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Morningstar | Low Expense Growth and Continued Development Execution Drive AvalonBay's 3Q; Raising FVE

No-moat AvalonBay Communities drove higher net operating income gains than we anticipated from stabilization of development properties while achieving higher margins on the company's established portfolio in the third quarter. We are increasing our fair value estimate to $189 from $181 for. For the established portfolio, occupancy came in at 96.1%, 10 basis points below our expectations, but rate growth was a little stronger than our 1.9% estimate with 2.5% growth for the portfolio in the third quarter. Operating expenses grew only 0.5% in the third quarter, leading to better-than-expected operating margins of 71.0% and net operating income growth of 3.1% for the established portfolio. AvalonBay has also achieved 7.8% net operating income growth year to date from its portfolio of stabilized development assets. As a result, AvalonBay reported $2.29 in core funds from operation in the third quarter of 2018, 4.1% above both our estimate for the quarter and the results from the third quarter of 2017. The company has raised the midpoint of 2018 core FFO guidance by 3 cents to $9, which is 1.8% above our prior estimate but is in line with our new estimate for 2018.

AvalonBay announced several developments on its Columbus Circle development in Manhattan. It has signed on Target as the retail tenant for the buildings two retail sublevel floors and is in negotiations with another tenant to take space on the second level. Even though the building isn't set to be completed until the fourth quarter of 2019, it has now signed 65% of the square footage and 45% of the projected revenue of the retail portion of the building. The bigger development is that it is considering converting the rental units to condos. The New York City condo market has softened somewhat over the past year with development inventory up 12%, forcing increased seller concessions, but AvalonBay thinks it can potentially generate $150 million in pretax incremental profit from switching to condo sales. It plans to market the condos at an average price point between $3.2 million and $3.5 million with 85% of the sales below $5 million, which management believes should have the fastest sales velocity. We like that if management can achieve the $3.5 million average price point on the 172 units it will almost entirely recoup its $604 million development cost for the project while still earning ongoing NOI from the retail portion. There is some execution risk in making the switch, but we applaud management for exploring different scenarios to maximize profit.