $19 million in annualized NOI this past quarter. As these assets proceed to lease-up and stabilization, we expect another $130 million in NOI, which will drive further earnings growth over the next several years. It’s also worth noting that this future growth is based on our conservative underwriting with untrended rents that are set when construction starts as we typically do not mark rents on these projects to current market levels until we’ve achieved roughly 20% lease status. And again, with only four of these assets currently at that level of leasing, the vast majority of our development underway should benefit from a further lift in NOI when they do open for business as evidenced by the $385 per month lift in rents shown on the prior slide on those four deals that are currently in lease-up. In the transaction market, we’ve also been ramping up our disposition activity in the past quarter, using the asset sales market to source attractively priced capital to fund this development. We were able to close on the sale of five wholly-owned assets in Q3, which were priced before the most recent increase in interest rates, generating $540 million of proceeds at a weighted average cap rate of 4.1% and pricing of $480,000 per home. We also completed the sale of the final assets in one of our private investment fund vehicles last quarter, generating additional capital and with pricing of $470,000 per home and a 3.6% cap rate. Since the start of the year, as best we can tell, cap rates have risen roughly 75 to 100 basis points in our established coastal regions, where we’ve been trading out of assets while cap rates in our expansion regions have risen more on the order of 100 to 150 basis points. Strong growth in NOI has offset some of this rise in cap rates. But on balance, as values might be down roughly 10% to 15% in our established regions and maybe 15% to 25% in these expansion markets, we think this bodes well for our future portfolio trading activity as the relative value of what we are selling has been less diminished than what we are buying. And with that, I’ll turn it over to Kevin to review our funding position and the balance sheet. Kevin O’Shea: Great. Thanks, Matt. Turning to slide 13, as Ben mentioned in his opening remarks, with the shift in the capital markets this year, we’ve taken a number of steps to bolster our already strong financial position. These steps include having increased our match-funding and development underway with long-term capital to approximately 95% as of the end of the third quarter, up from about 80% at the beginning of the year. As a result, we have locked in the cost of capital on nearly all of the $2.5 billion of development underway, essentially with yesterday’s lower cost of capital, which in turn will help to ensure that these projects will provide earnings and NAV growth when they are completed and stabilized. In addition, as you can see on slide 14, another step we’ve taken is the recent renewal and expansion of our line of credit $2.25 billion, which is up by $500 million from our previous $1.75 billion line of credit. As a result, we possess tremendous financial strength and flexibility. In particular, at quarter end, we enjoyed $1.9 billion in excess liquidity relative to our unfunded investment commitments of $300 million. Our leverage declined to 4.6 times net debt to EBITDA at quarter end versus 5.1 times in the fourth quarter of last year, and we remain comfortably below our target range of 5 to 6 times. Our unencumbered NOI percentage remained at a record level of strength at 95%, and our debt maturities are both relatively modest in size and well laddered with the weighted average years to maturity of just over eight years. Thus, as a consequence of our conservative approach to balance sheet management and the other actions we’ve taken recently, including the $500 million equity forward that we completed in April at a share price of $255, we possess tremendous financial flexibility and do not need to tap the capital markets to fund our business for an extended period of time. Finally, on slide 15, as you’re aware, AvalonBay has long maintained a commitment to being a leader in sustainability and corporate responsibility. It’s a goal that is consistent with our culture and our core values of integrity, spirit of carrying a continuous improvement, and it is of increasing [Technical Difficulty] to our residents, to our associates and to our investors. On slide 15, we are excited to report that we received our highest score yet from the Global Real Estate Sustainability Benchmark, or GRESB. This year, we earned the 5-star designation for the eighth year in a row. We also earned the number one spot among the 11 listed multifamily residential companies and the number one spot among the 37 listed residential companies. We are grateful for GRESB for acknowledging our progress in this important area, and we are especially grateful to our own people for their efforts in making these achievements possible and for their ongoing commitment to making a positive difference in the lives of our residents and the communities in which we operate. And with that, I’ll turn it back to Ben.

Thanks, Kevin. And quickly to summarize, we’re pleased with our continued strong earnings and operating momentum with a number of AvalonBay specific earnings drivers in front of us. In this environment, we have and will continue to adjust our approaches to strengthen our position and to allow us to keep our focus on long-term value creation. We’re confident that we are well positioned for a broad range of potential economic paths and to potentially step into opportunities based on dislocations in the marketplace. And I’ll end by reiterating our thanks to the wider AvalonBay associate base for their commitments to our ESG leadership and their broader dedication to our mission of creating a better way to live. With that, I’ll turn it to the operator to open the line for questions.

[Operator Instructions] Our first question comes from the line of Nick Joseph with Citi.

Thank you. So, I understand the seasonality returning this year, but a bit surprised that impacted 3Q as much as it did. I was hoping you could provide some more details on when it really started to diverge versus your expectations? And then if there are any specific markets that drove it?

Yes. Nick, it’s Sean. Happy to address that. And you are correct that more of the impact is being felt is our expectation in Q4 as compared to Q3 if you look at the road map that we have provided. But for the most part, when we did our [Technical Difficulty] forecast, we expected and I communicated on the last call that seasonality would return, but our expectation based on what we have seen thus far is it would be about half the normal rate that we typically see. And we started to see that begin to shift in August, kind of late August for us. It impacted sort of late August and moving into September and then continues to bleed into the fourth quarter. So, that’s really how it played out. I mean, if you look at the rent change that we expected, July was pretty much spot on what we expected. But then, as you move through the balance of the last couple of months here, it has decelerated from what we anticipated, mainly on the move-in side. Renewals have held up relatively well. But on the move-in side it’s decelerated, which corresponds with the adjustment in asking rents as you move through the season. So, that’s how that played out. And in terms of markets, for the most part, there’s really about three regions that are responsible for most of it is Northern California, the Pacific Northwest and to a somewhat lesser degree, the Mid-Atlantic. Those are really the primary three.

And then, I recognize you guys have been a bit tactical adjusting your approach being net sellers, slowing a bit on the start side. How are you thinking about now being the right time to grow the structured investment product program? And what changes are you seeing to the mezz market and yields there?

Hey Nick, this is Matt. The -- our entry into that space really was kind of a strategic decision that we made a year or two ago. And so, we’re just building the book. This is the first year we’ve originated investments. I actually think it’s probably a good time to be entering that market because capital is getting more and more scarce. So, for sure, our phone is ringing more and more. And some of that is some of the relationships we’ve established with some of the construction lenders, and some of that is just capital is getting harder to put together for new starts. So, we have the ability to be very selective and measured about the business that we take on, which we’re certainly doing. Our rates are rising a bit in terms of the coupon that we’ll be charging on those investments. And our underwriting will reflect what’s going on in the current market. So, we generally are looking at kind of where our lender basis will be on those assets when they’re completed and compare that to current spot values today. Again, everything kind of trended on the eyes. And then when we look at what the margin is between those two and we want to make sure that we’ve got an adequate margin there of safety in case asset values erode further. So, we think that it’s actually not a bad time to be in the business, but it’s going to certainly be harder for developers to get deals to work, and we may have to look at 15 deals for every 1 that we’re willing to commit to.

Our next question comes from the line of Steve Sakwa with Evercore.

I guess on slide 9, if you were to combine the impacts of slide 3 and 4 or charts 3 and 4, kind of into a net bad debt number for all of 2022, what is that number? And what is your expectation for that trend in ‘23 broadly?

Yes. Steve, it’s Sean. Happy to take that one. So for the full year 2022, we expect our reported net bad debt to be roughly 1.7% which includes the benefit of our estimation of $36 million to $37 million in rent relief that we’ve recognized or will recognize throughout the full calendar year. If you strip out the impact of rent relief, underlying bad debt is associated with our resident base essentially started the year in the high-4% range and is expected to end the year at roughly 2.7%. So, if you look forward to 2023, the way to think about it is, at this point, we expect really immaterial amounts of rent relief, if any, for 2023. As a result, underlying bad debt trends for the full year 2023 would need to average essentially that 1.7% that I mentioned to have a neutral impact on revenue growth for the full year. And so, we certainly expect continued improvement in underlying bad debt trends as we move into 2023. But it’s still early to provide a precise forecast. I’d say at this point, based on what we know, in terms of what’s happening with eviction moratorium in L.A. as an example, expiring in February and how things will play out in the courts and in markets like L.A. It’s probably more likely than not that net bad debt will be a modest headwind to 2023 revenue growth based on what we know today.

And then just secondly, maybe for Matt. I realize pegging construction cost is a little difficult. But if you were to kind of look at the projects that maybe are most near term on deck to start next year, where do you think those are sort of penciling out on a return basis? And is it that you need to see costs come down more to make those really work, or is it that rents need to keep going up to get them into the zone?

Yes. Steve, it’s probably -- it depends. It really does vary based on the [Technical Difficulty] and the region. So, the -- our target yields have been moving up. So, our current development underway as shown on the exhibit is in the high-5s yield, and a lot of those deals when they actually start leasing will be above 6, because a lot of those deals, as I mentioned, aren’t mark-to-market yet. On the deals in the pipeline that we haven’t yet started, that pipeline was underwriting somewhere on average to kind of the mid-5s, and that’s thin based on where cap rates are trending towards today. So some of those deals will be comfortably above prevailing cap rates and our targets and, therefore, generate good value creation, even based on today’s hard costs and rents. And then some of those deals will need some form of help in terms of hard costs potentially starting to level off or come down some. And then some may require some -- a second look at the land. Most of those deals that we have in the pipeline, we have not yet bought the land on. We’ve only bought the land on 7 of 30-some development rights that we have. So, we do have the ability at that time to have another conversation with those land sellers, if appropriate and if need be. So, it’s going to be a combination of all those things. We are definitely starting to see hard cost level off, much better bid coverage, not everywhere, but in a lot of regions. And I think that hopefully, there’s a pretty good chance that hard costs, some trades may start to come down. Obviously, some of the commodities come down, lumber, copper, but overall, total hard costs are still well north of where they were on a year-over-year basis, if not on a sequential basis.

Steve, this is Ben. I’d add -- that was well put by Matt. I’d add a couple of elements. This really gets into the underlying flexibility that we have in our development rights pipeline. So part of it is potential retrading land to today’s values. The other part if maybe not the more significant part is with respect to timing, right? So it allows us to manage the timing of our pipeline, which potentially allows some of the normalization that you were getting at in your question about the trend lines on rents and construction costs.

Great. Just one last one for Sean. Just are you seeing any sort of behavioral trends, doubling up, roommates, folks moving out just in any markets that creates any sort of concern going into ‘23 from a demand perspective?

Yes. Steve, nothing at this point, no. I mean, the trend that we talked about as we move through COVID, was the fewer number of adults per household. We looked at that carefully in the third quarter that sort of remains a tax. So, we’re not seeing the behavioral elements as you talked about that relate to people feeling pinched if you want to describe it that way. I mean, new lease income for our residents moved in, in the third quarter was up 11% compared to last year move-ins in the third quarter, move-in values were up around 10%, 11%. So it sort of matches, things are kind of running equal. And then, the only other thing I’d say is we continue to see good movement into our markets in terms of what we call these big moves I mentioned in the past, which is people moving in from greater than 150 miles away. That was up roughly 20% in terms of volume in the third quarter as compared to kind of pre-COVID norms, solid trend in the urban environment, solid trend in the suburban job center environments. Same trend, but not as strong in some of the more outlined suburban areas. So, that trend continues, which I think is a function of a number of different things, but certainly, people being called back to the office on a more consistent basis, probably has something to do with that.

Our next question comes from the line of Austin Wurschmidt with KeyBanc.

So, I appreciate all the detail you guys gave on seasonality, but the guidance reduction was a bit of a surprise given the loss to lease position you were in back in July. And I’m just curious if at any point you considered providing an intra-quarter update for -- operationally about what was happening more real time through your portfolio?

Yes. That’s not our practice overall. So, we didn’t feel like there was necessarily the need to do that. And if you look at the breakout of the road map for the third quarter, the revenue where things came in relative to our expectations was $0.01, and that’s it. So, we didn’t feel like it was material enough to preempt the normal process that we go through.

Understand. And then, just going to development a little bit. You guys have historically targeted development in the 10% to 15% of enterprise value, you’ve been running below that for various reasons in recent years. But over time, I guess, what’s the right level of development that you think kind of gets the benefit of value creation and also manages the earnings impact throughout a cycle without really getting dinged for the various risks associated with being in that business?

So, a good question, and one we’ve talked about from a strategic perspective. It is -- I’ll make a couple of comments on it. One, as we’ve thought about the opportunities in our expansion markets and other reasons, we’re headed to our expansion markets in addition to more and more of our type of customer and knowledge-based worker there, it allows us to take what we do well, including our development platform and have a wider playing field. So, that is part of the effort there. In terms of the percentage of where we are today towards where we’d like to get to, you’re right, it has been in the sort of 4% to 5% range. And for a lot of last year, we were very actively looking to build up our development rights pipeline to take advantage of the opportunities. Now, in reality, right, when our cost of capital changes, right, we’re going to change our return thresholds and we’re going to change the level that we’re pulling. So, longer term, right, we’d like to continue to grow our development book as a percentage of our business from where it is today, but we recognize in the near term that we’re going to be more restrained given the broader economic environment.

And then, just last part. So, when you kind of look at the development pipeline today, I know there are moving variables specifically in the owned versus option land portion. But what percentage of those deals would price based on the 100 to 150 basis-point spread you outlined in your prepared remarks?

I don’t know that I can put a percentage on it necessarily. A lot of those deals are deals that are going through an entitlement process are still a couple of years out. And so kind of knowing what comes out of that process, kind of is -- we’re very good at that, but that is speculative -- there’s a wide variety of outcomes on some of those. It’s really hard to say kind of -- what I’ll say is there’s certainly significant number that will work in today’s environment. And then there’s a significant number that probably will require some kind of change, whether it’s some combination of hard cost or land value. And we’re going to just continue to work through those -- dynamic environment.

Our next question comes from the line of Jeff Spector with Bank of America.

First question, can you talk about any differences you’re seeing between your urban portfolio versus suburban assets?

Anything specific, Jeff, just in terms of performance trends overall or…?

Yes, just -- yes, exactly performance trends. If you could talk a little bit more about move-ins versus turnover, rent trends? Are you seeing anything -- are there any differences between urban and suburban, or are they acting similar?

Okay. Yes. So, that’s helpful. So, yes, I mean what I would say is like on rent change, we provided rent change in the earnings release. And I highlighted in my prepared remarks, which was essentially 11% for the quarter. As you might expect given the recovery in the urban environment, was a little longer on the urban side, about 12.5% compared to suburban, which is around 10.2%. And then across the markets, I mean, the only thing that I would point out that I mentioned earlier is a little more weakness in the urban environments in both Northern California and Seattle as opposed to, say, New York City or urban Boston as an example. Other than that, things are about what you would expect in terms of rent income is moving up -- or excuse me, lease income is moving up with new move-ins, things of that sort. And then, as I mentioned, just a couple of moments ago that we are seeing more move-ins from 150 miles away into our urban job center and suburban job center environment as compared to maybe some of the more outlined suburban areas. Those are probably the three that are top of mind for me.

Jeff, the other area in terms of suburban versus urban and gets us to what we see as the general strength of our portfolio positioning is on the topic of supply, right? Two-thirds of our business is in the suburban coastal markets. Supply -- new supplies of [Technical Difficulty] stock has been in the range of 1.5%. And as we look out next year, that number is probably coming down even a little bit more. So, in a potentially softening environment or a recessionary environment, our belief is markets with lower supply are going to prove out to be more durable and more resilient.

Thank you. To clarify, are you saying that’s suburban versus urban or you’re saying in all, lower as a percentage…

So, that’s our 1.5% of stock. That’s in our suburban markets. And supply is higher in our urban markets. The other third of our portfolio is obviously also higher in the Sunbelt markets, right? So, as we look out on overall portfolio positioning, we think we’re in a relatively strong place from that perspective.

Thank you. And then I had a follow-up on the turnover. I guess, I think you do surveys on turnover like reasons to move out. Can you discuss that at all? I mean, do you -- I think you do those surveys?

Yes, we do. We track that -- and we [Technical Difficulty] all that kind of good stuff. So, a couple of things on turnover. First is the third quarter was the first quarter this year where turnover wasn’t materially lower as compared to last year. So, if you look back at the data we provided in the earnings release attachments, on previous quarter turnover on a year-over-year basis, it was down pretty significantly anywhere from 500 to 800 basis points versus the third quarter, it was basically flat year-over-year. So, it was a little more turnover than we anticipated. And in terms of reasons, a little bit of an increase in terms of people moving out due to rent increases, not surprising given how much and we were pushing rents. And then, the other piece that really is out there is I talked about the underlying bad debt trend improving, which is a function of a number of variables. One of those is more evictions as we move through the court process or people who are just skipping out because they know they’re getting to their court date. So, a little bit of a pickup there. Those are really the only two that had any kind of pickup in terms of reasons for move out. The others came down in terms of relocation, obviously came down as it relates to home and condo purchase as you might expect, things of that sort, all came down.

Thank you. Just curious on the move-outs because of rate, do they comment on if they’re going back to live with parents or do they comment on what they’re doing? Are they going to a lower-priced unit elsewhere?

Yes. That’s usually anecdotal. We don’t always have that data that we track it well. We track the ZIP code, so we have that kind of information. But in terms of what they’re actually doing and the reasons behind it, it’s kind of behavioral things and various things like that, that tend to be anecdotal as opposed to real data that you can count on.

Our next question comes from the line of Adam Kramer with Morgan Stanley.

I just wanted to ask about rent-to-income ratios in the portfolio, kind of the latest metric that you have and maybe how that compares to a year ago, two years ago or maybe kind of pre-COVID?

Yes. No. Good question, Adam. I think the right way to think about it is the comment that I made earlier in that when you look at new move-ins in the third quarter, for this year compared to last year, the household income associated with those move-ins is up around 11%. And if you look at the move-in value associated with those move-ins, it was up about 10%. So these, basically, people are kind of trading at a consistent level from -- if you think of it from a rent to income perspective. So, we have people moving in with that much higher income and our rents are up about that much. It sort of makes sense overall. Certainly, we have some people that are moving out, as I just mentioned, due to rent increase. Given the numbers we’ve been pushing through, that’s not surprising. But we continue to source demand that is comfortable paying what we are expecting and their incomes appear to support it.

Got it. That’s really helpful. And then, just in terms of the kind of loss to lease, I think it was 15% last quarter. I know you guys disclosed 6% last night. Just in terms of how you view kind of the last couple of months of the year here. I mean, do you anticipate kind of still having a loss to lease as you enter next year, or is kind of the rents that you’re going to run, so you’re going to sign in the next couple of months, probably going to heat up into the kind of that last 6%?

Yes, good question. We certainly won’t eat into everything, but I mean maybe a simple way to think about it is if you think about the lease expiration volume that we have typically in the fourth quarter, it’s around 20% of our leases expire. Those folks will get renewal rent increases and that will impact the loss to lease. The third quarter is closer to 30% of our leases expire, 30%, 32%, and that is when seasonal -- the kind of seasonality of rents kick in. So typically, the most impactful quarter is as you’re moving through the third quarter because of not only the heightened volume of lease expirations, but then you have rent seasonality kick in. The fourth quarter is typically much more moderate in terms of the impact on loss to lease as compared to the third quarter. Does that make sense?

Yes, that does. That’s really helpful. Just a final one here, I think the kind of revenue disclosure around this kind of 2023 building blocks is all really helpful. Just wondering on the cost side, and apologies if you guys mentioned and I missed it. But look, I think some peers kind of across the resi space are talking about property tax expense increases kind of given various dynamics there, certainly inflationary impacts, right? I was wondering, maybe again, not asking you to guide here, but just maybe put a little bit of color around 2023 expense growth kind of building blocks or kind of potential headwinds there?

Sure. Why don’t I give you a sense of maybe the top three or four categories just how to think about them a little bit. And so, for -- take property taxes, which obviously is the greatest percentage of our expense structure. This year, we’re kind of putting in numbers here that are just under 2%. We don’t expect a sort of 2% handle that we’re experiencing in 2022 to be in place as we move into ‘23, ‘24. There certainly will be upward pressure due to rates and assessments as you have heard from others. Payroll, similar to 2022, should remain very constrained due to our innovation efforts, and you can see what that looks like on the expense attachment to the earnings release in terms of what ‘22 looks like, and then, maybe just a couple of others. Repairs and maintenance, certainly, there’ll be some wage inflation from our contractors and a potential increase in turnover. And then utilities, there’ll be some pressure on rates in the first half of ‘23, given the contract that we signed for procurement of utilities in the middle of ‘22. And there may be some pressure -- or will be some pressure from our bulk internet and smart access offering, but we also expect that profit to be substantial in terms of the growth next year, probably more than triple the level in ‘22 as we move into 2023. So, while there be some pressure on the OpEx side, there’ll be a nice boost to NOI given the revenue contribution from that activity. So, those are kind of the top four in terms of maybe some color as to how to think about them.

Our next question comes from the line of Alan Peterson with Green Street.

Matt, to your earlier point regarding renegotiating land pricing on the development rights pipeline, from the conversations you’re having with brokers and other market participants, are you getting the sense that land sellers are starting to capitulate on pricing? And if so, to what degree?

Yes. Alan, I would say it’s early. So, the first thing is land only represents typically 10% to 15% of the total basis in the project, maybe 20% in areas where rents are higher and land represents a higher percentage. So, it doesn’t move the needle nearly as much as hard costs, and land transactions are long-lived deals. So, land deals that are closing now might be land deals that you cut depending on the region 1, 2, 3, 4, 5 years ago, depending if you’re in California or maybe if you’re in Texas, it could have been 6 months ago. But -- so they are a lagging indicator and those brokers sometimes are similar, but it’s going to take time there. You’ll see it first, and we are seeing it first in the transaction market. And then over time, it will work its way backwards through the system, so to speak.

I appreciate that. That’s helpful. And Sean, in regards to the operating trends in October, the high 3% effective rent change in Northern California, is that starting to imply negative new lease growth within that region?

No, it’s not. It’s still positive.

It’s still positive. Are you getting the sense that you’re going to need to turn on concessions or potentially reduce rents to maintain occupancy across Northern California or even the Pacific Northwest, which you mentioned was a little bit softer than the rest of the portfolio?

Yes. I mean, I don’t know exactly what it’s going to look like for the rest of the year. But certainly, that’s a possibility to the extent that we see some weak environments there, for sure.

Our next question comes from the line of John Kim with BMO Capital Markets.

I had a question on development starts that you’ve reduced. Ben, you mentioned in your prepared remarks the likelihood of compressed profit margins. And I’m assuming that means the yield -- the difference between yields and market cap rates. If that’s the case, what are you underwriting for cap rates on developments that you’re starting today?

John, the profits have come down. If you look back a year ago, we were running at development profits that were to tune of 50% because the spread between where we are developing to the underlying cap rates was out to 250 basis points. That’s the type of arena. So, that has compressed. And what I would guide you to, as I mentioned before, is our focus on maintaining 100 to 150 basis points of spread between where we’re developing and where underlying cap rates are. There can be and like would be certain deals that are slightly below that. But as a group, that’s the approach.

On the development and lease-up going to almost 7% yield, is that specific to those projects because your overall pipeline is at 5.8%? So, I was wondering if it was just these projects and leased up are currently at those levels, or is there a difference in the way that you calculate the rent as part of that stabilized yield number?

Yes. Hey John, it’s Matt. So I guess the answer to that is -- to be clear, that [Technical Difficulty] is on 4 deals, 4 of the 17 development right -- development communities are currently in lease-up. So, those are the only 4 that we’ve marked-to-market, and they are coming in at [Technical Difficulty] today. Now, they were originally underwriting -- underwritten, sorry, if you look at that slide 2, I think, 6.5%. So, they were among the higher-yielding deals on the -- in the development book when we started them based on -- some of that was timing, some of that was location. A lot of those are suburban Northeast deals. But if we see the same uplift in rents on the rest of the book when we mark it to market, when those deals come to lease, that would push the rest of the book up another 40 basis points as well. And obviously, that’s going to depend on what happens to market rents between when we started the deals in today and then between today when they start leasing. So, we may get less, we may get more, but on those deals, we saw that 40 bps uplift.

So just to clarify, the 5.8% yield on your overall development pipeline, that’s on your original underwriting, or is that based on the current market rents?

So, it’s based on the current market rents on those four deals, which are the [Technical Difficulty] and the other 15 -- or 13 are at what the initial underwriting was. So like I said, the other deals have the same amount of with that overall 5.8%, we’ll probably rise to a 6.0% or 6.1% is a way to think about it. That 5.8% represents 4 deals that are [Technical Difficulty] 13 deals that are not.

[Operator Instructions] Our next question comes from the line of Alexander Goldfarb with Piper Sandler.

So, two items. First, on the turnover, you guys pointed out in the presentation on page 8 that turnover is still below pre-pandemic levels. So just sort of curious, as you guys -- as the numbers fell below what you thought you would achieve in the third quarter, it still seems like turnover is low historically. So, were you guys just expecting turnover to be even lower? And if that is not the case, how do we think about turnover returning to its pre-pandemic level, especially because I think you said that new rents were the ones that were being hit, whereas the renewals were holding in there.

Yes. Alex, it’s Sean. Just to try to be clear, we expect it to be lower, independent of the historical norms. And the reason we had a belief is if you go back and look at the turnover that we experienced in Q1 and Q2 relative to last year as an example. The first quarter of this year, turnover was 35%. Last year, Q1 was 44%. Q2 this year was 46%. Last year, it was 50.8%. Q3 ended up being basically on top of last year. So, we had two quarters earlier this year, where we were pushing rents pretty aggressively that there was a pretty wide spread on a year-over-year basis. So we expect Q3 to continue that trend of being below what we experienced last year, even though we were continuing to push rents. And that was not the case. It was essentially on top of last year. So hopefully, that answers that question as it relates to turnover and our expectations.

That does. And the second question is I think initially, there were three markets that you guys highlighted as being weak, Northern Cal, Seattle and the Mid-Atlantic. You addressed Northern Cal and Seattle to Jeff Spector’s question. Mine is if Mid-Atlantic, if I heard correctly, that Mid-Atlantic is one of the weak ones. That’s a market that just perennially for the past decade has been sort of anemic. So, was this a case where the market you thought would rebound and it just didn’t or it’s weaker than sort of the normal stuff that goes on? Obviously, that market gets placed with supply.

Yes. And one thing we should probably try to be clear about, Alex, is when we talked about weaker, weaker, it was just a little bit weaker than our expectations. The revenue miss was $0.01 on $600 million for the quarter. So, it’s not a -- when you run the math, it’s not a significant dollar amount here. And so, we’re still seeing good growth in those markets. In the Mid-Atlantic, as an example, if you take a look at what we experienced in Q3 rent change, it was pushing 10%, California was 9%, Seattle was almost 12%. But things began to decelerate a little more quickly than we anticipated. So, I wouldn’t -- I’d be careful about saying those are the weak markets like things are going south quickly type of approach as opposed to the rate of deceleration was just a little more than we anticipated in terms of rent change. But it’s still -- in absolute terms, these are pretty healthy numbers, well above historical norms when you think about the long-term rent growth across our footprint. These numbers are pretty strong. So, that’s the way I would think about it. But specific to the Mid-Atlantic, there’s three major regions, the [Technical Difficulty] Northern Virginia and then the district. I’d say, the district maybe 1 or 2 pockets in Northern Virginia, probably have struggled the most, particularly D.C. where office utilization remains, I think, is the second lowest in the country at this point behind San Francisco, a lot of professional services jobs, government jobs. And so, the people haven’t necessarily had the need to be in the office. We continue to see positive movement in that trend, but it’s still not where it needs to be to really sort of push through and be in a position where we could see stronger results from the Mid-Atlantic overall, including D.C. So -- and if you look at just absolute job growth here of all of our regions, it’s been the weakest this year. So, you have a combination of weaker job growth. And then for the jobs that you do have, not everybody has to be in the office, and we just need to see better trends in that data to see the market pick up even more.

I mean, as you know, we’re just down there and we’re surprised that when speaking to some government folks that all the government people are still working from home. It’s only the political people who are back in the office, which blew us away. So, your message definitely resonates. So, thank you.

Yes.

Our next question comes from the line of Jamie Feldman with Wells Fargo.

Thank you. And this might be a little bit more theoretical. But your comment on underwriting developments at 100 to 150 basis-point spread to market cap rates. I mean, how do you think about cap rates going higher and the risk, especially by the time developments are delivered? Just kind of what are your thoughts around that? And how do you bake that into your underwriting?

Hey Jamie, it’s Matt. I’d say a couple of things. The first and most important is match-funding. So, if we’re match-funding that deal with permanent capital when we start it because we’re either sourcing equity or debt or selling an asset that’s based on those prevailing cap rates, then if cap rates are 100 basis points higher, when that deal is finished, we still locked in that spread. It typically works the other way. And honestly, it has like over the last few years, we finished deals and cap rates were a lot lower than they were in the environment in which we funded them. So -- and I think the equity forward is a good example of that in terms of locking in that capital based on kind of what the cap rate was or the yield was on our stock at that time. So, that’s the first thing. Beyond that, obviously, as I mentioned, we don’t trend rents and NOIs that also, most of the time, rents and NOIs are growing. So most of the time, there is some lift there, and that provides a little bit more conservatism as well.

As you think about underwriting today, what are you baking in for that cushion on the revenue side?

Well, like I said, we don’t -- we look at today’s NOI, today’s rents, today’s expenses, today’s cost, and so we come up with a spot yield. And we’ll compare that with a spot cap rate or spot asset value if the asset was being sold today. And then we don’t -- generally, what we find, if you look at -- we have a long history of the deals when they stabilize, stabilizing at yields higher than what we underwrite because of that because we don’t have the growth in there. We have the growth in kind of a 10-year forward IRR model in a long-term return, but not in the yields that we quote.

Okay. And so, you’re using spot expenses, too? Is that what you said?

Yes.

Yes. And how do you think about the risk of that?

I mean -- so again, typically what we would see is when a deal stabilizes, rents will have moved, OpEx will have moved some as well. The biggest piece of the OpEx is the property taxes, and that’s really based on the asset value. So, that’s going to be the biggest probably mover in where OpEx settles out relative to where it was [Technical Difficulty] significantly high. It’s usually because the assets were significantly more than we underwrote, which means we got more value creation there. But generally, if everything grows together, we’re at a very high margin -- operating margin business, so we get operating leverage. And if rents and OpEx grow at the same percentage rate, that means you’re going to wind up with that much more NOI.

Our next question comes from the line of Tayo Okusanya with Credit Suisse.

My question is around the strategic initiatives you guys started with industrials around co-working space. Just wondering if you could talk a little bit about the economics of that business, the size of the opportunity and potentially what it could contribute to your bottom line?

Sure. I would frame it just in the context of our overall initiatives of activating retail space at the bottom of our buildings. A couple of different components of that, one of which was we self-started our own small but self started own co-working program at a project out in California, which we call Second Space. The industrious relationship, which you referenced, is a pilot to further tap into their network of potential clients, as we think about our Second Space product. But it’s an area where we’re actively talking with multiple users, and we think it’s somewhere we can help create some incremental value, particularly to our residents above by creating activated space at the ground floor.

And you’re just renting the space to industrious, so there’s no kind of shared revenue model or anything like that?

It’s a -- I don’t want to get too much into details that would give it the pilot nature, but it’s a share -- it’s more of a shared model as opposed to a traditional retail model.

There are no further questions in the queue. I’d like to hand the call back to management for closing remarks.

Thank you all for joining us today. I appreciate the dialogue and look forward to seeing many of you at NAREIT soon.

Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.