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spk01: Welcome and thank you for attending today's Air Community's third quarter 2023 earnings conference call. My name is Judy and I will be your moderator for today's call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press a star followed by the number one on your telephone keypad. If you would like to withdraw your question, please press the star followed by the number two. Thank you. I would now like to pass the conference over to Lisa Cohn, President and General Counsel of Air Communities. You may proceed.
spk06: Thank you, and good day. My name is Lisa Cohn, and I am President and General Counsel of Air Communities. During this conference call, the forward-looking statements we make are based on management's judgments. including projections related to our 2024 expectations. These statements are subject to certain risks and uncertainties, a description of which can be found in our SEC filings. Actual results may differ materially from what may be discussed today. We will also discuss certain non-GAAP financial measures, such as FFO and AFFO. These are defined and are reconciled to the most comparable gap measures in the supplemental information as part of the full earnings release published on AIR's website. Comments today come from Terry Considine, our CEO, Steve Kimmel, President of Property Operations, Josh Minix, our Chief Investment Officer, and Paul Belden, our CFO. Other members of management are also present. And all of us will be available during the Q&A session, which will follow our prepared remarks. I will now turn the call to Terry Considine. Terry?
spk12: Good morning, and thank you, Lisa, and all of you on this call. I read the first takes this morning and last night and set aside my prepared remarks to address what I understand to be on your minds. There's considerable consensus on AIR's good operations. There's confusion about $0.07 of the increase in 2024 expected interest expense. $0.04 was the result of the third quarter refinancing fully disclosed in our third quarter report. It reflects the acceleration by a year or so of the difference between legacy interest rates and then current market rates. This will occur in every REIT balance sheet as debts reprice. A penny reflects the impact of fourth quarter share repurchases funded by borrowing at a somewhat higher interest rate than in the third quarter and was considered in our underwriting. Two cents reflects a $50 million increase in expected 2024 borrowings to fund accretive property upgrades. We have underwritten past and future investments at substantial accretive spreads to our cost of capital. The higher interest expense in 2024 is the price paid for a higher quality portfolio with faster free cash flow growth in 24, but more importantly in 2025 and later. There is some suggestion that leverage increases variability and lower leverage would reduce saving. Financial leverage does introduce exposure to changing interest rates. This was especially pronounced last year when, for example, the 10-year fluctuated from 3.25% to 5% and back to 4%. But even the highest rates are well below the returns on air investment. The bigger point is the use of the borrowed proceeds to upgrade the AIR portfolio and create shareholder value. We are focused on the long-term values of a better portfolio with higher earning power and look past the short-term noise of interest rate changes. Any discussion of leverage needs to consider risk. AIR leverage at 30% loan-to-value to stabilize properties is safe. Comparison to others needs to consider the stability of stabilized properties as owned by heir with the risk of other business models with development risk, the implicit financial leverage of unfunded completion costs, and the risk of second mortgage lending where the much higher leverage from senior debt is off balance sheet but remains real. There were some concerns about paired trades with minor year one FFO, and free cash flow impacts. To state the concern is to answer it. We're comfortable with the relatively minor year one noise if we see considerable long-term value creation. We are confident that 2023's pair trades will out-earn their cost of capital. There were some similar concerns about the complexity of joint ventures. This complexity is addressed by transparency, as, for example, shown in Schedule 2B, which provides a clear path from gap to economics. It fails to consider the benefits to shareholders, which we saw in 2023 and anticipate in 2024, including the opportunity to upgrade our portfolio by the sale of partial interest in an otherwise illiquid market and the opportunity to reinvest the proceeds in other properties, often at discounts to their construction costs, with higher free cash flow growth rates, all while others are sidelined. The long-term benefits to portfolio construction are real and predictable. The creation of additional service income lowers heirs already low G&A. A corollary benefit to stock investors might be the reassurance that the most sophisticated global real estate investors chose and choose to co-invest alongside AIR. There was some discussion of non-recurring income. It's just that, non-recurring. It's cash and needs to be reported. It was exaggerated in 2022 when we accelerated the termination of continuing agreements between AIR and ANCO. It declined considerably in 2023. AIR's focus on long-term free cash flow will naturally reduce non-recurring income, But when it's available, shareholders will be better off if we take it, disclosing, as we do, that it's not recurring. Finally, forecasts for 2024 are just that, forecasts. AIR has taken a conservative view to guidance of 2024 market rental rate growth. We also provided a range of guidance that shows a possible and substantial upside. Time will tell where results land. I encourage you to keep score at the end of the year, not at its beginning. My bottom line. Given the consensus on the performance of air operations and the continuing increases in the quality of the air portfolio and its growth rate, it seems likely that air shareholders at year end will own an enterprise whose value will have increased considerably. Given that our diversified portfolio is largely insulated from today's surge in new supply, I expect that our results will compare favorably to ours in 2023 and to peers in 2024. The expected value creation will be the work of a stable and cohesive team and the advice and oversight of an engaged board of directors. I thank both for their friendship and help. With that, I'd like to turn the call to Keith Kimmel. Keith?
spk09: Thanks, Terry. I'm pleased to report we wrapped up a good 2023 with a solid fourth quarter. More importantly, AIR is well positioned to begin 2024 with what we see as another good year ahead. Fourth quarter results met our expectations and were reflective of typical seasonality. AIR continues to benefit from Josh's good work building a portfolio with broad diversification of markets and limited exposure to new supply. Revenue was up 6.2%, with occupancy of 97.3%, up 200 basis points from the third quarter. Signed new leases were down 1.1% from the prior lease, as we pushed to build occupancy and pricing power. Renewals were up 4.7%. Expenses increased 30 basis points, and net operating income increased 8.1%. The air edge continues to drive out performance, with full-year controllable operating expenses up only 20 basis points, in part due to air's best-ever retention of 62.3%. Air's operating margin also reached an all-time high of 76.7%, up 130 basis points from the fourth quarter of 2022. The AIR edge also generates above market performance in our acquisition portfolio. In the fourth quarter, our classes of 2021 and 2022 had net operating income growth 300 basis points better than our same store portfolio. And in particular, benefited from the efficiencies of AIR's operating model and technology stack with expenses down 4.5% from last year. Our class of 2021 now owned for just over two years, has undergone a remarkable transformation. Compared to the fourth quarter of 2021, revenue is up 25%. Controllable expenses have decreased 21%. Net operating income is up 34%. Margins at these communities have expanded over 500 basis points from 68.6% at acquisition to 73.8% today. Our class of 2022 acquisitions, now entering same store, are expected to have net operating income growth this year approximately twice that of the balance of the portfolio. At Southgate, owned now for one year, the rent roll has increased 14% from day one, and we've had net operating income growth of 23% from the seller's prior year. The combination of above-market revenue growth and predictable expense savings And the AIR platform creates a reliable engine for repeatable growth. January results have strengthened from the fourth quarter, and we are well positioned to start the year. Occupancy continues to be strong at 97.7%. Our high occupancy brings pricing power with new leases up 1.8%, renewals up 5.6%, and signed blended lease-to-lease of 3.8%. Asking rents have increased 80 basis points year-to-date, and leasing volume has grown sequentially each week as we see the first green shoots of the spring leasing season. We anticipate the balance of 2024 will reflect a typical pre-pandemic year with strong demand, supply pressures but only in pockets, waning inflation, and a premium placed on sales and operational excellence. Our anticipated 2024 revenue growth of 3.8% is based on 2.4% of earn-in from our 2023 leasing activity and current pricing, 40 basis points of growth and occupancy, 10 basis points improvement from bad debt, 50 basis points contribution from community upgrades, and asking rates that grow another 1% between now and peak season, resulting in a blended lease to lease of 3.5% in 2024. We anticipate positive growth across all markets, with the South Florida, Boston, Washington, D.C., and San Diego expected to be our strongest markets, while the Bay Area continues to lag in revenue growth, though we remain optimistic for a strong recovery. My thanks to all AIR team members for a great year. Your dedication to serving our residents, innovative approach to our business, and consistent drive for results made 2023 one of AIR's best years.
spk08: look forward to the year ahead i'll now turn the call over to joshua minix our chief investment officer josh thank you keith in 2023 we grew our air edge portfolio with four acquisitions one located in miami beach florida one in bethesda maryland and two in raleigh-durham north carolina where we added a third this year the acquisitions were funded in a leverage neutral manner by two new joint ventures the 2023 sale of our last New York City properties, the issuance of operating partnership units, and the assumption of below-market fixed-rate debt. We did not have any transaction closings in the fourth quarter, though we remained focused on improving the portfolio and expanding our air edge allocation. In 2023, the acquisition classes of 21 and 22 were 13% of our portfolio and accounted for 22% of our growth. The 23 and 24 acquisitions expand our air edge allocation to 20% of the portfolio, which bodes well for future portfolio NOI growth. In 2024, we continue our work to improve the portfolio quality and growth through transaction activity that allocates capital to air edge properties. The class of 22 joins the same store for 24. We expect to execute transactions in 24 to replace and expand fat air edge allocation. We were off to a great start and closed Sunnybrook in Raleigh, North Carolina this quarter. To fund these acquisitions, we expect to sell property either outright or in JVs to maintain a leverage neutral position. Our investment philosophy remains the same. We focus on generating a positive spread to our cost of capital and on improving portfolio quality leveraging our great advantage created by Keith and his team to apply the AirEdge to generate outsized returns as newly acquired assets benefit from his expertise. With that, I'll turn the call over to Paul Belden, our Chief Financial Officer. Paul.
spk11: Thank you, Josh. Today I will discuss Air's strong and flexible balance sheet, full year 2023 results, our expectations for 2024, and conclude with a brief comment on our dividend. Their balance sheet is well positioned. It is investment grade, long in duration, fixed rate, two-thirds non-recourse, and about 30% loan-to-value. Low leverage when you consider our business is focused on stabilized properties and has no exposure to new construction or mezzanine loans or short-term rentals. We have abundant liquidity with just under $2 billion available sufficient to refinance substantially all maturing debt through 2027. Fourth quarter leveraged EBITDA was a tenth of a turn above our expectations, a result of opportunistic fourth quarter share repurchases. I was comfortable ending the year about $45 million above our leveraged expectation due to the strength of the balance sheet, anticipated 2024 EBITDA growth, then absent changes in leverage, is anticipated to be sufficient to reduce leverage by one half a turn and the accretive use of proceeds. The share repurchases are part of a balanced capital allocation program. In the past two years, we have used approximately 25% of our available capital to repurchase 8% of the company at a discount to NAV. To the extent AIR shares continue to trade at a significant discount, to NAV, we anticipate that we will continue to allocate a portion of any proceeds raised to repurchase additional shares in a leverage-neutral manner. To support us in this activity, our board of directors granted a new $500 million authorization. As we look to grow the company, we have excellent access to dry powder to fund future acquisitions through our evergreen joint ventures with two large global investors. Turning to full-year results. Proforma FFO equaled the midpoint of guidance at $2.41 per share. Run rate FFO, which excludes costs or income that are not anticipated to recur in future periods, was $2.36 per share, equaled to the midpoint of our expectations and up 7.8% from 2022 and up 20% cumulatively since 2021. Run rate AFFO was $2.09 per share up 7.7% from 2022 and up 23% cumulatively since 2021. Looking forward, we anticipate that free cash flow and AFFO will grow at a faster rate than NOI and run rate FFO respectively. As we look forward to 2024, we expect 2024 run rate AFFO per share at the midpoint will be $2.12 up 1.4% from 2023. We expect run rate FFO to be $2.38, up 80 basis points from 2023. We expect this growth at the midpoint to be the result of 11 cents per share of incremental contribution from the same store portfolio driven by NOI growth of 3.8%, the result of 3.8% revenue growth previously discussed by Keith, Expense growth of 3.8% comprised of controllable operating expense growth of approximately 120 basis points, elevated above AIR's 13-year trend of negative growth by about half of the expected CPI. Real estate taxes are expected to increase between 5% and 8%. 2024 is a particularly difficult year to forecast with two contrasting forces at play. Real estate values declined by approximately 30% during the past two years, a result of rising interest rates. While this provides a positive argument when challenging assessments, it is mitigated by continued healthy NOI growth. While the exact growth rate is subject to some uncertainty, I do know for certain that we'll be very active in appealing all assessments. Insurance expenses are also difficult to predict. Despite minimal losses being tendered to our carriers during the past decade, Our property and casualty insurance costs for like properties increased by approximately 30% in 2023. In 2024, I anticipate a significantly lower rate of growth, the amount of which I'll be able to address more specifically after our March 1st renewal. Outside of our same-store portfolio, we anticipate 2023 paired trades to result in a penny of NOI dilution, but be a penny accretive to free cash flow. Please note, this calculation compares the NOI loss from properties sold in 2023 to the properties acquired with their proceeds, including the January acquisition of Sunnybrook. It also includes the benefit from share repurchases. The bear trades are anticipated to be accretive to NOI later this year. We also anticipate interest expense to increase by $0.07, or approximately $11 million year over year. I understand that the increase in interest expense was a little more confusing than I anticipated, so let me spend a moment diving into the details. More sense of the increase is due to higher weighted average interest rates. In 2023, our weighted average interest costs increased from approximately 4.1% at the beginning of the year to 4.3% at the end of the year. As a result, and all else held equal, the effective interest rates are expected to be 21 basis points higher in 2024. The increase was a result of our third quarter refinancing activity, which extended duration but marked our debt to current rates of market interest, accelerating interest expense that would have otherwise occurred in future periods. Economically, the acceleration neither harmed nor benefited AIR as the swap acceleration income, which is excluded from run rate FFO, offsets the higher interest cost. In order to appropriately reflect 2023 interest expense, we bifurcated the swap acceleration income between the amounts that were attributable 2023, which we include as an offset to 23 interest expense, and allocated the remainder of the swap income, which was otherwise to be earned in 2024 and 2025, to other income and therefore excluded from run rate FFO. The result was to lower fourth quarter interest expense by 2.3 million. For those of you that are annualizing our fourth quarter interest expense as a proxy for 2024 interest expense, you need to increase our reported $33 million by the 2.3 million. This results in an annualized expense of 141.2 million. There are then two other adjustments necessary to fourth quarter interest expense to arrive at our $147 million guide for 24. First, our average effective interest rate increased by five basis points during the fourth quarter due to changes in the mix of our debt driven by increased levels of borrowings. Applying this increase to our 1231 debt balance increases 2024 interest expense by an additional $1.6 million, or one cent. We anticipate $50 million of incremental borrowings to fund property upgrades and other improvements whose ROI is included in our guidance. The impact to interest expense after consideration of any capitalized interest is approximately $3 million or 2 cents. A few other quick notes on guidance. First, run rate FFO at the midpoint of $2.38 per share is 2 cents above the 2023 run rate FFO three cents per share below our 2023 pro forma results which included five cents of net earnings that are anticipated to be non-recurring second third-party service income is anticipated to be about 11 cents per share six of which is anticipated to be earned through the execution of our currently in place property and asset management agreements the remaining five cents will be earned from short duration service income an amount that is similar to that achieved in 2022 and 2023. Third, as our guidance indicates, we anticipate being active in the transaction market through paired trades and in partnership with our joint venture partners. However, given uncertainty surrounding the cost of capital, volume of transactions, operating plans, and timing, we are not providing additional guidance on the impact of these activities to 2024 results. Portally leveraged EBITDA will likely fluctuate during the year based on the timing of transactions and changes in EBITDA that is anticipated in 2024 at approximately 6 to 1. Finally, the Arab Board of Directors declared a quarterly cash dividend of 45 cents per share. On an annualized basis, the dividend reflects a yield of 5.7% based on the current share price. With that, we will now open the call for questions. Please limit your questions to two for time and a queue. Operator, I'll turn it over to you for the first question.
spk01: Thank you, Paul. And at this time, I would like to remind everyone in order to ask a question, please press the star followed by the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. And your first question comes from the line of Eric Wolfe from Citi. Your line is open.
spk02: Hey, thanks for taking the questions. You mentioned that the 4 cent increase was due to your 3Q refinancing activity. I was just wondering if you could give sort of more detail on exactly what that was, what were the amounts, where did the rates go to and from, and, you know, just kind of like how you get to that sort of 6 million extra increase in interest expense. I'm just backing to that from the 4 cents. Thanks.
spk11: Eric, this is Paul, and there'd be two ways I'd direct you to look at that. The first and probably the quickest and easiest way would be to compare the weighted average interest rate as disclosed in Schedule 5 for the first and second quarters to our weighted average interest rate in the fourth quarter. If you do that, you'll see an increase of about 20 basis points. If you apply that 20 basis points to our debt balance at year end, you get about $6.5 to $7 million. That's the four cents.
spk02: Sure, sure. I guess I'm asking, but what drove that increase, meaning like what drove the 20 basis increase? It sounds like it's something you did in the third quarter. So what was it in the third quarter that drove that 20 basis point increase?
spk11: Yeah, there were two items. We refinanced to extend duration of $325 million of term loans that were otherwise coming due in 2024 and 2025 before consideration of extension options. and refinanced that 325 with five-year and seven-year debt that had an average interest rate of about 5.5%, 5.4%. The effective rate on that debt previously was about 4%, 4.1%. The second thing we did in one of our joint venture transactions, our joint venture partner assumed debt, and so that was at a lower-than-market rate of interest, which we were paid for in the transaction. But if you just focus solely on the impact to average interest rates, the result of removing that lower cost debt inflated the balance of the portfolio.
spk02: Okay. And then this last question, your one-two guidance bridge didn't show sort of any impact from the higher interest expense. Now, is this something that ends up kicking in later in the year, second quarter through fourth quarter? Just trying to understand, because it seems like, you know, there's, I understand the offsetting adjustment you made in 2023, but I would think that it would just go to a more normal level in the first quarter of 2024?
spk11: Eric, that's a good question. The reason you don't see it pop in our bridge walking 4Q results to the first quarter results is that you probably noted in Supplemental Schedule 5, we talked about fixing our interest rates on our revolver and also adjusting our hedges to better match the maturities of our term loads. And the net effect of that was to give us a little bit of a pop of about a penny, penny and a half or so in the first quarter. So that's why we're consistent on a 4Q versus 1Q basis. And you'll see the increase then in Q2 and beyond.
spk05: Okay. Thank you.
spk01: And your next question comes from the line of John Kim from BMO Capital Markets. Your line is open.
spk04: Thank you. One of the... takeaways from last quarter was the recent acquisitions that you've had. Once it's on your platform, it would be growing significantly faster than the rest of your same store pool. So I wanted to focus on your class of 2022 portfolio as well as other real estate. The class of 2022, the growth slowed considerably since the last quarter. I realize it's only four assets. There's probably some volatility in that, but Can you just comment on that slowdown and what you're expecting for the remainder of the year?
spk11: John, I'll start and see if Keith wants to add anything. Specifically on Class of 22, what you're seeing is the impact of a tax revaluation that occurred in the fourth quarter of 2023. And so that incremental tax expense is what's driving the slowdown in NLI growth. Keith, anything you'd add on the revenue side?
spk09: I think the other thing that I would just point to, John, is that we basically, we can see that the NOI growth of the class of 22 is going to be about double that what we're seeing in our same store portfolio as we look forward. So it's a combination of things in the early days of that transition. We are repopulating our residents in some degree, repositioning how we staff the communities, a whole series of different things that we go through. And there could be some volatility in those early parts of the year or for about a year or so, and then we start getting into the stabilization of the area that's taking hold.
spk04: And can you remind us what's in the other real estate bucket, those four assets, and if you see double-digit growth from this group?
spk11: John, the four assets that are included in other real estate are the four properties that we held a leasehold interest in at the separation from AIMCO. And AIMCO completed their redevelopment. And upon completion of that redevelopment work, we bought out the value of the improvements. And so that occurred in the summer of 2022. And so those assets will be included in our same store pool in 2024. As far as the expected growth rate relative to the same store population as a whole, we'd anticipate growth rate in that portfolio to be fairly similar to the legacy same store population because Keith and his great team were involved with the lease up and have been operating those properties from day one.
spk04: Okay, great. My second question is for Terry. On your opening remarks, you mentioned that you're confident this year AIR will be performing favorably versus your peers. And I just wanted to clarify how you define that.
spk12: Well, thank you very much. That is a very good question, John. It's what I would have addressed in my prepared remarks, which is to look at the big picture, that the most important things that are happening at AIR are the increased quality of the portfolio, higher average rents, faster growth rates, higher margins, higher credit customers, greater retention, bigger margins, so forth. And the off-balance sheet asset, of course, is a stable and productive workforce. So those are things that when we look back at the end of 2024 will show up in free cash flow growth and will show up in 2025 FFO and AFFO at a greater degree. In 2022, we had considerable non-recurring income because of the acceleration of the divorce from AIMCO. But we called it out so the market would see it and focus on the recurring number, which continues to grow comfortably. I think everything we see is that growth continues. I want to emphasize one thing that, again, gets to be lost. In 2023... The real estate markets were largely paralyzed with low volume in transactions because of the standoff in pricing between providers of capital and users of capital. We were very successful in using the kindness of our joint venture partners to participate, to buy properties at considerable discounts that are going to reward us in the future. We were able to do that also in a way that increased our scale, our assets under management, so our net effective G&A, which is already low, gets lower still. So I just think when we focus on the use of proceeds and not just the cost of proceeds, we're going to be satisfied with the outcome.
spk04: I think you mentioned FFO as part of that. Just wanted to clarify. Okay.
spk12: I think FFO, and I, of course, would direct people also to AFFO. I think it's important to consider both, and net asset values, which discount growth rates. I think that triumvirate will measure the value of the enterprise, which I predict will be significantly higher than it is today, and we'll have a rate of growth in 24 that will compare very favorably to our peers, who are wonderful companies, but face different challenges and have different exposures to new supply, have different exposures to foreclosures in their mezzanine loan portfolios, different exposures to development and other such activities. And I think net-net, we're going to do fine.
spk05: Great. Thank you.
spk01: And your next question comes from the line of Rob Stevenson from Jeannie. Your line is open.
spk07: Good afternoon, guys. I guess just piggybacking off of your comments there, Terry, in terms of difference between you and peers, Keith, can you talk about what your systems are telling you in terms of new lease rent growth goes from here? You were negative for a very short period of time and by a much smaller magnitude than almost all of your peers, and now it's positive on signed leases in January. Are you going to be able to stay positive on new lease rates in first quarter, and does it turn back negative at any point in 2024? given what you're seeing today?
spk09: Rob, thanks. You know, look, we're feeling very optimistic as we go into the year, as you point out here. And it's not just optimism. The facts are our occupancy today at 97.7 is setting us up for a strong acceleration into spring season. The 1.8, you know, look, implied in our 3.5%, blend that would get us to our 3.8 revenue guidance, it puts a 2% new lease and a 5% renewal. So that's essentially what we have in. We have a 1% market growth from today until, call it, July-ish, you know, when we get into peak season. And we're already starting to realize that today. So what will happen next, I will say, will be more importantly known probably in April. But we're already seeing volumes that are increasing coming out of the holidays and the winter months. And what we're seeing is more of a pre-pandemic kind of acceleration. When we look back, let's call it between 2014 and 2019, prior to the pandemic, this is the type of acceleration we would have seen. And so, you know, more work to be done, but we're feeling good about where we're at.
spk07: Okay, that's helpful. And then, Paul, has your Southern California portfolio had any material damage from the recent extreme weather? And are your California assets specifically insured for flood, or is that something that if it incurred would be self-insured?
spk11: Rob, I'll handle the first part of the question and turn it over to Patty Schwader, who runs our insurance program, to dive into some of the particular details. As far as any material damage, No, nothing material. We have seen what you would expect, leaky roofs in spots, some water intrusion, but the costs of which are less than half a million dollars based upon what we know to date.
spk06: And yes, we're insured for flood and all other perils in these properties around the country.
spk07: Okay, that's great. Thank you. Appreciate the time. Have a great weekend.
spk01: Thank you. And your next question comes from the line of Hendon St. Charles from Mizzou. Your line is open.
spk05: Hey there. Sorry, I was on mute.
spk03: Terry, I think you mentioned earlier that you don't have plans at the current moment to transact, but that you're certainly in a position to be able to. So I'm curious what you're seeing out there today in terms of cap rates, RRs, and maybe where they need to be for you to get more active, and where potentially could we see you get more active? Coastal, Sunbelt, any particular market you'd like to highlight next?
spk12: Thank you very much. I think that I like very much talking about the opportunities we see today, and you're pointing to something that is very real. that a benefit to people who have access to capital and can make it worth more is what we have at a time when sellers have few alternatives. For specific details, I'd like to turn it over to Josh because he's nodding his head and eager to go and tell you what he's seeing out there. Josh?
spk08: Yes, thank you, Terry. Thank you, Hidalgo. We're very active in the market in terms of talking with potential sellers and evaluating opportunities in our markets. We are seeing a pickup in likely transaction activities measured by chatter among sellers and broker listings as a proxy for what we might see in our typical off-market approaches to transactions. In terms of returns, I think we're still seeing something of a bid-ask spread. Most sellers are shooting for a low five cap rate and most buyers are shooting for a high five to six. We certainly would want to be at the very top end of the returns and we'll be focused on establishing our cost of capital and then executing transactions where we have the opportunity to both improve our portfolio quality by buying assets with the opportunity to apply to AirEdge and generate that outsized growth rate and ultimately generate a spread of 200 basis points or more to our cost of capital.
spk03: Got it, got it. Thanks. Keith, I guess maybe one for you. I think you outlined, I think, in the guide, market rate growth this year, effectively flat, I think, with renewals, you know, kind of in that plus five. I'm curious, you know, if you're concerned at all about, you know, kind of creating a gain-to-lease strategy situation for the portfolio next year and how that might impact your ability to push renewals next year?
spk09: So, Handel, just for clarification, we have a 1% market growth between now and peak season that's implied in the guidance. So, we have some optimism that we will start seeing that, and it could be better or worse than that. But at the end of the day, we're seeing it already in our January numbers. I don't have a particular concern about a gain-to-lease condition. I know that to be clear about that, I always get a little bit off-put around those terminologies because there are points in time. And so if we rent 10 apartments today, that will change up and down loss-to-lease or gain-to-lease. And really where I'd point your attention to is the 2.4% earn-in And more importantly, the 3.5% blend that we have in our plan that would put us through 2024. If all those things become realities, which we anticipate, that will then have earned, those will have earned into 25 and beyond.
spk03: Got it, got it. Okay, thanks for that. And then lastly, I'm not sure if you outlined it, expectations for turnover this year, how that's reflected in the guide. And I think you mentioned the bad debt situation. I forget what the number is, but maybe talk about how that plays into your outlook for the expenses as well. Thanks.
spk11: Well, Handel, this is Paul. I'll start with bad debt. In bad debt, we've actually had a very good track record coming out of the pandemic. If I go back to 2021, I think our bad debt as a percent of revenues was 1.6%. In 2022, it improved to 1%. And then in 2023, it improved to 60 basis points. So we do expect continued improvement in 2024. I don't think we can bank on another 40 BIF improvement, but as Keith mentioned in his remarks, we expect about a 10 basis point improvement.
spk09: And I'll just add a couple of pieces. First, I'll add a couple of things of insight on the bad debt. And then the second piece, I'll circle back to your question about retention. I think one of the things that has been a unique characteristic in our bad debt is just sort of our process. in some of the emphasis we put around our resident selection process and those folks that we went to that are not short-term renters, but more importantly, people that stay with us over long periods of time. This is going to dovetail right into your question about retention. But through that process of the resident selection, and then secondarily, is that we collect our rent centrally. And so I don't know if that's something we've talked about before, but here in Denver, we have our centralized rent collection team. And for a person that over multiple decades has done this work, typically you'd have, if you had $100 billion, you might have 100 community managers collecting rent. And you're trying to manage all of them and coach them up and figure out who's doing what. And what we have here is about 10 individuals that they're just experts, professionals at doing this. And so when you look at how this bad debt number has improved as Paul just went through the walk of a 1.6 to a 1 to a 60 BIPs and where we get to 24, there's a lot of very specific things we do. The one sort of flying the ointment I would tell you in bad debt is that courts have been a little bit slower coming out of the pandemic. So we'll see how that plays out in the future, but we're optimistic about our process. Going to the retention, What we have implied in our guidance of the 3-H is essentially more of the same. I just reported that we are at 62.3%, which would be our best number that we've ever marked. We would anticipate something similar, if not better. And when I say, if not better, every single day, we have a very strong emphasis around longer-staying residents, less turnover, avoidance costs, and creating total contribution to the bottom line.
spk12: And if I could join in, Terry, I just want to emphasize two points. Part of it that Keith touched on is the creditworthiness of our customer. And so we're just less exposed to bad debt because we have people who have a track record of paying their bills. The second is I want to throw a bouquet to Paul because we did not make accruals based on optimism during the pandemic, we were very disciplined in our accounting. And so we don't have to reverse those accruals. We're operating where anything, any news is basically good news. And so our bad debt for the fourth quarter was balls, slap, zero, zero. So net of those recoveries. Now we're not going to say it's zero for the year. I'm not trying to say that. But I just want to point out two things that you can use in thinking about the future. One is that the air customer is much less likely to have bad debt. And second, the air accounting is much more likely to be connected to cash.
spk05: Very helpful. Thank you.
spk01: Thank you. And your next question comes from the line of Rich Anderson from Redbush. Your line is open.
spk10: Hey, good morning, I guess. So I can't help it. I'm a cynic, right? 2.4% earn-in is way above your peers. 2% new lease growth is above your peers. These are all really good operators of multifamily real estate. And I'm so – I need to be a believer here, but – Is there an element of luck? And I don't mean that in a derogatory way, but supply is on everybody's mind, of course, particularly in the Sun Belt. Are you finding yourself just not positioned in a place where others are getting a lot of headwinds from new supply? Besides the fact that you're good at your job and all that sort of stuff, what is causing sort of this outsized level of relative growth there? for you guys relative to everybody else from a same-store perspective.
spk12: Rich, as usual, my dear friend, you've got great questions, and I look forward to the headline you attach to it. But it's really two things. They're really two, and they're very different, but they're measurable, and you can call them out. The first one is operations. We have a customer that, that, as I just said, has better credit, so it's more likely to behave the way we expect, more likely to be a good neighbor to the other residents. As a result, we do more of our business at higher renewal pricing and less of our business at lower new lease pricing. Those are structural advantages. We have a record of cost control that is superior And we give great credit for that to Keith. But I just have to say that that's Keith and Matt Holmes, who's here in the room, and hundreds of teammates around the country that have done a really good job and are highly productive and highly stable. So one of the most important metrics about operations is the turnover of our teammates. And what you see is high teammate engagement and stickiness and stability. They're well compensated, they get great job satisfaction, and they do a better job than the peers. So that's one. The second one, which goes with it, is portfolio composition. That is intentional, but it's also a very difficult exercise because we're subject to political wins and economic changes that go back and forth. And at times when a concentration pays off, you'll see that in the outperformance of an investor in California, concentrated there, did great for 10 or 15 years, levered by Prop 13. That was a terrific moment. You can see concentrated investors in Sunbelt markets did great during the pandemic when you had this influx of in-migrations. We're more of the steady-eddy. We want to avoid – we'd love to have those benefits, to say that, but we want to be balanced against those risks. And so we've made independent decisions. We've made decisions about Florida that were different than peers. We've made decisions about Philadelphia that were different than peers. They both have pluses or minuses, but that's part of a differentiation which results from diversification, which ends up with lower risk. That's how we get there.
spk10: All right. Second question is entirely unrelated, but on run rate FFO, I need another FFO definition like a hole in the head. I'm speaking for a lot of people. Why didn't you just put this swap gain in core FFO and then there would have been a lot less misunderstanding about how people were growing 2024? Is there a structural reason why you didn't just handle it that way, and two, can we get rid of run rate FFO for now in 2024 since it's the same thing as core FFO? It's a little self-serving, but I'd love to hear your comments about those too.
spk12: Rich, I think air culture and certainly my values are to be completely transparent. To the best I can, let you know what I know. And what we wanted to communicate with Run Rate FFO, which was originated following the ANCO separation in 22, not the original one in 2020, was that a lot of the income that we, real income, cash money, that we were receiving in 22 was a one-time event. We just wanted to ask the market to take the burden of a third definition of profitability, but to see that one part's recurring and one part isn't. We did it again last year with a lesser concern, but we had these swaps that had been accelerated, and we didn't want to either confuse the market or have the market confused thinking we were confused. But we knew these were non-recurring, and we're going to call them out. And so we're completely transparent in what we do, and I think sometimes People aren't used to that and just find the volatility of life upsetting. But that's why we do that. I think in 2024, you're right, it's increasingly likely that we won't have that exposure. But we will have non-recurring income and expenses that are unpredictable every year. Hopefully, they won't be as material.
spk10: Right. I think everybody does, is the point. Fair enough. Thanks very much.
spk01: Thank you. And once again, if you would like to ask a question, simply press the star followed by the number one on your telephone keypad. Your next question comes from the line of John Polosky from Green Street Advisors. Your line is open.
spk13: Thanks, Josh. I have two questions on recent acquisitions in the last few quarters just so I understand the underwriting process. One, the Raleigh market, I think it's expecting high single-digit per annum supply growth this year and next year. So it feels like rents are going to be more likely down than up. So how do you get comfortable pushing chips near Raleigh? Second question would be on the Bethesda acquisition several months ago, $550K per door, $3,600 rents. It's really, really high. And so how do you get comfortable pushing rents? over a longer period of time to get to these double-digit IRRs you're studying?
spk08: Thank you, John. Both really good questions. Taking them in order, with Raleigh, this has been a long-term plan for us and part of our intentional portfolio diversification strategy. We're attracted to the market for all the reasons that are probably obvious, the favorable rule of law there. And we looked to have a balance of factors across the portfolio, taking a long-term outlook and looking at discounts to replacement costs. We did underwrite the supply. That's not a secret to anyone, and we're well aware. We think this timing was a particular time where the buyers were all underwriting the supply. And we had the opportunity to purchase on income that took that into account and allow us to get an unusually attractive basis that we think will age quite well as we work in those properties. And we're benefited greatly by Keith and AirEdge, which will generate internal growth with those properties, not relying on the market to generate our returns, but really relying on the execution to generate the returns. Following up on Bethesda, the purchase of the Elm there, we're very excited about. It is an expensive building to buy and an expensive building to live at. It's also the highest quality building that I'm aware of in the greater D.C. metro. And we bought it under both development and replacement costs and believe that that will be a long-term asset with a strategic advantage in the space.
spk12: John, I'd just add, if I might, John, add to Josh's comments. Just as to Raleigh, don't miss the cost basis of buying at a discount to replacement. And as to Bethesda, we've had a show and tell in this SEC filing, which we'll walk through in great detail to show you exactly how we underwrote it.
spk13: Okay, maybe one follow-up on the Raleigh. So what's the exit cap rate assumption or long-term NOI growth assumption, however you want to frame it, to get from a mid-5% cap rate in a market where rents are going to be stagnant to over a 10% IRR? It seems like a massive pickup.
spk08: Yeah, no, really good question. It is a massive pickup, and that's driven by Keith and his team, not by just riding a market wave. So we're really looking at the nuances of the property and taking the in-place cap rate and then looking at what happens when Keith operates it at his usual level of efficiency. And that provides a significant increase in the yield. And you've seen that in our previous acquisition portfolios where we have roughly double the same store growth. And we expect that here. And that isn't market-driven growth. That's air and Keith-driven growth. So that's the biggest driver. In terms of exit cap rates, we're generally exiting roughly where cap rates are today. So we're not assuming the cap rates compress over time.
spk13: Okay, thanks. One more, Terry, on the balance sheet. So I know when you initially did the spin, you had a mid-five times leverage target. and there's been some good resistance around the six times mark the last few years. I'm not worried about, you know, balance sheet risk, but there is a missed opportunity, inability to play offense if opportunities come up. So I guess what I struggle with is not ripping off the Band-Aid and getting the lower leverage because it has prompted – you guys scrambling a little bit to do all this derivative activity to fix the debt and so why not keep life maybe an old-fashioned well why not keep life much simpler and just reduce the absolute level of leverage versus having to go out and do all this derivative activity to uh fix fix the debt um any any comments there will be really appreciated in short john uh i mean first
spk12: As you know, our debt is much of it, two-thirds of it or more, is non-recourse. One of my favorite analysts gives us a 10% discount in the burden of that debt just for that put. Second, the question of having an opportunity is a good thing, but it's a good thing when you use it. Having it by itself is sterile. So the time to use it is when there's blood in the streets, when prices are low. And so waiting to do this at another time when everything's harmonious is to say to miss the opportunity. So we embrace the opportunity to buy now. And the fact that we've been able to do that and stay within low leverage, certainly by comparison to the asset class and I think compared to our business model, is something that take advantage of what's a structural advantage for apartments generally is something that we're paid to do because it creates value for shareholders.
spk05: All right. Thanks for the time.
spk01: Thank you. And there are no further questions at this time. I would like to turn it back to Terry Contadine, CEO, for closing remarks.
spk12: Well, thank you very much, and thanks to all of you still on the call. I appreciate your interest in AIR. I'm excited about the future. If you have questions, please feel free to call any of us and look forward to seeing you soon at a long number of conferences. Be well. Bye.
spk01: Thank you, presenters. And ladies and gentlemen, this concludes today's conference call. Thank you for participating in the Now Disconnect.
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