AvalonBay Communities doesn’t have a secret weapon. If all goes well, the Alexandria, Va.-based REIT might begin construction this year on the 444-unit, garden-style Avalon Green II community in Greenburgh, N.Y., after 15-years-plus of steering the property through joint ventures and the permit and entitlement process. Nor is the company particularly magical. In its main boardroom at corporate headquarters, there is a Tandberg-6000 dual screen unit for video conferencing and pictures of several of the company’s new and notable high-rise developments. But there is no economic crystal ball, no all-seeing eye absconded underneath black cloth to be summoned by its multifamily masters. Yet here is AvalonBay in 2009: fortified in 16 core high-barrier-to-entry markets with 50,292 units under management across 178 properties. Though property fundamentals have taken a hit, average occupancy is at 96 percent and net operating income this year is forecast to be $539 million. Then there’s the balance sheet. Boasting the lowest leverage (debt as a percentage of assets) of any multifamily apartment REIT at 44 percent, AvalonBay has ample room to access and assume secured debt, and that’s not counting the $830 million already raised in 2008 against 16 existing assets. The company has an untapped $333 million equity investment fund, has accessed only $124 million of a $1 billion line of unsecured credit maturing in 2011 after a one-year extension, and has $66 million of cash on hand. Out of all the multifamily firms who lay claim to be prepared to takeadvantage of developing market opportunities, AvalonBay seems comparatively, transparently, and enviably at full strength.

“AvalonBay is our only overweight stock in the sector, and that overweight is driven by strength of balance sheet,” says New York City-based investment firm Barclays Capital analyst Ross Smotrich, who has been following AvalonBay and its predecessor companies since before the firm’s initial public offering in 1993. “That strength is conservative leverage levels, access to liquidity, unused lines of credit, and the further financing opportunities available across their asset base. It is a balance sheet built with financial flexibility.”

Envy them if you will, but AvalonBay didn’t become recession-resistant overnight. The company was made that way over 15 years of systematic, conservative, and, at times, almost boring balance-sheet management governed by one central strategy. “The guiding principle for financial management at AvalonBay is that we want to have continuous, uninterrupted access to cost-effective capital,” says Tom Sargeant, a 23-year AvalonBay veteran who has guided the firm as its CFO since 1995. Sargeant was treasurer of Avalon Properties from its formation in 1993, and prior to that, worked for real estate clients as a certified public accountant for Arthur Andersen.

A would-be journalist-turned-accounting major at the University of South Carolina, Sargeant is still specific about his selection of words and the relative weight of those words. He returns to the guiding maxim frequently as both litmus test and enabler of all things tactical and strategic at AvalonBay, and iterates the mantra in a patient, measured, economical cadence that belies his Southern heritage. Continuous … uninterrupted … cost-effective … capital.

Patient Perseverance

Sargeant is quick to point out that cost-effective capital has rarely meant the cheapest or most ubiquitous money available. Case in point: AvalonBay’s historic preference for unsecured debt. Normally coming with a 25 to 50 basis point interest premium over its asset-secured brethren, unsecured debt nonetheless has provided AvalonBay with a tactical advantage on the disposition front and in today’s lending environment: a quality-laden apartment portfolio with approximately 77 percent of its assets debt-free and ripe for as-needed securitization or opportunistic sale.

“Balance sheet flexibility is paramount to financial management as you build a cost-effective capital stack,” Sargeant explains. “Having many choices means you are not forced into doing any certain transaction. You could argue that secured debt has historically been a lower cost capital, but it is less flexible. In times like today when the only option is secured debt, if you have taken that option all along and have already secured your assets, you have no place to go. You can’t access additional debt.” Sargeant says the use of unsecured debt additionally allowed AvalonBay to quickly gain a disposition market premium on unencumbered assets when condo players made their asset-flipping run at multifamily apartment conversions until the foreclosure crisis. The unsecuritized portfolio model likewise assisted in clearing out a record $650 million in AvalonBay dispositions last year at a weighted average cap rate of 5.1 percent. In fact, during one of the worst multifamily transactional years on record that saw deal flow fall off by 63 percent, AvalonBay still generated approximately $288 million in (GAAP) gains and realized an unlevered internal rate of return of 14.1 percent.

As well as AvalonBay is positioned to endure the current economic climate, company executives insist that the firm never strategically prepared for a recession. Rather, company CEO Bryce Blair says the AvalonBay balance sheet gleans its resilience from its basic structure: uninterrupted cost effective capital streams to ensure portfolio performance and development opportunities in all economies.

“Where we are now goes back to our IPO in 1993 and the need for us to think about our balance sheet and corporate organization and strategy,” Blair says. “It wasn’t a change we made last year or the year before that in anticipation of today’s market conditions.” In strategy, the company decided to focus on best-in-class development in supply-constrained markets, with an organization marrying mothership efficiency with decentralized management and leadership. “All of that needed to be supported by a strong balance sheet designed to persevere through all phases of the business cycles,” Blair says.

Economics 101

This isn’t to say that life at AvalonBay is painless. The company is forecasting revenue declines between 1.5 percent and 3.5 percent this year as the weight of an expected 2 million to 3 million job losses impacts apartment fundamentals. Coupled with an expected expense growth of 3 percent to 4 percent, 2009 NOI is expected to decline within a range of -4.25 percent to -6.25 percent, resulting in a corresponding projected funds from operations decline of 5.5 percent by the midpoint of the year, according to the company’s 2008 fourth-quarter earnings call. “Our markets are clearly deteriorating, driven mostly be the economy,” says AvalonBay president Tim Naughton, who has been with the company for 23 years. “Markets are sputtering sideways. Occupancies are okay, although you would not say they were great, and you’d expect some pressure with the prospect of several million jobs being lost in 2009.”

Paradoxically, AvalonBay’s concentration of high-quality assets in equally high-barrier-to-entry markets is partially to blame for some of the portfolio stress. While still seen by analysts and company executives alike as a long-term strategic advantage, the portfolio has exposure to financial and trade employment sectors—particularly in New York, Chicago, and Los Angeles—that is catalyzing the deterioration in fundamentals.

“We think it is a great characteristic long term to be in the best quality real estate. However, in the current environment, AvalonBay will likely see more pressure on same-unit results than its peers, as its units are less affordable,” says Andrew McCulloch, an analyst with Newport Beach, Calif.-based Green Street Advisors, an independent research, trading, and consulting firm concentrating on publicly traded REITs. “In particular, AvalonBay has above-average exposure to the New York metro area, which will increasingly be negativelyaffected by sizable layoffs on Wall Street.”

Sargeant’s balance sheet will be a key defense against those exposures while AvalonBay navigates through the recession. If one were to grasp for business book clichés, his financial management tactics won’t resemble a back-to-basics approach as much as AvalonBay will maintain the straight and narrow and keep a simplistic transparent approach to balancing the books. Since his pre-Avalon career at former accounting firm giant Arthur Andersen, Sargeant has consistently applied the “think straight, talk straight” approach to the numbers, disdaining the use of synthetic transactions, opacity, and complexity in deal structures and capital management.

“I grimace when I see [the use of synthetic transactions and opacity and complexity in deal structures and capital management] because it is avoidable,” Sargeant says. “Business people have trusted relationships and work with smart people and often lean on that trust rather than trying to understand things. Well, it’s not about trust these days. It is about understanding what you are signing up for before you sign up for it.” As an example, Sargeant says he prefers to avoid synthetic transactions such as swaps and derivatives that could have unintended consequences not seen at the time of the transaction.

Conservative money management thus consists of an endurance contest in fiscal discipline, where ultimately it becomes the hold-outs and not the all-ins that enjoy long-term financial fortitude. Sargeant understands the ego that is drawn to the done deal, but also knows a longer-term satisfaction of outlasting the mediocrity supported by bull markets. “There is a thrill of excitement of doing an exotic transaction that makes the newspapers, but that is very fleeting, and it generally comes back to bite you,” he says. “I get more satisfaction out of delayed gratification than a quick pop, and delayed gratification comes with a clean balance sheet that is easily understood, that can stand the test of time when it comes to a 1998 Russian bond default, a long-term capital management meltdown, or a 2008 liquidity crisis.”

Harvesters of Value

AvalonBay executives don’t espouse a ‘who’s laughing now’ retort to the legions of distressed real estate players and capital-challenged REITs. There’s nevertheless some sense of vindication for resisting the call to push leverage limits for more than 15 years, at times in the face of intense criticism from investors. “We have built a machine around our skills, our decision-making, and our balance sheet to have staying power,” Blair says. “And over the years we have been challenged on why we maintain such a conservative approach. It’s for days like today. That’s the answer.”

It’s also to support one of the largest development pipelines in the REIT space, one which is evolving from garden-style stock to a proclivity for high-rise urban apartment towers and more challenging mixed-use projects. Even after taking impairment charges for cancelling several projects in the fourth quarter of 2008, AvalonBay’s development activity is robust by comparison to its peers. Currently, 14 communities are under active development, eight of which are expected to deliver this year including Avalon Towers in Bellevue, Wash.

That pleases an analyst community that traditionally dings REITs for development dilutive to net asset value (NAV). “In the previous cycle, rents were rising and cap rates were falling. In that type of environment, almost anyone could be a developer, and you saw a lot of REITs get into development in a big way, many of which should have probably stayed on the sidelines,” says McCulloch of Green Street Advisors. “On the whole, development pipelines are NAV-destructive right now, but you still want AvalonBay to maintain its platform. Over the long term and through market cycles, the company should create value via development.”

Not surprisingly, executives announced last fall that the company would not begin any new development during the first half of 2009, a mandate reiterated on the 2008 fourth-quarter and year-end earnings call. Instead, Sargeant says, the company will look to create value with smart and balanced capital allocations, funded via a combination of new secured or unsecured debt, draws on lines of credit, asset sales, and retained cash flow. “We could allocate capital to new development, acquisitions, repurchasing debt, or we could allocate it to shareholder dividends.”

The envious could claim that AvalonBay is just another example of dry powdered posturing for distressed real estate exploitation, and in fact that claim might not even get much of an argument out of the REIT’s executive team. “We think there will be more distress coming and a potential for better opportunities in the future,” Blair says. “By 2015, I think we will have stronger market fundamentals from an improved economic condition, constrained supply, and positive demographics. If we tie up land in 2010 and entitle and build on it, we will deliver in 2015 and be harvesting those opportunities.”

Sargeant casts more of a historical light on AvalonBay’s current market position, and thereby reveals the caveat to the argument that the REIT is opportunistic just like everybody else. Strong financial management and solid balance sheets result from long-term, consistent decision making, he argues. In particular, “financial positioning at AvalonBay is a series of decisions made over the past 15 years that are grounded in good risk management, don’t encumber the balance sheet, and provide transparency and visibility,” he says. “The result is a competitive advantage in an upturning economy. The strong will be stronger, the weak will be weaker.”

At AvalonBay, it’s an ultimate market validation that has been a long time coming.

Smooth Operators

Eschewing a transactional real estate model, AvalonBay looks to maximize operating income with smart same-store expense management and thoughtful capital spend.

Even as net operating income is projected to soften due to the economy, executives at Alexandria, Va.-based AvalonBay Communities seem steeled in the resilience of the company’s operating platform and underlying asset base. As the REIT’s CFO Tom Sargeant puts it, “This is a company that has built its income streams primarily from real estate cash flows, so when the music stops on transactions, our earnings continue.”

While AvalonBay isn’t immune to an economy demanding cost containment for all, the dependence on funds from operations as opposed to an acquisitive model demands what company executive vice president of operations Leo Horey calls real estate fiduciary responsibility. “You can’t just not spend; you need to spend smarter,” Horey explains. “Expense management and containment coupled with thoughtful spending is the best proxy for operational effectiveness.”

AvalonBay began an institutional program of expense management five years ago that has included centralized procurement for purchasing power and a near abandonment of print marketing in favor of a Web-centric approach. This year, the REIT will complete the transition of all properties to its Customer Care Center, which centralizes back-end leasing office administration and frees up property managers for more thoughtful and productive operations management and resident service.

“It’s an example of a different way of doing business that we expect will create greater efficiencies and help contain our expenses,” Horey says. “When we lose 600,000 jobs a month there is not a lot that operations people can do. It is what it is. You cannot control market supply; you can only focus on what you can control: delivering great customer service, maximizing revenue relative to market, and focusing on capital spend that is in the best interest of the property.”

Horey sets expectations for individual community performance but largely leaves execution in the hands of AvalonBay’s local property experts, who are expected to keep ahead of the market in terms of occupancy and prices by signing at least one lease a week and closing 30 percent of lease traffic. As for capital expenditures, he has one guiding principle that everyone in the economy can relate to. “Just spend it smartly. Spend it as though it is your own money.”

Leadership Lessons

Tom Sargeant

• Favorite Quote: “Never, never, never give up.”—Winston Churchill

• Greatest Business Challenge: Making the right decision with incomplete information

• Best Advice Someone Ever Gave You: Surround yourself with good people, and you will be a better person.

• Someone You Admire: Winston Churchill

• LEADERSHIP Philosophy: Hire great people, and get out of their way.

• Currently Reading: Benjamin Franklin: An American Life by Walter Isaacson (Simon & Schuster, 2003)

AvalonBay Communities

• Founded: 1978

• Headquarters: Alexandria, Va.

• 2008 Net Income: $411.4 million

• No. of Units: Own 46,102; manage 50,292; started 1,768 (as of 2008)

• Markets: Northeast, Midwest, West