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University Student Research

Business Description

AvalonBay Communities is the second largest residential REIT by revenue and focuses on developing, acquiring, and managing apartment complexes in high barrier to entry markets of the U.S. Many of its properties are concentrated along the east and west coasts of the U.S., as these areas have shown consistent population growth and demand for residential properties. The firm maintains 11 regional offices for the development and maintenance of its communities,

allowing AVB to be efficient when developing or redeveloping properties. AvalonBay has diversified its portfolio through the creation of three separate brands, Avalon, Ava, and Eaves by Avalon, that are designed to reach to different consumer tastes and preferences. Additionally, AVB has been a first mover in the effort to make residential apartments more sustainable through the use of “green” practices. In 2013, for the second consecutive year, AVB was awarded the NAREIT Leader in the Light Award, the highest award given to REITs that demonstrate superior energy consumption practices. Many of the cities in which AVB owns communities (New York City, San Francisco) have made strides to become more

environmentally conscious, suggesting that AVB’s vision aligns with the goals of these cities. Currently, AvalonBay owns 241 apartment communities, with a pipeline of 33 additional development or redevelopment projects. The firm’s current market cap is roughly $22.9 billion, and the firm has just under 3000 employees. AVB stock trades on the New York Stock Exchange and is headquartered in Arlington, VA. Industry Overview Due to low interest rates and an improving economy, REITs as an industry have become an attractive investment

area. In 2014, REITs had their highest yearly returns in nearly a decade, outperforming the S&P 500 in 2014—32.3% including dividends vs 14.9% for FTSE NAREIT Index and S&P 500, respectively. The apartment sector alone, in which AVB specializes, has been one of the biggest beneficiaries of this growth; apartment REITs produced an average total return of 41.9%. There has been more demand than supply for apartments for those unable or unwilling to buy homes, increasing residential rents. Health-care properties were the second best performing sector in 2014 returning 35.5%, followed by malls at 34.9% and hotels and resorts at 34.8%. Apartment REITs are trading at 20.2x 2015E FFO and at an implied cap rate of 5.1% as of 2/1/2015, compared to an implied cap rate of 5.2% on 12/5/2014. According to Bloomberg, there were 576,276 apartments by public

multifamily owners and 34.591 million apartments in the country by year-end 2013. AvalonBay constituted 14.1% of the total market share (public multifamily owners) totaling 81,522 units, but only 0.2% of total apartments in the country. For years ending 2013, 2012, 2011, and 2010, AvalonBay has had market share of 14.1%, 10.6%, 9% and

This report is published for educational purposes only by students competing in The CFA Institutional Research Challenge.

REIT Industry, Real Estate Sector

Date: Feb 1, 2015 Ticker NYSE: AVB

Current Price: $172.99 Price Target: $166.58

Recommendation: Hold

*Calculated using data from Capital IQ

*calculated using data from Capital IQ

AvalonBay Communities Inc.

3.2%3.5% 3.7%

4.7%

2.0%2.5%3.0%3.5%4.0%4.5%5.0%

Q1 Q2 Q3 Q4

Annual Rent Growth FY14*

*calculated using data from Capital IQ

8.5%, respectively. The jump in market share from 2012 to 2013 is in part due to the Archstone acquisition. As of 4Q14, effective rents for new leases jumped to 4.7% from 3.7% in the third quarter. The annual rent growth for 1Q14 and 2Q14 was 3.2% and 3.5%, respectively. In Q4, hitting a 14 year high, there were 246,579 annual units of supply (apartments completed in the nation’s 100 largest metros during 2014) versus 226,615 units of supply the previous quarter (+8.81% sequential increase). Although MPF Research does not clarify the actual size of the largest 100 metro areas, we are confident that it is a reliable indicator of the U.S. market since that the data we have, which is only 24/100 of the largest cities by population, already constitutes about 13.3% of 34.591 million apartments in the U.S (See Appendix 1). The remaining 76 cities would increase the representation of total US apartments, hence our accuracy in describing the overall market. In Q4, there were 268,532 units of demand versus 254,993 units the previous quarter (+5.31% sequential increase). Units under construction totaled 405,886 units versus 387,397 units the previous quarter (+4.77% sequential increase). About 290,145 are expected to complete in 2015, which is a relatively large number and will greatly contribute to supply and dilute demand. There are occasional delays of construction that lead to a less than expected number of actual deliveries, meaning supply may actually come in at 250,000 to 260,000 units. With supply metrics relatively high compared to demand, we must monitor how well demand can absorb supply in the coming quarters. The occupancy rate across the nation’s 100 largest metros is 95.3%, in line with AVB’s average occupancy rate of 95% across its properties. MPF Research suggests that occupancy could ease slightly, possibly by 30-40 basis points, but anywhere near the 95% mark (where we currently are) is still essentially full. MPF Research expects rent growth to be 3.5% to 4% in 2015. Competition will most likely be highest among newer, high-priced projects in the urban core, where AVB competes, given that completions over the past few years have likely satisfied some demand that was built up when supply was much lower. AVB is well-positioned and is growing presence in regions where demand for apartments exceeds supply. In

Los Angeles (14.2% portfolio exposure), AVB grew its number of apartments by 123.1% YoY totaling 10,344 units as of 1/31/14 in a demand heavy environment--1.73x demand multiplier vs supply (See Appendix 2). The strong demand pushed occupancy to 97% for the first time since early 2007. Rent grew 4.2% year-over-year as of 3Q14. Washington Metro (18% portfolio exposure), on the other hand, has not been a great area of investment being that supply has been exceeding demand (0.94x demand multiplier vs supply). AVB has grown their number of apartments in the Washington Metro area by 54.5% YoY totaling 13,118 units as of 1/31/14. Occupancy increased 0.3% during the third quarter to 95.4%; pricing inched up 0.3% as well during the quarter, leaving rental rates relatively flat as operators attempt to fill units. The

strengthening economy and favorable demographic characteristics in this area has supported a positive outlook, but we can still expect to see some short term pains since it is expected that demand will not keep up with supply this coming year, widening the gap of supply and demand. Beyond AVB’s presence in Boston (which has a demand multiplier of 0.99x with portfolio exposure of 11.7%), the rest of the portfolio is in a relatively healthy environment with demand multipliers ranging from 1.11-1.95x (See Appendix 2) while growing their number of apartments at an average of 32.1% YoY. And, although Boston may not have favorable metrics, the outlook is positive since supply volumes have increased but demand has kept up; inventory expansion is focused in urban areas where absorption should be relatively strong.

Our current economic market environment favors and supports AVB’s future growth. IBISWorld (2011b) identifies five most important key success factors in the REIT industry: Superior financial management and debt management, access to investment funding, proximity to key locations, access to highly skilled workforce, and densely populated areas. In order to achieve these, a REIT must have access to capital with low interest rates, so one key driving force of the industry is the interest rate. But,

*Calculated using data from Capital IQ

New England

15%

Metro NY/NJ26%

Mid-Atlantic

16%

Pacific NW5%

N. Cali20%

S. Cali.18%

Region's % of NOI

15.6%23.0%

33.2% 35.0%

54.5%65.0%

0%

20%

40%

60%

80%

Metro NY/NJNew England NorthernCalfornia

PacificNorthwest

Mid-Atlantic SouthernCalifornia

AVB Region YoY Apartment # Change

relatively high interest rates can be offset by positive GDP growth, to an extent. It is forecasted that the Federal Reserve will increase short-term rates in 2015, but many analysts are predicting REITs will continue to perform well. Rather than expecting falling prices due to an increase in the Fed Funds rate, it is more important to watch metrics such as strong underlying assets, possible inflation, and increases in growth of key operating metrics that would drive REIT prices themselves. The U.S. economy continues to gain strength since GDP rebounded in Q2, National Association for Business Economics projects corporate profit growth to stay constant at 6%, forecast for jobs in 2015 is a 12% increase from 2.5mn to 2.8mn increasing demand, capital is currently cheap incentivizing companies to invest and innovate, and there is an increase of rising stocks and rising home prices meaning rising wealth. AVB and the REIT industry is currently in a healthy cycle of an increase of cumulative multifamily rental starts (supply) and cumulative job creation (demand). All of this allows AVB to increase supply to meet an increase of demand due to more jobs and personal income, allowing for higher occupancy rates and increased rental revenue.

Management Analysis Management at AvalonBay Communities consists of an experienced team that has proven effective in the past and should continue to prove their merit in the future. Members of AVB’s management team are involved with a number of boards and councils outside of AVB that give them an understanding of their market and where it is going. This should help prepare them to adjust to the constantly changing demands of the REIT industry. While AvalonBay’s management is strong and has had success in almost all areas, major competitors such as Equity Residential and Essex Property Trust have management teams with similar credentials. The successful management team and board members of Avalon are an asset to the company, but the similarities between the management credentials of AVB and its competitors suggest the firm lacks any durable competitive advantage due to its management team.

Competition Analysis The REIT apartment sector has continued to consolidate over the past twenty years. AvalonBay Communities is currently the second largest REIT in the country. Their three main direct competitors in the apartment REIT sector are Equity Residential, Essex Property Trust, and UDR, Inc.

Equity Residential is a multifamily REIT that owns roughly 115,000 apartment units concentrated in coastal U.S. markets and has the largest market cap of the four major apartment REITs. Equity Residential focuses primarily on acquisition transactions. In 2013, Equity Residential acquired Archstone for more than $9 billion, while divesting about $5 billion of their own noncore assets. Their strategy is to focus on the coastal markets where demographics seem favorable, and where the high cost of alternative single family homes result in increased demand for their products. The majority of the firm’s portfolio is in strategic markets, including New York, Boston, Washington D.C., South Florida, Southern California, San Francisco, Denver, and Seattle. Equity’s NOI has continued to increase over the past several years and analysts believe the company has achieved its strongest performance in the company history. Since Equity Residential has seemed to hit their peak growth rate, the firm is expected to slow down and reach a more stable growth rate of about three percent. There has been a strong resurgence of apartment demand since the financial crisis and many office properties are being converted to multifamily developments in numerous core markets of Equity Residential. The firm has a strong management team, as both David Neithercut, CEO, and Sam Zell, chairman of the board, have extensive backgrounds in real estate. The total return of Equity Residential stock has outpaced the S&P 500 during Neithercut’s tenure.

AvalonBay’s next largest competitor is Essex Property Trust. Essex focuses on the metropolitan areas of the West coast such as Los Angeles, San Diego, San Francisco, and Seattle. One important factor to consider regarding Essex

Company Net Income (LTM 9/30/14) Div Yield D/E Share Price (as of 1/30) P/FFO (as of 1/30) Free Cash Flow (LTM 9/30/14)AvalonBay 683.6 2.6 0.7 $172.99 23.81 ($260)Equity Residential 524.5 2.5 0.5 $77.61 25.14 ($579)Essex 113.6 2.2 0.8 $229.52 29.76 ($197)UDR 125.6 3.1 1.3 $33.26 20.95 ($325)

*all data calculated using Capital IQ

AvalonBay versus Main Competitors

is that Northern California and Seattle are volatile markets, but most of the firm’s properties are in Southern California. Recently, Essex acquired BRE Properties for $4.3 billion. This deal helped the company increase its presence in the multifamily market on the West Coast. Also, in 2013, Essex acquired ownership interest in eight communities with a total of 1,472 units worth $462.5 million. The recent increase in revenue is heavily dependent upon their acquisitions and rising rents. From 2012 to 2013, Essex reported a 13% increase in revenue. Essex’s main strategy is to acquire properties with more than one hundred units for between $300 and $500 million. They focus on supply-constrained markets with a population of at least one million. Essex will sell their properties that no longer fit into their strategy to acquire a new community. AvalonBay’s third largest competitor is UDR, which began in 2010 through a joint venture with MetLife. UDR owns and operates more than 140 multifamily apartment communities with more than 51,000 units. Their properties are primarily located in fast-growing coastal urban markets. The Majority of UDR’s income is generated from California, Washington, and the metro Washington D.C. area, but the firm also has a presence in Boston, Tampa, Orlando, and the San Francisco Bay area. UDR’s target markets of operations are in areas with strong job growth, limited apartment supply, high single-family home prices, and high barriers-to-entry. UDR reported $759 million in revenue for 2013, a 4% increase from 2012. Their occupancy rates also increased 0.2% to 96% in 2013. Although revenue increased, net income fell 79% to $44.8 million because of a significant decrease from discontinued operations. UDR focuses on markets with strong employment growth potential and high cost rental markets and these are their core markets. Other noncore target markets include Dallas, Phoenix, and Richmond. UDR has focused on implementing technology to help its operations in regards to rent payment, service requests, and apartment searches. UDR’s CEO, Thomas Toomey, started UDR in February 2001 and has a background in real estate, working as the COO and CFO of AIMCO. His industry knowledge has helped UDR gain its position in the REIT market. Although Equity Residential, Essex, and UDR are some of AvalonBay’s main competitors, the four account for only a small percentage of the total industry units. As of 2014, there were a total of fourteen apartment REITs, but most of AvalonBay’s competitors in the apartment sector are private, “mom and pop” companies. This factor leads to AvalonBay’s biggest advantage, scale, as it is a large corporation that is diversified across a range of markets. Unlike their “mom and pop” competitors, AvalonBay has multiple operations in various locations. Scale also allows relatively cheap access to capital, giving a corporation like AvalonBay substantial buying power, which its smaller competitors may not have. These factors have combined to allow AvalonBay to better position itself in the apartment sector moving forward. Investment Summary

Business fundamentals and valuation support a HOLD rating We recommend a HOLD on AvalonBay, which trades at $172.99 as of January 30, 2015. Using a net asset value model described below, our intrinsic value estimate for AVB is $166.58, which sits roughly 4% below the current market price. While this suggests the stock may be slightly overvalued, there is

not a sufficient enough margin to recommend a sell at this time. Additionally, given the momentum of AvalonBay’s stock, we would like to see evidence of a slowdown or turnaround before issuing a sell.

Two related areas to watch that may drop the stock’s rating to a sell are cash flows and equity issuance. In recent years, the vast majority of the firm’s financing has come from external sources. (See Appendix 3) This is a concerning trend, as the firm will not be able to sustain this moving forward. Similarly, the firm has increased its equity outstanding by about 65% over the past five years, which dilutes earnings (and FFO) per share. If the firm

Source: Google Finance

continues to issue equity moving forward, and is unable to show consistent, positive free cash flow net of financing, current investors who are long AVB should consider closing their positions.

Slower organic growth through development and redevelopment AVB’s substantial growth during 2013 and 2014 can largely be attributed to the Archstone acquisition and the development of coastal multi-family apartment complexes. AVB has a number of apartment complexes that are currently under construction and will be completed in upcoming quarters (See Appendix 4). However, these will not be produced at the rate that have been displayed in recent years. Current Capital Environment With the historic low interest rate environment in recent years, AVB has been able to take advantage of low interest debt financing. With expectations that interest rates may rise during 2015, the advantages of financing through debt may subside. This increase in rates might limit the number of acquisitions and redevelopments that AVB will be able to perform as compared to previous years.

Valuation The NAV-based pricing model that was used to determine the intrinsic value is one of the most widely used valuation models within the REIT industry. The NAV model is comprised of two separate sections which combine to provide the overall intrinsic valuation. The first section is used to determine the core NAV which provides a per share valuation of the existing communities. The second section is used to value the future NAV and is used to determine the valuation of communities that are currently in the development pipeline. Core NAV In our core NAV analysis, we used several assumptions to estimate the intrinsic value. The model is based around the assumption of a 3.2% Fiscal Year 2015 rental growth rate. The 2015 growth rate is a weighted average growth rate based upon the Bloomberg projected growth rates per city, as they related to AVB’s exposure (See Appendix 5). Once the estimated exposure could be determined per city, the overall estimated growth rate could be projected. Historically the YOY rental growth rate has averaged anywhere between 2-5%. The 3.2% estimation falls within the historical range. An additional Core NAV assumption that was used for determining the intrinsic value is the Fiscal Year 2015 expenses as a percentage of revenue. The operating margin over the last three years has stayed relatively consistent, ranging from 69.38%-69.76% (See Appendix 6). Our research has found nothing to suggest that the range will stray too far going forward. Both of these assumptions are dependent upon a 95%

occupancy rate. As defined in the most recent 10-K for AVB, stabilized operations are the earlier of (1) 95% or greater physical occupancy or (2) the one-year anniversary of completion of development. This definition suggests

(in $thousands, except stock/NAV output)InputsEconomic Cap Rate 5.1%FY15 Rental Growth Rate (Core NAV) 3.2%FY15 Expenses as % of Revenue (Core NAV) 30%Occupancy Rate 95%Stock Price 172.99$ Shares Outstanding 132,014

SummaryCore NAV per share 132.90$ Future NAV per share 33.68$ Total NAV per share 166.58$ Upside/Downside Opportunity -3.7%

START: Market Value2015 Est. NOI 1,203,566$ Market Value of Owned Properties 23,599,330$

Add AssetsCash, Cash Equiv, Cash In Escrow 280$ Land held for development 176,484$ Investments in unconsolidated real estate entities 304,795$ Deferred financing costs, net 39,329$ Deferred development costs 36,945$ Prepaid expenses and other assets 210,514$

Subtract LiabilitiesTotal Liabilities 6,823,300$ Core NAV per share 132.90$

Add Future Development ValueDevelopments 4,446,467$ Future NAV per share 33.68$

Core + Future NAV 21,990,844$ END: Core + Future NAV per share 166.58$

AvalonBay Communities (AVB) NAV Model

that AVB expects their properties to be able to attain this 95% occupancy mark. Historically, AVB has been within 100 basis points on either side of 95% occupancy rate. Future NAV The future development NAV value is calculated based on the disclosed properties that are currently in the development pipeline and their estimated completion date. Within the future NAV calculation, there were two assumptions that were made which are discussed below. The first assumption is a 6% stabilized yield. The stabilized yield is multiplied by the cost of capital for each property, which is provided by AVB, in order to project NOI for the communities in the development pipeline. This 6% estimation is a fairly conservative figure in comparison to more recent rapid growth that has occurred within the Multifamily REIT industry; however this is in line with the projected yield for AVB’s closest competitors.

Another assumption that was used was a 5.1% implied cap rate. There are four types of cap rates that describe what yields investors are expecting from real estate: market, implied, nominal and economic. The nominal cap rate is used most by market participants, so we calculated a 5.1% nominal cap rate after using our FY15 NOI estimate and dividing it by AVB’s transaction price (current market cap). Nominal cap rates may overstate the yield because it disregards capital expenditures (a cost required for new apartments and

maintenance). By taking into account capex into the nominal cap rate, we then build an economic cap rate. After subtracting FY15 capital expenditures (estimate from Stifel Nicolaus) from transaction price and recalculating, the economic cap rate turns out to be the same 5.1%, as estimated capex is negligible). *The static asset and liability figures are based on 3Q 2014 data reporting within the 10-Q.

Financial Analysis Over the past five years, AvalonBay has increased its operating profits as a percentage of revenue from roughly 33% to roughly 41%. This reflects the high fixed-cost structure, and resulting operating leverage, employed by AVB. Moving forward, this operating leverage presents a risk, as a decrease in revenue would be reflected by a greater percentage decrease in operating profits. However, as long as AvalonBay continues to increase revenues, the company should see a relatively higher growth rate in operating profits.

Using data from Bloomberg, the only significant variable costs that AvalonBay faces are utilities and repairs and maintenance. (See Appendix 7) Given that utilities and repair costs represent a fairly consistent portion of revenue over time, it is reasonable to approximate AVB’s cost structure as roughly 80% fixed and 20% variable. Using AvalonBay’s total revenue and total operating costs for 2014 as base measures, a 10% decrease in revenue would lead to a 21% decrease in net operating profits. Conversely, a 10% increase in revenue would increase NOI by 21%. This

demonstrates the potential risks and rewards of a firm with significant operating leverage. Since 2009, AvalonBay has had trouble consistently producing positive cash flow when adjusting for financing. This means that the firm’s positive cash flows have primarily been a function of issuing both debt and equity, rather than operating and investing cash flows. This trend is unlikely to be sustainable for the long term. Due to aggressive real estate acquisitions, it is reasonable that the firm has had high cash outflows from investing for the past few years. Similarly, it seems justifiable for the firm to have issued significant debt in a low-rate

166.58$ 4.9% 5.0% 5.1% 5.2% 5.3%93.5% 171.13$ 167.46$ 163.94$ 160.55$ 157.29$ 94.0% 172.03$ 168.35$ 164.81$ 161.41$ 158.13$ 94.5% 172.95$ 169.25$ 165.69$ 162.27$ 158.98$ 95.0% 173.88$ 170.15$ 166.58$ 163.14$ 159.83$ 95.5% 174.81$ 171.07$ 167.48$ 164.02$ 160.70$ 96.0% 175.76$ 172.00$ 168.38$ 164.91$ 161.57$ 96.5% 176.71$ 172.93$ 169.30$ 165.81$ 162.45$

Source: Team Analysis

Cap Rate

Occ

upan

cy

Rat

e

Rev Growth Revenue

Operating Exp. NOI

% NOI Change

-10% 1,608$ 1,028$ 580$ -21%-5% 1,698$ 1,039$ 659$ -11%0% 1,787$ 1,049$ 738$ 0%5% 1,877$ 1,060$ 817$ 11%

10% 1,966$ 1,070$ 896$ 21%Source: Team Analysis

environment. But, as supply in the apartment industry catches up to demand, investors must determine whether AVB’s future cash flows are the result of sustainable sources, namely operations.

F rom year-end 2009 through the first three quarters of 2014, AvalonBay has increased its ROE from just over 5% to nearly 9%. Using a DuPont Analysis, it is clear that improving profit margins are largely driving AVB’s increase in ROE. On the positive side, the firm has not had to use additional financial leverage to increase its ROE, which is a risky strategy. However, the firm’s asset turnover has remained stagnant. This is likely to continue into the future, as the firm’s revenue is highly correlated to the amount of properties it operates. (See Appendix 8) Thus, after adjusting for financial leverage, the firm’s ROE will rely heavily on its net profit margin. As mentioned above, the firm’s operating leverage should allow it to increase operating profits faster than revenue, which should trickle down to net profits. However, given that AVB may be approaching the mature stage of its business cycle, revenue growth may slow, leading to a leveling of ROE, on a risk-adjusted basis.

Additional Upside Drivers Buying vs. Renting Household formation has increased with more help from renting than buying. In terms of occupied households, the market share of households being rented, compared to owned, is greater for people under the age of thirty. Owners under the age of thirty are 3.3x more likely to rent instead of own. (Appendix 9) The younger generation now is more inclined to rent rather than buy for a few key reasons. When renting, younger couples are minimizing their debt by signing short-term debt obligations compared to a long-term mortgage commitments that come with buying a house. Youths have also been delaying marriage over the years, which decreases their concerns to settle down in one place (appendix). Renting also grants the ability to move locations more frequently.

Unemployment Rate As of December, the unemployment rate was 5.6%, its lowest since June 2008. Since more people have jobs, they are more likely to have the income to pay rent. As unemployment decreases, FFO continues to rise. Also, information received from the AVB’s kickoff event confirms that there has been nearly fifty percent job growth among those aged 16-34, who have the highest propensity to rent, since 2013. Jobs are being created and consumers are now more likely to have the funds to account for their living expenses. Tech-driven job growth on the west coast will also help increase demand for apartments, which would widen the gap between supply and demand, leaving more room for growth.

Significant Development Pipeline

Based on our call with AvalonBay, they have $3 billion worth of property under development. If rental rates continue to grow, this new construction will help AvalonBay maintain a leading presence in their target markets. AvalonBay can strategically plan to invest in more properties because they know consumers are satisfied with their products and the demand is present. The firm prides themselves on some of its features that have helped them maintain a consistent 95% occupancy rate such as protected supply, relative cost of home ownership, better locations relative to education, and diversification of residents.

Source: Team Analysis

Source: Team Analysis

San Francisco, Oakland, and Seattle’s Future Apartment growth San Francisco, Oakland and Seattle are projected to be among the top five markets for apartment rent growth in 2015. The job growth in these specific areas has resulted in an influx of millennials who generally tend to prefer renting. This projection would be beneficial to AvalonBay because these areas have about a 14% weight in AvalonBay’s portfolio. Investment Risks Economic Risks Rising interest rates weighing on earnings & FFO. (ER1) The end of quantitative easing may have an adverse effect on AvalonBay, as rising interest rates would present multiple challenges for the firm. First, rising rates would make issuing debt more expensive. Due to the capital-intensive nature of developing residential communities, more expensive debt would likely weigh on AvalonBay’s earnings and FFO.

Rising interest increasing safer alternatives for dividend yield. (ER2) As interest rates increase, it seems likely that some investors will shift capital from equity to fixed-income markets. This may lead to multiple contractions across broad equity markets, causing stock prices to drop relative to earnings (or FFO). Furthermore, the REIT sector specifically, which offers a relatively high dividend yield, may be subject to further contraction than broader

markets. For some investors seeking consistent cash flows, REITs have served as a substitute for fixed-income securities during a period of historically low yields. But, should rates rise, fixed-income investments may become relatively more attractive, thus decreasing demand for REITs and potentially causing prices to drop.

Increasing unemployment. (ER3) With a high correlation between employment statistics and AvalonBay’s FFO, an increase in the unemployment rate could adversely affect the firm’s profitability. While recent GDP statistics indicate a healthy economy, investors should pay close attention to the unemployment rate and the general health of the US economy. Market Risks Lack of competitive advantage. (MR1) The multifamily REIT industry seems to be poorly protected by competitive advantages. While AVB may recognize some economies of scale due to its size or economies of scope through acquisitions, these opportunities also exist for its competitors. Supply catching up to demand. (MR2) The apartment REIT industry does not have any significant barriers to entry, and the multifamily commercial real estate supply has increased recently. If this trend continues and markets become saturated, market participants will have trouble producing returns on invested capital greater than their respective costs of capital, in the long run. This could especially be detrimental to AvalonBay considering they already have matched funding for a $3.3 billion dollar pipeline for development and redevelopment. Growth Slow Down. (MR3) AvalonBay seems to have already realized the returns from the high occupancy and rent rates coming out of the global financial crisis. FFO growth and same store operating income growth have slowed in the last two years and have possibly plateaued.

Source: Team Analysis

Fannie Mae & Freddie Mac reducing financing for apartment loans. (MR4) Fannie Mae & Freddie Mac have been subsidizing the apartment industry since the financial crisis, but have already begun to reduce their funding. Fannie Mae and Freddie Mac plan to continue reducing subsidies, which would lead to increased funding costs to multifamily landlords and ultimately AvalonBay. Low returns from high barrier to entry markets. (MR5) AvalonBay is currently focusing on expansion into markets with rapid job growth and economic stability. If successful, this may give AVB a comparative advantage, as its competitors might be unable to take market share in these areas. However, AvalonBay must pay a premium to enter these markets, and if economic growth slows, it is possible that the influx into the cities will slow as well. This may lead to AvalonBay realizing low returns on invested capital as a result of the high development costs incurred.

Operational Risks Diversification resulting in volatility. (OR1) Another factor that may have contributed to the slowdown of AVB’s growth is product diversification. In 2011, AVB implemented two new brands, AVA and Eaves. This move to diversify gives AvalonBay the possibility to penetrate new markets, but it could also have adverse effects on income. Adding more weight to the new brands in AvalonBay’s portfolio could expose the firm to new variables given the different demographics toward which each brand markets. Another factor that may point to the slowdown of

AvalonBay’s growth is their product diversification. In 2011 AvalonBay announced that they would be implementing two new brands into their business model, AVA and Eaves. This move to diversify gives AvalonBay the possibility to penetrate their markets deeper but it could also have adverse effects on their income. Adding more weight to the new brands in AvalonBay’s portfolio could expose them to more variables given the different demographics each brand markets to. Short-term lessees. (OR2) As a residential real estate investment trust, AvalonBay’s lessees tend to hold relatively short rental contracts, providing a degree of inherent instability. In comparison, the income stream of office REITs is more stable and predictable, due to the long-term leases that their tenants sign. Therefore, it is relatively difficult to predict cash flows to the firm, especially in the long-term. Possibility of sunk costs. (OR3) The firm may face choices between continuing to develop or abandoning opportunities, depending on market factors. Due to the capital-intensive nature of AvalonBay’s business, the firm will likely face steep sunk costs as a result of any abandoned opportunities. Under this scenario, the firm’s profitability would be adversely affected.

Natural Disaster Risk (NDR1) REITs face substantial natural disaster risk, as the value of real assets may be significantly impaired by natural disasters. While firms can hedge against natural disaster risk through insurance policies, it is unlikely that the full value of their assets would be protected under major disasters that cause significant damage. Because a significant portion of AvalonBay’s revenue comes from a few key markets, this presents a risk to the firm.

Source: Team Analysis

See Appendix 10 for Justification

Appendix 1: Number of Apartments in Largest US Cities

Appendix 2: AVB Regional Information

Appendix 3: Historical Financial Statements and Common-Size Financial Statements

Appendix 4: Property Development Pipeline

Appendix 5: Historical Operating Margin

Appendix 6: Projected Growth Rate

Appendix 7: AvalonBay Cost Structure (data from Bloomberg)

Description 5 Year Average 2014 Q3 2014 Q2 2014 Q1 2013 Q4 2013 Q3 2013 Q2 2013 Q1 2012 Q4 2012 Q3 2012 Q2 2012 Q1 2011 Q4AvalonBay Cost Structure Real Estate Taxes and Insurance 36.17% 38% 38% 36% 37% 35% 37% 38% 36% 35% 36% 35% 33% Personnel 22.73% 22% 22% 22% 22% 22% 23% 23% 23% 23% 23% 25% 23% Repairs and Maintenance 16.80% 18% 17% 15% 16% 18% 17% 15% 17% 18% 17% 16% 18% Utilities 10.68% 10% 9% 14% 11% 11% 8% 12% 10% 11% 10% 11% 11% Administrative and Marketing 13.54% 13% 13% 13% 14% 15% 15% 13% 14% 13% 14% 13% 13% Other Operating Expenses 0.17% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 2% Property Management Expense 0.00% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%

Source: Bloomberg

Appendix 8: AVB Operating Properties vs. FFO (data from Capital IQ)

Appendix 9: Renting vs. Owning by Age

Tenure by Age of Householder

Age Distribution Renter-

Occupied Households

Share Owner-Occupied Households Share

Under 30 Years Old 9,619,626 22.71% 2,910,331 3.94%

30 to 44 Years Old 14,243,341 33.63% 16,338,573 22.10%

45 to 64 Years Old 12,622,613 29.80% 33,343,219 45.10% 65 Years and Older 5,871,932 13.86% 21,341,339 28.87%

Total 42,357,512 100.00% 73,933,462 100%

Source: NMHC tabulations of 2013 American Community Survey

Appendix 10: Five Forces Model Justification

Bargaining Power of Suppliers: Bargaining power of suppliers is not as big of a threat as some would assume. AvalonBay gives their suppliers an abundant amount of business; therefore they have a sufficient amount of leverage when it comes to bargaining. Despite this positive, the change in commodity prices related to the construction of an apartment could increase costs for AvalonBay, ultimately decreasing their profit margin. That is why we gave the bargaining power of suppliers force a rating of only 2.

Bargaining Power of Customers: Since rent rates do rely on demand, customers do hold some weight in the apartment REIT industry. They have the ability as a whole to change occupancy rates, therefore they can directly affect AVB’s revenue and future strategies. For the reasons stated above we believe a threat to the business rating of 4 is adequate.

Competition in the Industry: AVB is among the top four apartment REITs which already reduces the threat of most competitors. The top apartment REITs are also not limited in terms of funds. They all are able to penetrate almost any market they wish, which reduces the issue of competitive advantage amongst these firms. That is why we gave AVB a moderate rating of 2 out of 5.

Threat of Substitute Products: We gave a fairly high rating for the threat of substitute products predominantly because investors might substitute the fixed returns they were receiving from dividend yields in AVB, for the less risky yields in fixed income given rising interest rates.

Threat of New Entrants: There are not a lot of risks from new entrants into the apartment REIT industry due to the economies of scale practiced by the top firms. However, the returns of the industry have made it a very attractive line of business to pursue. Therefore we gave this force a moderate rating of 2

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