Positioned for Growth ANNUAL REPORT 2005 s t H g i l H g i H l a i c n a n i F AvalonBay Communities, Inc. owns, operates, develops, redevelops and acquires quality apartment communities in high barrier-to-entry markets in the Northeast, Mid-Atlantic, Midwest, Pacific Northwest, and Northern and Southern California regions of the United States. As of December 31, 2005, we owned or held an ownership interest in 158 apartment communities containing 45,474 apartment homes in ten states and the District of Columbia, of which 17 communities were under development or redevelopment. Our strategy is to deeply penetrate our chosen markets with a broad range of products and services and an intense focus on our customer. Strong execution of this strategy by our integrated operating, development, redevelopment, investment and financial teams has resulted in a history of outsized value creation and financial performance. The high barrier-to-entry nature of our markets results from constraints to new development, such as difficult and lengthy entitlement processes and limited availability of zoned and entitled land. These constraints limit new rental apartment supply. A high cost of for-sale housing in our markets also helps to support rental demand. This combination of lower new supply and a higher propensity to rent generally leads to more favorable demand/supply fundamentals in our markets over the long term. More information about AvalonBay may be found on our website at www.avalonbay.com. Cover photo: AvAlon Chrystie plACe new york, ny 361 ApArtment homes Completed november 2005 Positioned for Growth AVALON AT MISSION BAY, CA AVALON AT TRAVILLE, MD To Our Shareholders AVALON DANBURY, CT Accelerating fundamentals, abundant capital, “condo-mania” and rising valuations were a few of the dominant trends shaping the real estate markets in 2005. Each of these trends offered opportunities for value creation, and AvalonBay participated: (cid:81)(cid:3) Our Same Store NOI growth accelerated throughout the year, topping 6 percent in the fourth quarter. (cid:81)(cid:3) As investors struggled to allocate abundant capital, our $4 billion Development Pipeline gained in importance. (cid:81)(cid:3) We expanded planned asset sales by 300 percent, targeting condo converters willing to pay premium prices over income buyers. (cid:81)(cid:3) (cid:48)(cid:81)(cid:79)(cid:80)(cid:77)(cid:90)(cid:3)(cid:94)(cid:73)(cid:84)(cid:93)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:91)(cid:3)(cid:95)(cid:77)(cid:90)(cid:77)(cid:3)(cid:90)(cid:77)(cid:198)(cid:77)(cid:75)(cid:92)(cid:77)(cid:76)(cid:3)(cid:81)(cid:86)(cid:3)(cid:87)(cid:93)(cid:90)(cid:3)(cid:60)(cid:87)(cid:92)(cid:73)(cid:84)(cid:3)(cid:59)(cid:80)(cid:73)(cid:90)(cid:77)(cid:80)(cid:87)(cid:84)(cid:76)(cid:77)(cid:90)(cid:3)(cid:58)(cid:77)(cid:92)(cid:93)(cid:90)(cid:86)(cid:3)(cid:87)(cid:78)(cid:3)(cid:26)(cid:27)(cid:3)(cid:88)(cid:77)(cid:90)(cid:75)(cid:77)(cid:86)(cid:92)(cid:20)(cid:3)(cid:77)(cid:96)(cid:75)(cid:77)(cid:77)(cid:76)(cid:81)(cid:86)(cid:79)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3) sector average of 12 percent. (cid:63)(cid:77)(cid:3) (cid:75)(cid:87)(cid:86)(cid:91)(cid:81)(cid:76)(cid:77)(cid:90)(cid:3) (cid:60)(cid:87)(cid:92)(cid:73)(cid:84)(cid:3) (cid:59)(cid:80)(cid:73)(cid:90)(cid:77)(cid:80)(cid:87)(cid:84)(cid:76)(cid:77)(cid:90)(cid:3) (cid:58)(cid:77)(cid:92)(cid:93)(cid:90)(cid:86)(cid:3) to be an important performance measure (cid:92)(cid:80)(cid:73)(cid:92)(cid:3)(cid:90)(cid:77)(cid:198)(cid:77)(cid:75)(cid:92)(cid:91)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:81)(cid:85)(cid:88)(cid:73)(cid:75)(cid:92)(cid:3)(cid:87)(cid:78)(cid:3)(cid:85)(cid:73)(cid:86)(cid:97)(cid:3)(cid:87)(cid:78)(cid:3)(cid:92)(cid:80)(cid:77)(cid:91)(cid:77)(cid:3) (cid:91)(cid:81)(cid:79)(cid:86)(cid:81)(cid:197)(cid:75)(cid:73)(cid:86)(cid:92)(cid:3) (cid:81)(cid:86)(cid:76)(cid:93)(cid:91)(cid:92)(cid:90)(cid:97)(cid:3) (cid:92)(cid:90)(cid:77)(cid:86)(cid:76)(cid:91)(cid:22)(cid:3) (cid:55)(cid:93)(cid:90)(cid:3) (cid:87)(cid:93)(cid:92)(cid:91)(cid:81)(cid:98)(cid:77)(cid:76)(cid:3) return of 23 percent was achieved while maintaining modest average Leverage of just 26 percent, well below the industry average. Simply said, relative risk-adjusted returns were outstanding. This is the third (cid:75)(cid:87)(cid:86)(cid:91)(cid:77)(cid:75)(cid:93)(cid:92)(cid:81)(cid:94)(cid:77)(cid:3)(cid:97)(cid:77)(cid:73)(cid:90)(cid:3)(cid:95)(cid:77)(cid:188)(cid:94)(cid:77)(cid:3)(cid:73)(cid:75)(cid:80)(cid:81)(cid:77)(cid:94)(cid:77)(cid:76)(cid:3)(cid:87)(cid:93)(cid:92)(cid:91)(cid:81)(cid:98)(cid:77)(cid:76)(cid:3) returns, following 65 percent in 2004 and 30 percent in 2003. 2 AVALONBAY COMMUNITIES, INC. AVALON PINES LONG ISLAND, NY 298 APARTMENT HOMES COMPLETED AUGUST 2005 Access to desirable amenities, like the 18-hole golf course at Avalon Pines, Enhances the Lives of Our Residents. AVALON AT PENASQUITOS HILLS, CA AVALON AT PRUDENTIAL CENTER, MA We’ve also achieved strong growth in other key metrics such as Earnings per Share (EPS), Funds from Operations (FFO), Net Operating Income (NOI), and Net Asset Value (NAV). (cid:55)(cid:93)(cid:92)(cid:91)(cid:81)(cid:98)(cid:77)(cid:76)(cid:3) (cid:90)(cid:81)(cid:91)(cid:83)(cid:21)(cid:73)(cid:76)(cid:82)(cid:93)(cid:91)(cid:92)(cid:77)(cid:76)(cid:3) (cid:90)(cid:77)(cid:92)(cid:93)(cid:90)(cid:86)(cid:91)(cid:3) (cid:81)(cid:86)(cid:76)(cid:81)(cid:75)(cid:73)(cid:92)(cid:77)(cid:3) (cid:77)(cid:96)(cid:75)(cid:77)(cid:84)(cid:84)(cid:77)(cid:86)(cid:92)(cid:3) (cid:77)(cid:96)(cid:77)(cid:75)(cid:93)(cid:92)(cid:81)(cid:87)(cid:86)(cid:3) (cid:73)(cid:86)(cid:76)(cid:3) (cid:94)(cid:73)(cid:84)(cid:81)(cid:76)(cid:73)(cid:92)(cid:77)(cid:3) (cid:87)(cid:93)(cid:90)(cid:3) (cid:84)(cid:87)(cid:86)(cid:79)(cid:21)(cid:77)(cid:91)(cid:92)(cid:73)(cid:74)(cid:84)(cid:81)(cid:91)(cid:80)(cid:77)(cid:76)(cid:3) strategy of deeply penetrating our chosen markets with a broad range of products and services and an intense focus on our customer. (cid:49)(cid:86)(cid:3)(cid:92)(cid:80)(cid:81)(cid:91)(cid:3)(cid:84)(cid:77)(cid:92)(cid:92)(cid:77)(cid:90)(cid:20)(cid:3)(cid:95)(cid:77)(cid:3)(cid:90)(cid:77)(cid:94)(cid:81)(cid:77)(cid:95)(cid:3)(cid:26)(cid:24)(cid:24)(cid:29)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:76)(cid:81)(cid:91)(cid:75)(cid:93)(cid:91)(cid:91)(cid:3)(cid:87)(cid:93)(cid:90)(cid:3)(cid:78)(cid:93)(cid:92)(cid:93)(cid:90)(cid:77)(cid:20)(cid:3)(cid:95)(cid:81)(cid:92)(cid:80)(cid:3)(cid:73)(cid:3)(cid:78)(cid:87)(cid:75)(cid:93)(cid:91)(cid:3)(cid:87)(cid:86)(cid:3)(cid:92)(cid:80)(cid:90)(cid:77)(cid:77)(cid:3)(cid:91)(cid:81)(cid:79)(cid:86)(cid:81)(cid:197)(cid:75)(cid:73)(cid:86)(cid:92)(cid:3)(cid:73)(cid:90)(cid:77)(cid:73)(cid:91)(cid:34) (cid:81)(cid:3) The economy and its impact on the industry and our performance; (cid:81)(cid:3) The key attributes of our strategy that create value for shareholders; and (cid:81)(cid:3) How we are positioned for growth and continued outperformance. 2 0 0 5 I N R E V I E W (cid:43)(cid:87)(cid:86)(cid:92)(cid:81)(cid:86)(cid:93)(cid:77)(cid:76)(cid:3)(cid:77)(cid:75)(cid:87)(cid:86)(cid:87)(cid:85)(cid:81)(cid:75)(cid:3)(cid:79)(cid:90)(cid:87)(cid:95)(cid:92)(cid:80)(cid:3)(cid:197)(cid:86)(cid:73)(cid:84)(cid:84)(cid:97)(cid:3)(cid:90)(cid:77)(cid:91)(cid:93)(cid:84)(cid:92)(cid:77)(cid:76)(cid:3)(cid:81)(cid:86)(cid:3)(cid:85)(cid:77)(cid:73)(cid:86)(cid:81)(cid:86)(cid:79)(cid:78)(cid:93)(cid:84)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:91)(cid:93)(cid:91)(cid:92)(cid:73)(cid:81)(cid:86)(cid:77)(cid:76)(cid:3)(cid:82)(cid:87)(cid:74)(cid:3)(cid:79)(cid:90)(cid:87)(cid:95)(cid:92)(cid:80)(cid:20)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:88)(cid:90)(cid:81)(cid:86)(cid:75)(cid:81)(cid:88)(cid:73)(cid:84)(cid:3) (cid:76)(cid:90)(cid:81)(cid:94)(cid:77)(cid:90)(cid:3)(cid:87)(cid:78)(cid:3)(cid:90)(cid:77)(cid:86)(cid:92)(cid:73)(cid:84)(cid:21)(cid:80)(cid:87)(cid:93)(cid:91)(cid:81)(cid:86)(cid:79)(cid:3)(cid:76)(cid:77)(cid:85)(cid:73)(cid:86)(cid:76)(cid:22)(cid:3)(cid:58)(cid:77)(cid:84)(cid:73)(cid:92)(cid:81)(cid:94)(cid:77)(cid:84)(cid:97)(cid:3)(cid:84)(cid:87)(cid:95)(cid:3)(cid:84)(cid:87)(cid:86)(cid:79)(cid:21)(cid:92)(cid:77)(cid:90)(cid:85)(cid:3)(cid:81)(cid:86)(cid:92)(cid:77)(cid:90)(cid:77)(cid:91)(cid:92)(cid:3)(cid:90)(cid:73)(cid:92)(cid:77)(cid:91)(cid:3)(cid:79)(cid:77)(cid:86)(cid:77)(cid:90)(cid:73)(cid:92)(cid:77)(cid:76)(cid:3)(cid:78)(cid:93)(cid:90)(cid:92)(cid:80)(cid:77)(cid:90)(cid:3)(cid:80)(cid:87)(cid:85)(cid:77)(cid:3) price appreciation, pushing the “rent-vs.-own” economics further in our favor. Job growth and low (cid:81)(cid:86)(cid:92)(cid:77)(cid:90)(cid:77)(cid:91)(cid:92)(cid:3)(cid:90)(cid:73)(cid:92)(cid:77)(cid:91)(cid:3)(cid:88)(cid:90)(cid:87)(cid:94)(cid:77)(cid:76)(cid:3)(cid:92)(cid:87)(cid:3)(cid:74)(cid:77)(cid:3)(cid:73)(cid:86)(cid:3)(cid:73)(cid:92)(cid:92)(cid:90)(cid:73)(cid:75)(cid:92)(cid:81)(cid:94)(cid:77)(cid:3)(cid:75)(cid:87)(cid:85)(cid:74)(cid:81)(cid:86)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:3)(cid:92)(cid:87)(cid:3)(cid:90)(cid:77)(cid:73)(cid:84)(cid:3)(cid:77)(cid:91)(cid:92)(cid:73)(cid:92)(cid:77)(cid:3)(cid:81)(cid:86)(cid:94)(cid:77)(cid:91)(cid:92)(cid:87)(cid:90)(cid:91)(cid:20)(cid:3)(cid:73)(cid:91)(cid:3)(cid:75)(cid:73)(cid:88)(cid:81)(cid:92)(cid:73)(cid:84)(cid:3)(cid:198)(cid:87)(cid:95)(cid:91)(cid:3)(cid:92)(cid:87)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3) industry continued at a brisk pace. Public-to-private M&A—another prominent trend in 2005— (cid:88)(cid:90)(cid:87)(cid:94)(cid:81)(cid:76)(cid:77)(cid:76)(cid:3)(cid:73)(cid:76)(cid:76)(cid:81)(cid:92)(cid:81)(cid:87)(cid:86)(cid:73)(cid:84)(cid:3)(cid:75)(cid:73)(cid:88)(cid:81)(cid:92)(cid:73)(cid:84)(cid:3)(cid:92)(cid:87)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:88)(cid:93)(cid:74)(cid:84)(cid:81)(cid:75)(cid:3)(cid:85)(cid:73)(cid:90)(cid:83)(cid:77)(cid:92)(cid:91)(cid:22)(cid:3)(cid:63)(cid:81)(cid:92)(cid:80)(cid:3)(cid:49)(cid:86)(cid:81)(cid:92)(cid:81)(cid:73)(cid:84)(cid:3)(cid:65)(cid:77)(cid:73)(cid:90)(cid:3)(cid:53)(cid:73)(cid:90)(cid:83)(cid:77)(cid:92)(cid:3)(cid:43)(cid:73)(cid:88)(cid:81)(cid:92)(cid:73)(cid:84)(cid:81)(cid:98)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:3)(cid:58)(cid:73)(cid:92)(cid:77)(cid:91)(cid:3) (cid:16)(cid:43)(cid:73)(cid:88)(cid:3)(cid:58)(cid:73)(cid:92)(cid:77)(cid:91)(cid:17)(cid:3)(cid:78)(cid:73)(cid:84)(cid:84)(cid:81)(cid:86)(cid:79)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:54)(cid:55)(cid:49)(cid:3)(cid:90)(cid:81)(cid:91)(cid:81)(cid:86)(cid:79)(cid:20)(cid:3)(cid:95)(cid:77)(cid:3)(cid:77)(cid:86)(cid:82)(cid:87)(cid:97)(cid:77)(cid:76)(cid:3)(cid:73)(cid:3)(cid:91)(cid:80)(cid:73)(cid:90)(cid:88)(cid:3)(cid:91)(cid:88)(cid:81)(cid:83)(cid:77)(cid:3)(cid:81)(cid:86)(cid:3)(cid:94)(cid:73)(cid:84)(cid:93)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:91)(cid:184)(cid:80)(cid:81)(cid:92)(cid:92)(cid:81)(cid:86)(cid:79)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:185)(cid:91)(cid:95)(cid:77)(cid:77)(cid:92)(cid:3) spot” of the real estate cycle. As the spread between new development yields and dispositions widened, we responded by expanding development activity and increasing dispositions, creating value on both sides of this historically wide spread. 4 AVALONBAY COMMUNITIES, INC. AVALON ROCKMEADOW, WA AVALON ESTATES, MA Condominium sales and conversion of rental to for-sale was “the” story for most of the year. We sold into this strong market, selling (cid:91)(cid:77)(cid:94)(cid:77)(cid:86)(cid:3)(cid:73)(cid:91)(cid:91)(cid:77)(cid:92)(cid:91)(cid:3)(cid:92)(cid:87)(cid:92)(cid:73)(cid:84)(cid:81)(cid:86)(cid:79)(cid:3)(cid:12)(cid:27)(cid:29)(cid:24)(cid:3)(cid:85)(cid:81)(cid:84)(cid:84)(cid:81)(cid:87)(cid:86)(cid:3)(cid:73)(cid:92)(cid:3)(cid:73)(cid:3)(cid:95)(cid:77)(cid:81)(cid:79)(cid:80)(cid:92)(cid:77)(cid:76)(cid:3)(cid:73)(cid:94)(cid:77)(cid:90)(cid:73)(cid:79)(cid:77)(cid:3)(cid:43)(cid:73)(cid:88)(cid:3)(cid:58)(cid:73)(cid:92)(cid:77)(cid:3) (cid:87)(cid:78)(cid:3)(cid:27)(cid:22)(cid:32)(cid:3)(cid:88)(cid:77)(cid:90)(cid:75)(cid:77)(cid:86)(cid:92)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:73)(cid:86)(cid:3)(cid:61)(cid:86)(cid:84)(cid:77)(cid:94)(cid:77)(cid:90)(cid:73)(cid:79)(cid:77)(cid:76)(cid:3)(cid:49)(cid:58)(cid:58)(cid:3)(cid:87)(cid:78)(cid:3)(cid:25)(cid:32)(cid:3)(cid:88)(cid:77)(cid:90)(cid:75)(cid:77)(cid:86)(cid:92)(cid:3)(cid:87)(cid:94)(cid:77)(cid:90)(cid:3)(cid:92)(cid:80)(cid:77)(cid:81)(cid:90)(cid:3) eight-year weighted average holding period. Economic Gains totaled $185 million. With a substantial portion of these sales made (cid:92)(cid:87)(cid:3) (cid:75)(cid:87)(cid:86)(cid:76)(cid:87)(cid:3) (cid:75)(cid:87)(cid:86)(cid:94)(cid:77)(cid:90)(cid:92)(cid:77)(cid:90)(cid:91)(cid:20)(cid:3) (cid:95)(cid:77)(cid:3) (cid:77)(cid:86)(cid:82)(cid:87)(cid:97)(cid:77)(cid:76)(cid:3) (cid:92)(cid:80)(cid:77)(cid:3) (cid:73)(cid:76)(cid:76)(cid:77)(cid:76)(cid:3) (cid:74)(cid:77)(cid:86)(cid:77)(cid:197)(cid:92)(cid:3) (cid:87)(cid:78)(cid:3) (cid:90)(cid:77)(cid:85)(cid:87)(cid:94)(cid:81)(cid:86)(cid:79)(cid:3) units from the rental market and improving the performance of our remaining assets. The level of condo conversion activity may impact the liquidity for asset sales, but we are not unduly reliant on condo converters as a source of capital or sales. Gains on asset sales and rising operating income drove EPS to a record level of $4.21, an increase of 44 percent over 2004. FFO was $3.77 per share, increasing 12 percent over 2004 and exceeding our original outlook. The principal reasons for this outperformance were better than expected revenue and operating results, opportunistic land sales and a sustained low interest rate environment. Continued job growth, modest new supply and a reduction in existing apartment inventory from conversion activity further supported revenue growth. These improving fundamentals and focused execution allowed us to achieve Same Store revenue growth of 3.6 percent and, through constrained expenses, NOI growth of 4.2 percent. Anticipating these improving fundamentals, we increased development starts in 2005 to $880 million from $240 million in 2004, timing new apartment deliveries for what we expect to be a robust leasing environment in 2006 and 2007. AVALONBAY COMMUNITIES, INC. 5 AVALON JUANITA VILLAGE KIRKLAND, WA 211 APARTMENT HOMES COMPLETED OCTOBER 2005 (cid:41)(cid:3)(cid:75)(cid:87)(cid:86)(cid:94)(cid:77)(cid:86)(cid:81)(cid:77)(cid:86)(cid:92)(cid:3)(cid:81)(cid:86)(cid:21)(cid:197)(cid:84)(cid:84)(cid:3)(cid:84)(cid:87)(cid:75)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:20)(cid:3)(cid:3) (cid:3) such as that provided by Avalon Juanita Village, often represents the key attraction for our young professional residents. AVALON AT CRANE BROOK, MA AVALON TOWERS BY THE BAY, CA L O O K I N G F O R W A R D — P O S I T I O N E D F O R G R O W T H With the backdrop of an expanding economy, continued job formation and revenue growth that accelerated into 2006, we are optimistic about the next several years and are well positioned for (cid:79)(cid:90)(cid:87)(cid:95)(cid:92)(cid:80)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:87)(cid:93)(cid:92)(cid:91)(cid:81)(cid:98)(cid:77)(cid:76)(cid:3)(cid:90)(cid:77)(cid:84)(cid:73)(cid:92)(cid:81)(cid:94)(cid:77)(cid:3)(cid:90)(cid:81)(cid:91)(cid:83)(cid:21)(cid:73)(cid:76)(cid:82)(cid:93)(cid:91)(cid:92)(cid:77)(cid:76)(cid:3)(cid:90)(cid:77)(cid:92)(cid:93)(cid:90)(cid:86)(cid:91)(cid:22)(cid:3)(cid:63)(cid:77)(cid:3)(cid:74)(cid:77)(cid:84)(cid:81)(cid:77)(cid:94)(cid:77)(cid:3)(cid:87)(cid:93)(cid:90)(cid:3)(cid:88)(cid:73)(cid:92)(cid:80)(cid:3)(cid:92)(cid:87)(cid:3)(cid:94)(cid:73)(cid:84)(cid:93)(cid:77)(cid:3)(cid:75)(cid:90)(cid:77)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:3)(cid:81)(cid:91)(cid:3)(cid:75)(cid:84)(cid:77)(cid:73)(cid:90)(cid:3) and visible, supported by: (cid:81)(cid:3) The economy, our markets and our product; (cid:81)(cid:3) A sector-leading development program; (cid:81)(cid:3) A well-positioned capital structure; and (cid:81)(cid:3) A “cycle-seasoned” management team. These attributes position us for growth and are discussed further in the remainder of this letter. Positioned for Growth — the Economy, Our Markets and Our Product Key economic forecasts suggest continued economic and employment growth. In addition, the outlook for industry liquidity is favorable, with no signs that abundant access to capital—debt and equity, public and private—is abating. Forecasts for economic, employment and population growth within our markets translate into continued strengthening of demand and supply fundamentals, which should help support the strongest rental revenue growth since 2001. The same forecasts that support improving apartment fundamentals generally support all housing—including the for-sale market. However, shifting demographics, the gap in “rent vs. buy” economics and softening home sales suggest that home ownership levels may have reached a plateau, with the relative balance between for-sale and for-rent housing demand shifting back in favor of rental housing. Given our market concentration, asset quality and product diversity, AvalonBay is (cid:95)(cid:77)(cid:84)(cid:84)(cid:3)(cid:88)(cid:87)(cid:91)(cid:81)(cid:92)(cid:81)(cid:87)(cid:86)(cid:77)(cid:76)(cid:3)(cid:92)(cid:87)(cid:3)(cid:74)(cid:77)(cid:86)(cid:77)(cid:197)(cid:92)(cid:3)(cid:78)(cid:90)(cid:87)(cid:85)(cid:3)(cid:81)(cid:85)(cid:88)(cid:90)(cid:87)(cid:94)(cid:81)(cid:86)(cid:79)(cid:3)(cid:78)(cid:93)(cid:86)(cid:76)(cid:73)(cid:85)(cid:77)(cid:86)(cid:92)(cid:73)(cid:84)(cid:91)(cid:22)(cid:3)(cid:63)(cid:81)(cid:92)(cid:80)(cid:3)(cid:88)(cid:90)(cid:87)(cid:76)(cid:93)(cid:75)(cid:92)(cid:91)(cid:3)(cid:76)(cid:77)(cid:91)(cid:81)(cid:79)(cid:86)(cid:77)(cid:76)(cid:3)(cid:92)(cid:87)(cid:3)(cid:73)(cid:88)(cid:88)(cid:77)(cid:73)(cid:84)(cid:3)(cid:92)(cid:87)(cid:3)(cid:73)(cid:3)(cid:74)(cid:90)(cid:87)(cid:73)(cid:76)(cid:3) AVALONBAY COMMUNITIES, INC. 7 range of prospective residents and a portfolio that is highly occupied, we expect to see revenue growth from our existing assets and from an accelerated pace of new development leasing. The acceleration of revenue growth in late 2005 should continue into 2006 at levels of 5 to 6 percent— (cid:92)(cid:80)(cid:77)(cid:3)(cid:80)(cid:81)(cid:79)(cid:80)(cid:77)(cid:91)(cid:92)(cid:3)(cid:81)(cid:86)(cid:3)(cid:197)(cid:94)(cid:77)(cid:3)(cid:97)(cid:77)(cid:73)(cid:90)(cid:91)(cid:22) Positioned for Growth— a Sector-Leading Development Program This positive outlook supports our operating, development and capital recycling programs. Our Development Pipeline now stands at $4 billion, comprised of $1 billion under construction and $3 billion in planning. This is the largest development program in the multifamily sector. With an average land basis per unit of approximately $35,000 and access to attractive capital sources to fund the pipeline, we expect future development activity to contribute to earnings growth for years to come. Adding to the pipeline is challenging, as competing for fully entitled land against for-sale developers is just plain not economic. We responded to this challenge with creative thinking while taking measured risk, successfully adding a diverse set of new opportunities: (cid:81)(cid:3) In the greater Boston area, we acquired a 300-acre site of a former state hospital, gaining entitlements (cid:78)(cid:87)(cid:90)(cid:3)(cid:73)(cid:88)(cid:73)(cid:90)(cid:92)(cid:85)(cid:77)(cid:86)(cid:92)(cid:20)(cid:3)(cid:75)(cid:87)(cid:86)(cid:76)(cid:87)(cid:85)(cid:81)(cid:86)(cid:81)(cid:93)(cid:85)(cid:20)(cid:3)(cid:90)(cid:77)(cid:92)(cid:73)(cid:81)(cid:84)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:87)(cid:78)(cid:197)(cid:75)(cid:77)(cid:3)(cid:93)(cid:91)(cid:77)(cid:91)(cid:3) (cid:95)(cid:80)(cid:81)(cid:84)(cid:77)(cid:3)(cid:88)(cid:90)(cid:77)(cid:91)(cid:77)(cid:90)(cid:94)(cid:81)(cid:86)(cid:79)(cid:3)(cid:85)(cid:73)(cid:86)(cid:97)(cid:3)(cid:87)(cid:78)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:80)(cid:81)(cid:91)(cid:92)(cid:87)(cid:90)(cid:81)(cid:75)(cid:73)(cid:84)(cid:84)(cid:97)(cid:3)(cid:91)(cid:81)(cid:79)(cid:86)(cid:81)(cid:197)(cid:75)(cid:73)(cid:86)(cid:92)(cid:3) architectural features of the structure. (cid:81)(cid:3) In New York City, we undertook a multi-million dollar environmental remediation effort to begin construction of a $170 million high-rise apartment community adjacent to our successful (cid:41)(cid:94)(cid:73)(cid:84)(cid:87)(cid:86)(cid:3)(cid:58)(cid:81)(cid:94)(cid:77)(cid:90)(cid:94)(cid:81)(cid:77)(cid:95)(cid:3)(cid:75)(cid:87)(cid:85)(cid:85)(cid:93)(cid:86)(cid:81)(cid:92)(cid:97)(cid:22)(cid:3) (cid:81)(cid:3) In the greater Washington DC market, we acquired several commercial properties that we intend (cid:92)(cid:87)(cid:3)(cid:90)(cid:77)(cid:21)(cid:98)(cid:87)(cid:86)(cid:77)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:90)(cid:73)(cid:98)(cid:77)(cid:3)(cid:78)(cid:87)(cid:90)(cid:3)(cid:76)(cid:77)(cid:94)(cid:77)(cid:84)(cid:87)(cid:88)(cid:85)(cid:77)(cid:86)(cid:92)(cid:3)(cid:87)(cid:78)(cid:3)(cid:86)(cid:77)(cid:95)(cid:3)(cid:73)(cid:88)(cid:73)(cid:90)(cid:92)(cid:85)(cid:77)(cid:86)(cid:92)(cid:91)(cid:20)(cid:3)(cid:88)(cid:90)(cid:87)(cid:94)(cid:81)(cid:76)(cid:81)(cid:86)(cid:79)(cid:3)(cid:75)(cid:73)(cid:91)(cid:80)(cid:3)(cid:198)(cid:87)(cid:95)(cid:3)(cid:78)(cid:90)(cid:87)(cid:85)(cid:3)(cid:84)(cid:77)(cid:73)(cid:91)(cid:77)(cid:91)(cid:3)(cid:81)(cid:86)(cid:3)(cid:88)(cid:84)(cid:73)(cid:75)(cid:77)(cid:3) while controlling the land and advancing the entitlement process. 8 AVALONBAY COMMUNITIES, INC. AVALON BELLEVUE, WA AVALON AT FOXHALL, DC Opportunities such as these are created by having an established local presence in each of our supply-constrained markets. We have over a hundred experienced construction and development (cid:88)(cid:90)(cid:87)(cid:78)(cid:77)(cid:91)(cid:91)(cid:81)(cid:87)(cid:86)(cid:73)(cid:84)(cid:91)(cid:3) (cid:81)(cid:86)(cid:3) (cid:92)(cid:77)(cid:86)(cid:3) (cid:90)(cid:77)(cid:79)(cid:81)(cid:87)(cid:86)(cid:73)(cid:84)(cid:3) (cid:87)(cid:78)(cid:197)(cid:75)(cid:77)(cid:91)(cid:3) (cid:76)(cid:77)(cid:76)(cid:81)(cid:75)(cid:73)(cid:92)(cid:77)(cid:76)(cid:3) (cid:92)(cid:87)(cid:3) (cid:81)(cid:76)(cid:77)(cid:86)(cid:92)(cid:81)(cid:78)(cid:97)(cid:81)(cid:86)(cid:79)(cid:3) (cid:73)(cid:86)(cid:76)(cid:3) (cid:77)(cid:96)(cid:77)(cid:75)(cid:93)(cid:92)(cid:81)(cid:86)(cid:79)(cid:3) (cid:76)(cid:77)(cid:94)(cid:77)(cid:84)(cid:87)(cid:88)(cid:85)(cid:77)(cid:86)(cid:92)(cid:3) (cid:87)(cid:88)(cid:88)(cid:87)(cid:90)(cid:92)(cid:93)(cid:86)(cid:81)(cid:92)(cid:81)(cid:77)(cid:91)(cid:184)(cid:84)(cid:87)(cid:75)(cid:73)(cid:84)(cid:3)(cid:77)(cid:96)(cid:77)(cid:75)(cid:93)(cid:92)(cid:81)(cid:87)(cid:86)(cid:3)(cid:95)(cid:81)(cid:92)(cid:80)(cid:3)(cid:75)(cid:77)(cid:86)(cid:92)(cid:90)(cid:73)(cid:84)(cid:81)(cid:98)(cid:77)(cid:76)(cid:3)(cid:91)(cid:93)(cid:88)(cid:88)(cid:87)(cid:90)(cid:92)(cid:22)(cid:3) (cid:59)(cid:81)(cid:79)(cid:86)(cid:81)(cid:197)(cid:75)(cid:73)(cid:86)(cid:92)(cid:3) (cid:75)(cid:80)(cid:73)(cid:84)(cid:84)(cid:77)(cid:86)(cid:79)(cid:77)(cid:91)(cid:3) (cid:78)(cid:73)(cid:75)(cid:81)(cid:86)(cid:79)(cid:3) (cid:92)(cid:80)(cid:77)(cid:3) (cid:81)(cid:86)(cid:76)(cid:93)(cid:91)(cid:92)(cid:90)(cid:97)(cid:3) (cid:81)(cid:86)(cid:75)(cid:84)(cid:93)(cid:76)(cid:77)(cid:3) (cid:80)(cid:81)(cid:79)(cid:80)(cid:77)(cid:90)(cid:3) (cid:90)(cid:77)(cid:88)(cid:84)(cid:73)(cid:75)(cid:77)(cid:85)(cid:77)(cid:86)(cid:92)(cid:3) (cid:75)(cid:87)(cid:91)(cid:92)(cid:91)(cid:3) (cid:78)(cid:90)(cid:87)(cid:85)(cid:3) (cid:79)(cid:77)(cid:86)(cid:77)(cid:90)(cid:73)(cid:84)(cid:3) (cid:75)(cid:87)(cid:91)(cid:92)(cid:3) escalation and scarce subcontractor resources, which add complexity and risk to new development. These challenges require increased vigilance on our part to contain cost increases, and we have (cid:73)(cid:86)(cid:3)(cid:87)(cid:90)(cid:79)(cid:73)(cid:86)(cid:81)(cid:98)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:3)(cid:87)(cid:78)(cid:3)(cid:77)(cid:96)(cid:88)(cid:77)(cid:90)(cid:81)(cid:77)(cid:86)(cid:75)(cid:77)(cid:76)(cid:3)(cid:88)(cid:90)(cid:87)(cid:78)(cid:77)(cid:91)(cid:91)(cid:81)(cid:87)(cid:86)(cid:73)(cid:84)(cid:91)(cid:20)(cid:3)(cid:85)(cid:73)(cid:90)(cid:83)(cid:77)(cid:92)(cid:3)(cid:92)(cid:77)(cid:86)(cid:93)(cid:90)(cid:77)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:77)(cid:75)(cid:87)(cid:86)(cid:87)(cid:85)(cid:81)(cid:77)(cid:91)(cid:3)(cid:87)(cid:78)(cid:3)(cid:91)(cid:75)(cid:73)(cid:84)(cid:77)(cid:3)(cid:95)(cid:80)(cid:81)(cid:75)(cid:80)(cid:3)(cid:80)(cid:77)(cid:84)(cid:88)(cid:3)(cid:3) insulate us from these pressures. After more than twenty years in our markets, we have developed a unique infrastructure of development, investment and property management skills. This translates into a competitive (cid:73)(cid:76)(cid:94)(cid:73)(cid:86)(cid:92)(cid:73)(cid:79)(cid:77)(cid:3)(cid:81)(cid:86)(cid:3)(cid:85)(cid:73)(cid:90)(cid:83)(cid:77)(cid:92)(cid:91)(cid:3)(cid:92)(cid:80)(cid:73)(cid:92)(cid:3)(cid:73)(cid:90)(cid:77)(cid:3)(cid:76)(cid:81)(cid:78)(cid:197)(cid:75)(cid:93)(cid:84)(cid:92)(cid:3)(cid:92)(cid:87)(cid:3)(cid:88)(cid:77)(cid:86)(cid:77)(cid:92)(cid:90)(cid:73)(cid:92)(cid:77)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:95)(cid:80)(cid:77)(cid:90)(cid:77)(cid:3)(cid:86)(cid:77)(cid:95)(cid:3)(cid:77)(cid:86)(cid:92)(cid:81)(cid:92)(cid:84)(cid:77)(cid:85)(cid:77)(cid:86)(cid:92)(cid:91)(cid:3)(cid:73)(cid:90)(cid:77)(cid:3)(cid:86)(cid:87)(cid:92)(cid:3)(cid:77)(cid:73)(cid:91)(cid:97)(cid:3)(cid:92)(cid:87)(cid:3) (cid:87)(cid:74)(cid:92)(cid:73)(cid:81)(cid:86)(cid:22)(cid:3)(cid:48)(cid:81)(cid:79)(cid:80)(cid:77)(cid:90)(cid:3)(cid:90)(cid:77)(cid:88)(cid:84)(cid:73)(cid:75)(cid:77)(cid:85)(cid:77)(cid:86)(cid:92)(cid:3)(cid:75)(cid:87)(cid:91)(cid:92)(cid:91)(cid:3)(cid:85)(cid:77)(cid:86)(cid:92)(cid:81)(cid:87)(cid:86)(cid:77)(cid:76)(cid:3)(cid:73)(cid:74)(cid:87)(cid:94)(cid:77)(cid:3)(cid:76)(cid:87)(cid:3)(cid:91)(cid:77)(cid:90)(cid:94)(cid:77)(cid:3)(cid:92)(cid:87)(cid:3)(cid:84)(cid:81)(cid:85)(cid:81)(cid:92)(cid:3)(cid:75)(cid:87)(cid:85)(cid:88)(cid:77)(cid:92)(cid:81)(cid:92)(cid:81)(cid:87)(cid:86)(cid:20)(cid:3)(cid:77)(cid:85)(cid:88)(cid:80)(cid:73)(cid:91)(cid:81)(cid:98)(cid:81)(cid:86)(cid:79)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3) value of our $9 billion of operating assets in place as well as land under control, further enhancing our competitive advantage. The value creation from our development activity is not captured in our balance sheet or earnings (cid:92)(cid:87)(cid:76)(cid:73)(cid:97)(cid:20)(cid:3)(cid:74)(cid:93)(cid:92)(cid:3)(cid:95)(cid:81)(cid:84)(cid:84)(cid:3)(cid:73)(cid:75)(cid:75)(cid:90)(cid:93)(cid:77)(cid:3)(cid:92)(cid:87)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:74)(cid:77)(cid:86)(cid:77)(cid:197)(cid:92)(cid:3)(cid:87)(cid:78)(cid:3)(cid:81)(cid:86)(cid:94)(cid:77)(cid:91)(cid:92)(cid:87)(cid:90)(cid:91)(cid:3)(cid:73)(cid:91)(cid:3)(cid:92)(cid:80)(cid:77)(cid:91)(cid:77)(cid:3)(cid:76)(cid:77)(cid:94)(cid:77)(cid:84)(cid:87)(cid:88)(cid:85)(cid:77)(cid:86)(cid:92)(cid:91)(cid:3)(cid:85)(cid:87)(cid:94)(cid:77)(cid:3)(cid:92)(cid:80)(cid:90)(cid:87)(cid:93)(cid:79)(cid:80)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:88)(cid:81)(cid:88)(cid:77)(cid:84)(cid:81)(cid:86)(cid:77)(cid:22)(cid:3) Positioned for Growth—a Well-Positioned Capital Structure Prepared for External Growth Our $4 billion Development Pipeline is an important source of future earnings growth and value creation, and we believe our balance sheet will continue to support that growth. With current Fixed Charge Coverage and Leverage of 3.0x and 26 percent, respectively, we have (cid:91)(cid:81)(cid:79)(cid:86)(cid:81)(cid:197)(cid:75)(cid:73)(cid:86)(cid:92)(cid:3)(cid:74)(cid:87)(cid:90)(cid:90)(cid:87)(cid:95)(cid:81)(cid:86)(cid:79)(cid:3)(cid:75)(cid:73)(cid:88)(cid:73)(cid:75)(cid:81)(cid:92)(cid:97)(cid:3)(cid:92)(cid:87)(cid:3)(cid:76)(cid:77)(cid:94)(cid:77)(cid:84)(cid:87)(cid:88)(cid:3)(cid:92)(cid:80)(cid:81)(cid:91)(cid:3)(cid:74)(cid:73)(cid:75)(cid:83)(cid:84)(cid:87)(cid:79)(cid:3)(cid:87)(cid:78)(cid:3)(cid:74)(cid:93)(cid:91)(cid:81)(cid:86)(cid:77)(cid:91)(cid:91)(cid:3)(cid:81)(cid:86)(cid:3) (cid:73)(cid:3) (cid:88)(cid:90)(cid:93)(cid:76)(cid:77)(cid:86)(cid:92)(cid:3) (cid:85)(cid:73)(cid:86)(cid:86)(cid:77)(cid:90)(cid:22)(cid:3) (cid:52)(cid:87)(cid:95)(cid:3) (cid:84)(cid:77)(cid:94)(cid:77)(cid:84)(cid:91)(cid:3) (cid:87)(cid:78)(cid:3) (cid:198)(cid:87)(cid:73)(cid:92)(cid:81)(cid:86)(cid:79)(cid:3) (cid:90)(cid:73)(cid:92)(cid:77)(cid:3) (cid:76)(cid:77)(cid:74)(cid:92)(cid:3) (cid:80)(cid:77)(cid:84)(cid:88)(cid:3) (cid:77)(cid:86)(cid:91)(cid:93)(cid:90)(cid:77)(cid:3) (cid:92)(cid:80)(cid:73)(cid:92)(cid:3) 10 AVALONBAY COMMUNITIES, INC. AVALON AT ROCK SPRING, MD AVALON AT FLANDERS HILL, MA future earnings growth will not be “taxed” with (cid:80)(cid:81)(cid:79)(cid:80)(cid:77)(cid:90)(cid:3)(cid:81)(cid:86)(cid:92)(cid:77)(cid:90)(cid:77)(cid:91)(cid:92)(cid:3)(cid:90)(cid:73)(cid:92)(cid:77)(cid:91)(cid:22)(cid:3)(cid:58)(cid:77)(cid:92)(cid:73)(cid:81)(cid:86)(cid:77)(cid:76)(cid:3)(cid:75)(cid:73)(cid:91)(cid:80)(cid:3)(cid:84)(cid:77)(cid:94)(cid:77)(cid:84)(cid:91)(cid:3)(cid:75)(cid:87)(cid:86)(cid:92)(cid:81)(cid:86)(cid:93)(cid:77)(cid:3)(cid:92)(cid:87)(cid:3) rise, providing cost-effective development capital and (cid:90)(cid:87)(cid:87)(cid:85)(cid:3) (cid:78)(cid:87)(cid:90)(cid:3) (cid:73)(cid:76)(cid:76)(cid:81)(cid:92)(cid:81)(cid:87)(cid:86)(cid:73)(cid:84)(cid:3) (cid:76)(cid:81)(cid:94)(cid:81)(cid:76)(cid:77)(cid:86)(cid:76)(cid:3) (cid:79)(cid:90)(cid:87)(cid:95)(cid:92)(cid:80)(cid:22)(cid:3) (cid:58)(cid:77)(cid:75)(cid:87)(cid:79)(cid:86)(cid:81)(cid:98)(cid:81)(cid:86)(cid:79)(cid:3) the prospects for future earnings growth, our board voted to increase the annual dividend by 10 percent, from $2.84 to $3.12 per share effective March 2006. This represents the largest percentage increase in the (cid:91)(cid:77)(cid:75)(cid:92)(cid:87)(cid:90)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:81)(cid:91)(cid:3)(cid:78)(cid:93)(cid:84)(cid:84)(cid:97)(cid:3)(cid:91)(cid:93)(cid:88)(cid:88)(cid:87)(cid:90)(cid:92)(cid:77)(cid:76)(cid:3)(cid:74)(cid:97)(cid:3)(cid:90)(cid:77)(cid:75)(cid:93)(cid:90)(cid:90)(cid:81)(cid:86)(cid:79)(cid:3)(cid:75)(cid:73)(cid:91)(cid:80)(cid:3)(cid:198)(cid:87)(cid:95)(cid:22)(cid:3) Long-term growth and safety of the dividend is also our focus. Since 1995, the growth in our recurring dividend was twice the multifamily sector average. This was acheived while maintaining one of the lowest payout ratios in the sector. (cid:63)(cid:77)(cid:188)(cid:94)(cid:77)(cid:3)(cid:88)(cid:90)(cid:77)(cid:88)(cid:73)(cid:90)(cid:77)(cid:76)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:74)(cid:73)(cid:84)(cid:73)(cid:86)(cid:75)(cid:77)(cid:3)(cid:91)(cid:80)(cid:77)(cid:77)(cid:92)(cid:3)(cid:78)(cid:87)(cid:90)(cid:3)(cid:73)(cid:75)(cid:75)(cid:90)(cid:77)(cid:92)(cid:81)(cid:94)(cid:77)(cid:3)(cid:76)(cid:77)(cid:94)(cid:77)(cid:84)(cid:87)(cid:88)(cid:85)(cid:77)(cid:86)(cid:92)(cid:20)(cid:3)(cid:74)(cid:93)(cid:92)(cid:3)(cid:90)(cid:77)(cid:75)(cid:87)(cid:79)(cid:86)(cid:81)(cid:98)(cid:77)(cid:3)(cid:92)(cid:80)(cid:73)(cid:92)(cid:3)(cid:94)(cid:73)(cid:84)(cid:93)(cid:77)(cid:3)(cid:75)(cid:73)(cid:86)(cid:3)(cid:73)(cid:84)(cid:91)(cid:87)(cid:3)(cid:74)(cid:77)(cid:3) created through selective capital allocation to acquisitions. Accordingly, we further positioned for growth through private equity, creating the AvalonBay Value Added Fund, L.P. This investment management fund provides enough equity capital to purchase and leverage investments totaling $900 million. This approach provides access to an alternative capital source, is consistent with our desire to keep our common stock scarce and presents an opportunity to create value for private investors. Investment management also provides an attractive and recurring income stream for our management efforts. A well-executed capital allocation strategy creates value. Access to multiple capital sources allows us to direct public equity to more accretive development while directing private equity to acquisitions. This helps ensure optimal value creation from our capital allocation efforts. AVALONBAY COMMUNITIES, INC.11 AVALON AT NEWTON HIGHLANDS, MA AVALON ON THE SOUND, NY Positioned for Growth—a “Cycle-Seasoned” Management Team The period from 2002-2004 that marked a severe downturn in operating fundamentals was (cid:76)(cid:81)(cid:78)(cid:197)(cid:75)(cid:93)(cid:84)(cid:92)(cid:3)(cid:74)(cid:93)(cid:92)(cid:3)(cid:81)(cid:86)(cid:91)(cid:92)(cid:90)(cid:93)(cid:75)(cid:92)(cid:81)(cid:94)(cid:77)(cid:22)(cid:3)(cid:63)(cid:77)(cid:3)(cid:84)(cid:77)(cid:73)(cid:90)(cid:86)(cid:77)(cid:76)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:73)(cid:76)(cid:73)(cid:88)(cid:92)(cid:77)(cid:76)(cid:3)(cid:92)(cid:73)(cid:75)(cid:92)(cid:81)(cid:75)(cid:91)(cid:3)(cid:92)(cid:87)(cid:3)(cid:87)(cid:88)(cid:92)(cid:81)(cid:85)(cid:81)(cid:98)(cid:77)(cid:3)(cid:88)(cid:77)(cid:90)(cid:78)(cid:87)(cid:90)(cid:85)(cid:73)(cid:86)(cid:75)(cid:77)(cid:20)(cid:3)(cid:74)(cid:93)(cid:92)(cid:3)(cid:87)(cid:93)(cid:90)(cid:3)(cid:92)(cid:81)(cid:85)(cid:77)(cid:21) tested strategy remained intact. Convinced our strategy was sound, we positioned the company for the upturn— installing new systems, streamlining processes, adjusting our development and construction infrastructure to match current and prospective opportunities, and preparing the balance sheet for the next up-cycle. We weathered the storm well, with a stock price double its pre-downturn level, a positive outlook from the rating agencies and a seasoned group of professional management that understands how (cid:92)(cid:87)(cid:3)(cid:85)(cid:73)(cid:96)(cid:81)(cid:85)(cid:81)(cid:98)(cid:77)(cid:3)(cid:94)(cid:73)(cid:84)(cid:93)(cid:77)(cid:3)(cid:76)(cid:93)(cid:90)(cid:81)(cid:86)(cid:79)(cid:3)(cid:73)(cid:84)(cid:84)(cid:3)(cid:88)(cid:80)(cid:73)(cid:91)(cid:77)(cid:91)(cid:3)(cid:87)(cid:78) (cid:3)(cid:73)(cid:3)(cid:90)(cid:77)(cid:73)(cid:84)(cid:3)(cid:77)(cid:91)(cid:92)(cid:73)(cid:92)(cid:77)(cid:3)(cid:75)(cid:97)(cid:75)(cid:84)(cid:77)(cid:22) C O N C L U S I O N Our 2005 results are part of a recurring theme of general outperformance over a sustained period of time, as AvalonBay outperformed the sector in EPS, FFO per Share, NAV per Share Growth and Total Shareholder (cid:58)(cid:77)(cid:92)(cid:93)(cid:90)(cid:86)(cid:3)(cid:87)(cid:94)(cid:77)(cid:90)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:84)(cid:73)(cid:91)(cid:92)(cid:3)(cid:25)(cid:24)(cid:3)(cid:97)(cid:77)(cid:73)(cid:90)(cid:91)(cid:22)(cid:3)(cid:41)(cid:86)(cid:76)(cid:3)(cid:85)(cid:73)(cid:86)(cid:97)(cid:3)(cid:87)(cid:78)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:73)(cid:92)(cid:92)(cid:90)(cid:81)(cid:74)(cid:93)(cid:92)(cid:77)(cid:91)(cid:3) (cid:92)(cid:80)(cid:73)(cid:92)(cid:3) (cid:76)(cid:90)(cid:87)(cid:94)(cid:77)(cid:3) (cid:91)(cid:81)(cid:79)(cid:86)(cid:81)(cid:197)(cid:75)(cid:73)(cid:86)(cid:92)(cid:3) (cid:91)(cid:80)(cid:73)(cid:90)(cid:77)(cid:80)(cid:87)(cid:84)(cid:76)(cid:77)(cid:90)(cid:3) (cid:94)(cid:73)(cid:84)(cid:93)(cid:77)(cid:3) (cid:75)(cid:90)(cid:77)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:3) (cid:87)(cid:94)(cid:77)(cid:90)(cid:3) this 10-year period remain in place. Today, apartment fundamentals are improving, with third-party economic forecasts calling for continued economic and employment growth. Many of our markets are projected to outperform, with revenue growth in (cid:26)(cid:24)(cid:24)(cid:30)(cid:3) (cid:73)(cid:92)(cid:3) (cid:92)(cid:80)(cid:77)(cid:3) (cid:80)(cid:81)(cid:79)(cid:80)(cid:77)(cid:91)(cid:92)(cid:3) (cid:84)(cid:77)(cid:94)(cid:77)(cid:84)(cid:91)(cid:3) (cid:91)(cid:81)(cid:86)(cid:75)(cid:77)(cid:3) (cid:26)(cid:24)(cid:24)(cid:25)(cid:22)(cid:3) (cid:58)(cid:77)(cid:86)(cid:92)(cid:73)(cid:84)(cid:3) (cid:90)(cid:73)(cid:92)(cid:77)(cid:91)(cid:3) (cid:73)(cid:90)(cid:77)(cid:3) rising, and future revenue growth is supported by the high occupancy platform we currently enjoy. Leasing activity at our development communities is strong. 12 AVALONBAY COMMUNITIES, INC. AVALON AT GALLERY PLACE, DC AVALON AT ARLINGTON SQUARE, VA We are positioned for growth.(cid:3)(cid:63)(cid:77)(cid:3)(cid:80)(cid:73)(cid:94)(cid:77)(cid:3)(cid:73)(cid:3)(cid:92)(cid:81)(cid:85)(cid:77)(cid:21)(cid:92)(cid:77)(cid:91)(cid:92)(cid:77)(cid:76)(cid:3)(cid:91)(cid:92)(cid:90)(cid:73)(cid:92)(cid:77)(cid:79)(cid:97)(cid:3)(cid:92)(cid:80)(cid:73)(cid:92)(cid:3)(cid:80)(cid:73)(cid:91)(cid:3)(cid:76)(cid:77)(cid:84)(cid:81)(cid:94)(cid:77)(cid:90)(cid:77)(cid:76)(cid:3)(cid:87)(cid:93)(cid:92)(cid:91)(cid:81)(cid:98)(cid:77)(cid:76)(cid:3)(cid:90)(cid:81)(cid:91)(cid:83)(cid:21)(cid:73)(cid:76)(cid:82)(cid:93)(cid:91)(cid:92)(cid:77)(cid:76)(cid:3) returns over an extended period. We have a competitive advantage in our development program in some of the strongest markets in the country. We have a high-quality and diverse offering of apartment homes that will be in demand as economic growth continues. We have an integrated real estate operating platform poised for additional value creation as we build out and add to our $4 billion pipeline. We have a well-positioned balance sheet that supports growth. Finally, we have a “cycle-seasoned” management team that is committed to our strategy, but nimble enough to make adjustments when opportunities arise. And although our strategy will evolve, it will not drift. We remain committed to these core elements of our time-tested strategy: (cid:81)(cid:3) To further penetrate our supply-constrained markets that offer strong long-term fundamentals; (cid:81)(cid:3) To create value through pursuit of ground-up development of land for which we gain entitlements; (cid:81)(cid:3) To effectively allocate capital through targeted acquisition and disposition activity; (cid:81)(cid:3) (cid:60)(cid:87)(cid:3)(cid:87)(cid:88)(cid:92)(cid:81)(cid:85)(cid:81)(cid:98)(cid:77)(cid:3)(cid:87)(cid:93)(cid:90)(cid:3)(cid:87)(cid:88)(cid:77)(cid:90)(cid:73)(cid:92)(cid:81)(cid:86)(cid:79)(cid:3)(cid:88)(cid:87)(cid:90)(cid:92)(cid:78)(cid:87)(cid:84)(cid:81)(cid:87)(cid:3)(cid:95)(cid:80)(cid:81)(cid:84)(cid:77)(cid:3)(cid:76)(cid:77)(cid:84)(cid:81)(cid:94)(cid:77)(cid:90)(cid:81)(cid:86)(cid:79)(cid:3)(cid:77)(cid:96)(cid:75)(cid:77)(cid:88)(cid:92)(cid:81)(cid:87)(cid:86)(cid:73)(cid:84)(cid:3)(cid:91)(cid:77)(cid:90)(cid:94)(cid:81)(cid:75)(cid:77)(cid:3)(cid:92)(cid:87)(cid:3)(cid:87)(cid:93)(cid:90)(cid:3)(cid:90)(cid:77)(cid:91)(cid:81)(cid:76)(cid:77)(cid:86)(cid:92)(cid:91)(cid:35)(cid:3)(cid:73)(cid:86)(cid:76) (cid:81)(cid:3) (cid:60)(cid:87)(cid:3)(cid:85)(cid:73)(cid:81)(cid:86)(cid:92)(cid:73)(cid:81)(cid:86)(cid:3)(cid:73)(cid:3)(cid:197)(cid:86)(cid:73)(cid:86)(cid:75)(cid:81)(cid:73)(cid:84)(cid:3)(cid:88)(cid:87)(cid:91)(cid:81)(cid:92)(cid:81)(cid:87)(cid:86)(cid:3)(cid:92)(cid:80)(cid:73)(cid:92)(cid:3)(cid:91)(cid:93)(cid:88)(cid:88)(cid:87)(cid:90)(cid:92)(cid:91)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:85)(cid:73)(cid:96)(cid:81)(cid:85)(cid:81)(cid:98)(cid:77)(cid:91)(cid:3)(cid:94)(cid:73)(cid:84)(cid:93)(cid:77)(cid:3)(cid:75)(cid:90)(cid:77)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:22) As always, I would like to thank our shareholders for their support, our associates for another year of outstanding achievements and our residents for making an AvalonBay community their home. Bryce Blair Chairman and (cid:43)(cid:80)(cid:81)(cid:77)(cid:78) (cid:3)(cid:45)(cid:96)(cid:77)(cid:75)(cid:93)(cid:92)(cid:81)(cid:94)(cid:77)(cid:3)(cid:55)(cid:78)(cid:197)(cid:75)(cid:77)(cid:90) AVALONBAY COMMUNITIES, INC. 13 Notes & Non-GAAP Financial Measures and Other Terms NO T E S (cid:25)(cid:22)(cid:3) (cid:60)(cid:87)(cid:92)(cid:73)(cid:84)(cid:3)(cid:59)(cid:80)(cid:73)(cid:90)(cid:77)(cid:80)(cid:87)(cid:84)(cid:76)(cid:77)(cid:90)(cid:3)(cid:58)(cid:77)(cid:92)(cid:93)(cid:90)(cid:86)(cid:184)(cid:60)(cid:80)(cid:77)(cid:3)(cid:75)(cid:80)(cid:73)(cid:86)(cid:79)(cid:77)(cid:3)(cid:81)(cid:86)(cid:3)(cid:94)(cid:73)(cid:84)(cid:93)(cid:77)(cid:3)(cid:87)(cid:94)(cid:77)(cid:90)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3) period stated with all dividends reinvested. Total Share- (cid:80)(cid:87)(cid:84)(cid:76)(cid:77)(cid:90)(cid:3)(cid:58)(cid:77)(cid:92)(cid:93)(cid:90)(cid:86)(cid:3)(cid:81)(cid:91)(cid:3)(cid:91)(cid:87)(cid:85)(cid:77)(cid:92)(cid:81)(cid:85)(cid:77)(cid:91)(cid:3)(cid:88)(cid:90)(cid:77)(cid:91)(cid:77)(cid:86)(cid:92)(cid:77)(cid:76)(cid:3)(cid:73)(cid:91)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:75)(cid:87)(cid:85)(cid:88)(cid:87)(cid:93)(cid:86)(cid:76)(cid:3) (cid:73)(cid:86)(cid:86)(cid:93)(cid:73)(cid:84)(cid:3)(cid:79)(cid:90)(cid:87)(cid:95)(cid:92)(cid:80)(cid:3)(cid:90)(cid:73)(cid:92)(cid:77)(cid:22)(cid:3)(cid:60)(cid:80)(cid:77)(cid:3)(cid:60)(cid:87)(cid:92)(cid:73)(cid:84)(cid:3)(cid:59)(cid:80)(cid:73)(cid:90)(cid:77)(cid:80)(cid:87)(cid:84)(cid:76)(cid:77)(cid:90)(cid:3)(cid:58)(cid:77)(cid:92)(cid:93)(cid:90)(cid:86)(cid:3)(cid:78)(cid:87)(cid:90)(cid:3) each year within the timeframe presented may vary. 2. Estimated NAV per Share Growth—The compound annual growth rate of Estimated NAV per Share as esti- mated by Green Street Advisors, Inc. during the periods indicated. Estimated NAV per Share Growth for each year within the timeframe presented may vary. 3. FFO per Share Growth—The compound annual growth rate of FFO per Share as reported during the period stated. FFO per Share Growth for each year within the timeframe presented may vary. (cid:28)(cid:22)(cid:3) (cid:44)(cid:73)(cid:92)(cid:73)(cid:3)(cid:88)(cid:90)(cid:87)(cid:94)(cid:81)(cid:76)(cid:77)(cid:76)(cid:3)(cid:74)(cid:97)(cid:3)(cid:56)(cid:56)(cid:58)(cid:22)(cid:3)(cid:44)(cid:77)(cid:85)(cid:73)(cid:86)(cid:76)(cid:21)(cid:91)(cid:93)(cid:88)(cid:88)(cid:84)(cid:97)(cid:3)(cid:76)(cid:77)(cid:197)(cid:86)(cid:77)(cid:76)(cid:3)(cid:73)(cid:91)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3) ratio of net renter demand and net completions. Net (cid:90)(cid:77)(cid:86)(cid:92)(cid:77)(cid:90)(cid:3)(cid:76)(cid:77)(cid:85)(cid:73)(cid:86)(cid:76)(cid:3)(cid:81)(cid:91)(cid:3)(cid:76)(cid:77)(cid:197)(cid:86)(cid:77)(cid:76)(cid:3)(cid:73)(cid:91)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:97)(cid:77)(cid:73)(cid:90)(cid:21)(cid:92)(cid:87)(cid:21)(cid:97)(cid:77)(cid:73)(cid:90)(cid:3)(cid:75)(cid:80)(cid:73)(cid:86)(cid:79)(cid:77)(cid:3)(cid:81)(cid:86)(cid:3) (cid:92)(cid:80)(cid:77)(cid:3)(cid:92)(cid:87)(cid:92)(cid:73)(cid:84)(cid:3)(cid:90)(cid:77)(cid:86)(cid:92)(cid:73)(cid:84)(cid:3)(cid:88)(cid:87)(cid:88)(cid:93)(cid:84)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:22)(cid:3)(cid:54)(cid:77)(cid:92)(cid:3)(cid:75)(cid:87)(cid:85)(cid:88)(cid:84)(cid:77)(cid:92)(cid:81)(cid:87)(cid:86)(cid:91)(cid:3)(cid:81)(cid:91)(cid:3)(cid:76)(cid:77)(cid:197)(cid:86)(cid:77)(cid:76)(cid:3) as the year-to-year change in rental completions net of condominium conversions. 5. Development Pipeline—The projected Total Capital Cost for Development in Planning plus the projected Total Capital Cost of communities under construction. Amounts represent the Development Pipeline at December 31 of each year presented. (cid:30)(cid:22)(cid:3) (cid:44)(cid:77)(cid:94)(cid:77)(cid:84)(cid:87)(cid:88)(cid:85)(cid:77)(cid:86)(cid:92)(cid:3) (cid:81)(cid:86)(cid:3) (cid:56)(cid:84)(cid:73)(cid:86)(cid:86)(cid:81)(cid:86)(cid:79)(cid:3) (cid:16)(cid:44)(cid:77)(cid:94)(cid:77)(cid:84)(cid:87)(cid:88)(cid:85)(cid:77)(cid:86)(cid:92)(cid:3) (cid:58)(cid:81)(cid:79)(cid:80)(cid:92)(cid:91)(cid:17)(cid:184) Development opportunities in the early phase of the development process for which: (i) we have an option to acquire land or enter into a leasehold interest; (ii) we are the buyer under a long-term conditional contract to purchase land; or (iii) we own land to develop a new community. The dollar amount for Development in Planning represents the projected Total Capital Cost if these opportunities were developed as anticipated. (cid:31)(cid:22)(cid:3) (cid:56)(cid:77)(cid:90)(cid:75)(cid:77)(cid:86)(cid:92)(cid:73)(cid:79)(cid:77)(cid:91)(cid:3) (cid:78)(cid:87)(cid:90)(cid:3) (cid:45)(cid:89)(cid:93)(cid:81)(cid:92)(cid:97)(cid:3) (cid:73)(cid:86)(cid:76)(cid:3) (cid:46)(cid:81)(cid:96)(cid:77)(cid:76)(cid:3) (cid:73)(cid:86)(cid:76)(cid:3) (cid:62)(cid:73)(cid:90)(cid:81)(cid:73)(cid:74)(cid:84)(cid:77)(cid:3) (cid:58)(cid:73)(cid:92)(cid:77)(cid:3) Debt represent the dollar amounts for each as a percent- (cid:73)(cid:79)(cid:77)(cid:3) (cid:87)(cid:78)(cid:3) (cid:92)(cid:80)(cid:77)(cid:3) (cid:43)(cid:87)(cid:85)(cid:88)(cid:73)(cid:86)(cid:97)(cid:188)(cid:91)(cid:3) (cid:60)(cid:87)(cid:92)(cid:73)(cid:84)(cid:3) (cid:53)(cid:73)(cid:90)(cid:83)(cid:77)(cid:92)(cid:3) (cid:43)(cid:73)(cid:88)(cid:81)(cid:92)(cid:73)(cid:84)(cid:81)(cid:98)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:3) (cid:73)(cid:92)(cid:3) (cid:44)(cid:77)(cid:75)(cid:77)(cid:85)(cid:74)(cid:77)(cid:90)(cid:3)(cid:27)(cid:25)(cid:20)(cid:3)(cid:26)(cid:24)(cid:24)(cid:29)(cid:22)(cid:3)(cid:60)(cid:87)(cid:92)(cid:73)(cid:84)(cid:3)(cid:53)(cid:73)(cid:90)(cid:83)(cid:77)(cid:92)(cid:3)(cid:43)(cid:73)(cid:88)(cid:81)(cid:92)(cid:73)(cid:84)(cid:81)(cid:98)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:3)(cid:90)(cid:77)(cid:88)(cid:90)(cid:77)- sents the aggregate of the market value of the Company’s common stock, the market value of the Company’s oper- ating partnership units outstanding (based on the mar- ket value of the Company’s common stock), the liquida- tion preference of the Company’s preferred stock and the outstanding principal balance of the Company’s debt. 8. Common Dividend per Share Growth—The increase in common dividends per share distributed during the period stated. The common dividend per share for 2006 (cid:90)(cid:77)(cid:198)(cid:77)(cid:75)(cid:92)(cid:91)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:73)(cid:86)(cid:86)(cid:93)(cid:73)(cid:84)(cid:81)(cid:98)(cid:77)(cid:76)(cid:3)(cid:197)(cid:90)(cid:91)(cid:92)(cid:3)(cid:89)(cid:93)(cid:73)(cid:90)(cid:92)(cid:77)(cid:90)(cid:3)(cid:26)(cid:24)(cid:24)(cid:30)(cid:3)(cid:76)(cid:81)(cid:94)(cid:81)(cid:76)(cid:77)(cid:86)(cid:76)(cid:3)(cid:88)(cid:77)(cid:90)(cid:3) (cid:91)(cid:80)(cid:73)(cid:90)(cid:77)(cid:3)(cid:78)(cid:87)(cid:90)(cid:3)(cid:73)(cid:84)(cid:84)(cid:3)(cid:75)(cid:87)(cid:85)(cid:88)(cid:73)(cid:86)(cid:81)(cid:77)(cid:91)(cid:3)(cid:92)(cid:80)(cid:73)(cid:92)(cid:3)(cid:80)(cid:73)(cid:94)(cid:77)(cid:3)(cid:76)(cid:77)(cid:75)(cid:84)(cid:73)(cid:90)(cid:77)(cid:76)(cid:3)(cid:73)(cid:3)(cid:197)(cid:90)(cid:91)(cid:92)(cid:3)(cid:89)(cid:93)(cid:73)(cid:90)- (cid:92)(cid:77)(cid:90)(cid:3) (cid:26)(cid:24)(cid:24)(cid:30)(cid:3) (cid:76)(cid:81)(cid:94)(cid:81)(cid:76)(cid:77)(cid:86)(cid:76)(cid:3) (cid:73)(cid:86)(cid:76)(cid:3) (cid:90)(cid:77)(cid:198)(cid:77)(cid:75)(cid:92)(cid:91)(cid:3) (cid:92)(cid:80)(cid:77)(cid:3) (cid:73)(cid:86)(cid:86)(cid:93)(cid:73)(cid:84)(cid:81)(cid:98)(cid:77)(cid:76)(cid:3) (cid:78)(cid:87)(cid:93)(cid:90)(cid:92)(cid:80)(cid:3) quarter 2005 dividend for all others. 9. EPS Growth—The compound annual growth rate of EPS during the period stated. EPS Growth for each year within the timeframe presented may vary. NON-GAAP FINANCIAL MEASURES AND OTHER TERMS (cid:60)(cid:80)(cid:77)(cid:3) (cid:78)(cid:87)(cid:84)(cid:84)(cid:87)(cid:95)(cid:81)(cid:86)(cid:79)(cid:3) (cid:86)(cid:87)(cid:86)(cid:21)(cid:47)(cid:41)(cid:41)(cid:56)(cid:3) (cid:197)(cid:86)(cid:73)(cid:86)(cid:75)(cid:81)(cid:73)(cid:84)(cid:3) (cid:85)(cid:77)(cid:73)(cid:91)(cid:93)(cid:90)(cid:77)(cid:91)(cid:3) (cid:73)(cid:86)(cid:76)(cid:3) (cid:87)(cid:92)(cid:80)(cid:77)(cid:90)(cid:3) (cid:92)(cid:77)(cid:90)(cid:85)(cid:91)(cid:20)(cid:3)(cid:73)(cid:91)(cid:3)(cid:93)(cid:91)(cid:77)(cid:76)(cid:3)(cid:81)(cid:86)(cid:3)(cid:92)(cid:80)(cid:81)(cid:91)(cid:3)(cid:41)(cid:86)(cid:86)(cid:93)(cid:73)(cid:84)(cid:3)(cid:58)(cid:77)(cid:88)(cid:87)(cid:90)(cid:92)(cid:20)(cid:3)(cid:81)(cid:86)(cid:75)(cid:84)(cid:93)(cid:76)(cid:81)(cid:86)(cid:79)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:52)(cid:77)(cid:92)(cid:92)(cid:77)(cid:90)(cid:3) (cid:92)(cid:87)(cid:3)(cid:59)(cid:80)(cid:73)(cid:90)(cid:77)(cid:80)(cid:87)(cid:84)(cid:76)(cid:77)(cid:90)(cid:91)(cid:20)(cid:3)(cid:73)(cid:90)(cid:77)(cid:3)(cid:76)(cid:77)(cid:197)(cid:86)(cid:77)(cid:76)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:78)(cid:93)(cid:90)(cid:92)(cid:80)(cid:77)(cid:90)(cid:3)(cid:77)(cid:96)(cid:88)(cid:84)(cid:73)(cid:81)(cid:86)(cid:77)(cid:76)(cid:3)(cid:80)(cid:77)(cid:90)(cid:77)(cid:81)(cid:86)(cid:3) (cid:87)(cid:86)(cid:3)(cid:88)(cid:73)(cid:79)(cid:77)(cid:91)(cid:3)(cid:30)(cid:27)(cid:21)(cid:30)(cid:30)(cid:3)(cid:81)(cid:86)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:91)(cid:77)(cid:75)(cid:92)(cid:81)(cid:87)(cid:86)(cid:3)(cid:92)(cid:81)(cid:92)(cid:84)(cid:77)(cid:76)(cid:3)(cid:185)(cid:44)(cid:77)(cid:197)(cid:86)(cid:81)(cid:92)(cid:81)(cid:87)(cid:86)(cid:91)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3)(cid:58)(cid:77)(cid:75)- onciliations of Non-GAAP Financial Measures and Other Terms”: (cid:127) Economic Gain (cid:127) Estimated Net Asset Value (NAV) per Share (cid:127) Fixed Charge Coverage (Interest Coverage) (cid:127) Funds from Operations (FFO) (cid:127)(cid:3) (cid:49)(cid:86)(cid:81)(cid:92)(cid:81)(cid:73)(cid:84)(cid:3)(cid:65)(cid:77)(cid:73)(cid:90)(cid:3)(cid:53)(cid:73)(cid:90)(cid:83)(cid:77)(cid:92)(cid:3)(cid:43)(cid:73)(cid:88)(cid:81)(cid:92)(cid:73)(cid:84)(cid:81)(cid:98)(cid:73)(cid:92)(cid:81)(cid:87)(cid:86)(cid:3)(cid:58)(cid:73)(cid:92)(cid:77)(cid:3)(cid:16)(cid:43)(cid:73)(cid:88)(cid:3)(cid:58)(cid:73)(cid:92)(cid:77)(cid:17) (cid:127) Leverage (cid:127) Multifamily Sector Average (cid:127) Net Operating Income (NOI) (cid:127) Same Store (Established) Communities (cid:127) Total Capital Cost (cid:127)(cid:3) (cid:61)(cid:86)(cid:84)(cid:77)(cid:94)(cid:77)(cid:90)(cid:73)(cid:79)(cid:77)(cid:76)(cid:3)(cid:49)(cid:58)(cid:58) F O R WA R D - L O O K I N G S TAT E M E N T S (cid:60)(cid:80)(cid:81)(cid:91)(cid:3)(cid:41)(cid:86)(cid:86)(cid:93)(cid:73)(cid:84)(cid:3)(cid:58)(cid:77)(cid:88)(cid:87)(cid:90)(cid:92)(cid:20)(cid:3)(cid:81)(cid:86)(cid:75)(cid:84)(cid:93)(cid:76)(cid:81)(cid:86)(cid:79)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:52)(cid:77)(cid:92)(cid:92)(cid:77)(cid:90)(cid:3)(cid:92)(cid:87)(cid:3)(cid:59)(cid:80)(cid:73)(cid:90)(cid:77)(cid:80)(cid:87)(cid:84)(cid:76)(cid:77)(cid:90)(cid:91)(cid:20)(cid:3) contains “forward-looking statements” within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934. Please see our discussion titled “Forward-Look- ing Statements” on page 32 of this report for a discussion regarding risks associated with these statements. 14 AVALONBAY COMMUNITIES, INC. SELECTED FINANCIAL DATA The following table pr ovides historical consolidated financial, operating and other data for AvalonBay Communities, Inc. You should read the table with our Consolidated Financial Statements and the Notes included in this report. (Dollars in thousands, except per share information) 12-31-05 12-31-04 12-31-03 12-31-02 12-31-01 Revenue: Rental and other income Management, development and other fees $ 666,376 4,304 $ 613,240 604 $ 556,582 931 $ 531,595 2,145 $ 521,805 1,386 Total revenue 670,680 613,844 557,513 533,740 523,191 For the year ended Expenses: Operating expenses, excluding pr operty taxes Pr operty taxes Interest expense Depreciation expense General and administrative expense Impair ment loss Total expenses Equity in income of unconsolidated entities Ventur e partner interest in profit-sharing Minority interest in consolidated par tnerships Income before gain on sale of real estate assets Gain on sale of real estate assets Income from continuing operations befor e cumulative effect of change in accounting principle Discontinued operations: Income from discontinued operations Gain on sale of real estate assets Total discontinued operations Income before cumulative effect of change in accounting principle Cumulative ef fect of change in accounting principle 191,558 65,487 127,099 158,822 25,761 — 568,727 7,198 — (1,481) 107,670 — 181,351 59,458 131,103 151,991 18,074 — 541,977 1,100 (1,178) (150) 71,639 — 164,253 53,257 130,178 138,725 14,830 — 501,243 25,535 (1,688) (950) 79,167 — 147,965 47,580 114,282 121,995 13,449 6,800 452,071 55 (857) (865) 133,352 43,178 92,597 106,670 14,705 — 390,502 856 1,158 (948) 80,002 — 133,755 62,852 107,670 71,639 79,167 80,002 196,607 14,942 199,766 214,708 21,134 122,425 143,559 31,368 160,990 192,358 44,723 48,893 93,616 52,390 — 52,390 322,378 215,198 271,525 173,618 248,997 — 4,547 — — — Net income Dividends attributable to prefer red stock 322,378 (8,700) 219,745 (8,700) 271,525 (10,744) 173,618 (17,896) 248,997 (40,035) Net income available to common stockholders $ 313,678 $ 211,045 $ 260,781 $ 155,722 $ 208,962 Per Common Share and Share Information: Ear nings per common share—basic Income from continuing operations (net of dividends attributable to prefer red stock) Discontinued operations $ $ Net income available to common stockholders $ 1.36 2.94 4.30 $ $ $ 0.94 2.01 2.95 $ $ $ 1.00 2.80 3.80 $ $ $ 0.90 1.36 2.26 $ $ $ 1.38 1.70 3.08 Weighted average common shares outstanding—basic 72,952,492 71,564,202 68,559,657 68,772,139 67,842,752 Ear nings per common share—diluted Income from continuing operations (net of dividends attributable to preferred stock) Discontinued operations $ $ Net income available to common stockholders $ 1.34 2.87 4.21 $ $ $ 0.94 1.98 2.92 $ $ $ 0.99 2.74 3.73 $ $ $ 0.89 1.34 2.23 $ $ $ 1.36 1.66 3.02 Weighted average common shares outstanding—diluted Cash dividends declared 74,759,318 2.84 $ 73,354,956 2.80 $ 70,203,467 2.80 $ 70,674,211 2.80 $ 69,781,719 2.56 $ 16 AVALONBAY COMMUNITIES, INC. 12-31-05 12-31-04 12-31-03 12-31-02 12-31-01 For the year ended Other Information: Net income Depreciation—continuing operations Depreciation—discontinued operations Inter est expense, net—continuing operations Interest expense, net—discontinued operations $ 322,378 158,822 3,241 127,099 — $ 219,745 151,991 10,676 131,103 525 $ 271,525 138,725 15,071 130,178 2,399 $ 173,618 121,995 22,482 114,282 3,122 $ 248,997 106,670 23,409 92,597 3,783 EBITDA (1) $ 611,540 $ 514,040 $ 557,898 $ 435,499 $ 475,456 Funds from Operations(2) Number of Cur rent Communities(3) Number of apartment homes $ 281,773 143 41,412 $ 246,247 138 40,142 $ 230,566 131 38,504 $ 251,410 137 40,179 $ 275,755 126 37,228 Balance Sheet Information: Real estate, before accumulated depreciation Total assets Notes payable and unsecured credit facilities Cash Flow Information: Net cash flows provided by operating activities Net cash flows provided by (used in) investing activities Net cash fl ows provided by (used in) financing activities $5,903,168 $5,165,060 $2,366,564 $5,697,144 $5,081,249 $2,451,354 $5,431,757 $4,909,582 $2,337,817 $5,369,453 $4,950,835 $2,471,163 $4,837,869 $4,664,289 $2,082,769 $ 306,639 $ 275,617 $ 239,677 $ 307,810 $ 320,528 $ (19,761) $ (251,683) $ 33,935 $ (435,796) $ (274,941) $ (282,293) $ (29,471) $ (279,465) $ 68,008 $ (29,909) Notes to Selected Financial Data (1) EBITDA is defi ned by us as net income before interest income and expense, income taxes, depreciation and amortization from both continuing and discontinued operations. Under this definition, which complies with the rules and regulations of the Securities and Exchange Commission, EBITDA includes gains on sale of assets and gain on sale of partnership interests. Management generally con- siders EBITDA to be an appropriate supplemental measure to net income of our operating performance because it helps investors to understand our ability to incur and service debt and to make capital expenditures. EBITDA should not be considered as an alter- native to net income (as determined in accordance with generally accepted accounting principles, or “GAAP”), as an indicator of our operating performance, or to cash flows from operating activities (as determined in accor dance with GAAP) as a measure of liquid- ity. Our calculation of EBITDA may not be comparable to EBITDA as calculated by other companies. (2) We gene rally consider Fu nds from O pe rat ions, or “FFO ,” to be a n a ppropriat e supple me nta l me asure o f our ope rat ing an d fin a n c i a l p e r f o r ma nc e be cau se , b ye xcludin g ga ins or losse s re lat ed t o disposition s of p re viously dep re cia te d pro p e rt y and e xcludin g re al e st ate d e p rec iation, which c an va ry a mong ow ne rs of iden tica l asse ts in similar c ondition based on historica l cost a ccou nting a nd use ful life e stim ate s, FFO ca n he lp one co mpare the ope ratin g p erf o r man ce of a re al e st ate com pany b etwe en periods or as comp ared to diff e r- e nt c ompan ies. We belie ve t hat in orde r to understa nd our operat ing results, FFO shou ld be exam ined wit h ne t in come as pre s e n t e d in t he Consolidate d Stat em ent s of O pera tions an d O the r Compreh en sive In come inclu ded elsewhe re in this re p o rt . Consistent with the definition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts®‚ (“NAREIT”), we calculate FFO as net income or loss computed in accordance with GAAP, adjusted for: • gains or losses on sales of previously depreciated operating communities; • extraordinary gains or losses (as defi ned by GAAP); • cumulative effect of change in accounting principle; • depreciation of real estate assets; and • adjustments for unconsolidated partnerships and joint ventur es. FFO does not represent net income in accordance with GAAP, and therefor e it should not be considered an alter native to net income, which r emains the primary measure, as an indication of our perfor mance. In addition, FFO as calculated by other REITs may not be comparable to our calculation of FFO. The following is a reconciliation of net income to FFO: (dollars in thousands, except per share data) 12-31-05 12-31-04 For the year ended 12-31-03 12-31-02 12-31-01 Net income Dividends attributable to prefer red stock Depreciation—real estate assets, including discontinued operations and joint venture adjustments Minority interest expense, including discontinued operations Cumulative effect of change in accounting principle Gain on sale of previously depreciated real estate assets Funds from Operations attributable to common stockholders Weighted average common shares outstanding—diluted FFO per common share—diluted $ 322,378 (8,700) $ 219,745 $ 271,525 $ 173,618 (8,700) (10,744) (17,896) $ 248,997 (40,035) 162,019 157,988 128,278 142,980 128,086 1,363 3,048 — (4,547) 1,263 — 1,601 — 1,559 — (195,287) (121,287) (159,756) (48,893) (62,852) $ 281,773 $ 246,247 $ 230,566 $ 251,410 $ 275,755 74,759,318 3.77 $ 73,354,956 3.36 $ 70,203,467 3.28 $ 70,674,211 3.55 $ 69,781,719 3.95 $ FFO also doe s not re p r e se nt cash ge ne ra te d from opera ting a ctivit ies in acc ord anc e with GA AP, a nd t here f o re should n ot be con sid- e re d a n a lt ern ative to net cash fl ows from opera ting ac tivitie s, a s d ete rmin ed by G AAP, a s a me asure of liquidity. Addition ally, it is not ne ce ssarily in dica tive of ca sh ava ilable to fund c ash ne e ds. A pre se nta tion of GAA P ba se d ca sh flow me trics is provide d in “Cash Flow I n f o rma tion” in the ta ble a bove. (3) Current Communities consist of all communities other than those which are still under construction and have not r eceived a certifi- cate of occupancy. AVALONBAY COMMUNITIES, INC. 17 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS We ar e primarily engaged in developing, acquiring, owning and operating apartment communities in high bar rier-to-entry markets of the United States. We seek to create long-term shar eholder value by accessing capital on cost effective terms; deploying that capital to develop, redevelop and acquir e apartment communities in high barrier-to-entr y markets; operating apartment communities; and selling communities when they no longer meet our long-term investment strategy and when pricing is attractive. The net operating income of our current operating communities, as defined later in this report, is one of the fi nancial measures that we use to evaluate community performance. Net operating income is affected by the demand and supply dynamics within our markets, our rental rates and occupancy levels, and our ability to control operating costs. Our overall financial per formance is also impacted by the general availability and cost of capital and the performance of our newly developed and acquired apartment communities. Th is re p o r t, in clu din g th e fo llo win g d iscu ss ion an d an alysis o f o ur fin an cial co n ditio n an d results of o peration s, con tain s f o r w a rd-lo oking s tatemen ts re g a rd ing fu tu re even ts or tren ds as des crib ed more fully u nd er “Fo r w a rd-Loo kin g Statements ” on p ag e 3 2 of th is re p o rt. Actu al res ults or d evelo pmen ts cou ld differ materially fro m th ose p rojected in such statemen ts . Th e fo l- lo win g discussio n an d an alysis of ou r finan cial co nd ition and res ults of op eratio ns sh ou ld b e read in co n jun ctio n with ou r Co n so lid ated Fin an cial Statements and n otes in clud ed elsewh ere in this re p o rt . Business Description and Community Information Over view We believe that apartment communities pr esent an attractive long-term investment opportunity compared to other real estate investments because a broad potential resident base should help reduce demand volatility over a real estate cycle. We intend to continue to pursue real estate investments in markets where constraints to new supply exist, and where new r ental household for mations are expected to out-pace multifamily permit activity over the course of the real estate cycle. Bar riers- to-entr y in our markets generally include a difficult and lengthy entitlement process with local jurisdictions and dense urban or suburban areas where zoned and entitled land is in limited supply. We regularly evaluate the allocation of our investments by the amount of invested capital and by product type within our individual markets, which are located in the Northeast, Mid-Atlantic, Midwest, Pacific Nor thwest, and Norther n and Southern Califor nia regions of the United States. Our strategy is to mor e deeply penetrate these markets with a broad range of products and ser vices and an intense focus on our customer. A substantial majority of our communities are upscale, which generally command among the highest rents in their markets. However, we also pursue the ownership and operation of apartment communities that target a variety of customer segments and price points, consistent with our goal of offering a broad range of products and ser vices. We believe that, over an entire real estate cycle, lower housing af fordability and the limited new supply of apartment homes in our markets will r esult in a higher propensity to rent and larger increases in cash flow relative to other markets. However, thr oughout the real estate cycle, apar tment market fundamentals, and therefore operating cash flows, ar e affected by overall economic conditions. A number of our markets experienced economic contraction due to job losses in 2002 and 2003, particularly in the technology, telecom and financial ser vices sectors. This resulted in a prolonged period of weak apartment market fundamentals as refl ected in declining rental rates and demand. However, 2004 was a year of transition, where the economy showed signs of an early phase recover y, as evidenced by modest job growth and declining unemployment claims. The improvement in the economic envir onment in 2005 has resulted in stronger apartment market fundamentals. This is supported by the following operating r esults achieved within our Established Community portfolio during 2005: • we achieved year-over-year revenue growth; • we transitioned from occupancy gains to incr eases in rental rates as the primar y driver of rental revenue growth; • we achieved the highest year-over-year increase in average rental rates in four years; and • average economic occupancy was at or above 95% in each of our markets. Based on these results and our expectations for improving demand/supply fundamentals, we expect continued growth in the revenue and net operating income generated by our operating communities in 2006. We expect continued job growth and household formation in our markets in 2006, the principal drivers of housing demand. Condominium conversion activity has 18 AVALONBAY COMMUNITIES, INC. reduced the availability of rental apartments, while low single-family home af fordability makes rental apartments an economically attractive housing alter native. Accordingly, we expect apartment market fundamentals to continue to improve in our markets such that apartment rental demand will outpace new supply, resulting in rental revenue growth of 5.0% to 6.0% in our Established Community por tfolio in 2006, and projected NOI growth of 6.0% to 7.0%. In p ositio ning fo r futu re gro wth, we in creased ou r d evelo p ment vo lu me. We cur ren tly h ave in excess of $1,00 0,000,0 00 u nd er co n str uction (measu red b y total p ro jected cap italized co st o f th e commu n ities at co mpletio n , in clu din g th e p o rt i o n s owned b y jo in t ventu re par tn ers). In ad d ition , we con tin u e to secu re n ew Develop ment Righ ts , as d iscu ssed b elo w, inclu d in g the acq u isition of lan d for futur e d evelo p me nt. We cu rr en tly h ave Develo p men t Righ ts fo r co n str uction o f n ew ap art m e n t commu nities th at, b ased o n total p rojected cap italized co st, to tal app ro ximately $3,000 ,000,00 0. We an ticipate startin g n ew d evelo pmen ts with to tal pr ojected cap italized co s ts of $ 700,00 0,000 to $ 800,00 0,000 in 2 006. Th ese total pro j e c t e d capitalized co sts may b e imp acted b y increasin g co nstru ction cos ts, particu larly in th e areas of p ayro ll, u tilities, con crete and stee l. We also anticip ate acq uirin g ad ditio n al lan d h eld fo r fu tu re d evelop ment for an ag gregate p urch ase p rice of $75 ,000,00 0 to $100,00 0,000. We continue to look for opportunities to acquire existing communities thr ough our investment in and management of a discr etionary investment fund (the “Fund”). During its investment period (which will end on or before March 16, 2008), the Fund will be our exclusive vehicle for acquiring apar tment communities, subject to certain exceptions. The Fund acquired four communities for an aggregate purchase price of $99,907,000 during 2005 and has approximately $90,000,000 under contract for acquisition in early 2006. We will continue to focus on acquisition opportunities where we believe we can create value, generally through redevelopment or repositioning opportunities. Strong capital flows to the industry and the str ength of the condominium market have resulted in an attractive selling environment. We sold seven communities during 2005 for an aggregate sales price of approximately $350,000,000, of which approximately $315,000,000 was sold to condominium converters. W e anticipate asset sales of approximately $225,000,000 to $300,000,000 in 2006. While the active condominium market has created demand for multifamily apartment communities, it has also created a challenging environment for us in other ways such as: • increased competition for land, resulting in, at times, the acquisition of land zoned for uses other than residential with the potential for rezoning; • increased competition for subcontractors; • increased competition for experienced multifamily development and construction professionals, par ticularly in our markets; • increased competition for our customers, resulting in increased move-outs due to home ownership; and • increased risks as a result of sales to condominium converters. There are indications that condominium conversion activity is slowing, which could impact the market for our assets held for sale, and as a result, the volume of assets we of fer for sale. Our real estate investments consist primarily of current operating apartment communities, communities in various stages of development (“Development Communities”) and Development Rights (i.e., land or land options held for development). Our current operating communities are fur ther distinguished as Established Communities, Other Stabilized Communities, Lease- Up Communities and Redevelopment Communities. Established Communities are generally operating communities that are consolidated for financial reporting purposes and were owned and had stabilized occupancy and operating expenses as of the beginning of the prior year, which allows the performance of these communities and the markets in which they are located to be compared and monitored between years. Other Stabilized Communities are generally all other operating communities that have stabilized occupancy and operating expenses as of the beginning of the cur rent year, but had not achieved stabilization as of the beginning of the prior year. Lease-Up Communities consist of communities wher e construction is complete but stabilization has not been achieved. Redevelopment Communities consist of communities where substantial redevelopment is in pr ogress or is planned to begin during the curr ent year. A mor e detailed description of our repor table segments and other related operating information can be found in Note 9, “Segment Repor ting,” of our Consolidated Financial Statements. AVALONBAY COMMUNITIES, INC. 19 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Although each of these categories is important to our business, we generally evaluate overall operating, industry and market tr ends based on the operating results of Established Communities, for which a detailed discussion can be found in “Results of Operations” as part of our discussion of overall operating results. We evaluate our cur rent and future cash needs and futur e operating potential based on acquisition, disposition, development, redevelopment and financing activities within Other Stabilized, Redevelopment and Development Communities, for which detailed discussions can be found in “Liquidity and Capital Resources.” As of Decemb er 3 1, 2005, we own ed o r h eld an own ersh ip in terest in 15 8 ap artmen t co mmun ities co n tain in g 45,4 74 apar tment homes in ten states and the District of Columbia, of which 15 communities were under construction and two communities were under reconstr uction. In addition, we owned a direct or indirect ownership interest in Development Rights to develop an additional 47 communities that, if developed in the manner expected, will contain an estimated 12,495 apar tment homes. Critical Accounting Policies The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) requires management to use judgment in the application of accounting policies, including making estimates and assumptions. If our judgment or interpretation of the facts and circumstances relating to various transactions had been different, or different estimates or assumptions had been made, it is possible that different accounting policies would have been applied, resulting in different financial results or a different presentation of our financial statements. Below is a discussion of accounting policies that we consider critical to an understanding of our financial condition and operating r esults and that may require complex judgment in their application or require estimates about matters which are inherently uncertain. As a REIT that owns, operates and develops apartment communities, our critical accounting policies r elate to revenue recognition, cost capitalization, asset impair ment evaluation and REIT status. A discussion of our significant accounting policies, including further discussion of the accounting policies described below, can be found in Note 1, “Organization and Significant Accounting Policies” of our Consolidated Financial Statements. Revenue Recognition Rental income related to leases is r ecognized on an accrual basis when due fr om residents in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition” and Statement of Financial Accounting Standards No. 13, “Accounting for Leases.” In accordance with our standard lease terms, rental payments are generally due on a monthly basis. Any cash concessions given at the inception of the lease are amortized over the approximate life of the lease, which is generally one year. A discussion r egarding the impact of cash concessions on rental revenue for Established Communities can be found in “Results of Operations.” Cost Capitalization We capitalize costs during the development of assets (including interest and related loan fees, property taxes and other direct and indir ect costs) beginning when development efforts commence until the asset, or a portion of the asset, is deliver ed and is ready for its intended use, which is generally indicated by the issuance of a certificate of occupancy. We capitalize costs during redevelopment of apartment homes (including interest and related loan fees, property taxes and other direct and indirect costs) beginning when an apartment home is taken out-of-service for redevelopment until the apar tment home redevelopment is completed and the apartment home is available for a new resident. Rental income and operating expenses incurred during the initial lease-up or post-redevelopment lease-up period are fully recognized as they accrue. We capitalize pre-development costs incurred in pursuit of Development Rights for which we curr ently believe future development is probable. These costs include legal fees, design fees and related overhead costs. Future development of these Development Rights is dependent upon various factors, including zoning and regulator y approval, rental market conditions, construction costs and availability of capital. Pre-development costs incurred in the pursuit of Development Rights for which future development is not yet considered pr obable are expensed as incurr ed. In addition, if the status of a Development Right changes, making future development no longer probable, any capitalized pre-development costs ar e written-off with a char ge to expense. 20 AVALONBAY COMMUNITIES, INC. We generally capitalize only non-recurring expenditur es. We capitalize improvements and upgrades only if the item: (i) exceeds $15,000; (ii) extends the useful life of the asset; and (iii) is not related to making an apartment home ready for the next resident. Under this policy, virtually all capitalized costs are non-recurring, as recurring make-ready costs are expensed as incur red. Recurring make-ready costs include: (i) carpet and appliance replacements; (ii) floor coverings; (iii) interior painting; and (iv) other r edecorating costs. Because we expense recurring make-r eady costs, such as carpet replacements, our expense levels and volatility are greatest in the third quar ter of each year as this is when we experience our greatest amount of turnover. We capitalize purchases of personal property, such as computers and fur niture, only if the item is a new addition and the item exceeds $2,500. We generally expense r eplacements of personal property. In 2005, 2004 and 2003, the amounts capitalized (excluding land costs) related to acquisitions, development and redevelopment were $425,170,000, $347,091,000 and $296,764,000, r espectively. For Established and Other Stabilized Communities, we recorded non-revenue generating capital expenditures of $16,753,000 or $471 per apartment home in 2005, $12,347,000 or $354 per apartment home in 2004 and $11,064,000 or $333 per apartment home in 2003. In addition, revenue generating capital expenditures, such as water submetering equipment and cable installations, were $817,000, $637,000 and $529,000 in 2005, 2004 and 2003, respectively. The average maintenance costs charged to expense per apartment home, including carpet and appliance replacements, related to these communities was $1,546 in 2005, $1,348 in 2004 and $1,262 in 2003. Historically, we have experienced a gradual increase in capitalized costs and expensed maintenance costs per apartment home as the average age of our communities has increased, and expensed maintenance costs have fluctuated with turnover. Although we expect these trends to continue in the future, capitalized costs increased in 2005 over prior year growth levels as we embarked on a number of community upgrades and improvements. We expect capitalized costs in 2006 to be at or slightly above 2005 levels as we continue with these community upgrades and improvements. Asset Impair ment Evaluation If there is an event or change in circumstance that indicates an impairment in the value of a community, our policy is to assess the impair ment by making a comparison of the current and projected operating cash flow of the community over its remaining useful life, on an undiscounted basis, to the car rying amount of the community. If the carr ying amount is in excess of the estimated projected operating cash flow of the community, we would recognize an impairment loss equivalent to an amount r equired to adjust the car rying amount to its estimated fair market value. Real estate assets held for sale are measured at the lower of the carr ying amount or the fair value less the cost to sell. We account for our investments in unconsolidated entities that were created prior to and have not been modifi ed since June 29, 2005, and are not variable interest entities in accordance with Statement of Position 78-9, “Accounting for Investments in Real Estate Ventures” and Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” Any investments in entities that were cr eated or modified subsequent to June 29, 2005, and are not variable interest entities are accounted for in accordance with EITF Issue No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights.” If there is an event or change in circumstance that indicates a loss in the value of an investment, we recor d the loss and reduce the value of the investment to its fair value. A loss in value would be indicated if we could not recover the car rying value of the investment or if the investee could not sustain an earnings capacity that would justify the carr ying amount of the investment. REIT Status We are a Mar yland corporation that has elected to be treated, for federal income tax purposes, as a REIT. We elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended, for the year ended December 31, 1994 and have not revoked such election. A corporate REIT is a legal entity which holds real estate interests and must meet a number of organizational and operational r equirements, including a requirement that it currently distribute at least 90% of its adjusted taxable income to stockholders. As a REIT, we generally will not be subject to corporate level federal income tax on taxable income we distribute currently to our stockholders. If we fail to qualify as a REIT in any taxable year, we will be subject to federal income taxes at regular corporate rates (subject to any applicable alternative minimum tax) and may not be able to elect to qualify as a REIT for four subsequent taxable years. AVALONBAY COMMUNITIES, INC. 21 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED ) Results of Operations O ur year- o v e r-year o per atin g p erf o r man ce is p rimarily affected by ch an ges in n et op eratin g income o f ou r cur ren t o per atin g a p a rtmen t commu nities d ue to: mark et con d ition s; n et o peratin g in co me der ived fro m acq uisitio n s an d develop ment comp letio n s; th e loss o f n et o peratin g in come related to d is po sed commun ities ; and capital market, d isp osition an d fin a n c i n g a c t i v i t y. A co mpariso n of ou r o peratin g resu lts for th e years 2005, 20 04 an d 2 003 follo ws: (dollars in thousands) 2005 2004 $ % 2004 2003 $ % Change Change Revenue: Rental and other income Management, development and other fees $666,376 $613,240 $ 53,136 8.7% $613,240 $556,582 $ 56,658 10.2% 4,304 604 3,700 612.6% 604 931 (327) (35.1%) Total revenue 670,680 613,844 56,836 9.3% 613,844 557,513 56,331 10.1% Expenses: Direct property operating expenses, excluding proper ty taxes Pr operty taxes Total community operating expenses Corporate-level property management and other indir ect operating expenses Investments and investment management Interest expense, net Depr eciation expense General and administrative expense 155,481 65,487 148,705 59,458 6,776 6,029 4.6% 148,705 10.1% 59,458 134,182 53,257 14,623 6,201 10.8% 11.6% 220,968 208,163 12,805 6.2% 208,163 187,439 20,724 11.1% 31,243 27,956 3,287 11.8% 27,956 27,123 833 3.1% 4,834 127,099 158,822 4,690 131,103 151,991 144 (4,004) 6,831 4,690 3.1% (3.1%) 131,103 4.5% 151,991 2,948 130,178 138,725 1,742 925 13,266 59.1% 0.7% 9.6% 25,761 18,074 7,687 42.5% 18,074 14,830 3,244 21.9% Total other expenses 347,759 333,814 13,945 4.2% 333,814 313,804 20,010 6.4% Equity in income of unconsolidated entities Venture partner interest in pr ofit-sharing Minority interest in consolidated partnerships Income from continuing operations befor e cumulative effect of change in accounting principle Discontinued operations: Income from discontinued operations Gain on sale of r eal estate assets 7,198 1,100 6,098 554.4% 1,100 25,535 (24,435) n/a — (1,178) 1,178 (100.0%) (1,178) (1,688) 510 (30.2%) (1,481) (150) (1,331) 887.3% (150) (950) 800 (84.2%) 107,670 71,639 36,031 50.3% 71,639 79,167 (7,528) (9.5%) 14,942 199,766 21,134 122,425 (6,192) 77,341 (29.3%) 21,134 63.2% 122,425 31,368 160,990 (10,234) (32.6%) (38,565) (24.0%) Total discontinued operations 214,708 143,559 71,149 49.6% 143,559 192,358 (48,799) (25.4%) Income before cumulative effect of change in accounting principle Cumulative effect of change in accounting principle Net income Dividends attributable to preferred stock Net income available to common stockholders 322,378 215,198 107,180 49.8% 215,198 271,525 (56,327) (20.7%) — 4,547 (4,547) (100.0%) 4,547 — 4,547 100.0% 322,378 219,745 102,633 46.7% 219,745 271,525 (51,780) (19.1%) (8,700) (8,700) — — (8,700) (10,744) 2,044 (19.0%) $313,678 $211,045 $102,633 48.6% $211,045 $260,781 $(49,736) (19.1%) 22 AVALONBAY COMMUNITIES, INC. Net income available to common stockholders increased $102,633,000, or 48.6%, to $313,678,000 in 2005. This increase is primarily attributable to higher gains on sales of assets in 2005, including the gain r elated to the sale of a technology investment, as well as increased net operating income from Established Communities and newly developed communities. Net income available to common stockholders decreased $49,736,000, or 19.1%, to $211,045,000 in 2004. This decr ease is primarily attributable to lower gains on sales in 2004 as compared to 2003, including the gain realized from an unconsolidated entity, and increased depr eciation expense, partially offset by increased net operating income from newly developed and acquired communities. N et operating income (“N OI”) is co nsid ered by managemen t to be an impo rtan t an d ap pro pr iate sup p lemental p e rf o r man ce measu re to n et in co me becaus e it helps b oth in vestors an d man ag emen t to u n derstan d th e core op eration s of a co mmu n ity o r co mmun ities p rio r to th e allocatio n o f any co rpo rate- level or fin a n c i n g - related co sts. NOI re flects th e op eratin g p erf o r man ce of a co mmun ity an d allows for an easy co mpariso n of the o p eratin g p erf o r man ce o f in d ividu al assets or gro u ps of assets. In add ition , because prospective bu yers of real estate h ave diff e ren t finan cin g an d o verh ead stru c t u re s , with var yin g mar gin al imp acts to o verh ead by acq uirin g real estate, NO I is con s id ered by man y in th e real estate in d ustry to be a u sefu l measu re fo r determin in g the valu e of a r eal estate asset or gr ou p o f assets. We d efine NO I as to tal p ro p e rty re v e n u e less d irect pro p e rty op erating exp enses, inclu ding pro p e rty tax es, and NO I exclu des: • corporate-level income (including management, development and other fees); • corporate-level property management and other indirect operating expenses; • investments and investment management costs; • interest expense, net; • general and administrative expense; • equity in income of unconsolidated entities; • minority interest in consolidated partnerships; • venture partner inter est in profit-sharing; • depreciation expense; • gain on sale of real estate assets; • cumulative effect of change in accounting principle; and • income from discontinued operations. NOI does not represent cash generated from operating activities in accordance with GAAP. Therefore, NOI should not be considered an alternative to net income as an indication of our per formance. NOI should also not be considered an alternative to net cash flow from operating activities, as deter mined by GAAP, as a measure of liquidity, nor is NOI necessarily indicative of cash available to fund cash needs. A calculation of NOI for the years ended December 31, 2005, 2004 and 2003, along with a reconciliation to net income for each year, is as follows: (dollars in thousands) 12-31-05 12-31-04 12-31-03 For the year ended Net income Corporate-level property management and other indirect operating expenses Corporate-level other income Investments and investment management Interest expense, net General and administrative expense Equity in income of unconsolidated entities Minority interest in consolidated par tnerships Ventur e partner interest in profit-sharing Depreciation expense Cumulative effect of change in accounting principle Gain on sale of real estate assets Income from discontinued operations Net operating income $322,378 $219,745 $271,525 31,243 (4,568) 4,834 127,099 25,761 (7,198) 1,481 — 158,822 — (199,766) (14,942) $445,144 27,956 (1,344) 4,690 131,103 18,074 (1,100) 150 1,178 151,991 (4,547) (122,425) (21,134) $404,337 27,123 (1,520) 2,948 130,178 14,830 (25,535) 950 1,688 138,725 — (160,990) (31,368) $368,554 AVALONBAY COMMUNITIES, INC. 23 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED ) The NOI increases of $40,807,000 and $35,783,000 in 2005 and 2004, respectively, as compared to the prior years, consist of changes in the following categories: (dollars in thousands) Established Communities Other Stabilized Communities Development and Redevelopment Communities Total 2005 Increase $13,052 3,786 23,969 $40,807 2004 Increase (Decrease)(1) $(3,363) 16,010 23,136 $35,783 (1) For purposes of this table, amounts have been restated from amounts previously r eported for changes in discontinued operations as described in Note 7, “Discontinued Operations—Real Estate Assets Sold or Held for Sale,” of our Consolidated Financial Statements. The NOI incr ease in Established Communities in 2005 was largely due to the improved apartment market fundamentals. We maintained average economic occupancy of at least 95% in all regions during the year ended December 31, 2005 and we experienced the first year -over-year increase in rental rates in thr ee years. We reached a transition point in the components of r ental revenue growth, shifting fr om occupancy gains to increases in rental rates. We will continue to seek increases in rental rates by incr easing market rents and/or reducing concessions, and we expect revenue growth from our Established Communities of 5.0% to 6.0% in 2006 as compared to 2005. In addition, although we will continue to aggressively manage operating expenses, there is upward pr essure on operating expenses from increasing utility, labor and property tax expenses. We expect operating expenses at our Established Communities to increase by 3.0% to 4.0% in 2006 as compared to 2005. Overall, we anticipate growth in NOI from our Established Communities of 6.0% to 7.0% in 2006 as compared to 2005. Th e Comp an y h as given p rojected NOI growth in 2006 on ly for Es tablish ed Commun ities an d n ot on a compan y-wid e b asis. Th e Co mpan y b elieves that NOI gro wth o f th e Es tablish ed Commu n ities assists in vestors in u n ders tan d in g managemen t’s estimate of the likely co ntrib ution to o p er atio ns from Estab lish ed Commu nities. However, th e Comp any h as n o t p rovid ed a p ro j e c t i o n of NOI gro wth o n a co mpan y-wid e b asis d u e to the difficulty in pro jectin g th e timing of n ew d evelo pmen t s tarts , dis p os ition s an d acqu isition s, as well as th e co mplexities in vo lved in p rojectin g th e allocatio n of co rpo rate-level pr o p e rty man agement o v e rhead , gen eral an d ad min istrative costs an d interest exp en se to commu nities n ot yet d evelo ped , disp osed or acqu ired . NOI g ro wth exp ected from Estab lish ed Co mmu n ities is n o t a pro jectio n o f the Comp an y’s p ro jected con solidated fin a n c i a l p e rf o r man ce or p ro jected cash flo w. Rental and other income incr eased in 2005 due to increased rental rates and occupancy for our Established Communities, coupled with additional r ental income generated from newly developed communities. Rental and other income increased in 2004 due to rental income generated from newly developed and acquired communities, as well as incr eased occupancy for our Established Communities, partially of fset by declines in effective rental rates for our Established Communities. We expect apartment fundamentals to continue to strengthen in 2006. Overall Portfolio—The weighted average number of occupied apar tment homes increased to 36,520 apartment homes for 2005 as compared to 34,540 apartment homes for 2004 and 30,774 apartment homes for 2003. This change is primarily the result of an increase in the overall occupancy rate and increased homes available from newly developed and acquired communities, par tially offset by communities sold in 2005 and 2004. The weighted average monthly revenue per occupied apar tment home increased to $1,516 in 2005 as compared to $1,477 in 2004 and $1,505 in 2003. Established Communities—Rental revenue incr eased $16,523,000, or 3.6%, in 2005 and decreased $1,496,000, or 0.3%, in 2004. The increase in 2005 is due to both increased rental rates and increased economic occupancy as compared to 2004. The decr ease in 2004 is due to declining rental rates, par tially of fset by increased economic occupancy as compared to 2003. For 2005, the weighted average monthly revenue per occupied apartment home increased 2.7% to $1,503 compared to $1,464 in 2004, primarily due to increased market rents and decreased concessions. The average economic occupancy increased from 95.2% in 2004 to 96.1% in 2005. Economic occupancy takes into account the fact that apartment homes of dif ferent sizes and locations within a community have different economic impacts on a community’s gross r evenue. Economic occupancy is defined as gross potential revenue less vacancy loss, as a percentage of gross potential revenue. Gross potential revenue is deter mined by valuing occupied homes at leased rates and vacant homes at market rents. We expect rental revenue from Established Communities to increase 5.0% to 6.0% in 2006 as compared to 2005. We experienced increases in Established Communities’ r ental revenue in all six of our regions in 2005 as compared to 2004. The lar gest increases in rental revenue were in Southern California, the Pacific Northwest and the Nor theast, with increases 24 AVALONBAY COMMUNITIES, INC. of 5.7%, 4.3% and 3.7%, respectively, between years. The Nor theast and Northern California r egions comprise the majority of our Established Community revenue, and ther efore are discussed in more detail below. Th e No rtheast regio n re p resented app ro ximately 35.5% o f Establish ed Commun ity rental r even ue du rin g 2005. Av e r a g e ren tal r ates in creased 2 .2% to $1,892 in 2 005 and econ omic occup ancy increas ed 1.5 % du rin g 2005 . We exp ect job gro w t h to impr ove in th e No rth east in 2006, altho u gh at a mor e mo derate r ate th an o ur oth er markets. We expect mo derate re n t a l rate gr owth in the No rth east d ur in g 2006, with No rt h e r n New Jersey lead in g th e regio n in reven u e growth . We exp ect Bo ston , Massachu setts to lag th e region in revenu e growth , as eco no mic re c o v e ry is n ot o ccu rrin g as q uickly as in o th er a r eas of th e r e g i o n . Northern Califor nia, which represented approximately 31.0% of Established Community rental revenue during 2005, experienced an increase in rental revenue of 2.8% in 2005 as compar ed to 2004. Average rental rates incr eased by 2.1% to $1,448 in 2005, and economic occupancy increased 0.7% to 96.2% in 2005. Although apartment fundamentals have been weak in certain areas of Nor thern California, par ticularly in San Jose, California, 2005 was a transition point for the region. We expect Norther n California to see continued improvement in apartment fundamentals, driven by accelerating job growth and reduced pr oduct in the rental market due to condominium conversion activity. We expect the improving fundamentals to translate into accelerated revenue growth. In accordance with GAAP, cash concessions ar e amortized as an offset to r ental revenue over the appr oximate lease term, which is generally one year. As a supplemental measure, we also present rental r evenue with concessions stated on a cash basis to help investors evaluate the impact of both curr ent and historical concessions on GAAP based rental revenue and to more readily enable comparisons to revenue as repor ted by other companies. Rental revenue with concessions stated on a cash basis also allows investors to understand historical trends in cash concessions, as well as current rental market conditions. The following table reconciles total rental r evenue in conformity with GAAP to total rental r evenue adjusted to state concessions on a cash basis for our Established Communities for the years ended December 31, 2005 and 2004. Information for the year ended December 31, 2003 is not presented, as Established Community classification is not applicable prior to Januar y 1, 2004. See Note 9, “Segment Reporting,” of our Consolidated Financial Statements. (dollars in thousands) Rental revenue (GAAP basis) Concessions amortized Concessions granted Rental revenue adjusted to state concessions on a cash basis Year-over-year % change—GAAP revenue Year-over-year % change—cash concession based r evenue For the year ended 12-31-05 12-31-04 $472,367 17,102 (14,835) $474,634 3.6% 4.1% $455,844 19,127 (18,891) $456,080 n/a n/a Management, development and other fees increased in 2005 as compared to 2004 due to increased asset management, pr operty management and redevelopment fees earned from the Fund, which was formed in Mar ch 2005. In addition, constr uction and development fees earned from one of our unconsolidated entities in 2005 contributed to increased fee income. We expect fee income to increase in 2006 as compar ed to 2005 due to a full year of operations of, and an increased number of assets owned by, the Fund. Direct proper ty operating expenses, excluding proper ty taxes increased in both 2005 and 2004, primarily due to the addition of recently developed and acquired apar tment homes. Fo r Established Communities, d i r ect p ro p e r ty op eratin g ex pen ses, ex clud in g p ro p e rty taxes, in creased $96 5,000 , or 0.9% , to $10 4,346 ,000 in 2005 d ue p rimarily to in creas es in p ayro ll an d u tility co sts , p artially o ffset b y d ecr eases in marketin g and b ad d ebt exp en ses. Du rin g 2004, op eratin g exp en ses in creased $2,13 1,000 , or 2.2%, du e p rimar ily to in creased payro l l costs, as well as in creased mak e-ready costs asso ciated with in creasin g o ccu pan cy. We expect op eratin g exp en ses fo r Es tab lish ed Commu nities to in crease b y 3.0 % to 4. 0% in 2 006 as co mp ared to 2 005, p rimar ily as a res u lt of con tin ued h igh er utility ex pen ses an d p ayro ll co sts. O per atin g exp ens e gro wth in 20 06 as co mpare d to 200 5 will be temp ered d u e to $88 0,000 o f exp en ses in cu rred in 2 005 fo r lan d lease p aymen ts th at will n ot be in cur red in 200 6 d u e to th e ex ercise o f a p u r ch ase o ptio n . AVALONBAY COMMUNITIES, INC. 25 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Property taxes increased in both 2005 and 2004 due to overall higher assessments and the addition of newly developed and redeveloped apartment homes, and are impacted by the size and timing of successful tax appeals in both years. For Established Communities, property taxes increased in 2005 and 2004 by $1,530,000 and $333,000, respectively, due to overall higher assessments throughout all regions, and are impacted by the size and timing of successful tax appeals in both years. We expect property taxes to continue to increase in 2006 as compared to 2005 as local jurisdictions are expected to continue to seek additional revenue sources to offset budget defi cits. However, property taxes may fl uctuate due to the timing and size of successful tax appeals. We evaluate property tax incr eases internally, as well as engage third-party consultants, and appeal increases when appr opriate. Corporate-level property management and other indirect operating expenses increased in 2005 as compared to 2004 due to increased compensation costs, as well as increased costs relating to corporate initiatives, including investments in technology and training. We expect corporate-level proper ty management and other indirect operating expenses to increase in 2006 as compared to 2005 as compensation costs continue to increase. Investments and investment management refl ects the costs incurr ed related to investment acquisitions, investment management and abandoned pursuit costs, which include the abandonment or impairment of development pursuits, acquisition pursuits, disposition pursuits and technology investments. Investments and investment management increased in 2005 as compared to 2004 due primarily to increased costs incur red in forming and managing the Fund, partially of fset by a decrease in abandoned pursuit costs. Investments and investment management increased in 2004 as compared to 2003 due to the costs incurred in preparing for and for ming the Fund, increased compensation costs and increased abandoned pursuit costs. We expect investments and investment management costs to increase in 2006 as compared to 2005 as Fund activity increases. Abandoned pursuit costs were $816,000, $1,726,000 and $1,180,000 in 2005, 2004 and 2003, respectively. Abandoned pursuit costs can be volatile, and the costs incurred in any given period may be widely different in future years. Interest expense, net decreased in 2005 as compared to 2004 primarily due to the repayment of unsecured debt and a partial reissuance at lower interest rates, as well as higher levels of capitalized interest, in connection with our incr eased development activity, par tially offset by overall higher short-term interest rates and higher average outstanding balances on our unsecured cr edit facility. Inter est expense, net increased in 2004 as compared to 2003 primarily due to the interest income related to a participating mortgage note included in interest expense, net in 2003 (as described more fully below), par tially offset by the repayment of unsecur ed debt and reissuance at lower inter est rates, overall lower interest rates and lower average outstanding balances on our unsecured credit facility. We expect interest expense, net to decr ease during 2006 primarily due to higher levels of capitalized interest resulting fr om increased development activity, as well as lower average outstanding balances on our unsecured cr edit facility. Depreciation expense increased in both 2005 and 2004 primarily due to the completion of development and redevelop- ment activities. General and administrative expense (“G&A”) in creas ed in 2005 as co mpared to 2004 as a result of: (i) sep aration costs of a p p ro ximately $2,100 ,000 d ue to the d ep ar t u re of a s enior execu tive; (ii) th e accru al of co s ts related to variou s litigation matters o f ap p roximately $1,500 ,000; ( iii) in creased bo ard of d irector fees d u e to th e acceler atio n of eq uity awards with th e res ign ation o f a d irecto r d u e to d isability; an d ( iv) h igh er co mpen satio n costs. G&A increased in 20 04 as co mp ared to 2 003 as a result of h igh er comp ensation cos ts, in creased litigatio n and settlemen t costs asso ciated with certain co mmu n ity and corp or ate matter s, an d ad d ition al co rp orate gover n an ce co sts, in clu din g costs relatin g to comp lian ce with th e Sarban es-Oxley Act of 2002. We exp ect exp en sed o verh ead costs, in clud in g G&A, cor po rate-level p ro p e rty managemen t an d in vestmen ts and in vestment man ag emen t, to in crease from 0.0 % to 5.0 % in 20 06 as comp ar ed to 2005. Equity in income of unconsolidated entities increased in 2005 primarily due to the gain recognized in the amount of $6,252,000 related to the sale of our investment in Rent.com to eBay. Equity in income of unconsolidated entities decreased in 2004 as compared to 2003 primarily due to our 50% share of the gain received on a community sold in 2003 which was accounted for under the equity method. Venture partner interest in profi t-sharing in 2004 and 2003 represented the income allocated to our venture partner in a profit-sharing arrangement as discussed in Note 6, “Investments in Unconsolidated Entities,” of our Consolidated Financial Statements. Effective December 2004, we no longer account for our inter est in this venture as a profit-sharing ar rangement, and therefore during 2005, no income or loss from venture partner interest in profit-sharing was recognized. 26 AVALONBAY COMMUNITIES, INC. Minorityintere st in consolidated partnerships i n c reased in 2005 an d d ecreased in 2004 d ue to th e con solid ation of an entity u nd er FASB In terp retatio n No. 46 (“FIN 46”), “Con solid ation of Variab le In terest En tities, an In ter pretatio n of ARB No. 51,” as revised in Decemb er 2003. Effective Jan u ar y 1, 20 04, we co nso lid ated an entity from wh ich we h eld a particip atin g mort g a g e n ote d ue to th e imp lementatio n of FIN 46 as discu s sed in N ote 1, “O rgan ization an d Sign ifican t Acco un tin g Policies,” of ou r Co n so lid ated Fin ancial Statements. We did no t h old an equ ity in terest in th is en tity, an d th ere f o re 100% o f th e entity’s net lo ss was recogn ized as mino rity in terest in con solidated partn ersh ips du rin g th e year en ded December 31, 200 4. In Octob er 2004 , we received p aymen t in fu ll of the ou tstand in g mortgage n ote d u e from th is en tity. Up on rep aymen t of the mort g a g e n ote, o ur eco no mic in ter est in th is en tity en ded , an d th ere f o re th is en tity was n o lon ger co nsid ered a variab le interest entity u nd er FIN 46 an d we d isco n tin u ed co nso lid atio n. Income from discontinued operations re p resen ts th e n et in come gen erated by commun ities so ld du rin g th e perio d fro m J a n u a ry 1, 20 03 thro u gh December 31, 200 5 or co n sidered h eld fo r sale as of Decemb er 31 , 2005. See Note 7, “Dis con tin ued Operation s —Real Estate Assets Sold o r H eld for Sale” o f ou r Con so lid ated Fin an cial Statemen ts fo r ad ditio nal in fo rm a t i o n . Th e decreases in 2005 an d 2004 are du e to th e sale of seven commu nities and on e office bu ild in g in 20 05 an d five commun ities in 20 04, eliminatin g the in co me gen erated from th ese assets u po n disp o sitio n . Gain on sale of real estate assets increased in 2005 and decreased in 2004 due to the volume and size of dispositions in each year. The amount of gains realized depends on many factors, including the number of communities sold, the size and carr ying value of those communities and local market conditions. We expect to continue to sell communities based on overall portfolio allocation needs as well as to respond to market opportunities. Cumulative effect of change in accounting principle in 2004 is a result of the implementation of FIN 46, discussed above, and repr esents the difference between the net assets consolidated under FIN 46 and the previously recorded net assets. Dividends attributable to pre f e rred stock d e c r eased du rin g 2004 p rimarily as a result of several pre f e rred s tock re d e m p t i o n s d uring 2003. Funds from Operations Attributable to Common Stockholders (“FFO”) FFO is consider ed by management to be an appropriate supplemental measure of our operating and financial performance because, by excluding gains or losses related to dispositions of previously depreciated property and excluding real estate depreciation, which can var y among owners of identical assets in similar condition based on historical cost accounting and useful life estimates, FFO can help one compare the operating performance of a real estate company between periods or as compared to different companies. We believe that in order to understand our operating results, FFO should be examined with net income as presented in our Consolidated Financial Statements. For a more detailed discussion and presentation of FFO, see “Selected Financial Data,” included elsewhere in this repor t. Liquidity and Capital Resour ces Factors affecting our liquidity and capital resources are our cash flows from operations, financing activities and investing activities. Operating cash flow has historically been deter mined by: (i) the number of apar tment homes currently owned, (ii) rental rates, (iii) occupancy levels and (iv) operating expenses with respect to apartment homes. The timing, source and amount of cash flow provided by financing activities and used in investing activities are sensitive to the capital markets environment, particularly to changes in interest rates. The timing and type of capital markets activity in which we engage, as well as our plans for development, redevelopment, acquisition and disposition activity, are af fected by changes in the capital markets environment, such as changes in interest rates or the availability of cost-effective capital. We regularly r eview our liquidity needs, the adequacy of cash flow from operations, and other expected liquidity sources to meet these needs. We believe our principal short-ter m liquidity needs are to fund: • normal recur ring operating expenses; • debt service and maturity payments; • prefer red stock dividends and DownREIT partnership unit distributions; • th e min imum divid end paymen ts re q u i red to main tain o ur REIT q ualificatio n u n der the In ter nal Revenu e Cod e of 1 986; • development and redevelopment activity in which we are currently engaged; and • capital calls for the Fund as requir ed. AVALONBAY COMMUNITIES, INC. 27 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED ) We anticipate that we can fully satisfy these needs from a combination of cash flow provided by operating activities, proceeds from asset dispositions and borrowing capacity under our variable rate unsecured credit facility. Cash an d cash equ ivalents totaled $6, 106,00 0 at Decemb er 31, 2 005, an in cr ease of $4, 585,00 0 from $1,521 ,000 at D e c e m b e r 31, 20 04. Th e fo llo win g d iscussio n relates to ch ang es in cash du e to o per atin g, in vestin g an d fin an cin g activities, wh ich are p resen ted in ou r Co nso lid ated Statements o f Cash Flows inclu d ed elsewh ere in th is re p o rt . Operating Activities—Net cash provided by operating activities increased to $306,639,000 in 2005 from $275,617,000 in 2004, primarily due to additional NOI from our Established Community operations, as well as NOI from recently developed com- munities, partially offset by the loss of NOI from the 12 communities sold in 2005 and 2004, as discussed earlier in this report. Investing Activitie s—Net cash us ed in in vestin g activities o f $19,76 1,000 in 2005 related to in vestmen ts in assets th ro u g h d evelop men t, r ed evelo pmen t and acqu isition of ap artment co mmu nities , in clu ding the acq uisition of a p artn er interest in a re a l estate join t ventur e, s u bstantially all o f wh ich is offset b y p roceeds from asset disp ositio ns, in clud in g the p roceed s from the sale of a techn o logy in vestmen t. Du rin g 2005, we in vested $4 59,376,000 in th e p u rch ase an d develop ment of real estate an d capital e x p e n d i t u re s : • we began the d evelo pmen t of 12 n ew commun ities. Th ese co mmun ities, if develop ed as exp ected, will con tain a total of 3,365 ap artmen t h o mes, an d th e total cap italized co st, in clud in g lan d acq uis itio n costs, is p rojected to be ap pr o x i m a t e l y $882,700 ,000. We co mp leted the d evelo pmen t o f seven commun ities co n tain in g an aggregate of 1,971 ap ar tmen t h omes fo r a total cap italized cost, in clu d in g lan d acqu isition cost, o f $4 08,200,000 ; • we completed the redevelopment of three communities containing 1,094 apartment homes for a total capitalized cost of $196,700,000, of which $165,700,000 was incurr ed prior to redevelopment; • we acquired the 75% equity inter est of a third-party partner in a joint venture owning one community for a net purchase price of $57,415,000; • we contributed $6,278,000 for a 15.2% equity interest in the Fund, which upon contribution owned four apartment communities containing a total of 879 apartment homes with an aggregate gross r eal estate value of $112,852,000. We also received net pr oceeds of $87,948,000 as reimbursement for acquiring and warehousing these communities. In December 2005, we contributed an additional $5,303,000 to the Fund, bringing our total equity investment in the Fund to approximately $11,600,000; • we acq uired 13 p arcels o f lan d in con n ectio n with Develo pmen t Righ ts, for an agg regate p ur ch ase p rice of $115, 849,00 0; an d • we had capital expenditures relating to cur rent communities’ real estate assets of $17,570,000 and non-real estate capital expenditures of $1,520,000. Financing Activities—Net cash used in financing activities totaled $282,293,000 in 2005, consisting primarily of dividends paid, certain unsecured note r epayments and mortgage note r epayments, partially offset by the issuance of common stock for option exercises, the issuance of unsecured notes and mortgage notes payable including draws on construction loans and an increase in borrowings under our unsecured credit facility. See Note 3, “Notes Payable, Unsecur ed Notes and Credit Facility,” and Note 4, “Stockholders’ Equity,” of our Consolidated Financial Statements, for additional information. Variable Rate Unsecured Credit Facility We have a $500,000,000 revolving variable rate unsecur ed credit facility with JPMorgan Chase Bank and W achovia Bank, N.A. serving as banks and syndication agents for a syndicate of commercial banks and Bank of America, ser ving as bank and administrative agent. Under the terms of the credit facility , we may elect to increase the facility by up to an additional $150,000,000, provided that one or more banks (from the syndicate or otherwise) voluntarily agr ee to provide the additional commitment. No member of the syndicate of banks can prohibit such incr ease; such an increase in the facility will only be effective to the extent banks (from the syndicate or otherwise) choose to commit to lend additional funds. We pay participating banks, in the aggregate, an annual facility fee of appr oximately $750,000. The unsecured credit facility bears interest at varying levels based on the London Interbank Of fered Rate (“LIBOR”), rating levels achieved on our unsecured notes and on a maturity schedule selected by us. The cur rent stated pricing is LIBOR plus 0.55% per annum (5.12% on January 31, 2006). The spread over LIBOR can var y from LIBOR plus 0.50% to LIBOR plus 1.15% based upon the rating of our long-term unsecured debt. In addition, a competitive bid option is available for borrowings of up to $250,000,000. This option allows banks that are part of the lender consortium to bid to pr ovide us loans at a rate that is lower than the stated pricing provided by the unsecured credit facility. The competitive bid option may result in lower pricing if market conditions allow. We had no outstanding balance under this competitive bid option at Januar y 31, 2006. We 28 AVALONBAY COMMUNITIES, INC. are subject to (i) certain customar y covenants under the unsecured cr edit facility, including, but not limited to, maintaining certain maximum leverage ratios, a minimum fixed charges coverage ratio and minimum unencumbered assets and equity levels, and (ii) prohibitions on paying dividends in amounts that exceed 95% of our FFO, except as may be required to maintain our REIT status. The credit facility matur es in May 2008, assuming our exercise of a one-year renewal option. At Januar y 31, 2006, $16,000,000 was outstanding, $39,504,000 was used to provide letters of credit and $444,496,000 was available for borrowing under the unsecur ed credit facility. Future Financing and Capital Needs—Debt Maturities One of our principal long-term liquidity needs is the repayment of long-term debt at the time that such debt matures. For unsecured notes, we anticipate that no significant por tion of the principal of these notes will be repaid prior to maturity. If we do not have funds on hand suf ficient to repay our indebtedness as it becomes due, it will be necessar y for us to refi nance the debt. This r efinancing may be accomplished by uncollateralized private or public debt offerings, additional debt financing that is collateralized by mor tgages on individual communities or groups of communities, draws on our unsecured credit facility or by additional equity offerings. Although we believe we will have the capacity to meet our long-term liquidity needs, we cannot assure you that additional debt fi nancing or debt or equity offerings will be available or, if available, that they will be on terms we consider satisfactor y. The following debt activity occurred during the year ended December 31, 2005: • We repaid $150,000,000 in previously issued unsecur ed notes in Januar y 2005, along with any unpaid interest, pursuant to their scheduled maturity. No prepayment penalty was incur red; • We issued $100,000,000 in unsecured notes in March 2005 under our existing shelf registration statement at an annual effective inter est rate of 4.999%. Interest on these notes is payable semi-annually on March 15 and September 15, and they mature in March 2013; • In co nn ection with th e ad mission of o utside in ves to rs in to the Fun d , we d econ solid ated the as sets an d liab ilities of fou r co mmu n ities own ed b y the Fu n d, inclu ding $ 24,869,000 in fixed rate mor tgage d ebt secu red b y two of th e commun ities; • We mad e a p ayment in th e amo un t of $36,1 42,000 to th e third - p a rty len d er of a jo in t ventu re en tity th at was un con solidated at December 31, 200 4 bu t was con solidated in Mar ch 20 05 u po n acq uisitio n of th e 75% eq u ity in ter e s t of the th ird - p a rty partn er; an d • We assumed $4,566,000 in fi xed rate debt in connection with the acquisition of a parcel of improved land. We currently have an ef fective shelf registration statement on file with the Securities and Exchange Commission. The shelf registration statement originally provided for the issuance of $750,000,000 of debt and equity in one or more public offer- ings, however, only $370,984,000 remains available for issuance. We expect to increase our debt and equity capacity in early 2006. However, we cannot assure you that market conditions will per mit us to issue debt or equity securities on cost-effective ter ms or that the registration statement will remain available and effective at all times. Future Financing and Capital Needs—Por tfolio and Other Activity As of December 31, 2005 , we had 15 n ew commu nities un d er co nstru ction , for wh ich a total estimated cost o f $ 598,41 2,000 remain ed to b e in vested . In add itio n, we h ad two co mmu n ities un d er re c o n s t ru ction , fo r wh ich a to tal estimated cost of $1,656 ,000 remain ed to be invested . Su bs tantially all of th e cap ital exp en d itu res n ecess ary to co mplete th e co mmun ities cur ren tly un d er co n str uction and re c o n s t ru ctio n , as well as d evelop ment co sts related to pu rsu in g Develop men t Righ ts, will b e fun d ed fr o m : • the remaining capacity under our current $500,000,000 unsecured credit facility; • the net proceeds from sales of existing communities; • retained operating cash; • the issuance of debt or equity securities; and/or • private equity funding. Before planned reconstruction activity, including reconstr uction activity related to the Fund as discussed below, or the construction of a Development Right begins, we intend to arrange adequate financing to complete these undertakings, although we cannot assure you that we will be able to obtain such financing. In the event that financing cannot be obtained, we may have to abandon Development Rights, write-off associated pre-development costs that were capitalized and/or forego reconstr uction activity. In such instances, we will not realize the increased revenues and ear nings that we expected from such Development Rights or reconstr uction activity and significant losses could be incurred. AVALONBAY COMMUNITIES, INC. 29 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) We h ave in ves ted in th e Fu n d, a private, d iscr e t i o n a ry in vestment veh icle th at will acqu ire an d op erate ap ar tmen t commun ities in our markets. The Fund will serve, until March 16, 2008 or until 80% of its committed capital is invested, as the exclusive vehicle through which we will acquir e apartment communities, subject to certain exceptions. These exceptions include significant individual asset and portfolio acquisitions, pr operties acquired in tax-defer red transactions and acquisitions that are inadvisable or inappropriate for the Fund, if any. The Fund will not restrict our development activities, and will ter minate after a term of eight years, subject to two one-year extensions. The Fund has nine institutional investors, including us, with combined capital commitments of $330,000,000. A significant portion of the investments made in the Fund by its investors are being made through AvalonBay Value Added Fund, Inc., a Mar yland corporation that will qualify as a REIT under the Inter nal Revenue Code (the “Fund REIT”). A wholly-owned subsidiary of the Company is the general partner of the Fund and has committed $50,000,000 to the Fund and the Fund REIT (of which approximately $11,600,000 has been invested as of Januar y 31, 2006) representing a 15.2% combined general partner and limited partner equity interest. Under the Fund documents, the Fund has the ability to employ leverage through debt financings up to 65% on a portfolio basis, which, if achieved, would enable the Fund to invest up to $940,000,000. From time to time we use joint ventures to hold or develop individual r eal estate assets. We generally employ joint ventures primarily to mitigate asset concentration or market risk and secondarily as a source of liquidity. We may also use joint ventures related to mixed-use land development opportunities where our partners bring development and operational expertise to the venture. Each joint venture or partnership agreement has been and will continue to be individually negotiated, and our ability to operate and/or dispose of a community in our sole discretion may be limited to var ying degrees depending on the terms of the joint venture or partnership agreement. However, we cannot assure you that we will achieve our objectives through joint ventures. In evalu atin g o ur allocatio n of cap ital within o ur mar kets, we sell assets th at do n ot meet o ur lon g-ter m in vestmen t criteria o r wh en cap ital an d real estate markets allo w us to realize a p or tio n o f th e value created over th e past bu sines s cycle an d re d e p l o y the p roceeds fro m th ose sales to develop an d r edevelop commu nities. In resp on se to real es tate an d capital mark ets co nd ition s , in clud in g stro n g institu tion al deman d for real estate assets in o ur markets an d d emand fro m con d omin iu m co nverters, we sold seven co mmu n ities with net pro ceed s in th e agg regate of $344,185 ,000 in 2005, and exp ect to sell commu nities at an aggr e g a t e sales price o f $22 5,000,000 to $ 300,000,00 0 in 2006. We can n ot assu re yo u th at assets can con tinu e to be so ld on ter ms th at we con sider satisfacto ry or th at market co nd ition s will co n tin u e to make th e sale of assets an app ealin g s tr ategy. Becau s e th e p roceeds fr om th e sale o f commun ities may no t be immed iately redep loyed in to reven ue gen erating ass ets, the immediate e f fect o f a sale o f a co mmu n ity fo r a gain is to in crease net in come, bu t redu ce fu tu re total reven ues, total exp enses, NOI and FFO. As of Jan uar y 31, 200 6, we h ave o ne commun ity clas sified as h eld fo r sale u nd er GAAP. We are actively p ursu in g th e d ispo sitio n o f this commu nity an d exp ect to clo se o n this d ispo sition with in th e n ext twelve mon th s . Ho wever, we cann o t assu re yo u th at th is commun ity will b e s old as p lann ed . Of f Balance Sheet Arrangements We own interests in unconsolidated real estate entities, with ownership interests up to 50%. Four of these unconsolidated real estate entities, Avalon Terrace, LLC, CVP I, LLC, Mission Bay Venture Partners, LLC and the Fund, have debt outstanding as of December 31, 2005 as follows. Additional discussion of these entities can be found in Note 6, “Investments in Unconsolidated Entities,” of our Consolidated Financial Statements located elsewhere in this repor t. • Avalon Terrace, LLC has $37,200,000 of fixed rate debt which matures in November 2010 and is payable by the unconsolidated real estate entity with operating cash flow from the underlying real estate. We have not guaranteed the debt on Avalon Ter race, LLC, nor do we have any obligation to fund this debt should the unconsolidated real estate entity be unable to do so. • CVP I, LLC has outstanding bonds in the amount of $117,000,000 which mature in Febr uary 2009, assuming exercise of two one-year renewal options, and are payable by the unconsolidated r eal estate entity. In connection with the general contractor services that we provided to CVP I, LLC, the entity that owns and developed Avalon Chrystie Place I, we have provided a constr uction completion guarantee to the lender in order to fulfill their standard financing requirements related to the bond fi nancing. Our obligations under this guarantee will terminate once all of the lender’s standard completion requirements have been satisfied. We cur rently expect this to occur in early 2006. 30 AVALONBAY COMMUNITIES, INC. • Mission Bay Venture Par tners, LLC has a construction loan in the amount of $94,400,000 (of which $28,354,000 is outstanding as of December 31, 2005), which matures in September 2010, assuming exercise of two one-year renewal options, and is payable by the unconsolidated real estate entity. In connection with the general contractor services that we provide to Mission Bay Ventur e Partners, LLC, the entity that owns and is developing Avalon Mission Bay North II, we have provided a construction completion guarantee to the lender in order to fulfill their standard fi nancing requirements related to the constr uction financing. Our obligations under this guarantee will terminate following constr uction completion once all of the lender’s standard completion requirements have been satisfied. We cur rently expect this to occur in 2007. • Th e Fu n d h as six mo rtgage loan s with amou n ts o utstan din g of $16 ,765,000, $16,575,000, $31,500,00 0, $23,8 06,000, $7,960,000 an d $16,500,00 0, wh ich matu re in O ctob er 2011, April 2012, Ju ly 2012, Au gu st 2013, Febr u a ry 2028 (b ut can be p repaid after Feb ru a r y 2008 with ou t p enalty) an d Octob er 2012, re s p e c t i v e l y. T hese mortgage loans are secu red b y th e un d er lyin g real estate. In ad dition , th e Fu n d has a cred it facility with $37,100,000 ou tstan d ing as of Decemb er 31, 2005, wh ich matu res in Jan uar y 2 008. Th e mo rtgage loan s and th e credit facility are p ayab le b y th e Fu n d with o peratin g cash flow fro m th e un derlyin g real estate, an d the cred it facility is secu red by capital commitmen ts. We have n ot gu ar an teed th e d ebt of th e Fu nd , n or do we h ave any ob ligatio n to fu n d this debt sh ou ld th e Fu nd b e un able to d o so . In addition, as part of the formation of the Fund, we have pr ovided to one of the limited partners a guarantee. The guarantee provides that, if, upon final liquidation of the Fund, the total amount of all distributions to that partner during the life of the Fund (whether from operating cash flow or proper ty sales) does not equal the total capital contributions made by that par tner, then we will pay the partner an amount equal to the shor tfall, but in no event more than 10% of the total capital contributions made by the partner (maximum of approximately $1,700,000 as of December 31, 2005). We have not recor ded a liability related to this guarantee as of December 31, 2005, as the fair value of the r eal estate assets owned by the Fund is considered adequate to cover such payment under a liquidation scenario. T h e re are n o o th er line s o f cred it, side agreemen ts, fin an cial gu ar antees or an y o th er d erivative fin an cial in s tr umen ts r e l a t e d to or between us and ou r un con so lid ated r eal estate en tities. In evalu atin g ou r cap ital stru c t u re an d overall leverage, man ag ement takes in to co n sider atio n ou r pr o p o rtio n ate sh are of th is un con so lid ated d ebt. Contractual Obligations We curr ently have contractual obligations consisting primarily of long-term debt obligations and lease obligations for cer tain land parcels and regional and administrative office space. Scheduled contractual obligations requir ed for the next five years and thereafter are as follows as of December 31, 2005: (dollars in thousands) Long-Term Debt Obligations(1) Operating Lease Obligations(2) Total Total $2,367,382 1,185,093 $3,552,475 Less than 1 Year $223,787 3,454 $227,241 Payments due by period 1–3 Years 3–5 Years More than 5 Years $510,799 6,915 $517,714 $463,185 6,044 $1,169,611 1,168,680 $469,229 $2,338,291 (1) Includes $66,800 outstanding under our variable rate unsecured credit facility as of December 31, 2005. The table of contractual obligations assumes repayment of this amount in 2006—See “Liquidity and Capital Resources.” Amounts exclude interest payable as of December 31, 2005. (2) In clud es land le ases e xpiring be twee n July 2029 a nd Marc h 2142. A moun ts do not inc lude any adju stment fo r p urcha se op tions ava ilabl e un de r the la nd le a se s. Inflation and Deflation Substantially all of our apartment leases are for a ter m of one year or less. In an inflationary environment, this may allow us to realize increased rents upon renewal of existing leases or the beginning of new leases. Short-term leases generally minimize our risk from the adverse effects of inflation, although these leases generally permit residents to leave at the end of the lease term and therefore expose us to the effect of a decline in market rents. In a deflationar y rent environment, we may be exposed to declining rents more quickly under these shorter ter m leases. AVALONBAY COMMUNITIES, INC. 31 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) For ward-Looking Statements This Annual Report contains “for ward-looking statements” as that term is defined under the Private Securities Litigation Refor m Act of 1995. You can identify forward-looking statements by our use of the words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “assume,” “project,” “plan,” “may,” “shall,” “will” and other similar expressions in this Annual Report, that predict or indicate future events and tr ends and that do not report historical matters. These statements include, among other things, statements regarding our intent, belief or expectations with respect to: • our potential development, redevelopment, acquisition or disposition of communities; • th e timin g an d co st of comp letion o f ap artmen t co mmu nities u n d er co n str uctio n, r e c o n s t ructio n, d evelop men t o r re d e v e l o p m e n t ; • the timing of lease-up, occupancy and stabilization of apartment communities; • the pursuit of land on which we are considering futur e development; • the anticipated operating perfor mance of our communities; • cost, yield and earnings estimates; • our declaration or payment of distributions; • our joint venture and discretionary fund activities; • our policies regarding investments, indebtedness, acquisitions, dispositions, fi nancings and other matters; • our qualification as a REIT under the Internal Revenue Code; • the real estate markets in Nor thern and Souther n California and markets in selected states in the Mid-Atlantic, Northeast, Midwest and Pacific Nor thwest regions of the United States and in general; • the availability of debt and equity financing; • interest rates; • general economic conditions; and • trends af fecting our financial condition or results of operations. We can no t as sur e the futur e resu lts o r o u tcome of th e matters described in th ese statemen ts ; r ath er, these statemen ts m e rely re flect ou r cu rre nt exp ectatio ns of th e ap p rox imate ou tcomes of th e matters d iscu ssed . You sh o uld n o t rely on f o r w a rd -loo kin g statements b ecau se they in volve kn o wn and u n kn own risks, u n certain ties an d o th er facto rs, s o me of wh ich a r e beyo n d ou r co n tr ol. Th ese r isks, u n certainties an d o ther factors may cau se o ur actu al resu lts, p erf o rman ce or achieve- men ts to d iffer mater ially from th e an ticip ated fu tu re results, p er f o rman ce or achievemen ts exp ressed or imp lied b y th ese facto rs are d iscussed in o u r An n u al Rep o rt on f o r w a rd -lo okin g s tatements. T hese risks, u n certainties an d oth er F o rm 10-K fo r 2005 in th e s ection titled “Risk Factors ” an d in oth er re p o rts and d ocumen ts filed with th e Secu rities and Exch ang e Co mmission . In addition, these for ward-looking statements represent our estimates and assumptions only as of the date of this report. We do not under take to update these forward-looking statements, and therefore they may not r epresent our estimates and assumptions after the date of this report. Quantitative and Qualitative Disclosures About Market Risk We are exposed to certain financial market risks, the most predominant being fluctuations in inter est rates. We monitor interest rate fluctuations as an integral part of our overall risk management program, which recognizes the unpredictability of fi nancial markets and seeks to reduce the potentially adverse effect on our results of operations. The effect of inter est rate fluctuations historically has been small relative to other factors af fecting operating results, such as rental rates and occupancy. The specific market risks and the potential impact on our operating results are described below. Our operating r esults are af fected by changes in interest rates as a result of borrowings under our variable rate unsecured credit facility as well as outstanding bonds with variable interest rates. We had $241,712,000 and $217,881,000 in variable rate debt outstanding (excluding variable rate debt effectively fi xed through swap agreements) as of December 31, 2005 and 2004, respectively. If interest rates on the variable rate debt had been 100 basis points higher throughout 2005 and 2004, our annual interest costs would have increased by approximately $3,990,000 and $3,682,000, respectively, based on balances outstanding during the applicable years. 32 AVALONBAY COMMUNITIES, INC. We currently use interest rate protection agreements (consisting of interest rate swap and cap agreements) to r educe the impact of interest rate fl uctuations on certain variable rate indebtedness. Under swap agreements: • we ag ree to p ay to a cou n terp ar ty th e in terest th at wou ld h ave b een in cur red o n a fix ed pr in cipal amou n t at a fix e d i n t e rest r ate ( gen erally, th e in terest rate o n a p articu lar tre a s u r y b on d on th e date the ag reemen t is entered in to, p lu s a fixed in cremen t); an d • the counterparty agrees to pay to us the interest that would have been incurred on the same principal amount at an assumed floating interest rate tied to a particular market index. As of Decemb er 31, 2005, th e effect of swap agreemen ts is to fix th e in terest rate on ap pro ximately $67,400 ,000 of ou r variab le rate, tax-exempt deb t. Th e in terest r ate pro tection pro vid ed b y certain swap agreemen ts on th e co n so lid ated variable rate, tax-ex emp t d ebt was no t electively en ter ed in to b y us bu t, rather, was a r e q u i remen t of eith er th e b on d issu er or th e cr e d i t en h an cement p rovid er related to cer tain o f ou r tax-exemp t bo n d fin an cings . Becau se th e co un terparties p rovid in g the swap a g r eemen ts are majo r fin an cial in stitu tion s wh ich h ave an A+ o r b etter credit r atin g b y the Stan d ar d & Po or’s Ratin gs Gro u p an d th e in terest rates fixed b y th e swap agreemen ts are sign ificantly h igh er th an cur ren t market rates fo r su ch agre e m e n t s , we d o n o t b elieve th ere is ex po s ure at th is time to a d efau lt by a co un terpar ty pro v i d e r . Had th ese swap ag reements n ot been in place d u rin g 2005 and 2004, ou r an n u al interest costs wou ld have b een app ro ximately $1, 878,000 an d $2,769 ,000 lower, re s p e c t i v e l y, b ased on balan ces ou tstand in g an d re p o rted interest rates d ur in g th e ap p licable years. Ad ditio n ally, if th e variab le i n t e r est rates o n this d ebt h ad been 1 00 b asis p oin ts h igh er th rou gh ou t 2005 an d 2004 and th ese swap agreemen ts had n ot been in place, o ur ann u al in terest co sts wo uld h ave been app ro ximately $1,2 00,000 an d $2,07 3,000 lower, re s p e c t i v e l y. In ad ditio n , ch an ges in in ter est rates affect th e fair valu e of o ur fixed rate d eb t, wh ich imp acts th e fair valu e o f ou r aggre- gate in d ebtedn ess. Deb t secu rities an d no tes payab le ( exclu din g ou r variable rate u n s ecured cred it facility) with an a g g r eg ate carr ying valu e of $2, 300,58 2,000 at December 3 1, 2005 had an estimated aggregate fair valu e o f $2 ,426,2 50,000 at December 31, 2005 . Fixed rate d eb t (exclu d in g ou r variab le r ate deb t effectively fixed th ro ug h swap agre e m e n t s ) re p resen ted $1 ,981,6 70,000 of th e carr yin g value an d $2,10 7,342, 000 o f th e fair value at December 3 1, 200 5. If in ter est rates h ad been 10 0 b asis po in ts h igh er as o f Decemb er 3 1, 20 05, th e fair value of th is fixed rate d ebt wo uld have d ecre a s e d by $8 8,418,0 00. AVALONBAY COMMUNITIES, INC. 33 CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share data) 12-31-05 12-31-04 Assets Real estate: Land Buildings and impr ovements Fur niture, fixtures and equipment Less accumulated depr eciation Net operating real estate Constr uction in progress, including land Land held for development Operating real estate assets held for sale, net Total real estate, net Cash and cash equivalents Cash in escrow Resident security deposits Investments in unconsolidated r eal estate entities Deferred financing costs, net Deferred development costs Pr epaid expenses and other assets Total assets Liabilities and Stockholders’ Equity Unsecured notes Variable rate unsecured credit facility Mortgage notes payable Dividends payable Payables for construction Accrued expenses and other liabilities Accrued interest payable Resident security deposits Liabilities related to real estate assets held for sale Total liabilities $ 874,199 4,288,168 133,192 5,295,559 (938,297) 4,357,262 317,823 188,414 82,289 4,945,788 6,106 48,266 26,290 41,942 17,976 31,467 47,225 $ 863,867 4,080,462 127,520 5,071,849 (769,459) 4,302,390 173,290 156,350 245,795 4,877,825 1,521 22,138 23,478 41,379 21,859 37,007 56,042 $5,165,060 $5,081,249 $1,809,182 66,800 490,582 54,476 28,203 82,564 34,649 35,640 1,837 $1,859,448 102,000 489,906 52,982 23,005 73,223 37,254 33,208 3,407 2,603,933 2,674,433 Minority interest of unitholders in consolidated partnerships 19,464 21,525 Commitments and contingencies Stockholders’ equity: Pr eferred stock, $0.01 par value; $25 liquidation prefer ence; 50,000,000 shares authorized at both December 31, 2005 and 2004; 4,000,000 shares issued and outstanding at both December 31, 2005 and 2004 Common stock, $0.01 par value; 140,000,000 shares authorized at both December 31, 2005 and 2004; 73,663,048 and 72,582,076 shares issued and outstanding at December 31, 2005 and 2004, respectively Additional paid-in capital Defer red compensation Accumulated ear nings less dividends Accumulated other comprehensive loss Total stockholders’ equity Total liabilities and stockholders’ equity See accompanying notes to Consolidated Financial Statements. 40 40 737 2,442,528 (12,960) 115,788 (4,470) 726 2,389,511 (8,659) 10,769 (7,096) 2,541,663 2,385,291 $5,165,060 $5,081,249 34 AVALONBAY COMMUNITIES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE INCOME (Dollars in thousands, except per share data) 12-31-05 12-31-04 12-31-03 For the year ended Revenue: Rental and other income Management, development and other fees Total revenue Expenses: Operating expenses, excluding property taxes Pr operty taxes Interest expense, net Depreciation expense General and administrative expense Total expenses Equity in income of unconsolidated entities Ventur e partner interest in profit-sharing Minority interest in consolidated par tnerships Income from continuing operations before cumulative effect of change in accounting principle Discontinued operations: Income from discontinued operations Gain on sale of real estate assets Total discontinued operations Income before cumulative effect of change in accounting principle Cumulative ef fect of change in accounting principle Net income Dividends attributable to prefer red stock $666,376 4,304 670,680 $613,240 604 613,844 $556,582 931 557,513 191,558 65,487 127,099 158,822 25,761 568,727 7,198 — (1,481) 181,351 59,458 131,103 151,991 18,074 541,977 1,100 (1,178) (150) 164,253 53,257 130,178 138,725 14,830 501,243 25,535 (1,688) (950) 107,670 71,639 79,167 14,942 199,766 214,708 322,378 — 322,378 (8,700) 21,134 122,425 143,559 215,198 4,547 219,745 (8,700) 31,368 160,990 192,358 271,525 — 271,525 (10,744) Net income available to common stockholders $313,678 $211,045 $260,781 Other comprehensive income: Unrealized gain on cash flow hedges Comprehensive income Ear nings per common share—basic: Income from continuing operations (net of dividends attributable to pr eferred stock) Discontinued operations Net income available to common stockholders Ear nings per common share—diluted: Income fr om continuing operations (net of dividends attributable to pr eferred stock) Discontinued operations Net income available to common stockholders See accompanying notes to Consolidated Financial Statements. 2,626 1,116 4,428 $316,304 $212,161 $265,209 $ $ $ $ 1.36 2.94 4.30 1.34 2.87 4.21 $ $ $ $ 0.94 2.01 2.95 0.94 1.98 2.92 $ $ $ $ 1.00 2.80 3.80 0.99 2.74 3.73 AVALONBAY COMMUNITIES, INC. 35 CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY S h a res issue d P re f e r re d C o m m o n P re f e rre d C o m m o n s t o c k s t o c k s t o c k s t o c k A c c u m u l a t e d A c c u m u l a t e d A d d i t i o n a l D e f e rre d c o m p e n - s a t i o n p a i d - i n c a p i t a l e a r nings l e s s d i v i d e n d s other com- p r e h e n s i v e l o s s S t o c k - h o l d e r s ’ e q u i t y 7,267,700 — 68,202,926 — $73 — $682 — $2,273,668 $ (7,855) (Dollars in thousands) Balance at December 31, 2002 Net income Unrealized gain on cash flow hedges Dividends declared to common and preferred stockholders Issuance of common stock, net of withholdings Issuance of stock options Repur chase of common stock, including repurchase costs Issuance of prefer red stock, — — — — — 3,833,600 — — — (1,099,000) net of issuance costs 3,336,611 Redemption of preferred stock Amor tization of (6,604,311) deferred compensation — — — — Balance at December 31, 2003 4,000,000 70,937,526 Net income Unrealized gain on cash flow hedges Dividends declared to common and preferred stockholders Issuance of common stock, net of withholdings Issuance of stock options Amor tization of deferred compensation Balance at — — — — — — — 1,644,550 — — — — December 31, 2004 4,000,000 72,582,076 Net income Unrealized gain on cash fl ow hedges Dividends declared to common and preferred stockholders Issuance of common stock, net of withholdings Issuance of stock options Amor tization of deferred compensation Balance at — — — — — — — 1,080,972 — — — — — (202,694) 162,674 754 (1,383) (754) — — — — — $ (59,388) 271,525 $(12,640) — $2,194,540 271,525 — 4,428 4,428 (114) — (7,025) — (280) — — — — — — — (202,694) 161,215 — (39,877) 81,737 (163,724) 4,184 (11) (32,841) 81,704 (163,378) — 4,184 — 709 2,322,581 (5,808) 2,024 (8,212) 2,311,334 — — 219,745 — 219,745 — 1,116 1,116 — (210,338) 64,849 2,081 (5,702) (2,081) (662) — — 4,932 — — — — — (210,338) 58,502 — 4,932 726 2,389,511 (8,659) 10,769 (7,096) 2,385,291 — — 322,378 — 322,378 — 2,626 2,626 — — — — — — — — — — (216,982) 48,496 4,521 (8,118) (4,521) (377) — — 8,338 — — — — — (216,982) 40,012 — 8,338 — — 38 — — — — — — — 17 — — — — — 11 — — — — — — — 33 (66) — 40 — — — — — — 40 — — — — — — December 31, 2005 4,000,000 73,663,048 $40 $737 $2,442,528 $(12,960) $115,788 $ (4,470) $2,541,663 See accompanying notes to Consolidated Financial Statements. 36 AVALONBAY COMMUNITIES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) 12-31-05 12-31-04 12-31-03 For the year ended Cash flows from operating activities: Net income Adjustments to reconcile net income to cash provided by operating activities: Depreciation expense Depreciation expense from discontinued operations Amortization of deferred financing costs and debt premium/discount Amortization of deferred compensation Income allocated to minority interest in consolidated partnerships including discontinued operations Income allocated to venture partner interest in profit-sharing Gain on sale of real estate assets Gain on sale of technology investment Gain on sale of joint venture community Cumulative effect of change in accounting principle Increase in cash in operating escrows Decrease (increase) in resident security deposits, prepaid expenses and other assets Increase (decrease) in accr ued expenses, other liabilities and accrued interest payable Net cash provided by operating activities Cash flows from investing activities: Development/redevelopment of real estate assets including land acquisitions and defer red development costs Acquisition of real estate assets, including par tner equity interest Capital expenditures—existing real estate assets Capital expenditures—non-real estate assets Pr oceeds from sale of communities and technology investment, including reimbursement for Fund communities, net of selling costs Increase (decrease) in payables for construction Decrease (increase) in cash in construction escrows Repayment of participating mor tgage note, including interest and prepayment premium Decrease (increase) in investments in unconsolidated real estate entities Net cash provided by (used in) investing activities Cash flows from financing activities: Issuance of common stock Repurchase of common stock Issuance of preferred stock, net of r elated costs Redemption of preferred stock and related costs Dividends paid Net borr owings (repayments) under unsecured credit facility Issuance of mor tgage notes payable and draws on construction loans Repayments of mor tgage notes payable Issuance (r epayment) of unsecured notes Payment of deferr ed financing costs Redemption of units for cash by minority par tners Distributions to DownREIT par tnership unitholders Distributions to joint ventur e and profit-sharing partners Net cash used in financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year Cash paid during year for interest, net of amount capitalized See accompanying notes to Consolidated Financial Statements. $322,378 $219,745 $271,525 158,822 3,241 4,022 8,338 1,481 — (199,766) (6,252) — — (4,344) 8,938 9,781 306,639 (382,871) (57,415) (17,570) (1,520) 469,737 5,198 (21,784) — (13,536) (19,761) 36,611 — — — (215,391) (35,200) 26,269 (41,932) (50,000) (1,292) (50) (1,194) (114) (282,293) 4,585 1,521 $ 6,106 $121,526 151,991 10,676 3,962 4,932 187 1,178 (122,425) — — (4,547) (1,451) 138,725 15,071 3,850 4,184 1,388 1,688 (160,990) — (23,448) — (557) (10,589) (7,025) 21,958 275,617 (4,734) 239,677 (355,938) (128,238) (12,984) (860) 219,649 (3,962) 201 34,846 (4,397) (251,683) 54,031 — — — (209,095) 50,900 105,843 (40,270) 25,000 (9,318) (1,691) (1,425) (3,446) (29,471) (5,537) 7,058 $ 1,521 $124,895 (357,520) — (11,593) (274) 403,118 (331) (1,040) — 1,575 33,935 146,934 (39,877) 81,737 (163,724) (202,416) 22,130 38,829 (4,582) (150,000) (1,477) (600) (2,152) (4,267) (279,465) (5,853) 12,911 $ 7,058 $131,266 AVALONBAY COMMUNITIES, INC. 37 CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED ) Supplemental disclosures of non-cash investing and financing activities (dollars in thousands): During the year ended December 31, 2005: • As described in Note 4, “Stockholders’ Equity,” 165,790 shares of common stock were issued in connection with stock grants, 1,295 shares were issued through the Company’s dividend reinvestment plan, 8,971 shares were issued to a member of the Board of Directors in fulfi llment of a deferred stock award, 50,916 shares were withheld to satisfy employees’ tax withholding and other liabilities and 9,965 shares wer e forfeited, for a net value of $9,317. In addition, the Company granted 696,484 options for common stock, net of forfeitures, at a value of $4,521. • 49,263 units of limited partnership, valued at $2,202, were pr esented for redemption to the DownREIT partnerships that issued such units and were acquired by the Company in exchange for an equal number of shares of the Company’s common stock. • The Company deconsolidated mortgage notes payable in the aggregate amount of $24,869 upon admittance of outside investors into the Fund (as defined in Note 6, “Investments in Unconsolidated Entities”). • The Company assumed fixed rate debt of $4,566 as part of the acquisition of an improved land parcel. • The Company recor ded a decrease to other liabilities and a cor responding gain to other comprehensive income of $2,626 to adjust the Company’s Hedged Derivatives (as defined in Note 5, “Derivative Instruments and Hedging Activities”) to their fair value. • Common and preferr ed dividends declared but not paid totaled $54,476. During the year ended December 31, 2004: • 147,517 sh ares of commo n sto ck were is su ed in co nn ection with stock gr an ts, 78,5 09 sh ares were issued in co n nection with no n -cash sto ck op tio n exercises, 1,545 shares wer e is sued thr ou gh th e Comp an y’s divid en d reinvestmen t p lan , 75,515 sh ar es were with h eld to satis fy employees’ tax with ho ld in g an d oth er liab ilities an d 3,01 2 sh ares were fo rf e i t e d , fo r a n et valu e o f $ 6,138. In ad d ition , the Co mp an y gr an ted 465,232 op tion s for co mmo n sto ck , n et o f fo rf e i t u res, at a valu e of $2 ,081. • 104,160 units of limited partnership, valued at $4,035, were presented for redemption to the DownREIT partnerships that issued such units and were acquired by the Company in exchange for an equal number of shares of the Company’s common stock. • The Company sold two communities with mortgage notes payable of $28,335 in the aggregate, that were assumed by the r espective buyers as part of the total sales price. • The Company assumed fixed rate debt of $8,155 in connection with the acquisition of a community and $20,141 in connection with the acquisition of three impr oved land parcels. • The Company recorded a decrease to other liabilities and a corresponding gain to other comprehensive income of $1,116 to adjust the Company’s Hedged Derivatives to their fair value. • Common and prefer red dividends declared but not paid totaled $52,982. During the year ended December 31, 2003: • 114,895 shares of common stock wer e issued in connection with stock grants, 37,124 shares were withheld to satisfy employees’ tax withholding and other liabilities and 12,102 shares were forfeited, for a net value of $2,419. In addition, the Company granted 268,101 options for common stock, net of forfeitures, at a value of $754. • 328,731 units of limited partnership, valued at $13,245, were presented for redemption to the DownREIT par tnerships that issued such units and were acquired by the Company in exchange for an equal number of shares of the Company’s common stock. • The Company sold two communities that were subject to mortgage notes payable of $39,665 in the aggregate, that were assumed by the buyers as part of the total sales price. $260 of deferr ed stock units were converted into 6,989 shares of common stock. • The Company recor ded a decrease to other liabilities and a corresponding gain to other comprehensive income of $4,428 to adjust the Company’s Hedged Derivatives to their fair value. • Common and preferr ed dividends declared but not paid totaled $51,831. 38 AVALONBAY COMMUNITIES, INC. NOTES TO CONSOLIDA TED FINANCIAL STATEMENTS (Dollars in thousands, except per share data) 1. Organization and Significant Accounting Policies Organization AvalonBay Communities, Inc. (the “Company,” which term, unless the context otherwise requir es, refers to AvalonBay Communities, Inc. together with its subsidiaries) is a Maryland corporation that has elected to be taxed as a real estate investment trust (“REIT”) under the Inter nal Revenue Code of 1986, as amended. The Company focuses on the development, ownership and operation of apartment communities in high barrier-to-entr y markets of the United States. These markets are located in the Northeast, Mid-Atlantic, Midwest, Pacific Nor thwest, and Northern and Souther n California regions of the countr y. At December 31, 2005, the Company owned or held a direct or indirect ownership interest in 143 operating apartment communities containing 41,412 apartment homes in ten states and the District of Columbia, of which two communities containing 506 apar tment homes were under reconstr uction. In addition, the Company owned or held a direct or indirect ownership interest in 15 communities under construction that ar e expected to contain an aggregate of 4,062 apartment homes when completed. The Company also owned or held a direct or indirect ownership interest in rights to develop an additional 47 communities that, if developed in the manner expected, will contain an estimated 12,495 apartment homes. Principles of Consolidation The Company is the surviving corporation from the mer ger (the “Merger”) of Bay Apar tment Communities, Inc. (“Bay”) and Avalon Proper ties, Inc. (“Avalon”) on June 4, 1998, in which Avalon shareholders received 0.7683 of a share of common stock of the Company for each share owned of Avalon common stock. The Merger was accounted for under the purchase method of accounting, with the historical financial statements for Avalon presented prior to the Mer ger. At that time, Avalon ceased to legally exist, and Bay as the surviving legal entity adopted the historical financial statements of Avalon. Consequently, Bay’s assets were recor ded in the historical financial statements of Avalon at an amount equal to Bay’s debt outstanding at that time plus the value of capital stock retained by the Bay stockholders, which approximates fair value. In connection with the Merger, the Company changed its name from Bay Apartment Communities, Inc. to AvalonBay Communities, Inc. Th e Co mpan y assesses con solidation o f variab le in ter est en tities un d er th e gu id ance of FASB In terp retatio n No . 46 (“FIN 46”) , “Co nso lid atio n o f Variab le In terest En tities, an In ter pretatio n o f ARB No. 51,” as revised in December 2003. Th e Co mpan y accou n ts for join t ven tu re p artn erships an d s ub sidiary partn erships stru c t u r ed as Do wn REITs th at are n ot variab le i n t e r est en tities in acco rdan ce with Statemen t o f Positio n (“SOP”) 78-9, “Accou n tin g for In ves tments in Real Estate Ve n t u re s . ” Un d er SOP 78-9, the Comp an y con so lid ates join t ven tu re and Down REIT p artnersh ip s wh en the Comp an y co ntro ls th e majo r op eratin g and fin ancial p olicies of th e p artn ersh ip th ro ug h majo rity ownersh ip or in its cap acity as gen eral p art n e r. Th e acco mp an yin g Co nso lid ated Fin an cial Statemen ts in clu de th e accou n ts of th e Compan y an d its wh olly-own ed p art n e r s h i p s , c e r tain join t ven tu re p artnersh ip s, sub sid iary p ar tn ersh ip s stru c t u r ed as Down REITs and an y variable in terest en tities con solidated u n der FIN 4 6. All sign ifican t in terco mpan y b alan ces an d tran sactio ns have been eliminated in con s olidation . In each of th e p artner sh ip s s tr u c t u red as DownREITs, eith er th e Comp an y or o ne o f the Compan y’s wh o lly-o wn ed su bsid iaries is th e gen eral part n e r, and th ere are on e o r mo re limited p artners wh ose interest in th e p artn ersh ip is re p resen ted by u nits of limited p artner sh ip in ter est. Fo r each Down REIT p artnersh ip , limited p artner s are en titled to receive an initial d istribu tion b e f o r e any distrib u tio n is made to th e gen eral p art n e r. Alth ou gh the p artner sh ip agreemen ts for each o f th e Down REITs are d i ff e ren t, gen erally th e d istr ibu tion s per un it p aid to th e h o lder s of un its of limited p artn ersh ip in ter ests h ave ap pro x i m a t e d the Comp any’s current common stock d ivid en d per sh are. Each Do wn REIT p artn ersh ip h as b een stru c t u red so th at it is u nlikely th e limited p ar tn ers will b e entitled to a distrib utio n greater th an th e in itial distrib ution p rovided fo r in th e p a rtn ers h ip ag reemen t. Th e ho ld ers of un its o f limited par tn ersh ip interest h ave the r igh t to p res ent all or so me o f th eir u nits for red emp tio n fo r a cash amou n t as d eter min ed b y th e ap p licable p artnersh ip agreemen t an d bas ed on the fair value of th e C o m p a n y ’ s co mmon sto ck. In lieu o f a cash red emp tio n , th e Comp any may elect to acqu ire s uch u nits for an equ al n u mb er of sh ares of th e Co mpan y’s co mmo n sto ck. The Company accounts for investments in unconsolidated entities that ar e not variable interest entities in accordance with SOP 78-9 and Accounting Principles Board (“APB”) Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” The Company uses the equity method to account for these investments when it owns greater than 20% of the equity value or has significant influence over that entity. Investments in which the Company owns 20% or less of the equity value and does not have significant influence are accounted for using the cost method. If there is an event or change in circumstance that indicates a loss in the value of an investment, the Company’s policy is to record the loss and reduce the value of the investment to its fair value. A loss in value would be indicated if the Company could not recover the car rying value of the investment or if the investee could not sustain an ear nings capacity that would justify the carr ying amount of the AVALONBAY COMMUNITIES, INC. 39 NOTES TO CONSOLIDATED FINANCIAL STA TEMENTS ( CONTINUED) investment. During the year ended December 31, 2004, the Company recorded an impairment loss of $1,002 related to a tech n ology in vestmen t, which is in clud ed in o peratin g ex pen ses, exclu d in g p ro p e rty taxes o n th e accomp anyin g Consolidated Statements of Operations and Other Comprehensive Income. The Company did not recognize an impairment loss on any of its investments in unconsolidated entities during the years ended December 31, 2005 or 2003. Revenue Recognition Rental income related to leases is recognized on an accrual basis when due fr om residents in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition” and Statement of Financial Accounting S t a n d a rd s (“SFAS”) No. 13 , “Acco u ntin g for Leases.” In accor dan ce with th e Co mp an y’s stand ard lease ter ms, re n t a l payments are generally due on a monthly basis. Any cash concessions given at the inception of the lease are amortized over the approximate life of the lease, which is generally one year. Real Estate Significant expenditures which improve or extend the life of an asset are capitalized. The operating real estate assets ar e stated at cost and consist of land, buildings and improvements, furniture, fi xtures and equipment, and other costs incurred during their development, redevelopment and acquisition. Expenditures for maintenance and repairs are charged to operations as incur red. The Company’s policy with respect to capital expenditures is generally to capitalize only non-recur ring expenditures. Improvements and upgrades are capitalized only if the item exceeds $15, extends the useful life of the asset and is not related to making an apar tment home ready for the next resident. Purchases of personal property, such as computers and furniture, are capitalized only if the item is a new addition and exceeds $2.5. The Company generally expenses purchases of personal property made for replacement purposes. Th e cap italization of co s ts du rin g the d evelo pmen t o f assets (in clu din g in terest an d related lo an fees, p ro p e rty taxes an d o th er d i rect and ind irect costs) begin s when develop ment eff o r ts co mmen ce an d en ds wh en th e asset, o r a po rtion of an asset, is d e l i v e r ed an d is ready fo r its in tend ed u se, wh ich is gen erally in dicated by th e is su an ce o f a cer t i ficate of occup ancy. Co st cap italization d u rin g red evelo p men t of ap artmen t ho mes (in clu ding in teres t and related loan fees, p ro p e rty tax es an d o th er d i rect an d in dir ect costs) begins when an apartmen t h ome is taken ou t-of-s ervice for redevelop men t an d end s wh en th e a p a rtmen t h ome redevelop men t is co mpleted an d the ap artmen t h ome is available for a n ew res id en t. Ren tal in come and op eratin g co sts in cur red d ur in g th e in itial lease-u p or p ost-redevelop ment lease-up per iod are fu lly r eco gn ized as th ey accru e . In accordance with SFAS No. 67, “Accounting for Costs and Initial Rental Operations of Real Estate Projects,” the Company capitalizes pre-development costs incurred in pursuit of new development opportunities for which the Company cur rently believes future development is probable (“Development Rights”). Future development of these Development Rights is dependent upon various factors, including zoning and regulator y approval, rental market conditions, construction costs and availability of capital. Pre-development costs incurred in the pursuit of Development Rights for which future development is not yet considered probable are expensed as incurred. In addition, if the status of a Development Right changes, deeming futur e development no longer probable, any capitalized pre-development costs are written-off with a charge to expense. The Company expensed costs related to abandoned pursuits, which includes the abandonment or impairment of Development Rights, acquisition pursuits, disposition pursuits and technology investments, in the amounts of $816, $1,726 and $1,180 for the years ended December 31, 2005, 2004 and 2003, r espectively. These costs are included in operating expenses, excluding pr operty taxes on the accompanying Consolidated Statements of Operations and Other Comprehensive Income. Th e Comp any own s lan d imp roved with o ffice b uilding s an d in d ustrial sp ace occup ied by un related th ird - p a rties in connection with five Development Rights. The Company intends to manage the cur rent improvements until such time as all tenant obligations have been satisfied or eliminated through negotiation, and construction of new apar tment communities is ready to begin. As provided under the guidance of SFAS No. 67, the revenue from incidental operations received fr om the current improvements in excess of any incremental costs are being recorded as a reduction of total capitalized costs of the Development Right and not as part of net income. In connection with the acquisition of an operating community, the Company performs a valuation and allocation to each asset and liability acquired in such transaction, based on their estimated fair values at the date of acquisition in accordance with SFAS No. 141, “Business Combinations.” The purchase price allocations to tangible assets, such as land, buildings and improvements, and furniture, fixtures and equipment, are r efl ected in real estate assets and depreciated over their estimated useful lives. Any purchase price allocation to intangible assets, such as in-place leases, is included in prepaid expenses and other assets and amortized over the average remaining lease term of the acquired leases. The fair value of acquired in-place leases is determined based on the estimated cost to replace such leases, including foregone rents during an assumed re-lease period, as well as the impact on projected cash flow of acquired leases with leased rents above or below current market r ents. 40 AVALONBAY COMMUNITIES, INC. D e p r eciation is calcu lated on bu ild in gs an d impr ovemen ts u sing th e straigh t-lin e metho d o ver their estimated useful lives, wh ich ran ge fr om seven to thir ty year s. Furn i t u re, fix t u r es an d eq uip men t are gener ally d ep reciated usin g the straight-lin e meth o d over th eir estimated u sefu l lives, wh ich r an ge from th ree years (p rimarily co mpu ter- related eq uip men t) to s even years. If there is an event or change in circumstance that indicates an impairment in the value of an operating community, the Company’s policy is to assess any impairment in value by making a comparison of the current and projected operating cash flow of the community over its remaining useful life, on an undiscounted basis, to the carr ying amount of the community. If the carr ying amount is in excess of the estimated projected operating cash flow of the community, the Company would recognize an impair ment loss equivalent to an amount requir ed to adjust the carr ying amount to its estimated fair market value. The Company has not recognized an impairment loss on any of its operating communities during the years ended December 31, 2005, 2004 or 2003. Income Taxes The Company elected to be taxed as a REIT under the Inter nal Revenue Code of 1986, as amended, for the year ended December 31, 1994 and has not revoked such election. A corporate REIT is a legal entity which holds r eal estate interests and must meet a number of organizational and operational r equirements, including a requirement that it cur rently distribute at least 90% of its adjusted taxable income to stockholders. As a REIT, the Company generally will not be subject to corporate level federal income tax on taxable income it distributes currently to its stockholders. Management believes that all such conditions for the avoidance of income taxes have been met for the periods presented. Accor dingly, no provision for federal and state income taxes has been made. If the Company fails to qualify as a REIT in any taxable year, it will be subject to federal income taxes at regular corporate rates (including any applicable alternative minimum tax) and may not be able to qualify as a REIT for four subsequent taxable years. Even if the Company qualifies for taxation as a REIT, the Company may be subject to certain state and local taxes on its income and property, and to federal income and excise taxes on its undistributed taxable income. In addition, taxable income from non-REIT activities managed through taxable REIT subsidiaries is subject to federal, state and local income taxes. Th e follo win g reco n ciles n et D e c e m b e r 31, 2005, 200 4 an d 2003 : in co me available to common stockh o ld ers to taxable n et in co me for th e year s en ded Net income available to common stockholders Dividends attributable to preferred stock, not deductible for tax GAAP gain on sale of communities less than (in excess of) tax gain Depreciation/Amortization timing differences on real estate Tax compensation expense in excess of GAAP Other adjustments Taxable net income 2005 Estimate 2004 Actual 2003 Actual $313,678 $211,045 $260,781 8,700 (2,482) (3,861) (18,969) (2,021) 8,700 8,305 (3,793) (19,758) (9,835) 10,744 (3,795) (5,574) (4,254) (9,190) $295,045 $194,664 $248,712 The following summarizes the tax components of the Company’s common and pr eferr ed dividends declared for the years ended December 31, 2005, 2004 and 2003: Ordinar y income 20% capital gain 15% capital gain Unrecaptur ed §1250 gain 2005 9% — 77% 14% 2004 39% — 51% 10% 2003 11% 15% 56% 18% Defer red Financing Costs Deferred fi nancing costs include fees and costs incurr ed to obtain debt financing and are amortized on a straight-line basis, which approximates the ef fective interest method, over the shor ter of the term of the loan or the related credit enhancement facility, if applicable. Unamortized financing costs are written-off when debt is retired before the maturity date. Accumulated amortization of defer red financing costs was $16,074 at December 31, 2005 and $12,966 at December 31, 2004. AVALONBAY COMMUNITIES, INC. 41 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ( CONTINUED) Cash, Cash Equivalents and Cash in Escrow Cash and cash equivalents include all cash and liquid investments with an original maturity of three months or less from the date acquired. The majority of the Company’s cash, cash equivalents and cash in escrows is held at major commercial banks. Interest Rate Contracts The Company utilizes derivative financial instr uments to manage interest rate risk and has designated these financial instruments as hedges under the guidance of SFAS No. 133, “Accounting for Derivative Instr uments and Hedging Activities,” and SFAS No. 138, “Accounting for Certain Instr uments and Certain Hedging Activities, an Amendment of Statement No. 133.” For fair value hedge transactions, changes in the fair value of the derivative instrument and changes in the fair value of the hedged item due to the risk being hedged are recognized in cur rent period earnings. For cash flow hedge transactions, changes in the fair value of the derivative instrument are reported in other comprehensive income. For cash flow hedges where the changes in the fair value of the derivative exceed the change in fair value of the hedged item, the ineffective portion is r ecognized in current period earnings. Derivatives which are not part of a hedge relationship are r ecor ded at fair value through earnings. As of December 31, 2005 and 2004, the Company had approximately $233,000 and $236,000, respectively, in variable rate debt subject to cash flow hedges. See Note 5, “Derivative Instr uments and Hedging Activities.” Comprehensive Income Comprehensive Income, as refl ected on the Consolidated Statements of Operations and Other Comprehensive Income, is defined as all changes in equity during each period except for those r esulting from investments by or distributions to shareholders. Accumulated other comprehensive loss as refl ected on the Consolidated Statements of Stockholders’ Equity refl ects the changes in the fair value of effective cash flow hedges. Ear nings per Common Share In accord ance with th e provision s of SFAS No. 128, “Earn in gs per Share,” basic ear nings p er s h a re is co mp u ted by dividing ear nings availab le to common sto ck ho ld ers by th e weigh ted average n umb er of sh are s ou tstand in g d ur in g th e p erio d. Oth er p oten tially d ilu tive co mmo n shares, an d th e related imp act to earn in gs, are co n sidere d wh en calculatin g ear n in gs p er share o n a diluted b asis. The Compan y’s earn in gs per commo n sh are are d eter mined as follows: Basic and diluted shares outstanding Weighted average common shares—basic Weighted average DownREIT units outstanding Effect of dilutive securities For the year ended 12-31-05 12-31-04 12-31-03 72,952,492 474,440 1,332,386 71,564,202 573,529 1,217,225 68,559,657 893,279 750,531 Weighted average common shares—diluted 74,759,318 73,354,956 70,203,467 Calculation of Earnings per Share—basic Net income available to common stockholders Weighted average common shares—basic Ear nings per common share—basic Calculation of Earnings per Share—diluted Net income available to common stockholders Add: Minority interest of DownREIT unitholders in consolidated par tnerships, including discontinued operations $ 313,678 $ 211,045 $ 260,781 72,952,492 71,564,202 68,559,657 $ 4.30 $ 2.95 $ 3.80 $ 313,678 $ 211,045 $ 260,781 1,363 3,048 1,263 Adjusted net income available to common stockholders $ 315,041 $ 214,093 $ 262,044 Weighted average common shares—diluted Ear nings per common share—diluted 74,759,318 73,354,956 70,203,467 $ 4.21 $ 2.92 $ 3.73 Certain options to purchase shares of common stock in the amounts of 4,500, 6,000 and 1,348,738 were outstanding during the years ended December 31, 2005, 2004 and 2003, respectively, but were not included in the computation of diluted earnings per shar e because the options’ exercise prices were greater than the average market price of the common shares for the period and therefore, are anti-dilutive. Stock-Based Compensation E ffective Jan uar y 1 , 2003, th e Co mpan y ad op ted th e fair valu e recogn itio n p ro visio ns o f SFA S No. 1 23, “Accou ntin g fo r Stock- Based Co mpen satio n ,” as amen ded by SFAS No. 1 48, “Accou ntin g fo r Stock-Based C o m p e n s a t i o n — Tr an s ition and Disclosur e—an amen d ment of FASB Statemen t No. 123,” p rosp ectively to all emp lo yee awar d s 42 AVALONBAY COMMUNITIES, INC. gran ted , mo dified , o r settled on o r after Janu ary 1, 2003. Aw a rd s u n der th e Comp any’s stock o ptio n plan s vest over p erio ds ran gin g fro m o n e to th ree years. Th ere f o re, th e co st related to stock-based emp loyee co mp en sation fo r emplo yee sto ck o ption s in clud ed in th e d eter mination o f n et in co me fo r th e years end ed Decemb er 31, 2005, 2004 and 2 003 is less than th at which wo uld have b een recogn ized if the fair value b as ed metho d h ad b een app lied to all award s sin ce the o rigin al effective d ate of SFAS No. 123. Th e Comp any will ad op t the p rovision s o f SFAS 123 (R), “Share Based Paymen t,” usin g th e mo difie d p rosp ective transitio n metho d o n Jan uar y 1, 20 06. Th e Co mp an y do es no t exp ect the ad op tio n of SFAS 123( R) to h ave a material imp act on its fin an cial p osition or resu lts o f op eration s. However, the ad op tio n o f SFAS1 23(R) will ch ange th e ser v i c e p eriod fo r, an d timin g of, th e reco gn itio n o f comp en sation cost related to re t i rement eligib ility, which will g en erally result in accelerated expen se recogn ition b y th e Co mp an y for its stock based co mpen satio n pro grams. Th e Co mpan y cu rre n t l y re c o rd s co mpen s atio n co st over th e vesting perio d, r e g a rdless of eligibility for re t i remen t (see Note 8, “Co mmitmen ts an d Co n tin gen cies,” for a d iscu ssion of th e Comp an y’s re t i remen t p lan). If th e Co mpan y h ad re c o rd ed compen sation co st based on re t i remen t eligibility, th e in cr eas e to co mpen satio n cost du rin g th e year en ded Decemb er 31 , 2005 wou ld n ot h ave been mater ial. The following table illustrates the effect on net income available to common stockholders and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each period based on the fair market value as deter mined on the date of grant: Net income available to common stockholders, as reported Add: Actual compensation expense recorded under fair value based method, net of related tax effects Deduct: Total compensation expense determined under fair value For the year ended 12-31-05 12-31-04 12-31-03 $313,678 $211,045 $260,781 2,133 867 246 based method, net of related tax effects (2,245) (1,834) (2,335) Pr o forma net income available to common stockholders $313,566 $210,078 $258,692 Ear nings per share: Basic—as reported Basic—pro forma Diluted—as r eported Diluted—pro forma $ $ $ $ 4.30 4.30 4.21 4.21 $ $ $ $ 2.95 2.94 2.92 2.91 $ $ $ $ 3.80 3.77 3.73 3.70 Variable Interest Entities under FIN 46 The Company adopted the fi nal provisions of FIN 46 as of Januar y 1, 2004, which resulted in the consolidation of one entity during 2004 from which the Company held a par ticipating mortgage note. As a result, the Company recognized a cumulative ef fect of change in accounting principle in January 2004 in the amount of $4,547, which increased earnings per common share—diluted by $0.06. The Company did not hold an equity interest in this entity, and therefor e 100% of the entity’s net income or loss was recognized by the Company as minority interest in consolidated partnerships on the Consolidated Statements of Operations and Other Compr ehensive Income. In October 2004, the Company received payment in full of the outstanding mortgage note. Upon note repayment, the Company did not continue to hold a variable interest in this entity and therefore the Company discontinued consolidating the entity under the pr ovisions of FIN 46. Related interest income for the year ended December 31, 2003 of $3,168 is included in interest expense, net, in the accompanying Consolidated Statements of Operations and Other Comprehensive Income. Related inter est income in the year ended December 31, 2004 has been eliminated in consolidation. Discontinued Operations The Company follows SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” which requires that the assets and liabilities and the results of operations of any communities which have been sold, or other wise qualify as held for sale, be presented as discontinued operations in the Company’s Consolidated Financial Statements in both current and prior years presented. The community specifi c components of net income that are presented as discontinued operations include net operating income, depreciation expense, minority interest expense and interest expense. In addition, the net gain or loss (including any impairment loss) on the eventual disposal of communities held for sale will be presented as discontinued operations when recognized. A change in pr esentation for discontinued operations will not have any impact on the Company’s fi nancial condition or results of operations. Real estate assets held for sale are measured at the lower of the car rying amount or the fair value less the cost to sell, and are presented separately in the AVALONBAY COMMUNITIES, INC. 43 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) accompanying Consolidated Balance Sheets. Subsequent to classifi cation of a community as held for sale, no further depreciation is recorded. Recently Issued Accounting Standards In Ju n e 2005, th e Fin an cial Acco un tin g Stan d ard s Bo ard (“FASB”) r atified th e con sen sus in EITF Issu e No . 04-5 , “Determin ing Wh ether a Gen eral Part n e r, o r th e Gen eral Partn ers as a Gro u p, Co n tro l s a Limited Partn ersh ip o r Similar En tity Wh en th e Limited Partners H ave Certain Righ ts ,” wh ich p ro vid es gu id an ce in d e t e rmin in g wheth er a gen eral p artn er con trols a limited p ar tn ersh ip . EITF Issu e No. 04-5 s tates th at th e gen eral part n e r in a limited partn ers h ip is p resu med to con trol th at limited p artn er sh ip. Th at p resu mptio n may b e overcome if th e limited p a rtn ers h ave eith er (i) the s u bs tan tive ab ility, eith er by a sin gle limited p artner or thr ou gh a simp le majo rity vo te, to d issolve the limited p artn ersh ip or oth erwise remo ve th e gen eral p artn er with ou t cau se o r ( ii) s u bs tantive p articipatin g r igh ts. Th e Co mp an y ad op ted EITF Is su e No . 04-5 on J un e 29, 20 05 fo r all n ew limited p artner ships fo rmed or exis tin g limited p a rtn ersh ip s that were mo dified after Ju n e 29, 20 05 an d will ad op t EIT F Iss ue No. 04 -5 on Jan uar y 1, 2006 for oth er existin g limited p artner ships . Th e Co mpan y do es n ot exp ect th e fin al ad op tion o f EITF Issu e No . 04-5 to h ave a material impact on its fin ancial po sition or res ults o f op eration s. In October 2005, the FASB issued Staff Position (“FSP”) 13-1, “Accounting for Rental Costs Incurred During a Construction Period,” which addresses the accounting for rental costs incur red during and after construction. FSP 13-1 is applicable for all reporting periods beginning after December 15, 2005 and concludes that rental costs incur red during and after a construction period are for the right to contr ol the use of a leased asset during and after construction of a lessee asset. Ther e is no distinction between the right to use that asset after the construction period. Therefore, r ental costs associated with ground or building operating leases that are incurr ed during a construction period shall be r ecognized as rental expense. However, the capitalization of rental costs as allowed under the guidance of SFAS No. 67 is still appropriate and applicable. As such, the adoption of FSP 13-1 will not have a material impact on the Company’s financial position or results of operations. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting principles (“GAAP”) in the United States requires management to make certain estimates and assumptions. These estimates and assumptions affect the repor ted amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the fi nancial statements and the reported amounts of r evenue and expenses during the reporting periods. Actual results could dif fer from those estimates. Reclassifi cations Cer tain reclassifications have been made to amounts in prior years’ financial statements to confor m with current year presentations. 2. Interest Capitalized Capitalized interest associated with communities under development or redevelopment totaled $25,284, $20,566 and $24,709 for the years ended December 31, 2005, 2004 and 2003, respectively. 3. Notes Payable, Unsecured Notes and Credit Facility The Company’ s mortgage notes payable, unsecured notes and variable rate unsecured credit facility as of December 31, 2005 and 2004 are summarized as follows: Fixed rate unsecured notes(1) Fixed rate mortgage notes payable—conventional and tax-exempt Variable rate mortgage notes payable—conventional and tax-exempt Total notes payable and unsecured notes Variable rate secured short-term debt Variable rate unsecured credit facility 12-31-05 12-31-04 $1,809,182 239,025 219,010 2,267,217 32,547 66,800 $1,859,448 263,669 219,959 2,343,076 6,278 102,000 Total mortgage notes payable, unsecured notes and unsecured credit facility $2,366,564 $2,451,354 (1) Balances at December 31, 2005 and 2004 include $818 and $552 of debt discount, respectively, from issuance of unsecured notes. 44 AVALONBAY COMMUNITIES, INC. The following debt activity occur red during the year ended December 31, 2005: • The Company repaid $150,000 in previously issued unsecur ed notes in January 2005, along with any unpaid interest, pursuant to their scheduled maturity. No prepayment penalty was incurred; • Th e Comp an y is su ed $100, 000 in u n secu red n otes in March 2005 u n der its exis tin g sh elf registr ation statemen t at an ann u al effective in teres t rate o f 4.99 9%. Interest o n th ese n otes is payab le semi-an n ually on March 15 an d Sep temb er 15, and they matu re in March 2013; • In connection with the admittance of outside investors into the Fund (as defined in Note 6, “Investments in Unconsolidated Entities”), the Company deconsolidated the assets and liabilities of four communities owned by the Fund including $24,869 in fixed rate mortgage debt secur ed by two of the communities; • Th e Comp an y made a p aymen t in the amou n t of $36,1 42 to th e th ird - p a rty le nd er of a jo in t ven ture en tity th at was un con so lid ated at Decemb er 31, 20 04 b ut was co n solidated in March 20 05 u po n acq uisition o f th e 75% eq uity in ter e s t of th e th ird - p a rty p artn er; an d • The Company assumed $4,566 in fixed rate debt in connection with the acquisition of a parcel of improved land. In the aggregate, secur ed notes payable mature at various dates from September 2007 through April 2043 and are secured by cer tain apartment communities (with a net carr ying value of $689,624 as of December 31, 2005). As of December 31, 2005, the Company has guaranteed approximately $100,844 of mortgage notes payable held by wholly-owned subsidiaries; all such mor tgage notes payable are consolidated for financial reporting purposes. The weighted average interest rate of the Company’s fixed rate mortgage notes payable (conventional and tax-exempt) was 6.8% at December 31, 2005 and 6.7% at December 31, 2004. The weighted average interest rate of the Company’s variable rate mortgage notes payable and its unsecured credit facility (as discussed on the following page), including the effect of certain financing related fees, was 5.5% at December 31, 2005 and 3.8% at December 31, 2004. Scheduled payments and maturities of mortgage notes payable and unsecured notes outstanding at December 31, 2005 are as follows: Year 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Thereafter Secur ed notes payments Secured notes maturities Unsecur ed notes maturities Stated interest rate of unsecured notes $ 6,987 6,741 7,155 6,141 4,271 4,095 3,570 3,513 3,754 4,012 70,678 $120,917 $ — 32,547 4,356 73,784 28,989 7,204 12,096 — 33,100 — 177,589 $369,665 $ 150,000 110,000 150,000 50,000 150,000 150,000 200,000 300,000 50,000 250,000 100,000 150,000 — — $1,810,000 6.800% 6.875% 5.000% 6.625% 8.250% 7.500% 7.500% 6.625% 6.625% 6.125% 4.950% 5.375% — — The Company’s unsecured notes contain a number of financial and other covenants with which the Company must comply, including, but not limited to, limits on the aggregate amount of total and secured indebtedness the Company may have on a consolidated basis and limits on the Company’s required debt ser vice payments. Th e Comp any h as a $ 500,00 0 revo lvin g variab le r ate u n secu red cr edit facility with JPMo rgan Chase Ban k an d Wa c h o v i a Ban k, N. A. ser ving as ban ks an d syn d icatio n agen ts fo r a syn d icate of commercial b an ks an d Ban k of America, s erv i n g a s b an k and ad min istrative agen t. Th e Comp an y h ad $66, 800 o uts tan d in g u n d er the facility an d $40,15 4 in letters o f cr e d i t AVALONBAY COMMUNITIES, INC. 45 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ( CONTINUED) on Decemb er 3 1, 20 05 an d $10 2,000 ou tstan ding u n der th e facility an d $26,58 0 in letters of cred it on Decemb er 3 1, 20 04. Un d er th e terms o f th e cred it facility, th e Co mp an y may elect to in creas e th e facility b y u p to an ad d ition al $150,0 00, p rovid ed th at o ne o r mor e b an ks (from th e syn dicate or o th er wis e) vo lu ntarily agree to p ro vid e th e ad ditio n al co mmitment. No member o f th e synd icate of ban ks can p roh ib it such in crease; su ch an in crease in th e facility will o nly b e effective to th e exten t b ank s (from th e syn dicate or o ther wise) ch oo se to co mmit to lend ad ditio n al fu n d s. Th e Co mpan y p ays p art i c i p a t i n g ban ks, in the aggregate, an an n ual facility fee of ap pr oximately $750 . Th e u n secu red cred it facility b ears in terest at vary i n g levels b ased on th e Lo n do n In terban k Off e red Rate (“LIBO R”) , ratin g levels ach ieved o n the Co mpan y’s u n secu red n o tes an d on a matu rity sched u le selected b y th e Comp an y. Th e cu rr en t stated pricin g is LIBOR p lu s 0 .55% per an n um (5.9 4% on December 31, 200 5). Th e spr ead over LIBO R can var y from LIBOR p lu s 0 .50% to LIBOR p lu s 1. 15% based u p on th e ratin g of the Comp an y’s lon g-term u nsecu red deb t. In ad dition , the u n secured cred it facility in clud es a co mpetitive bid op tion , wh ich allo ws ban ks th at are p art o f th e len der co n sortiu m to bid to make lo ans to th e Co mpan y at a r ate that is lo wer than th e stated r ate pro vided b y th e un secur ed cr edit facility fo r up to $250 ,000. Th e co mp etitive bid op tion may resu lt in lo wer p ricin g if market co n ditio n s allow. Th e Comp any has $2 5,000 o utstan d in g u n der th is comp etitive bid op tion as of December 31, 2 005 p riced at LIBO R p lu s 0 .29%, o r 4.48%. T he Comp an y is s ub ject to (i) c e rtain cu sto mar y coven ants un d er the un secured cre dit facility, in clu ding , bu t n ot limited to, main tain in g cer tain maximum leverage ratio s, a minimum fix e d c h a rges co verage ratio an d min imu m u n encu mbered assets an d e qu ity levels an d (ii) p r oh ibitio ns on p ayin g divid en ds in amou n ts th at exce ed 9 5% o f th e Comp an y’s Fun d s from Op eration s, as d efin ed th erein , excep t as may b e re q u i red to main tain th e Comp an y’s REIT statu s. Th e cre dit facility matur es in May 2 008, as suming ex ercise o f a o ne-year ren ewal op tion by th e Co mpan y. 4. Stockholders’ Equity As of both December 31, 2005 and 2004, the Company had authorized for issuance 140,000,000 and 50,000,000 shares of common and prefer red stock, respectively. As of December 31, 2005 the Company has the following series of r edeemable pr eferred stock outstanding at a stated value of $100,000. This series has no stated maturity and is not subject to any sinking fund or mandator y redemptions. Series Shares outstanding December 31, 2005 Payable quarterly Annual rate Liquidation preference Non-redeemable prior to H 4,000,000 March, June, September, December 8.70% $25.00 October 15, 2008 Dividends on the pr eferred stock are cumulative from the date of original issue and are payable quarterly in ar rears on or befor e the 15th day of each month as stated in the table above. The preferred stock is not redeemable prior to the date stated in the table above, but on or after the stated date, may be redeemed for cash at the option of the Company in whole or in part at a redemption price of $25.00 per share, plus all accr ued and unpaid dividends, if any. During the year ended December 31, 2005, the Company (i) issued 903,162 shares of common stock in connection with stock options exercised, (ii) issued 49,263 shares of common stock in exchange for the r edemption of an equal number of DownREIT limited partnership units, (iii) issued 13,372 shares to employees under the Employee Stock Purchase Plan, (iv) issued 8,971 shares of common stock to a member of the Boar d of Directors in fulfi llment of a deferred stock award, (v) issued 1,295 shar es through the Company’s dividend reinvestment plan, (vi) issued 165,790 common shar es in connection with stock grants to employees of which 80% are r estricted, (vii) had for feitures of 9,965 shares of restricted stock grants to employees and (viii) withheld 50,916 shares to satisfy employees’ tax withholding and other liabilities. Divide nd s p er common sh are for th e year en ded December 3 1, 200 5 were $ 2.84, an d fo r each of th e years en ded D e c e m b e r 31, 20 04 and 2003 we re $ 2.80 p er share . In 2005 an d 2 004, averag e d ivid end s fo r all n on -red eemed p re f e rre d s h a res d u rin g th e year were $ 2.18 per sh are, an d n o p re f e rred shares were red eemed. In 20 03, average divid en ds fo r p re f e rred sh ares r edeemed d urin g th e year were $0.2 7 pe r share an d average d ivid end s for all no n -red eemed p re f e rre d s h a res were $2.18 per sh are . In 2004, the Company resumed its Dividend Reinvestment and Stock Purchase Plan (the “DRIP”). The DRIP allows for holders of the Company’s common stock or pr eferred stock to purchase shares of common stock thr ough either reinvested 46 AVALONBAY COMMUNITIES, INC. dividends or optional cash payments. The purchase price per share for newly issued shares of common stock under the DRIP will be equal to the last reported sale price for a share of the Company’s common stock as reported by the New York Stock Exchange (“NYSE”) on the applicable investment date. 5. Derivative Instruments and Hedging Activities Th e Co mp any has histor ically used interes t rate swap an d cap agreements (co llectively, th e “Hed ged Derivatives”) to red uce th e imp act of in terest rate flu ctu ation s o n its variab le rate, tax-exempt b on ds an d its variab le rate co n ven tio nal secu red d ebt. T h e Comp an y has n o t en tered in to any in terest rate h edg e agreements or tr e a s u ry lo cks fo r its con ven tion al u nsecur ed d ebt an d do es n o t h old interest rate h ed ge agreemen ts fo r trad in g or oth er sp ecu lative pu rp oses. As o f Decemb er 31, 2005, th e Hed ged Derivatives fix app ro ximately $67,000 of th e Co mpan y’s tax-exempt d ebt at a weigh ted average in terest r ate o f 6.3% t h ro ug h in terest rate swaps. In ad ditio n, as o f Decemb er 31, 2005, the Co mpan y h as H edged Der ivatives on ap pr o x i m a t e l y $166, 000 o f its variab le rate d ebt, wh ich flo ats at a weighted average co up on in terest rate of 4 .5% an d h as been cap ped at a weigh ted average interes t rate of 8.0% thr ou gh interest r ate cap s . Th ese Hed ged Derivatives have maturity d ates ran gin g fro m 2007 to 2010 . Th e Hedged Derivatives are accou n ted for in accor dan ce with SFAS No . 133 . SFAS No. 133 re q u i r es th at ever y d erivative in str umen t b e re c o rd ed o n th e balan ce sh eet as eith er an asset o r liab ility measured at its fair value, with chan ges in fair valu e recogn ized cu rren tly in earn in gs u n less s pecific hed ge acco un tin g criter ia are met. Th e Co mpan y h as determined th at its Hedged Derivatives qu alify as effective cas h -flow h ed ges un d er SFAS No . 133, re s u l t i n g in th e Co mpan y re c o rding th e effective p ortio n o f ch ang es in th e fair valu e o f th e Hedged Derivatives in oth er c o m p reh en sive in co me. Amo u nts re c o rd ed in o th er co mpreh ensive inco me will b e re c l a s s i fi ed in to earn in gs in th e per iod in which earn in gs ar e affecte d by the h edge d cash flo w. To adju st th e Hed ged Der ivatives to th eir fair valu e, th e Comp an y re c o r ded un r ealized gain s to oth er co mpr ehen sive in come of $2,62 6, $1,11 6 an d $4,42 8 du rin g th e years en ded D e c e m b e r 3 1, 2005 , 2004 an d 200 3, re s p e c t i v e l y. Th e estimated amou n t, in clu d ed in accu mulated oth er comp re h e n s i v e in come as o f Decemb er 31 , 2005 , exp ected to b e re c l a s s i fi ed in to ear nin gs with in th e nex t twelve mon th s to o ffset th e variability o f cash flo w d ur in g th is p erio d is n ot material. The Company assesses, both at inception and on an on-going basis, the effectiveness of all hedges in offsetting cash flow of hedged items. Hedge ineffectiveness did not have a material impact on earnings and the Company does not anticipate that it will have a material effect in the future. The fair values of the obligations under the Hedged Derivatives ar e included in accrued expenses and other liabilities on the accompanying Consolidated Balance Sheets. By u s in g d erivative fin ancial in stru ments to hed ge exp osu res to ch an ges in in terest rates, the Comp any expo ses itself to cr e d i t risk an d market risk. T he cred it risk is th e r isk o f a cou n terparty n o t p erf o r min g u nd er th e ter ms of th e H ed ged Der ivatives. Th e co un terparties to these Hed ged Derivatives are majo r fin an cial in stitu tion s wh ich h ave an A+ or b etter cred it ratin g b y the Stand ard & Poo r’s Ratin gs Gro up . Th e Comp any mo n ito rs th e cred it ratin gs of co un terp ar ties an d the amou n t of th e C o m p a n y ’s d ebt su bject to Hedg ed Derivatives with an y o ne p art y. Th ere f o re, th e Comp an y b elieves the likelih oo d o f re a l i z i n g material lo sses fro m cou nterp arty n on -p erf o r man ce is remo te. Mar ket risk is th e ad verse effect o f th e value of fin a n c i a l i n s t r umen ts th at r esu lts fr om a chan ge in interest rates. T he market risk asso ciated with interest-r ate con tracts is managed b y the estab lish ment and mon itoring o f p arameters that limit th e typ es and deg ree of market ris k that may b e un d ertaken . Th ese risks are man aged by the Co mp an y’s Chief Fin ancial Officer an d Sen io r Vice Pre s i d e n t – F i n a n c e . 6. Investments in Unconsolidated Entities Investments in Unconsolidated Real Estate Entities As of December 31, 2005, all of the Company’s investments in unconsolidated real estate entities were originated prior to and had not been modified since June 29, 2005, and were not considered variable interest entities under FIN 46. Therefor e, these investments are accounted for in accordance with SOP 78-9 and APB Opinion No. 18. As of December 31, 2005, the Company had investments in the following real estate entities. • Town Run Associates was for med as a general partnership in November 1994 to develop, own and operate Avalon Run, a 426 apartment-home community located in Lawrenceville, New Jersey. Since formation of this venture, the Company has invested $1,803 and, following a prefer red retur n on all contributed equity (which was not achieved in 2005), has a 40% ownership and cash flow inter est with a 49% residual economic interest. The Company is responsible for the day-to-day AVALONBAY COMMUNITIES, INC. 47 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ( CONTINUED) operations of the Avalon Run community and is the management agent subject to the terms of a management agreement. The development of Avalon Run was funded entir ely through equity contributions from Avalon as well as the other venture partner, and therefore Avalon Run is not subject to any outstanding debt as of December 31, 2005. This community is unconsolidated for financial repor ting purposes and is accounted for under the equity method. • Town Grove, LLC was formed as a limited liability corporation in December 1997 to develop, own and operate Avalon Grove, a 402 apartment-home community located in Stamford, Connecticut. Since for mation of this venture, the Company has invested $14,653 and, following a preferred return on all contributed equity (which was achieved in 2005), has a 50% ownership and a 50% cash flow and residual economic interest. The Company is responsible for the day-to-day operations of the Avalon Grove community and is the management agent subject to the terms of a management agr eement. The development of Avalon Grove was funded through contributions from the Company and the other ventur e partner, and therefore Avalon Grove is not subject to any outstanding debt as of December 31, 2005. This community is unconsolidated for financial reporting purposes and is accounted for under the equity method. • Avalon Ter race, LLC—The Company acquired A valon Bedford, a 368 apartment-home community located in Stamford, Connecticut in December 1998. In May 2000, the Company transferred Avalon Bedford to Avalon Terrace, LLC and subsequently admitted a joint venture partner, while retaining a 25% ownership interest in this limited liability company for an investment of $5,394 and a right to 50% of cash flow distributions after achievement of a threshold retur n (which was not achieved in 2005). The Company is responsible for the day-to-day operations of the Avalon Bedford community and is the management agent subject to the terms of a management agreement. In 2005, Avalon Bedford r efi nanced its outstanding debt. As of December 31, 2005, Avalon Bedfor d has $37,200 in 5.2% fixed rate debt outstanding, which matures in November 2010. As part of the r efi nancing, the Company received a distribution of $3,714. Avalon Bedford’s debt is neither guaranteed by nor recourse to the Company. This community is unconsolidated for financial reporting purposes and is accounted for under the equity method. • Arna Valley View LP—In co n nection with th e mun icip al ap p roval p rocess for th e d evelo pmen t o f a co nso lid ated commu nity, th e Co mpan y agreed to participate in th e fo rmatio n of a limited partn ership in Feb ru a ry 1 999 to develop , finan ce, own and op erate Arn a Valley Vi e w, a 1 01 apartment- ho me co mmun ity lo cated in Arlin gton , Vi rginia. Th is co mmu n ity h as aff o r d a b l e ren ts for 100% o f ap artmen t h omes related to th e tax-exemp t bo nd fin ancin g an d tax cred its used to fin ance con str u c t i o n of the co mmu n ity. A sub sid iary of the Co mp an y is th e gen eral p artn er of th e p artnersh ip with a 0.01% own ersh ip in ter e s t . Th e Comp an y is respo nsib le fo r th e d ay-to -day op eration s o f th e co mmun ity an d is th e man agemen t agent su bject to th e t e rms of a man agemen t agr eemen t. As o f Decemb er 31, 2005, Arn a Valley View has $5,843 o f variab le rate, tax-exemp t bo n ds ou tstan d in g, wh ich matu re in Jun e 2032. In ad d ition , Arn a Valley View h as $ 4,805 of 4% fixed rate cou nty bo n ds ou tstand in g th at mature in Decemb er 2030 . Arn a Valley Vi e w ’s d ebt is n eith er gu ar an teed b y n o r recou rse to th e Co mpan y. Due to th e C o m p a n y ’s limited own ersh ip and investment in th is ven ture, it is accou n ted fo r u sin g the co st meth o d. • CVP I, LLC—In February 2004, the Company enter ed into a joint venture agreement with an unrelated third-par ty for the development of Avalon Chrystie Place I, a 361 apar tment-home community located in New York, New York, for which construction was completed in late 2005. The Company has contributed $6,270 to this joint venture and holds a 20% equity interest (with a right to 50% of distributions after achievement of a threshold return, which was not achieved in 2005). The Company is the managing member of CVP I, LLC, however proper ty management services at the community are performed by a third party. As of December 31, 2005, CVP I, LLC has a variable rate construction loan in the amount of $117,000 outstanding which matures in Febr uary 2009. In connection with the general contractor services that the Company provided to CVP I, LLC during the development of Avalon Chr ystie Place I, the Company has provided a construction completion guarantee to the construction loan lender in order to fulfill their standard financing requirements related to the construction financing. Under the ter ms of the guarantee, in the event of default, the Company would be required to make payment for any excess cost to complete construction over any undisbursed loan proceeds. The obligation of the Company under this guarantee will terminate once all of the lender’ s standard completion requirements have been satisfied, which the Company expects to occur in early 2006. As construction of Avalon Chr ystie Place I is complete, no liability for this guarantee is recorded as of December 31, 2005. This community is unconsolidated for financial r eporting purposes and is accounted for under the equity method. • Avalon Del Rey Apar tments, LLC—In March 2004, the Company entered into an agreement with an unrelated third-party which provides that, after the Company completes constr uction of Avalon Del Rey, the community will be owned and operated by a joint venture between the Company and the third-party. Avalon Del Rey, if developed as expected, will be a 309 apartment-home community located in Los Angeles, California. Upon construction completion, the third-party 48 AVALONBAY COMMUNITIES, INC. venture partner will invest $49,000 and will be granted a 70% ownership interest in the venture, with the Company retaining a 30% equity inter est. The Company will be responsible for the day-to-day operations of the community and will be the management agent subject to the terms of a management agreement. Avalon Del Rey Apar tments, LLC has a variable rate $50,000 secured construction loan, of which $32,547 is outstanding as of December 31, 2005 and which matures in September 2007. In conjunction with the general contractor services that the Company provides to Avalon Del Rey Apar tments, LLC, the Company has provided a construction completion guarantee to the construction loan lender in order to fulfill their standard fi nancing requirements related to constr uction financing. The obligation of the Company under this guarantee will terminate following constr uction completion once all of the lender’s standard completion requirements have been satisfied, which the Company expects to occur in 2007. The Company consolidates this community for financial repor ting purposes since it holds a 100% equity interest. However, the Company expects this community to be unconsolidated for financial reporting purposes in periods subsequent to the contribution by the third- party venture partner. • Juanita Construction, Inc.—In April 2004, the Company entered into an agreement to develop Avalon at Juanita Village, a 211 apartment-home community located in Kirkland, Washington, for which constr uction was completed in late 2005. Avalon at Juanita Village was developed through Juanita Construction, Inc., a wholly-owned taxable REIT subsidiar y and, upon completion of certain conditions pr ecedent to closing, will contribute the community to a joint venture. Upon contribution of the community to the joint venture, the Company expects to be reimbursed for all costs incurred to develop the community (approximately $45,300). The third-party joint venture partner will receive a 100% equity inter est in the joint venture and will manage the joint venture. The Company will receive a residual profits interest and will be engaged to manage the community for a property management fee. The Company consolidates this community for financial reporting purposes since it holds a 100% equity interest. However, the Company expects this community to be unconsolidated for financial repor ting purposes after it is contributed to the joint venture. • Mission Bay Venture Partners, LLC—In Decemb er 2004, th e Co mp an y entered in to a jo in t ventu re agreemen t with an u n related third - p a rty for th e d evelop ment o f Avalon at Missio n Bay No rth II. Avalo n at Mission Bay North II, if d evelo ped as ex pecte d, will be a 313 ap artmen t-h ome commun ity located in San Fran cisco , Califor n ia. Th e Co mpan y h as co n tribu ted $5,90 2 to th is ven tu re an d h olds a 25% equ ity interest. Th e Comp an y will be respo n sible fo r th e d ay-to-d ay o per atio n s of th e commu nity an d will b e th e man agemen t agen t sub ject to th e te rms of a man ag ement agreemen t. Mis sion Bay Ve n t u re P a r tn ers, LLC h as a variab le rate $94, 400 secu red co nstru ction loan , of wh ich $28,35 4 is o utstan d in g as of D e c e m b e r 3 1 , 200 5 an d which matur es in Sep te mb er 2 010, assu min g exercise of two o n e-year ex ten sio ns. In co n jun ction with th e gen eral co ntracto r ser vices th at the Co mpan y pr ovides to Mis sion Bay Ve n t u re Partn ers, LLC, th e Comp an y h as p rovided a con stru ctio n comp letion gu aran tee to th e co nstru ction lo an len der in o rder to fulfill their stan d ard fin a n c i n g re q u i rements related to co n struction fin an cin g. Under the terms of the guarantee, in the event of default, the Company would be requir ed to make payment for any excess cost to complete construction over any undisbursed loan proceeds. T h e ob ligatio n o f th e Co mpan y u n d er th is g uaran tee will terminate fo llo win g co nstru ction comp letion o nce all o f th e len d er’s s t a n d a rd co mple tio n re q u i rements h ave b een satisfied , wh ich th e Co mpan y ex pects to occu r in 20 07. The Company does not expect there to be any excess cost to complete construction, as the construction of Avalon at Mission Bay North II is currently on budget, therefore no liability for this guarantee has been recorded by the Company at December 31, 2005. This community is unconsolidated for financial reporting purposes and is accounted for under the equity method. • AvalonBay Value Added Fund, L.P., (the “Fund”)—In March 2005, the Company admitted outside investors into the Fund, a private, discretionar y investment vehicle, which will acquir e and operate communities in the Company’s markets. The Fund will serve, until Mar ch 16, 2008 or until 80% of its committed capital is invested, as the exclusive vehicle through which the Company will acquire apartments communities, subject to certain exceptions. The Fund has nine institutional investors, including the Company, and combined capital commitments of $330,000. A significant portion of the investments made in the Fund by its investors are being made through AvalonBay Value Added Fund, Inc., a Maryland corporation that will qualify as a REIT under the Internal Revenue Code (the “Fund REIT”). A wholly-owned subsidiar y of the Company is the general partner of the Fund and has committed $50,000 to the Fund and the Fund REIT, representing a 15.2% combined general partner and limited partner equity interest, with $11,581 of this commitment funded as of December 31, 2005. Under the Fund documents, the Fund has the ability to employ leverage of up to 65% on a portfolio basis, which, if achieved, would enable the Fund to invest up to approximately $940,000. Upon the admittance of the outside investors, the Fund held four communities, containing a total of 879 apartment homes with an aggregate gross real estate value of $112,852, that were acquired in 2004. Prior to the admittance of outside investors, the Fund was directly or AVALONBAY COMMUNITIES, INC. 49 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) indirectly wholly-owned by the Company, and therefore the revenues and expenses, and assets and liabilities of these four communities were consolidated in the Company’s results of operations and fi nancial position. However, upon admittance of the outside investors in March 2005, the Company deconsolidated the revenue and expenses, and assets and liabilities of these four communities and accounts for its 15.2% equity interest in the Fund under the equity method of accounting. Although the Company holds less than a 20% equity interest in the Fund, the Company accounts for the Fund under the equity method due to its significant infl uence over the Fund. The Company received net pr oceeds of $87,948 as reimbursement for acquiring and warehousing these communities. The Company receives asset management fees, property management fees and redevelopment fees, as well as a promoted inter est if certain thresholds are met (which were not achieved in 2005). As of December 31, 2005, the Fund owns the following communities, subject to certain mortgage debt. In addition, as of December 31, 2005, the Fund has $37,100 outstanding under its variable rate credit facility, which matures in Januar y 2008. The Company has not guaranteed the debt, nor does it have any obligation to fund this debt should the Fund be unable to do so. • Avalon at Redo nd o Beach , a 105 apartment-ho me commun ity located in Lo s An geles , Califo rn ia. As o f December 31, 2005, Avalo n at Red on do Beach h as $16,765 in 4.8% fixed rate deb t o utstan din g, which matu res in Octo ber 2011; • Avalon Lakeside, a 204 apartment-home community located in Chicago, Illinois. As of December 31, 2005, Avalon Lakeside has $7,960 in 6.9% fixed rate debt outstanding, which matures in Februar y 2028 (but can be prepaid after Februar y 2008 without penalty); • Avalon Columbia, a 170 apar tment-home community located in Baltimore, Maryland. As of December 31, 2005, Avalon Columbia has $16,575 in 5.3% fixed rate debt outstanding, which matures in April 2012; • Ravenswood at the Park, a 400 apartment-home community located in Chicago, Illinois. As of December 31, 2005, Ravenswood at the Park has $31,500 in 5.0% fixed rate debt outstanding, which matures in July 2012; • Avalon at Poplar Creek, a 196 apartment-home community located in Chicago, Illinois. As of December 31, 2005, Avalon at Poplar Cr eek has $16,500 in 4.8% fixed rate debt outstanding, which matures in October 2012; • Fuller Martel, an 82 apartment-home community located in Los Angeles, Califor nia; • Civic Center Place, a 192 apartment-home community located in Nor walk, California. As of December 31, 2005, Civic Center Place has $23,806 in 5.3% fixed rate debt outstanding, which matures in August 2013; and • Paseo Park, a 134 apartment-home community located in Fremont, California. In addition, as part of the formation of the Fund, the Company has provided to one of the limited partners a guarantee. The guarantee provides that, if, upon final liquidation of the Fund, the total amount of all distributions to that partner during the life of the Fund (whether from operating cash flow or proper ty sales) does not equal the total capital contributions made by that partner, then the Company will pay the partner an amount equal to the shor tfall, but in no event more than 10% of the total capital contributions made by the partner (maximum of approximately $1,700 as of December 31, 2005). The Company has not recorded a liability related to this guarantee as of December 31, 2005, as the fair value of the r eal estate assets owned by the Fund is considered adequate to cover such payment under a liquidation scenario. The following is a combined summary of the financial position of the entities accounted for using the equity method, as of the dates presented: Assets: Real estate, net Other assets Total assets Liabilities and par tners’ equity: Mortgage notes payable and credit facility Other liabilities Par tners’ equity Total liabilities and partners’ equity 50 AVALONBAY COMMUNITIES, INC. 12-31-05 12-31-04 $491,919 86,247 $578,166 $349,260 27,497 201,409 $578,166 $221,236 86,821 $308,057 $139,500 32,579 135,978 $308,057 The following is a combined summar y of the operating results of the entities accounted for using the equity method, for the years presented: Rental income Operating and other expenses Interest expense, net Depreciation expense Net income For the year ended 12-31-05 12-31-04 12-31-03 $37,133 (20,364) (7,585) (8,875) $ 309 $21,148 (8,291) (1,786) (4,003) $ 7,068 $20,939 (8,038) (1,688) (3,986) $ 7,227 In March 2 005, th e Co mp an y pu rchased its join t ventu re p art n e r ’s in teres t in Avalo nBay Red evelo p men t, LLC, th e limited liab ility compan y that own s Avalon on the So un d . Avalon on th e So un d , a 412 ap ar tmen t- h ome commun ity lo cated in th e N e w Yo rk, New Yor k metro po litan area, was d evelo ped th ro ug h th e join t ven tu re in 2 001. Th e Compan y p u rch ased th e th ird - p a rty p art n e r ’s 75% eq uity in terest in th e join t ventur e for a gross pu rch ase p rice ( in clud in g th e impact of th e Co mp an y’s s h a re of p romoted in terest) o f $ 84,521. After con sid er atio n of th e th ird - p a rty p ar t n e r ’s p ro rata sh are of o uts tan din g deb t, as well as th e Co mp an y’s sh are of pro moted interest, th e n et p urch ase price was $57,4 15. In co n jun ctio n with th e pu rc h a s e tran sactio n, th e th ir d - p a rty len der to th e limited liability co mpan y received a p ayment o f $36 ,142 in con sid eratio n of th e ou tstand in g d ebt, o f wh ich $9,036 was th e Comp an y’s share o f su ch paymen t. Prior to December 31, 200 4, th e Comp an y h ad a re p u rch ase o ption for Avalon o n th e Sou n d an d acco u nted for its in vestment as a p ro fit- sharin g arrangemen t as re q u i r ed b y S FAS No. 66 , “Acco u ntin g for Sales of Real Estate.” As a resu lt, th e revenu es and exp en ses, an d assets and liab ilities o f Av a l o n on th e Sou n d were in clud ed in th e Comp any’s Con s olidated Fin an cial Statemen ts fo r period s p rior to Decemb er 3 1, 2 004. Th e in come allo cated to th e con tr olling partn er is s h own as ven ture p artner in terest in pr o fit-sh arin g on th e Co mp an y’s Co n so lid ated Statements of Op eration s an d Oth er Co mpreh en sive In co me fo r th e years en d ed December 31 , 2004 an d 2 003. Th e r e p u rch as e o ption expir ed in Decemb er 200 4, an d th ere f o re as of Decemb er 31 , 2004 and for the th ree mo n th s en ded M a r ch 31 , 2005, the Comp an y accou nted for its 25% in terest in Avalon o n th e Sou nd u nd er the eq uity metho d of accou ntin g. Due to th e p urch ase o f th e remain ing 75 % equ ity interes t, this en tity is con s olidated as o f Decemb er 31, 2005 and fo r th e p eriod from April 1, 2 005 thr ou gh December 31, 200 5. Investments in Unconsolidated Non-Real Estate Entities At December 31, 2004, the Company held a minority inter est investment in one non-r eal estate entity, which was a technology investment (Rent.com). Based on ownership and control criteria, the Company accounted for this investment using the cost method. In Februar y 2005, this technology investment was acquired by a third-party. As a result of this transaction, the Company received net proceeds of approximately $6,700 and recognized a gain on the sale of this investment of $6,252, which is refl ected in equity in income of unconsolidated entities on the accompanying Consolidated Statement of Operations and Other Comprehensive Income for the year ended December 31, 2005. The following is a summary of the Company’s equity in income of unconsolidated entities for the years presented: Town Grove, LLC Falkland Partners, LLC(1) Avalon at Chr ystie Place Town Run Associates Avalon Terrace, LLC Avalon at Mission Bay North II AvalonBay Value Added Fund, L.P. Avalon on the Sound Rent.com Total For the year ended 12-31-05 12-31-04 12-31-03 $1,286 — (339) 266 58 (57) (341) 73 6,252 $7,198 $ 950 — — 43 (28) — — — 135 $1,100 $ 1,158 24,255 — 214 (21) — — — (71) $25,535 (1) The activity for the year ended December 31, 2003 includes the Company’s share of the GAAP gain reported by Falkland Par tners, LLC as a r esult of the sale of Falkland Chase in the amount of $21,816 and the liquidation of the limited liability company’s assets in the amount of $1,632. The sale of Falkland Chase resulted in net proceeds to the Company of $16,729. AVALONBAY COMMUNITIES, INC. 51 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ( CONTINUED) 7. Discontinued Operations—Real Estate Assets Sold or Held for Sale During the year ended December 31, 2005, the Company sold seven communities, containing a total of 1,305 apartment homes. These communities were sold for a gross sales price of approximately $351,450, resulting in net pr oceeds of $344,185 and a GAAP gain of $192,469. Details regar ding the community asset sales are summarized in the following table: Community Name Location Period of sale Apartment homes San Diego, CA Sunnyvale, CA Danbury, CT Rockville, MD Fremont, CA Lynnwood, WA Jersey City, NJ 1Q05 1Q05 2Q05 3Q05 3Q05 3Q05 4Q05 Avalon at Penasquitos Hills Avalon Sunnyvale Avalon Lake Avalon Crossing Avalon Fremont II Avalon W ildwood The Tower at Avalon Cove Total of all 2005 asset sales Total of all 2004 asset sales Total of all 2003 asset sales 176 220 135 132 135 238 269 1,305 1,360 3,184 Debt $ — — — — — — — $ — $38,735 $39,665 Gross sales price Net pr oceeds $ 34,250 45,000 37,700 44,500 39,500 44,500 106,000 $351,450 $241,050 $424,650 $ 33,657 44,324 36,869 43,896 38,723 43,047 103,669 $344,185 $210,001 $379,789 As o f Decemb er 3 1, 20 05, th e Comp an y h ad th ree co mmun ities th at q u alified as h eld for sale u nd er th e p ro visio n s of S FA S No . 144. Th e Comp any an ticipates sellin g th ese co mmu n ities in th e n ext twelve mon th s. As re q u i r ed un d er SFAS No . 144 , the op eration s for an y co mmu n ities so ld fr om Jan uar y 1, 2 003 th ro ugh Decemb er 31 , 200 5 an d co mmun ities held fo r sale as o f De cemb er 31, 2005 h ave b een pre sen ted as disco n tin u ed op eration s in th e accomp an yin g Con solidated Fin an cial Statemen ts. Acco rd i n g l y, cer tain re c l a s s i ficatio n s have b een mad e in p rio r years to re flect d is con tin ued op eration s con s istent with cu r ren t year p resen tatio n . Th e fo llo win g is a summar y o f in come fro m d iscon tin ued o peratio ns for th e years p re s e n t e d : Rental income Operating and other expenses Interest expense, net Minority interest expense Depreciation expense Income from discontinued operations For the year ended 12-31-05 12-31-04 12-31-03 $26,867 (8,684) — — (3,241) $14,942 $ 48,018 (15,646) (525) (37) (10,676) $ 21,134 $ 75,981 (26,705) (2,399) (438) (15,071) $ 31,368 Th e Comp any’s Con solid ated Balan ce Sh eets in clud e o th er assets (ex clu d in g n et real estate) o f $485 an d $1 ,497, an d o th er liab ilities of $1,837 an d $3,407 as o f December 31, 2005 an d December 31, 2004, re s p e c t i v e l y, relatin g to real estate assets sold or h eld fo r sale. Th e estimated pro ceed s less an ticip ated co sts to sell th e real estate ass ets h eld fo r sale as of December 31 , 2 005 a r e greater than the carr ying valu e as of Decemb er 31, 2005, an d th ere f o re n o pro visio n fo r p ossib le lo ss was r e c o rd e d . During the year ended December 31, 2005, the Company decided to relocate one of its regional offices and as a result sold an office building in Connecticut. This office building, which was owned through a limited partnership in which the Company is the general partner with majority ownership, was sold for a purchase price of $7,650, resulting in a GAAP gain of $2,818. In addition, the Company sold three par cels of land, one located in Dublin, California, one in Madison, Washington and one in Freehold, New Jersey, for an aggregate gross sales price of $23,620 and an aggregate GAAP gain of $4,479. The Company recorded an impairment loss in the amount of $3,000 in 2002 related to one of these land parcels to refl ect the land at fair value based on its entitlement status at the time it was deter mined to be land held for sale. 52 AVALONBAY COMMUNITIES, INC. 8. Commitments and Contingencies Employment Agreements and Ar rangements As of December 31, 2005, the Company had employment agreements with four executive officers. The employment agreements pr ovide for severance payments and generally provide for accelerated vesting of stock options and restricted stock in the event of a termination of employment (except for a termination by the Company with cause or a voluntar y termination by the employee). The cur rent terms of these agreements ends on dates that vary between November 2006 and June 2007. The employment agreements provide for one-year automatic renewals (two years in the case of the Chief Executive Officer (“CEO”)) after the initial ter m unless an advance notice of non-renewal is provided by either party. Upon a notice of non-renewal by the Company, each of the of ficers may terminate his employment and receive a severance payment. Upon a change in control, the agreements provide for an automatic extension of up to thr ee years from the date of the change in control. The employment agreements provide for base salar y and incentive compensation in the form of cash awar ds, stock options and stock grants subject to the discretion of, and attainment of perfor mance goals established by, the Compensation Committee of the Board of Directors. In Februar y 2005, the Company announced certain management changes including the departure of a senior executive who became entitled to severance benefits in accor dance with the terms of his employment agreement with the Company. The Company entered into an agreement with this executive regarding his departur e that is consistent with the terms of his employment agreement and provides for a consulting arrangement for up to one year. The Company recorded a charge of approximately $2,100 in the year ended December 31, 2005 r elated to cash payments associated with this agreement. This char ge is included in general and administrative expense on the accompanying Consolidated Statements of Operations and Other Comprehensive Income. The Company’s stock incentive plan, as described in Note 10, “Stock-Based Compensation Plans,” provides that upon an employee’s Retirement (as defi ned in the plan documents) from the Company, all outstanding stock options and restricted shares of stock held by the employee will vest, and the employee will have up to 12 months to exercise any options held upon retirement. Under the plan, Retirement means a ter mination of employment, other than for cause, after attainment of age 50, provided that (i) the employee has worked for the Company for at least 10 years, (ii) the employee’s age at Retirement plus years of employment with the Company equals at least 70, (iii) the employee pr ovides at least six months written notice of his intent to retire, and (iv) the employee enters into a one year non-compete and employee non-solicitation agreement. The Company also has an Officer Severance Program (the “Program”) for the benefit of those of ficers of the Company who do not have employment agreements. Under the Program, in the event an officer who is not other wise cover ed by a severance arrangement is terminated (other than for cause) within two years of a change in control (as defined) of the Company, such officer will generally receive a cash lump sum payment equal to the sum of such officer’s base salary and cash bonus, as well as accelerated vesting of stock options and restricted stock. Costs related to the Company’s employment agreements and the Pr ogram are accounted for in accordance with SFAS No. 5, “Accounting for Contingencies,” and therefore are recognized when considered by management to be probable and estimable. Legal Contingencies The Co mp an y is sub ject to vario us legal p ro ceed in gs an d claims th at arise in th e o rd i n a r y cou rs e of bu sin ess. Th ese matters are freq uen tly co vered b y in suran ce. If it h as been determin ed th at a lo ss is pr obab le to o ccur, th e estimated amou nt of th e los s is ex pen sed in th e finan cial statemen ts. Wh ile th e resolution of th ese matters can n ot be pre d i c t e d with cer t a i n t y, man agemen t believes th e fin al ou tco me of s uch matter s will n o t h ave a mater ial advers e effect o n th e fin a n c i a l p osition o r resu lts o f op eratio ns of th e Compan y. The Company is currently involved in construction litigation with a general contractor and a surety bond provider related to a community that has since completed development. A non-jury trial ended in April 2004, and in May 2004, the court issued a ruling, fi nding that these parties were liable to the Company for consequential damages due to breach of contract and other failures to perfor m. The court issued a r uling in October 2004, awarding the Company approximately $1,250 plus inter est. In September 2005, the Company filed an appeal to seek an increase in the damage award and the general contractor and surety has filed an appeal seeking a reduction. There is no guarantee that a higher, or any, damage award, will be r eceived by the Company after all appeals are filed and a final r uling is provided. AVALONBAY COMMUNITIES, INC. 53 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) The Company is currently involved in a lawsuit regarding the handling of security deposits in California. The lawsuit alleges that the amounts withheld by the Company from security deposits at the end of tenancies exceeded the Company’ s actual damages. The Company has agreed with the plaintiff on the terms of a settlement with the purpor ted class. The settlement ter ms have been approved by the court, subject to final cer tification and approval after administration of the settlement, which is expected in April 2006. During the year ended December 31, 2005, the Company accr ued $1,500 related to this and other various litigation matters. O n Sep temb er 2 3, 2005, th e Equ al Righ ts Cen ter, an ad vo cacy gro up for th e d isabled, filed a lawsuit again st th e Co mp an y alleging th at commu nities con stru cted b y th e Comp an y vio late th e access ibility re q u i remen ts o f th e Fair Hou sin g Act an d th e American s with Disab ilities Act. Th e lawsuit seeks mo netary damages as well as in ju n ctive relief, such as mo d ification s to existin g assets. Due to th e p re l i m i n a r y n ature o f th e litigatio n , th e Co mpan y cann o t p red ict or determin e th e o utco me of th is lawsu it, no r is it reason ably po ssible to estimate the amo un t of lo ss, if an y, th at wou ld be asso ciated with an ad verse d ecision . Lease Obligations The Company owns five apartment communities which are located on land subject to land leases expiring between July 2029 and March 2142. In addition, the Company leases certain office space. These leases are accounted for as operating leases in accordance with SFAS No. 13, “Accounting for Leases.” These leases have varying escalation terms, and three of these leases have purchase options exercisable between 2006 and 2052. The Company incurred costs of $4,486, $4,399 and $3,348 in the years ended December 31, 2005, 2004 and 2003, respectively, related to these leases. The following table details the future minimum lease payments under the Company’s current operating leases: Payments due by period 2006 $3,454 2007 $3,495 2008 $3,420 2009 $2,986 2010 $3,058 Thereafter $1,168,680 During the year ended December 31, 2005, the Company executed a purchase option on one of its land leases, for a purchase price of approximately $14,000. Lease payments for this lease totaled $880 for the year ended December 31, 2005. 9. Segment Reporting The Company’s reportable operating segments include Established Communities, Other Stabilized Communities, and Development/Redevelopment Communities. Annually as of Januar y 1st, the Company determines which of its communities fall into each of these categories and maintains that classification, unless disposition plans regarding a community change, thr oughout the year for the purpose of reporting segment operations. • Established Communities (also known as Same Store Communities) a r e commun ities wh ere a co mpariso n of op eratin g results from the prior year to the cu rren t year is mean in gful, as th ese co mmun ities were o wned an d had stab ilized occu p an cy an d o perating ex pen ses as of th e b eg inn in g o f the p rio r year. For the year 2005, th e Established Co mmu nities a r e commu nities th at are co ns o lid ated for fin an cial re p o rtin g p urp os es, had stabilized o ccup ancy an d o perating exp enses as of Janu ary 1, 2004, a r e no t co n du ctin g o r p lan ning to con d uct s ub stantial redevelop men t activities an d are n o t held fo r sale o r plan n ed for d ispo sition with in th e cur rent year. A commu nity is con sid ered to h ave stabilized o ccu pan cy at th e earlier of ( i) attain men t o f 95% p h ys ical o ccup ancy o r (ii) th e o ne-year an niversary o f completio n of develop men t o r redevelop men t. • Other Stabilized Communities in clud es all o th er co mpleted co mmu n ities th at h ave stab ilized o ccu pan cy, as d efin e d th at ar e co nd u ctin g o r plann ing to co nd u ct a b o v e . Oth er Stabilized Co mmun ities d o n o t in clu de co mmu n ities sub stan tial red evelop men t activities within th e cu rr ent year. • Development/Redevelopment Communities con sis ts of commu n ities that are un d er co nstru ction an d h ave n o t received a fin a l c e rt i ficate of o ccu pan cy, commu nities wh ere s u bs tan tial r edevelo pmen t is in p ro g ress o r is plan n ed to b egin du ring th e cur ren t year an d commu nities u n der lease-up , that h ad n ot reached stab ilized occup an cy, as defin ed abo ve, as of J an uar y 1, 20 05. 54 AVALONBAY COMMUNITIES, INC. In addition, the Company owns land held for future development and has other corporate assets that are not allocated to an operating segment. SFAS No. 131, “Disclosur es about Segments of an Enterprise and Related Information,” requires that segment disclosures present the measure(s) used by the chief operating decision maker for purposes of assessing such segments’ perfor mance. The Company’s chief operating decision maker is comprised of several members of its executive management team who use Net Operating Income (“NOI”) as the primary financial measure for Established and Other Stabilized Communities. NOI is defined by the Company as total r evenue less direct property operating expenses, including property taxes, and excludes corp or ate-level p ro p e rty man agemen t and other in d irect op erating exp en ses, in vestmen ts an d in vestmen t man agement, i n t e rest income an d ex pen s e, gen eral an d ad min istrative exp en se, equ ity in income of u n co nso lidated en tities, min o rity in tere s t in con solidated p artnersh ip s, ven ture partner in terest in p ro fit-sh arin g, d ep reciation ex pen se, cumu lative effect o f ch an ge in acco un ting p rin cip le, gain on sale of real es tate assets an d income from d isco n tin u ed o peration s. Alth ou gh th e Co mp an y con sider s NOI a useful measur e of a commu nity’s or commun ities ’ o peratin g per f o r man ce, NOI sho uld n ot be con sid ered an a l t e r n ative to n et in come o r n et cash flow fro m op eratin g activities, as d etermin ed in acco rdan ce with GAAP. A reconciliation of NOI to net income for the years ended December 31, 2005, 2004 and 2003 is as follows: Net income Corporate-level property management and other indirect operating expenses Corporate-level other income Investments and investment management Interest expense, net General and administrative expense Equity in income of unconsolidated entities Minority interest in consolidated par tnerships Venture partner interest in profit-sharing Depreciation expense Cumulative effect of change in accounting principle Gain on sale of real estate assets Income from discontinued operations For the year ended 12-31-05 12-31-04 12-31-03 $ 322,378 $ 219,745 $ 271,525 31,243 (4,568) 4,834 127,099 25,761 (7,198) 1,481 — 158,822 — (199,766) (14,942) 27,956 (1,344) 4,690 131,103 18,074 (1,100) 150 1,178 151,991 (4,547) (122,425) (21,134) 27,123 (1,520) 2,948 130,178 14,830 (25,535) 950 1,688 138,725 — (160,990) (31,368) Net operating income $ 445,144 $ 404,337 $ 368,554 The primar y perfor mance measure for communities under development or r edevelopment depends on the stage of completion. While under development, management monitors actual construction costs against budgeted costs as well as lease-up pace and rent levels compared to budget. Th e table on th e following p ag e p rovid es details of the Co mp an y’s segment infor mation as o f th e d ates sp ecified . Th e segmen ts are clas sified based o n th e in d ividu al commu n ity’s status as of the b egin n in g o f th e g iven calen dar year. Ther e f o re , each year the co mpo sition o f commu n ities with in each b usiness segmen t is ad justed. Acco rd i n g l y, th e amo u nts between y e a r s a r e n ot directly co mparab le. Th e acco un tin g po licies ap plicab le to th e op eratin g s egmen ts d escribed abo ve are th e same as th ose describ ed in Note 1, “Organ izatio n an d Sign ifican t Acco u ntin g Po licies.” Segmen t in formatio n for th e years en din g Decemb er 31, 2005, 2 004 an d 2003 h as been ad ju sted fo r the co mmun ities that were so ld fro m Jan u ar y 1, 20 03 t h r ou gh December 31, 2 005 as describ ed in No te 7, “Disco n tin u ed Op eratio ns—Real Estate Assets So ld o r H eld for Sale.” AVALONBAY COMMUNITIES, INC. 55 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) For the year ended December 31, 2005 Established Northeast Mid-Atlantic Midwest Pacifi c Northwest Nor thern California Southern Califor nia Total Established Other Stabilized Development / Redevelopment Land Held for Future Development Non-allocated(2) Total revenue NOI % NOI change from prior year Gross real estate(1) $167,636 68,575 11,113 30,080 146,432 48,800 472,636 77,552 116,144 n/a 4,348 $111,734 48,613 6,627 19,312 99,769 35,319 321,374 50,621 73,149 n/a n/a 3.5% 3.9% 7.1% 8.0% 3.5% 6.7% 4.2% n/a n/a n/a n/a $1,062,981 387,801 91,755 315,331 1,489,363 331,315 3,678,546 653,399 1,259,371 188,414 22,066 Total $670,680 $445,144 10.1% $5,801,796 For the year ended December 31, 2004 Established Northeast Mid-Atlantic Midwest Pacifi c Northwest Northern California Southern Califor nia Total Established Other Stabilized Development / Redevelopment Land Held for Future Development Non-allocated(2) $135,059 51,390 10,734 28,836 126,196 56,124 408,339 111,894 93,096 n/a 515 $ 89,547 36,316 6,188 17,874 87,067 39,634 276,626 71,744 55,967 n/a n/a (2.5%) (0.2%) 6.8% 1.1% (5.9%) 1.8% (1.2%) n/a n/a n/a n/a $ 722,482 273,774 91,121 314,717 1,270,848 401,204 3,074,146 1,068,859 1,074,733 156,350 27,401 Total $613,844 $404,337 9.7% $5,401,489 For the year ended December 31, 2003 Established Northeast Mid-Atlantic Midwest Pacifi c Northwest Norther n California Southern Califor nia Total Established Other Stabilized Development / Redevelopment Land Held for Future Development Non-allocated(2) $136,132 57,014 16,141 24,410 126,484 41,051 401,232 77,370 77,714 n/a 1,197 $ 89,383 40,159 8,553 15,015 89,878 28,851 271,839 52,152 44,563 n/a n/a (9.2%) (4.5%) (16.7%) (12.1%) (11.9%) (20.4%) (11.2%) n/a n/a n/a n/a $ 767,035 307,777 140,631 264,760 1,219,242 290,192 2,989,637 706,601 1,197,218 81,358 23,946 Total $557,513 $368,554 (0.2%) $4,998,760 (1) Does not include gross real estate assets for discontinued operations of $101,372, $295,655 and $432,997 as of December 31, 2005, 2004 and 2003 respectively. (2) Revenue represents third-party management, accounting and developer fees and miscellaneous income which are not allocated to a reportable segment. 10. Stock-Based Compensation Plans The Company has a stock incentive plan (the “1994 Plan”), which was amended and restated on December 8, 2004. Individuals who are eligible to participate in the 1994 Plan include of ficers, other associates, outside directors and other key persons of the Company and its subsidiaries who are r esponsible for or contribute to the management, growth or profitability of the Company and its subsidiaries. The 1994 Plan authorizes (i) the grant of stock options that qualify as incentive stock 56 AVALONBAY COMMUNITIES, INC. options (“ISOs”) under Section 422 of the Inter nal Revenue Code, (ii) the grant of stock options that do not so qualify, (iii) grants of shares of restricted and unrestricted common stock, (iv) grants of deferred stock awards, (v) perfor mance share awards entitling the recipient to acquire shares of common stock and (vi) dividend equivalent rights. Shares of common stock of 2,066,308, 2,311,249 and 2,358,393 were available for future option or r estricted stock grant awards under the 1994 Plan as of December 31, 2005, 2004 and 2003, respectively. Annually, on Januar y 1st, the maximum number available for issuance under the 1994 Plan is increased by between 0.48% and 1.00% of the total number of shares of common stock and DownREIT units actually outstanding on such date. Notwithstanding the foregoing, the maximum number of shares of stock for which ISOs may be issued under the 1994 Plan shall not exceed 2,500,000 and no awards shall be granted under the 1994 Plan after May 11, 2011. Options and restricted stock granted under the 1994 Plan vest and expire over varying periods, as determined by the Compensation Committee of the Board of Dir ectors. Before the Mer ger, Avalon had adopted its 1995 Equity Incentive Plan (the “Avalon 1995 Incentive Plan”). Under the Avalon 1995 Incentive Plan, a maximum number of 3,315,054 shares (or 2,546,956 shar es as adjusted for the Merger) of common stock were issuable, plus any shares of common stock represented by awards under Avalon’s 1993 Stock Option and Incentive Plan (the “Avalon 1993 Plan”) that were for feited, canceled, reacquired by Avalon, satisfied without the issuance of common stock or other wise terminated (other than by exercise). Options granted to officers, non-employee dir ectors and associates under the Avalon 1995 Incentive Plan generally vested over a three-year term, expire ten years from the date of grant and are exercisable at the market price on the date of grant. In connection with the Merger, the exercise prices and the number of options under the Avalon 1995 Incentive Plan and the Avalon 1993 Plan were adjusted to r efl ect the equivalent Bay shares and exercise prices based on the 0.7683 share conversion ratio used in the Merger. Of ficers, non-employee directors and associates with Avalon 1995 Incentive Plan or Avalon 1993 Plan options may exercise their adjusted number of options for the Company’s common stock at the adjusted exercise price. As of June 4, 1998, the date of the Mer ger, options and other awar ds ceased to be granted under the Avalon 1993 Plan or the Avalon 1995 Incentive Plan. Accordingly, there were no options to pur chase shares of common stock available for grant under the Avalon 1995 Incentive Plan or the Avalon 1993 Plan at December 31, 2005, 2004 or 2003. Information with respect to stock options granted under the 1994 Plan, the Avalon 1995 Incentive Plan and the A valon 1993 Plan is as follows: Options Outstanding, December 31, 2002 Exercised Granted For feited Options Outstanding, December 31, 2003 Exer cised Granted For feited Options Outstanding, December 31, 2004 Exer cised Granted For feited Options Outstanding, December 31, 2005 Options Exercisable: December 31, 2003 December 31, 2004 December 31, 2005 Weighted average exercise price per share Avalon 1995 and Avalon 1993 Plan shares Weighted average exercise price per share $39.05 32.36 37.14 43.45 $39.57 39.06 50.71 43.98 $42.39 41.89 70.09 55.66 $51.40 $38.51 $39.72 $42.45 640,506 (165,264) — (1,280) 473,962 (287,700) — — 186,262 (159,638) — — 26,624 473,962 186,262 26,624 $35.27 29.39 — 34.07 $37.32 37.05 — — $36.23 37.82 — — $37.09 $37.32 $38.15 $37.09 1994 Plan shares 3,166,007 (454,843) 425,101 (157,000) 2,979,265 (1,167,679) 545,809 (80,577) 2,276,818 (743,524) 725,988 (29,504) 2,229,778 2,069,704 1,366,009 1,158,591 For options outstanding at December 31, 2005 under the 1994 Plan, 653,310 options had exercise prices ranging between $31.50 and $39.99 and a weighted average remaining contractual life of 4.1 years, 425,308 options had exercise prices ranging between $40.00 and $49.99 and a weighted average remaining contractual life of 5.7 years, 441,408 options had exercise prices between $50.00 and $59.99 and a weighted average remaining contractual life of 8.13 years, 705,252 options had exercise prices ranging between $69.93 and $79.99 and a weighted average remaining contractual life of 9.3 years, and 4,500 AVALONBAY COMMUNITIES, INC. 57 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS ( CONTINUED) options had exercise prices between $80.00 and $86.65 and a weighted average remaining contractual life of 9.72 years. Options outstanding at December 31, 2005 for the Avalon 1993 and Avalon 1995 Plans had exercise prices ranging from $28.15 to $37.66 and a weighted average contractual life of 2 years. Effective January 1, 2003, the Company adopted the fair value recognition provisions of SFAS No. 123 pr ospectively to all employee awards granted, modified, or settled on or after Januar y 1, 2003. The effect on net income available to common stockholders and earnings per share if the fair value based method had been applied to all outstanding and unvested awards in each year based on the fair market value as determined on the date of grant is refl ected in Note 1, “Or ganization and Significant Accounting Policies.” The weighted average fair value of the options granted during 2005 is estimated at $6.40 per share on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: dividend yield of 5.5% over the expected life of the option, volatility of 17.56%, risk-free inter est rates of 3.91% and an expected life of approximately 7 years. The weighted average fair value of the options granted during 2004 is estimated at $3.87 per share on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: dividend yield of 6.05% over the expected life of the option, volatility of 17.28%, risk-free interest rates of 3.58% and an expected life of approximately 7 years. The weighted average fair value of the options granted during 2003 is estimated at $1.94 per share on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: dividend yield of 7.56% over the expected life of the option, volatility of 18.68%, risk-free inter est rates of 3.31% and an expected life of approximately 7 years. The cost related to stock-based employee compensation for employee stock options included in the determination of net income is based on actual forfeitures for the given year. In October 1996, the Company adopted the 1996 Non-Qualified Employee Stock Purchase Plan (as amended, the “ESPP”). Initially 1,000,000 shares of common stock were reser ved for issuance under this plan. There ar e currently 800,142 shares remaining available for issuance under the plan. Full-time employees of the Company generally are eligible to participate in the ESPP if, as of the last day of the applicable election period, they have been employed by the Company for at least one month. All other employees of the Company are eligible to participate provided that as of the applicable election period they have been employed by the Company for twelve months. Under the ESPP, eligible employees ar e permitted to acquire shar es of the Company’s common stock through payr oll deductions, subject to maximum purchase limitations. The purchase period is a period of seven months beginning each April 1 and ending each October 30. The purchase price for common stock purchased under the plan is 85% of the lesser of the fair market value of the Company’s common stock on the first day of the applicable purchase period or the last day of the applicable purchase period. The offering dates, purchase dates and duration of purchase periods may be changed by the Boar d of Directors, if the change is announced prior to the beginning of the affected date or purchase period. The Company issued 13,372 shares, 14,476 shares and 14,393 shares and recognized compensation expense of $134, $109 and $95 under the ESPP for the years ended December 31, 2005, 2004 and 2003, respectively. The Company accounts for transactions under the ESPP using the fair value method prescribed under SFAS No. 123, as further discussed in Note 1, “Organization and Significant Accounting Policies.” 11. Fair Value of Financial Instr uments In su ran ce Corp oratio n limit. T he Comp an y mo nito rs cre dit Cash an d cash eq uivalen t b alan ces are h eld with vario us fin an cial in stitutio ns an d may at times exceed th e app licab le Fed eral Dep os it in stitu tion s an d th e concentration of cash and cash equivalent balances with any one financial institution and believes the likelihood of realizing material losses from the excess of cash and cash equivalent balances over insurance limits is r emote. rating s o f th ese finan cial Th e followin g estimated fair valu es of fin ancial instru men ts were d etermined b y man ag emen t u sin g available mark et i n f o rmatio n an d estab lish ed valu atio n meth o do logies, in clud in g discou n ted cash flo w. Acco rd i n g l y, the estimates p resented are n ot n ecessarily ind icative of th e amou n ts th e Comp an y cou ld realize o n d ispo sitio n of th e fin ancial in stru men ts. The u se of d i ff e ren t mar ket assu mption s an d /o r estimatio n metho do logies may have a material effect on th e estimated fair valu e amou n ts. • Cash equivalents, rents receivable, accounts payable and accr ued expenses, and other liabilities are car ried at their face amounts, which reasonably approximate their fair values. • Bond indebtedness and notes payable with an aggregate car rying value of approximately $2,301,000 and $2,350,000 had an estimated aggregate fair value of $2,426,000, and $2,541,000 at December 31, 2005 and 2004, r espectively. 12. Related Party Arrangements U nconsolidate d Entities Th e Co mp any man ages un con so lid ated real estate en tities fo r wh ich it receives asset man agem e n t , p ro p e rty management, develo pment and redevelo pmen t fee reven u e. From th ese entities, th e Co mp any received fees of $4,304, 58 AVALONBAY COMMUNITIES, INC. $604 and $931 in th e years en ded Decemb er 31, 20 05, 200 4 an d 2003 re s p e c t i v e l y. Th ese fees are in clu ded in man agement, d evelopmen t an d o th er fees on the acco mp anying Con solid ated Statements of O peration s an d Other Compreh ensive In come. In ad d itio n , in co nn ection with the gen eral con tractor ser vices th at the Comp an y p ro vid ed to CVP I, LLC, th e en tity th at own s an d d evelo ped Avalo n Ch rystie Place I, the Comp an y h as fu n ded cer tain con str uction costs o n b ehalf of CVP I, LLC and exp ects to be reimb ursed th rou gh d raws fro m escrowed b on d p ro ceed s. As of December 31, 2005 an d Decemb er 3 1, 2 004, the Company has recor ded a receivable from CVP I, LLC in the amounts of $2,365 and $19,983, r espectively. The Company provides similar services to Mission Bay Venture Partners, LLC, the entity that owns and is developing Avalon at Mission Bay North II. The Company has funded $6,653 in construction costs on behalf of Mission Bay Venture Partners, LLC as of December 31, 2005 and has recorded a corresponding receivable from Mission Bay Venture Par tners, LLC. The Company expects to be reimbursed through draws on a construction loan. The Company is generally reimbursed for the funding of construction costs by both CVP I, LLC and Mission Bay Venture Partners, LLC within 30 to 60 days. These receivables are included in prepaid expenses and other assets on the accompanying Consolidated Balance Sheets. Director Compensation The Company’s 1994 Plan pr ovides that directors of the Company who are also employees r eceive no additional compensation for their ser vices as a dir ector. On May 14, 2003, the Company’s Boar d of Directors approved an amendment to the 1994 Plan pursuant to which, in lieu of the stock and option awards described above, each non-employee director would receive, following the 2004 Annual Meeting of Stockholders and each annual meeting ther eafter, (i) a number of shar es of restricted stock (or defer red stock awards) having a value of $100 based on the last repor ted sale price of the common stock on the NYSE on the fifth business day following the prior year’s annual meeting and (ii) $30 cash, payable in quarterly installments of $7.5. A non-employee director may elect to receive all or a portion of such cash payment in the form of a deferred stock award. In addition, the Lead Independent Director receives an annual fee of $30 payable in equal monthly installments of $2.5. The Company recor ded non-employee director compensation expense relating to the restricted stock grants, defer red stock awards and stock options in the amount of $966, $940 and $824 in the years ended December 31, 2005, 2004 and 2003 respectively. Deferred compensation relating to these restricted stock grants, defer red stock awards and stock options was $579 and $748 on December 31, 2005 and December 31, 2004, r espectively. In December 31, 2005, one of the Company’s dir ectors resigned due to a disability. The Company accelerated the vesting of all outstanding equity awards at that date. 13. Quar terly Financial Information (Unaudited) The following summary represents the quarterly results of operations for the years ended December 31, 2005 and 2004: Total revenue Income from continuing operations Income from discontinued operations Net income available to common stockholders Net income per common share—basic Net income per common share—diluted Total revenue Income from continuing operations Income from discontinued operations Net income available to common stockholders Net income per common share—basic Net income per common share—diluted 14. Subsequent Events 3-31-05 $161,245 $ 27,861 $ 41,749 $ 67,435 0.93 $ 0.92 $ 3-31-04 $146,262 $ 15,169 $ 5,561 $ 23,102 0.33 $ 0.32 $ For the three months ended 6-30-05 $165,586 $ 25,360 $ 31,551 $ 54,736 0.75 $ 0.74 $ 9-30-05 $170,751 $ 26,885 $ 72,243 $ 96,953 1.32 $ 1.30 $ For the three months ended 6-30-04 $151,393 $ 17,494 $ 17,539 $ 32,858 0.46 $ 0.46 $ 9-30-04 $156,496 $ 17,374 $ 27,992 $ 43,191 0.60 $ 0.60 $ 12-31-05 $173,098 $ 27,564 $ 69,165 $ 94,554 1.29 $ 1.26 $ 12-31-04 $159,693 $ 21,602 $ 92,467 $111,894 1.55 $ 1.52 $ In Jan uar y 200 6, th e Co mpan y s old two commun ities to un related th ird p arties. Avalo n Estates, a g ar den -style co mmu n ity lo cated in Bo sto n, Massach usetts, co ntain in g 16 2 ap artmen t h omes, was s o ld for a sales p rice o f $ 34,450. Avalo n Cu p ert i n o , a gard en -style co mmu n ity lo cated in San Jose, Califo rn ia, con tain in g 311 ap artment h omes, was so ld fo r a sales p rice of $88,0 00. Th e d isp osition o f th ese two commu nities resu lted in an aggr egate GAAP g ain of app rox imately $66,000 . Th es e two commun ities were classified as h eld fo r sale un d er th e p rovis io ns o f SFAS No. 14 4 as o f December 3 1, 2005 ( see Note 7, “Discon tin ued O peration s—Real Estate Assets So ld or Held for Sale”) . AVALONBAY COMMUNITIES, INC. 59 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders of AvalonBay Communities, Inc.: We have audited the accompanying consolidated balance sheets of AvalonBay Communities, Inc. and subsidiaries as of December 31, 2005 and 2004, and the r elated consolidated statements of operations and other comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and schedule ar e the responsibility of the Company’ s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and signifi cant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a r easonable basis for our opinion. In our opinion, the financial statements referr ed to above present fairly, in all material r espects, the consolidated financial position of AvalonBay Communities, Inc. and subsidiaries at December 31, 2005 and 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related fi nancial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects, the information set for th therein. We also have audited, in accordance with the standar ds of the Public Company Accounting Oversight Board (United States), the effectiveness of AvalonBay Communities, Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 3, 2006 expressed an unqualified opinion thereon. McLean, Virginia March 3, 2006 60 AVALONBAY COMMUNITIES, INC. The Board of Dir ectors and Shareholders of AvalonBay Communities, Inc.: We have audited management’s assessment, included in the accompanying Management’s Report on Internal Contr ol Over Financial Reporting in Item 9a., that AvalonBay Communities, Inc. maintained effective inter nal control over fi nancial repor ting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Tr eadway Commission (the COSO criteria). AvalonBay Communities, Inc.’s management is responsible for maintaining ef fective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial repor ting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perfor m the audit to obtain reasonable assurance about whether ef fective inter nal control over fi nancial repor ting was maintained in all material respects. Our audit included obtaining an understanding of inter nal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other pr ocedures as we considered necessar y in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial repor ting is a process designed to provide reasonable assurance regarding the reliability of financial repor ting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial repor ting includes those policies and pr ocedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly refl ect the transactio n s an d disp o sitio n s o f th e assets of th e comp any; (2) p rovide reas o nab le assu ran ce th at trans action s ar e re c o rd ed as n e c e s s a r y to per mit p rep aratio n o f fin an cial statemen ts in acco rd ance with gen erally accep ted accou ntin g p rin ciples, an d th at receipts and expenditures of the company are being made only in accor dance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’ s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degr ee of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that AvalonBay Communities, Inc. maintained effective inter nal control over financial repor ting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, AvalonBay Communities, Inc. maintained, in all material respects, effective inter nal control over financial reporting as of December 31, 2005, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of AvalonBay Communities, Inc. as of December 31, 2005 and 2004, and the related consolidated statements of operations and other comprehensive income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005 of AvalonBay Communities, Inc. and our repor t dated March 3, 2006 expressed an unqualified opinion thereon. McLean, Virginia March 3, 2006 AVALONBAY COMMUNITIES, INC. 61 MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Our common stock is traded on the New York Stock Exchange (NYSE) and the Pacific Exchange (PCX) under the ticker symbol AVB. We are in the process of delisting our shares on the PCX. The following table sets forth the quar terly high and low sales prices per share of our common stock for the years 2005 and 2004, as reported by the NYSE. On Januar y 31, 2006 there were 1,178 holders of record of an aggr egate of 73,998,786 shares of our outstanding common stock. The number of holders does not include individuals or entities who beneficially own shares but whose shar es are held of record by a broker or clearing agency, but does include each such broker or clearing agency as one record holder. 2005 Sales Price High Low Dividends declared Quarter ended March 31 Quarter ended June 30 Quarter ended September 30 Quarter ended December 31 $75.59 $81.80 $88.23 $92.99 $65.18 $64.99 $78.37 $78.82 $0.71 $0.71 $0.71 $0.71 2004 Sales Price High Low $54.66 $57.80 $62.25 $75.93 $46.72 $48.30 $55.89 $59.90 Dividends declared $0.70 $0.70 $0.70 $0.70 We expect to continue our policy of paying regular quar terly cash dividends. However, dividend distributions will be declared at the discretion of the Board of Directors and will depend on actual cash fr om operations, our financial condition, capital requirements, the annual distribution requirements under the REIT provisions of the Inter nal Revenue Code and other factors as the Board of Directors may consider r elevant. The Board of Directors may modify our dividend policy from time to time. In Januar y 2006, we announced that our Board of Dir ectors declared a dividend on our common stock for the first quarter of 2006 of $0.78 per share, a 9.8% increase over the previous quar terly dividend of $0.71 per share. The increased dividend is payable on April 17, 2006 to all common stockholders of record as of Mar ch 31, 2006. During the three months ended December 31, 2005, we did not issue shar es of common stock in exchange for units of limited par tnership held by certain limited par tners. O ur Board o f Dir ectors has ad op ted a Stock Repu rchase Pro gram un d er wh ich we may acq uir e, fr om time to time, sh ares of common stock in th e o pen mark et with an aggr egate p u rch as e p rice o f u p to $ 100,000,0 00. No p urch ases were made un d er this pr ogram in 2005 . In d etermining wh eth er to r e p u rch ase sh ares, we con sider a variety o f facto rs, inclu din g ou r liq uid ity n eeds , the then cur rent mar ket p rice o f o ur s h ares an d th e effect of th e share re p u rch ases o n o ur p er share earn in gs and FFO. 62 AVALONBAY COMMUNITIES, INC. DEFINITIONS AND RECONCILIATIONS OF NON-GAAP FINANCIAL MEASURES AND OTHER TERMS This Annual Repor t, including the Letter to Shareholders, contains certain non-GAAP fi nancial measures and other ter ms. The definition and calculation of these non-GAAP financial measures and other terms may differ from the definitions and methodologies used by other REITs and, accor dingly, may not be comparable. The non-GAAP financial measures referred to below should not be considered an alternative to net income as an indication of our per formance. In addition, these non-GAAP financial measures do not repr esent cash generated from operating activities in accordance with GAAP and ther efore should not be considered as an alternative measure of liquidity or as indicative of cash available to fund cash needs. Economic Gain The gain on sale in accordance with GAAP, less accumulated depreciation through the date of sale and any other non-cash adjustments that may be required under GAAP accounting. Management generally considers Economic Gain to be an appropriate supplemental measur e to gain on sale in accordance with GAAP because it helps investors to understand the relationship between the cash proceeds from a sale and the cash invested in the sold community. The Economic Gain for each community is estimated based on the respective fi nal settlement statement. A reconciliation of Economic Gain to gain on sale in accordance with GAAP is as follows: For the Y ear Ended (dollars in thousands) 12-31-05 12-31-04 12-31-03 12-31-02 12-31-01 GAAP Gain (1) Accumulated depr eciation and other Economic Gain $199,766 (14,928) $184,838 $122,425 (19,320) $184,438 (52,613) $103,105 $131,825 $ 48,893 (7,462) $ 41,431 $ 62,852 (21,623) $ 41,229 (1) 2005 GAAP Gain includes $2,819 related to the sale of an offi ce building and $4,479 related to the sale of three land parcels. 2004 GAAP Gain includes $1,138 related to the sale of a land parcel. 2003 GAAP Gain includes $23,448 related to the sale of a community in which the Company held a 50% membership interest and $1,234 related to the sale of a land parcel. Estimated Net Asset Value (NAV) Per Share The estimated market value of a company’s assets less the estimated market value of all current and long-term liabilities divided by the number of outstanding common shares and operating par tnership units. Fixed Charge Coverage (Interest Coverage) EBITDA from continuing operations divided by the sum of interest expense, net, and prefer red dividends. Fixed Char ge Coverage is presented by the Company because it pr ovides rating agencies and investors an additional means of comparing our liquidity to that of other companies. EBITDA is defined by the Company as net income before interest income and expense, income taxes, depreciation and amortization. Under this definition, which complies with the r ules and regulations of the Securities and Exchange Commission, EBITDA includes gains on sale of assets and gains on sale of partnership interests. A reconciliation of EBITDA and a calculation of Fixed Charge Coverage for the quar ter ended December 31, 2005 are as follows: For the Quarter Ended 12-31-05 Net income Interest expense, net Depreciation expense Depr eciation expense (discontinued operations) EBITDA EBITDA from continuing operations EBITDA from discontinued operations EBITDA EBITDA from continuing operations Interest expense, net Dividends attributable to prefer red stock Interest charges Interest coverage $ 96,729 31,076 41,341 217 $169,363 $ 99,981 69,382 $169,363 $ 99,981 $ 31,076 2,175 $ 33,251 3.0 AVALONBAY COMMUNITIES, INC. 63 Funds fr om Operations (FFO) FFO is determined based on a definition adopted by the Board of Governors of NAREIT. See the section titled “Selected Financial Data” contained herein on page 17 for a definition and discussion of FFO. A reconciliation of FFO to Net Income is included below. (dollars in thousands) 12-31-05 12-31-04 12-31-03 12-31-02 12-31-01 12-31-00 12-31-99 12-31-98 12-31-97 12-31-96 12-31-95 For the Year Ended Net income Dividends attributable to pr eferred stock Depreciation—real estate assets, including discontinued operations and joint venture adjustments Minority interest expense, including discontinued operations Cumulative effect of change in accounting principle Gain on sale of previously depreciated r eal estate assets Funds from Operations attributable to common stockholders Weighted average common shares outstanding—diluted EPS—diluted FFO per common share—diluted $ 322,378 $ 219,745 $ 271,525 $ 173,618 $ 248,997 $ 210,604 $ 172,276 $ 123,535 $ 64,916 $ 51,651 $ 30,937 (8,700) (8,700) (10,744) (17,896) (40,035) (39,779) (39,779) (28,132) (19,656) (10,422) — 162,019 157,988 128,278 142,980 128,086 120,208 108,679 76,339 27,759 18,887 14,784 1,363 3,048 1,263 1,601 1,559 1,759 1,975 1,770 — (4,547) — — — — — — — — — — (195,287) (121,287) (159,756) (48,893) (62,852) (40,779) (47,093) (25,270) (677) (7,850) — — — $ 281,773 $ 246,247 $ 230,566 $ 251,410 $ 275,755 $ 252,013 $ 196,058 $ 148,242 $ 72,342 $ 52,266 $ 45,721 74,759,318 73,354,956 70,203,467 70,674,211 69,781,719 68,140,998 66,110,664 51,771,247 28,431,823 23,691,447 21,828,020 $ $ 4.21 $ 2.92 $ 3.77 $ 3.36 $ 3.73 3.28 $ $ 2.23 $ 3.02 $ 3.55 $ 3.95 $ 2.53 3.70 $ $ 2.03 $ 1.88 $ 2.97 $ 2.86 $ 1.59 2.54 $ $ 1.74 $ 2.21 $ 1.42 2.09 Initial Year Market Capitalization Rate (Cap Rate) Pr ojected NOI of a single community for the first twelve months of operations following the date of the buyer’s valuation, less estimates for non-routine allowance of approximately $200–$300 per apartment home, divided by the gross sales price for the community. For this purpose, Management’s projection of stabilized operating expenses for the community includes a management fee of approximately 3.0%–3.5%. The Cap Rate, which may be determined in a different manner by others, is a measure fr equently used in the real estate industr y when determining the appr opriate purchase price for a pr operty or estimating the value for the property. Buyers may assign different Cap Rates to different communities when determining the appropriate value because they (i) may project different rates of change in operating expenses, including capital expenditure estimates and (ii) may project different rates of change in future rental r evenue due to differ ent estimates for changes in rent and occupancy levels. The weighted average Cap Rate is weighted based on the gross sales price of each community. Leverage Leverage is calculated by the Company as total debt as a percentage of Total Market Capitalization. Total Market Capitalization repr esents the aggregate of the market value of the Company’s common equity (defi ned as the sum of the market value of the Company’s common stock and the market value of the Company’s operating partnership units outstanding based on the market value of the Company’s common stock), the liquidation preference of the Company’s preferred stock and the outstanding principal balance of the Company’s fixed and variable debt. Management believes that Leverage can be one useful measure of a real estate operating company’s long-term liquidity and balance sheet strength, because it shows an approximate relationship between a company’s total debt and the cur rent total market value of its assets 64 AVALONBAY COMMUNITIES, INC. based on the cur rent price at which the company’s common stock trades. Changes in Leverage also can influence changes in per share results. A calculation of Leverage as of December 31, 2005 is as follows: (dollars in thousands) Common equity Pr efer red equity Fixed debt Variable debt Total Market Capitalization 12-31-05 $6,612,275 100,000 2,058,869 308,513 $9,079,657 As a Percentage of Total Market Capitalization 73% 1% 23% 3% 100% Becau se Leverage ch ang es with flu ctu atio ns in th e Comp any’s stock pr ice, wh ich o ccu rs re g u l a r l y, th e Co mpan y’s Leverage may chan ge even wh en th e Co mpan y’s earn in gs, in ter est and d ebt levels remain stable. Investors sh ou ld also n ote th at th e net realizab le valu e of th e Comp an y’s assets in liqu id ation is n o t easily determin ed an d may differ sub stantially fro m th e C o m p a n y ’s Total Market Cap italization . Mulifamily Sector Average Th e Mu ltifamily Sector Average is a weigh ted average based o n Total Enterp rise Value p er Bloomb erg. Th e weigh ted average for Total Sh areh old er Retur n, FFO p er Share Gro wth , and Co mmo n Dividen d per Sh are Gr owth in clu des AEC, AIV, ASN, BRE, CPT, EQR, ESS, H ME, MAA, PPS an d UDR. Th e 10-year weig hted aver age for EPS Gro wth exclud es co mpan ies with n eg- ative EPS in 2005 and comp anies fo r which th ere is in s ufficien t d ata for 1995. Th e weigh ted average fo r Es timated NAV p er S h a re Gro wth inclu des all comp anies un d er Green Street Ad vis o rs, In c.’s co verage for wh ich data is available du rin g each of the time p erio ds p re s e n t e d . Net Operating Income (NOI) Total pr o p e rty reven u e les s d irect p ro p e rty op eratin g ex pen s es (in clu din g pro p e r ty taxes), and exclu ding co rp orate-level in come ( in clud in g man agemen t, d evelop men t an d o th er fees ), co rpo rate-level p ro p e rty man agemen t an d other in d ire c t op erating ex pen ses, investmen ts an d in vestmen t man agement, n et in terest exp ense, gen eral an d ad ministrative exp en se, joint v e n t u re in come, mino rity in terest an d ventu re p artner in terest in pro fi t-sh ar ing , d ep reciation exp ense, gain on sale o f re a l estate as sets, cu mulative effect of ch ange in accou ntin g princip le an d in come fro m d is co n tin u ed op eration s. Th e Co mp an y con sider s N OI to be an ap pro priate sup p lemental measu re to Net Income o f o peratin g p er f o rman ce o f a commu nity o r com- mun ities because it h elp s b oth in ves to rs and Managemen t to un der stand the co re op eratio n s o f a commu nity o r commun ities p rior to th e allocatio n of an y corp o rate-level p ro p e rty man agemen t o verh ead o r gen eral an d admin istr ative costs. Th is is mo re re flective of th e o peratin g p erf o r man ce of a co mmu n ity, and allows for an easier comp aris on o f th e op eratin g per f o r m a n c e of single assets o r grou ps of assets. In add ition , becau se p ro sp ective b uyer s of r eal estate h ave diff e r ent overh ead str u c t u re s , with varyin g margin al imp act to overh ead by acqu irin g real estate, NO I is co n s idered by many in th e real estate in du str y to be a us eful measur e for determin in g th e valu e of a r eal es tate asset or g rou ps o f as sets. Fo r fu rther d iscussio n an d a re c o n c i l i a t i o n of NOI to Net Income see “Results of Operation s ” with in “Man agemen t’s Discussion an d An alysis o f Fin an cial Con ditio n and Resu lts o f Op eratio n s” co n tain ed her ein on p age 23. AVALONBAY COMMUNITIES, INC. 65 NOI as reported by the Company does not include the operating results from discontinued operations (i.e., assets sold or held for sale as of December 31, 2005). A reconciliation of NOI from communities sold or held for sale to Net Income for these communities is as follows: (dollars in thousands) Income from discontinued operations Interest expense, net Minority interest expense Depr eciation expense NOI from discontinued operations NOI from assets sold NOI from assets held for sale NOI from discontinued operations Same Store (Established) Communities For the Y ear Ended 13-31-05 $14,942 — — 3,241 $18,183 $ 9,501 8,682 $18,183 12-31-04 $21,134 525 37 10,676 $32,372 $23,978 8,394 $32,372 Communities that are consolidated for financial reporting purposes and where a comparison of operating results fr om the prior year to the current year is meaningful, as these communities wer e owned and had Stabilized Operations, as defined below, as of the beginning of the prior year. Therefore, for 2005, Same Store Communities were consolidated communities that had Stabilized Operations as of January 1, 2004. Same Store Communities do not include communities that ar e held for sale or planned for disposition or redevelopment during the cur rent year. Stabilized Operations The earlier of (i) attainment of 95% physical occupancy or (ii) the one-year anniversary of completion of development. Total Capital Cost All capitalized costs projected to be or actually incurr ed to develop the respective development community or development right, including land acquisition costs, construction costs, real estate taxes, capitalized interest and loan fees, permits, professional fees, allocated development overhead and other regulator y fees, all as deter mined in accordance with GAAP. With r espect to communities where development has been completed, Total Capital Cost refl ects the actual cost incurred, plus any contingency estimate made by Management. Unleveraged IRR The internal rate of retur n calculated by the Company considering the timing and amounts of (i) total revenue during the period owned by the Company and (ii) the gross sales price net of selling costs, offset by (iii) the undepreciated capital cost of the communities at the time of sale and (iv) total dir ect operating expenses during the period owned by the Company. Each of the items (i), (ii), (iii) and (iv) is calculated in accordance with GAAP. The calculation of Unleveraged IRR does not include an adjustment for the Company’s general and administrative expense, inter est expense, or corporate-level proper ty management and other indirect operating expenses. Therefore, Unleveraged IRR is not a substitute for Net Income as a measure of our per formance. Management believes that the Unleveraged IRR achieved during the period a community is owned by the Company is useful because it is one indication of the gross value created by the Company’s acquisition, development or redevelopment, management and sale of the community, before the impact of indir ect expenses and Company overhead. The Unleveraged IRR achieved on the communities as cited in this Annual Report should not be viewed as an indication of the gr oss value created with respect to other communities owned by the Company, and the Company does not repr esent that it will achieve similar Unleveraged IRRs upon the disposition of other communities. The weighted average Unleveraged IRR for sold communities is weighted based on all cash flows over the holding period for each respective community, including net sales proceeds. 66 AVALONBAY COMMUNITIES, INC. AvalonBay Corporate Information BOARD OF DIRECT OR S Bryce Blair (4) Chairman and CEO AvalonBay Communities, Inc. Bruce A. Choate (2,4) CEO and President Watson Land Company John J. Healy, Jr. (3,4) Founder and CEO Hyde Street Holdings, Inc. Gilbert M. Meyer (4) Founder and President Greenbriar Homes Communities, Inc. Timothy J. Naughton (4) President AvalonBay Communities, Inc. Lance R. Primis (1,4,5) Managing Partner Lance R. Primis and Partners, LLC H. Jay Sarles (2,3) Private Investor Allan D. Schuster (2,4,5) Private Investor Amy P. Williams (2,3) Private Investor 1 Lead Independent Director 2 Audit Committee 3 Compensation Committee 4 Investment and Finance Committee 5 Nominating and Corporate Governance OFFICERS Bryce Blair Chairman and CEO Timothy J. Naughton President Thomas J. Sargeant (cid:43)(cid:80)(cid:81)(cid:77)(cid:78) (cid:3)(cid:46)(cid:81)(cid:86)(cid:73)(cid:86)(cid:75)(cid:81)(cid:73)(cid:84)(cid:3)(cid:55)(cid:78)(cid:197)(cid:75)(cid:77)(cid:90) Leo S. Horey Executive Vice President Operations Charlene Rothkopf Executive Vice President Human Resources David W. Bellman Senior Vice President Construction–National Sean J. Breslin Senior Vice President Investments–West Coast Jonathan B. Cox Senior Vice President Development–Mid-Atlantic, Midwest Lili F. Dunn Senior Vice President Investments–National Frederick S. Harris Senior Vice President Development–NY Dirk V. Herrman Senior Vice President (cid:43)(cid:80)(cid:81)(cid:77)(cid:78) (cid:3)(cid:53)(cid:73)(cid:90)(cid:83)(cid:77)(cid:92)(cid:81)(cid:86)(cid:79)(cid:3)(cid:55)(cid:78)(cid:197)(cid:75)(cid:77)(cid:90) Joanne M. Lockridge Senior Vice President Finance and Assistant Treasurer William M. McLaughlin Senior Vice President Development–MA, RI, CT, NJ J. Richard Morris Senior Vice President Construction–National Edward M. Schulman Senior Vice President General Counsel and Secretary Lawrence A. Scott Senior Vice President Development–Southern CA Sean P. Sullivan Senior Vice President Property Operations–Metro NY, NJ, Midwest Bernard J. Ward Senior Vice President Property Operations–West Coast Stephen W. Wilson Senior Vice President Development–West Coast Shannon E. Brennan Vice President Property Operations–Mid-Atlantic Alfred Brockunier III Vice President Construction–NY Duane W. Carlson Vice President Construction–Northern CA Darren R. Carrington Vice President Investments–East Coast, Midwest Deborah A. Coombs Vice President Property Operations–Southern CA, (cid:56)(cid:73)(cid:75)(cid:81)(cid:197)(cid:75)(cid:3)(cid:54)(cid:87)(cid:90)(cid:92)(cid:80)(cid:95)(cid:77)(cid:91)(cid:92) Scott W. Dale Vice President Development–MA Mark J. Forlenza Vice President Development–CT Nathan K. Hong Vice President Development–Northern CA Scott R. Kinter Vice President Construction–Northeast Ronald S. Ladell Vice President Development–NJ Lyn C. Lansdale Vice President Strategic Business Services Sarah A. Mathewson Vice President Property Operations–MA, RI Janice A. Miner Vice President Property Operations–CT, NY Kevin P. O’Shea Vice President Investment Management Christopher L. Payne Vice President Development–Southern CA Walter A. Rebenson Vice President Development–Midwest Michael J. Roberts Vice President Development–MA Keri A. Shea Vice President Controller and Treasurer Mona R. Stahling Vice President Property Operations Matthew B. Whalen Vice President Development–Long Island Philip M. Wharton Vice President Development–NY James R. Willden Vice President Engineering AVALONBAY COMMUNITIES, INC. 67 AvalonBay Corporate Information (continued) Form 10-K A copy of the Company’s annual report on (cid:46)(cid:87)(cid:90)(cid:85)(cid:3)(cid:25)(cid:24)(cid:21)(cid:51)(cid:3)(cid:73)(cid:91)(cid:3)(cid:197)(cid:84)(cid:77)(cid:76)(cid:3)(cid:95)(cid:81)(cid:92)(cid:80)(cid:3)(cid:92)(cid:80)(cid:77)(cid:3)(cid:59)(cid:77)(cid:75)(cid:93)(cid:90)(cid:81)(cid:92)(cid:81)(cid:77)(cid:91)(cid:3)(cid:73)(cid:86)(cid:76)(cid:3) (cid:45)(cid:96)(cid:75)(cid:80)(cid:73)(cid:86)(cid:79)(cid:77)(cid:3)(cid:43)(cid:87)(cid:85)(cid:85)(cid:81)(cid:91)(cid:91)(cid:81)(cid:87)(cid:86)(cid:3)(cid:85)(cid:73)(cid:97)(cid:3)(cid:74)(cid:77)(cid:3)(cid:87)(cid:74)(cid:92)(cid:73)(cid:81)(cid:86)(cid:77)(cid:76)(cid:3)(cid:95)(cid:81)(cid:92)(cid:80)- 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Phone: Fax: (408) 983-1500 (408) 287-9167 Seattle, WA 11808 Northup Way Suite W311 Bellevue, WA 98005 Phone: Fax: (425) 576-2100 (425) 576-8447 Woodbridge, NJ Woodbridge Place 517 Route One South Suite 5500 Iselin, NJ 08830 Phone: Fax: (732) 404-4800 (732) 283-9105 Investor Relations Investor Relations AvalonBay Communities, Inc. 2900 Eisenhower Avenue Suite 300 Alexandria, VA 22314 Phone: ir@avalonbay.com (703) 329-6300 Website www.avalonbay.com Transfer Agent The Bank of New York Shareholder Relations Department-12E P.O. Box 11258 Church Street Station New York, NY 10286 (800) 524-4458 Independent Auditors Ernst & Young, LLP 8484 Westpark Drive McLean, VA 22102 (703) 747-1000 Headquarters Washington, DC 2900 Eisenhower Avenue Suite 300 Alexandria, VA 22314 Phone: Fax: (703) 329-6300 (703) 329-1459 (cid:58)(cid:77)(cid:79)(cid:81)(cid:87)(cid:86)(cid:73)(cid:84)(cid:3)(cid:55)(cid:78)(cid:197)(cid:75)(cid:77)(cid:91) Boston, MA 1250 Hancock Street Suite 804N Quincy, MA 02169 Phone: Fax: (617) 472-9491 (617) 472-5553 Chicago, IL 200 North Arlington Heights Road Suite 15 Arlington Heights, IL 60004 Phone: Fax: (847) 342-0065 (847) 342-0075 (cid:46)(cid:73)(cid:81)(cid:90)(cid:197)(cid:77)(cid:84)(cid:76)(cid:21)(cid:54)(cid:77)(cid:95)(cid:3)(cid:48)(cid:73)(cid:94)(cid:77)(cid:86)(cid:20)(cid:3)(cid:43)(cid:60) 1000 Bridgeport Avenue Suite 258 Shelton, CT 06484 Phone: Fax: (203) 926-2302 (203) 926-2301 Long Island, NY 135 Pinelawn Road Suite 130 South Melville, NY 11747 Phone: Fax: (631) 843-0736 (631) 843-0737 Newport Beach, CA 4440 Von Karman Avenue Suite 300 Newport Beach, CA 92660 Phone: Fax: (949) 955-6200 (949) 955-6235 New York, NY 535 Fifth Avenue 17th Floor New York, NY 10017 Phone: Fax: (212) 370-9269 (212) 370-1511 68 AVALONBAY COMMUNITIES, INC. 2900 Eisenhower Avenue n Suite 300 n Alexandria n VA n 22314 www.avalonbay.com