Good morning, ladies and gentlemen, and welcome to the AvalonBay Communities Q3 2022 earnings conference call. At this time, all participants are on a listen only mode. Following remarks by the company, we will conduct a question-and-answer session. You may enter the question-and-answer queue at any time during this call by pressing star one. If your question has been answered or you wish to remove yourself from the queue, press star two. If you are using a speakerphone, please lift the handset before asking your question, and we ask that you refrain from typing and have your cell phones turned off during the question-and-answer session. 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 Q3 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's 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.
With that, I'll turn the call over to Benjamin Schall, CEO and President of AvalonBay Communities, for his remarks. Benjamin?
Thank you, Jason, and thank you, everyone, for joining us today. I'm 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, as Sean will describe more fully, we expect to head into 2023 with an earn-in above traditional levels.
In short, just the 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 earning 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. The return on our structured investment program as we build that book of business up to $300 million-$500 million. In a potentially recessionary environment, the $200 million in 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 investment 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 a nearly $700 million total swing.
In an environment where profit margins on new development were likely to come down and the cost associated with that incremental capital has increased, we've also reduced new development starts. For 2022, we've 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 points spread and our cost of incremental capital, with a laser focus on making the appropriate long-term value creation decisions. 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 seven, 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 two 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 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, excuse me, 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 in chart three, our collection rate from residents 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 progress. As eviction moratorium 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 four, 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 2023 revenue growth. Now I'll turn it over to Matt to address development. Matt?
All right, great. Thanks, Sean. Turning to slide 10, we have 4 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 in 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. 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 5 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 75-100 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 100-150 basis points. Strong growth in NOI has offset some of this rise in cap rates, but on balance, asset values might be down roughly 10%-15% in our established regions and maybe 15%-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. With that, I'll turn it over to Kevin to review our funding position and the balance sheet.
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 funding and development underway with long-term capital to approximately 95% as of the end of the Q3 , 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 to $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 4.6x net debt to EBITDA at quarter end versus 5.1x in the Q4 of last year, and we remain comfortably below our target range of 5x-6x.
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 a weighted average years to maturity of just over 8 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 caring, and continuous improvement, and it is of increasing importance 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 five-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.
We're 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. With that, I'll turn it back to Ben.
Thanks, Kevin. Quickly to summarize, we're pleased with our continued strong earnings and operating momentum with a number of AvalonBay-based 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. 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.
Thank you. Ladies and gentlemen, at this time, we will be conducting a question-and-answer session. If you'd like to ask a question, you may press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. Our first question comes from the line of Nick Joseph with Citi. Please proceed with your question.
Thank you. I understand the seasonality returning this year, but a bit surprised it 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.
Yeah, Nick, it's Sean. Happy to address that. You are correct that more of the impact is being felt as our expectation in Q4 as compared to Q3 if you look at the roadmap that we provided. For the most part, when we did our material forecasts, we expected, and I communicated on the last call, that seasonality would return. Our expectation based on what we had seen thus far is it would be about half the normal rate that we typically see. 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 Q4 . That's really how it played out.
I mean, if you look at the
The rent change that we expect in July was pretty much spot on what we expected. 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. That's how that played out. In terms of markets, for the most part, there's really about three regions that are responsible for most of it. It's Northern California, the Pacific Northwest, and to a somewhat lesser degree, the Mid-Atlantic. Those are really the primary three.
Thank you. I recognize you guys are being 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 mass market and yields there?
Hey, Nick, this is Matt. You know, our entry into that space really was kind of a strategic decision that we made a year or two ago, 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. For sure, our phone is ringing more and more. You know, 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. You know, we have the ability to be very selective and measured about the business that we take on, which we're certainly doing.
You know, our rates are rising a bit in terms of, the coupon that we'll be charging on those investments. You know, our underwriting will reflect what's going on in the current market. You know, 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 untrended on NOIs. You know, when you look at what the margin is between those two, and we wanna make sure that we've got an adequate margin there of safety in case asset values erode further.
You know, we think that it's actually not a bad time to be in the business, but it's gonna certainly be harder for developers to get deals to work and , we may have to look at 15 deals for every one that that we're willing to commit to.
Thank you.
Our next question comes from the line of Steve Sakwa with Evercore. Please proceed with your question.
Yes, thanks. Good morning. 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, you know, what is your expectation for that trend in 2023 broadly?
Yes, Steve, it's Sean. Happy to take that one. 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-$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 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%. 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. 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, the eviction moratorium in L.A. is an example expiring in February and how things will play out in the courts 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.
Great. Thanks. Just secondly, maybe for Matt, I realize pegging construction costs is a little difficult, but if you were to kinda 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? You know, 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?
Yeah, Steve, it's probably it depends. It really does vary based on the deal and the region. You know, our target yields have been moving up. You know, 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.
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. Some of those deals, will need some form of help in terms of hard costs potentially starting to level off or come down some. Some may require, some, a second look at the land. You know, 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 thirty-some development rights that we have. You know, we do have the ability at that time to have another conversation with those land sellers if appropriate and if need be.
It's gonna be a combination of all those things. We are definitely starting to see hard costs level off, much better bid coverage, not everywhere, but in a lot of regions. You know, 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. Part of it is potential, retrading land to today's values. The other part is maybe not the more significant part is the respect to timing, right? 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 2023 from a demand perspective?
Yeah, Steve, nothing at this point, no. I mean, the trend that we talked about as we moved through COVID was the fewer number of adults per household. We looked at that carefully in the Q3 . That sort of remains intact. 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 residents moved in in the Q3 was up 11% compared to last year move-ins in the Q3 Move-in values were up around 10-11%, so it sort of matches. Things are kind of running equal.
The only other thing I'd say is, continue to see good movement into our markets, in terms of what we call these big moves I've 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 Q3 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 outlying suburban areas. 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.
Great. Thanks. That's it for me.
Our next question comes from the line of Austin Wurschmidt with KeyBank. Please proceed with your question.
Hey, good morning, everyone. 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. I'm just curious if at any point you considered providing an interquarter update, for, operationally, about what was happening, more real-time, through your portfolio.
Yeah, that's not our practice overall, so we didn't feel like there was necessarily the need to do that. If you look at the breakout of the roadmap for the Q3 , the revenue where things came in relative to our expectations was $0.01, and that's it. We didn't feel like it was material enough to preempt the normal process that we go through.
Understand. Just going to development, a little bit. You guys have historically targeted, development in the 10%-15% of enterprise value. You've been running below that for various reasons in recent years. 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?
Yeah. It's a good question and one we've talked about from a strategic perspective. I'll make a couple of comments on it. One is we've thought about the opportunities in our expansion markets and, one of the 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%-5% range.
You know, 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 gonna change our return thresholds, and we're gonna change, the level that we're pulling. Longer term, right, we'd like to continue to grow our development book as a percentage of our business from where it is today. We recognize in the near term that we're gonna be, more restrained, given the broader economic environment.
Just last part. When you kind of look at the development pipeline today, I know there are moving variables specifically in the owned versus optioned land portion, but what percentage of those deals would price based on the 100-150 basis point spread you outlined in your prepared remarks?
I don't know that I can put a percentage on it necessarily. You know, a lot of those deals are deals that, are going through an entitlement process are still a couple of years out. Kind of knowing what comes out of that process, kind of, 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. You know, kind of, what I'll say is, there's certainly a 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 costs or land value. You know, we're gonna just continue to work through those.
It's a very dynamic environment.
No, that's fair. Thanks, Matt.
Our next question comes from the line of Jeff Spector with Bank of America. Please proceed with your question.
Great. Good morning. Thank you. 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?
Yeah. Just, yep, exactly. Performance trends. You know, if you could talk a little bit more about move-ins, versus turnover, rent trends. Are you seeing anything, you know? Are there any differences between urban and suburban, or are they acting similar?
Okay. Yeah. That's helpful. Yeah, I mean, what I would say is, like on rent change, we provided rent change in the earnings release. You know, I highlighted in my prepared remarks, which was, essentially 11% for the quarter. As you might expect, given the recovery in the urban environment, it was a little stronger on the urban side, about 12.5 as compared to suburban, which is around 10 too. 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, lease incomes moving up with new move-ins, things of that sort. As I mentioned, just a couple moments ago, that we are seeing more move-ins from 150 miles away into our urban job center and suburban job center environments as compared to maybe some of the more outlying suburban areas. Those are probably the three that are, top of mind for me.
Great. Thank you.
Jeff, the other area in terms of suburban versus urban, and I guess just to what we see as the general strength of our portfolio positioning is on the topic of supply, right? You know, two-thirds of our businesses in the suburban coastal markets, supply, new supply as a percent of stock's been in the range of 1.5%. As we look out next year, that number is probably coming down even a little bit more. You know, in a potentially softening environment or recessionary environment, our belief is, markets with lower supply are gonna 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 of stock?
That's our 1.5% of stock. That's in our suburban markets. Supply is higher in our urban markets. You know, the other third of our portfolio is obviously also higher in the Sun Belt markets, right? As we look out kind of over our overall portfolio positioning, we think we're in a, relatively strong place from that perspective.
Thank you. I had a follow-up on the turnover. You know, 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, you know, forwarding costs, all that kind of good stuff. A couple things on turnover. First is, the Q3 was the Q1 this year where turnover wasn't materially lower, as compared to last year. 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 500-800 basis points versus the Q3, it was basically flat year-over-year. It was a little more turnover than we anticipated.
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. 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 for people who are just skipping out because they know they're getting to their court date. 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 purchases, 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 price unit elsewhere?
Yeah, 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. In terms of what they're actually doing, and the reasons behind 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.
Great. Thank you.
Yep.
Our next question comes from the line of Adam Kramer with Morgan Stanley. Please proceed with your question.
Hey, guys. Thanks for the question. Just wanted to ask about, rent-to-income ratios in the portfolio, kind of the latest metric that you have, and then maybe how that compares to a year ago, two years ago, or maybe kind of pre-COVID.
Yeah, 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 Q3 for this year compared to last year, the household income associated with those move-ins is up around 11%. If you look at the move-in value associated with those move-ins, it was up about 10%. Basically, people are kind of , treading at a consistent level from a if you think of it from a rent income perspective. We have people moving in, but that much higher income and our rents are up about that much. It sort of makes sense overall. Certainly you 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. We continue to source demand that is comfortable paying what we are expecting, and their incomes appear to support it.
Got it. No, that's really helpful. 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, you know, in terms of, how you view kind of, the last couple 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 gonna sign the next couple months probably gonna eat up into kind of that last 6%?
Yes, good question. We certainly won't eat into everything. I mean, this may be a simple way to think about it is if you think about the lease expiration volume that we have, typically in the Q4 , it's around 20% of our leases expire. Those folks will get renewal rent increases, and that will impact the loss to lease. The Q3 is closer to 30% of our leases expire, 32, and that is when seasonality of rents kick in. Typically the most impactful quarter is as you're moving through the Q3 because of not only the heightened volume of lease expirations, but then you have rent seasonality kick in.
The Q4 is typically much more moderate in terms of the impact on loss to lease, as compared to the Q3 . Does that make sense?
Yeah, no, that does. That's really helpful. Just a final one here. I think the kind of revenue disclosure around, these 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. You know, 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. For, take property taxes, which obviously is the greatest percentage of our expense structure. You know, this year, we're kind of putting in numbers here that are just under 2%. We don't expect the sort of 2% handle that we're experiencing in 2022 to be, in place as we move into 2023, 2024. 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 2022 looks like. Maybe just a couple of others. Repairs and maintenance. Certainly, there'll be some wage inflation from our contractors. Excuse me. A potential increase in turnover. Sorry about that. Utilities. There'll be some pressure on rates in the first half of 2023, given the contract that we signed for procurement of utilities in the middle of 2022. There may be some pressure, or will be some pressure, from our bulk internet and smart access offering. We also expect that profit to be substantial in terms of the growth next year.
Probably more than triple the level in 2022 as we move into 2023. While there'll be some pressure on the OpEx side, there'll be a nice boost to NOI, given the revenue contribution from that activity. Those are kind of the top four in terms of maybe some color as to how to think about them.
Great. Thank you so much for the time. Really appreciate it.
Yep.
Our next question comes from the line of Alan Peterson with Green Street. Please proceed with your question.
Thanks, everyone, for the time. 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? If so, to what degree?
Yeah, Alan, I would say it's early. So, the first thing is, land only represents typically 10%-15% of the total basis in the project, maybe,V maybe 20% in areas where rents are higher and land represents a higher percentage. It doesn't move the needle nearly as much as hard costs, and land transactions are long-lived deals. You know, 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 on if you're in California or maybe if you're in Texas, it could have been six months ago. They are a lagging indicator and those brokers, sometimes are similar, but it's gonna take time there.
You know, you'll see it first and we are seeing it first in the transaction market, and then over time, it'll work its way backwards through the system, so to speak.
Appreciate that. That's helpful. 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 gonna 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?
Yeah. I mean, but I don't know exactly what it's gonna 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.
Okay. Thanks for the time, guys.
Our next question comes from the line of John Kim with BMO Capital Markets. Please proceed with your question.
Thanks. Good morning. I had a question on your 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?
Yeah. John, the profits have come down. When you know, if you look back a year ago, we were running at development profits that were to the tune of 50% because the spread between where we were developing to the underlying cap rates, was out to 250 basis points. That's the type of margin. So that has compressed. What you know, 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 likely be certain deals that are slightly below that. As a group, that's the approach.
On the developments and lease up going to almost 7% yield, is that specific to those projects? Because your overall pipelines at 5.8%. I was wondering if it was just these projects and lease 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?
Hey, John, it's Matt. I guess the answer to that is, but to be clear, that 6.9% is on 4 deals. 4 of the 17 development communities are currently in lease-up. Those are the only 4 that we've marked to market, and they are coming in at a 6.9% today. Now, they were originally underwritten, sorry, if you look at that slide, to, I think, 6.65%. You know, 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.
If we see the same uplift in rents on the rest of the book when we mark to market, when those deals come to lease, that would push the rest of the book up another 40 basis points as well. Obviously, that's gonna depend on what happens to market rents between when we started the deals and today and then between today and when they start leasing. We may get less, we may get more, but on those deals, we saw that 40 basis points uplift.
Thanks, Matt. 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?
It's based on the current market rents on those 4 deals, which are at the 6.9%, and the other 15 or 13 are at, what the initial underwriting was. You know, like I said, if the other deals have the same amount of uplift, that overall 5.8% will probably rise to a 6.0% or a 6.1%, is a way to think about it. That 5.8% represents 4 deals that are marked, 13 deals that are not.
Understood. Thanks a lot.
As a reminder, it is star one to ask a question. Our next question comes from the line of Alexander Goldfarb with Piper Sandler. Please proceed with your question.
Hey, good morning, and thanks for taking the questions. Two items. First, on the turnover, you guys pointed out and in the presentation on page 8, that turnover is still below, pre-pandemic levels. Just sort of curious, as you guys, as the numbers fell below what you thought you would achieve in the Q3 , it still seems like turnover is low historically. Were you guys just expecting turnover to be even lower? If that's 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.
Yeah, Alex, it's Sean. Just to try to be clear, we expected turnover to be lower.
You know, independent of the historical norms. The reason we had that 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 Q1 of this year turnover is 35%. Last year, Q1, it was 44%. Q2 this year is 46%, last year was 58.8%. Q3 ended up being basically on top of last year. We had two quarters earlier this year where we're pushing rents pretty aggressively that there was a pretty widespread on a year-over-year basis. 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.
Hopefully that answers that question as it relates to turnover and our expectations.
That does. 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. 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 plagued with supply.
Yeah. You know, one thing we should probably try to be clear about, Alexander, is, when we talk about weak or weaker, it was just a little bit weaker than our expectations. You know, the revenue miss was a penny on, $600 million for the quarter. It's not. When you run the math, it's not a significant dollar amount here. We're still seeing, good growth in those markets. You know, 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%. You know, things began to decelerate a little more quickly than we anticipated.
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. It's still at 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. That's the way I would probably think about it. Specific to the Mid-Atlantic, there's three major regions, the suburban Maryland, Northern Virginia, and then the District.
I'd say, you know, the District and maybe one or two pockets in Northern Virginia probably have struggled the most, particularly D.C., where office utilization remains. I think it's the second lowest in the country at this point behind San Francisco. A lot of professional services jobs, government jobs, people haven't necessarily had the need to be in the office. You know, 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 for the Mid-Atlantic overall, including D.C. If you look at just absolute job growth here of all of our regions, it's been the weakest this year.
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. We just need to see better trends in that data to see the market pick up even more.
Yeah. I mean, as you know, we're just down there and 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. Your message has definitely resonated. Thank you.
Yep. Yep.
Our next question comes from the line of Jamie Feldman with Wells Fargo. Please proceed with your question.
Thank you. This might be a little bit more theoretical, but, you know, your comment on, u nderwriting 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 kinda what are your thoughts around that, and how do you bake that into your underwriting?
Jamie, it's Matt. I'd say a couple of things. The first and most important is match funding. 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've still locked in that spread. If, you know, it works the other way. 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.
I think the equity forward is a good example of that in terms of, you know, locking in that capital based on kind of what the cap rate was, or the yield was on our stock at that time. That's the first thing. Beyond that, obviously, as I mentioned, we don't trend rents, and NOIs at all. You know, 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.
Like, as you think about underwriting today, what are you baking in for that cushion on the revenue side?
Well, like I said, we look at today's NOIs, today's rents, today's expenses, today's cost, and so we come up with a spot yield. We'll compare that with a spot cap rate or spot asset value if the asset was being sold today.
You know, 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. You're using spot expenses too, is that what you said?
Yes. Yep.
How do you think about the risk of that?
I mean, 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. That's gonna be the biggest probably mover in where OpEx settles out relative to where it was originally. If it's significantly high, it's usually because the asset's worth significantly more than we underwrote, which means we got more value creation there. Generally, if everything grows together, we're in a very high margin, high operating margin business, so we get operating leverage. You know, if rents and OpEx grow at the same percentage rate, that means you're gonna wind up with that much more NOI.
Okay. All right, great. Thanks so much for taking my question.
Our next question comes from the line of Tayo Okusanya with Credit Suisse. Please proceed with your question.
Yes. Good morning. Thanks for keeping the call moving. My question is around the strategic initiative you guys started with Industrious 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. There's been a couple of different components of that. One of which was we self-started our 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. 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.
You're just renting the space to Industrious? There's no kind of shared revenue model or anything like that?
I don't wanna get too much into the details of it, given the pilot nature, but you know, it's a share. It's more of a shared model, as opposed to a traditional retail model.
Great. Thank you.
If 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. 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.