AvalonBay Communities Annual Report 2007

Plain-text annual report

2 0 0 7 A N N U A L R E P O R T A v a l o n B a y C o m m u n i t i e s , I n c . A N N U A L R E P O R T 2 0 0 7 2900 Eisenhower Avenue Suite 300 • Alexandria • VA • 22314 www.avalonbay.com Excellent Excellent Execution Execution F I N A N C I A L H I G H L I G H T S TOTAL SHAREHOLDER RETURN (1) e t a R h t w o r G l a u n n A d n u o p m o C 20.0% 15.0% 10.0% 5.0% 0% % 7 . 4 1 % 0 . 0 1 % 1 . 1 1 % 1 . 4 3-Year 10 Year AVB Multifamily Sector Avg. Source: SNL Financial e t a R h t w o r G l a u n n A d n u o p m o C e t a R h t w o r G l a u n n A d n u o p m o C NAV PER SHARE GROWTH (2) 30.0% 20.0% % 4 . 5 2 % 5 . 9 1 % 7 . 5 1 10.0% % 1 . 6 0% 3-Year 10 Year AVB Multifamily Sector Avg. Source: Green Street Advisors, SNL Financial AvalonBay Communities, Inc. is an equity Real Estate Investment Trust primarily engaged in developing, redeveloping, acquiring, and managing quality apartment communities in high barrier-to-entry markets within the United States. Our markets are located in the Northeast, Mid-Atlantic, Midwest, Paciﬁ c Northwest, and Northern and Southern California regions. At year-end 2007, our Total Market Capitalization was $10.6 billion. Over the last ten years, our Total Shareholder Return averaged 14.7% per year, and the growth rate of our dividend averaged 7.4% per year during the same time period. Our time-tested strategy is to more deeply penetrate our chosen markets with a broad range of products and services and an intense focus on our customer. AvalonBay Communities common shares are traded on the New York Stock Exchange under the ticker symbol AVB and were included in the S&P 500 Index in 2007. More information about AvalonBay may be found on our website at www.avalonbay.com. FFO PER SHARE GROWTH (3) PAGE 1, TOP: AVALON DEL REY, CA BOTTOM: AVALON GLEN COVE NORTH, NY COVER: AVALON RIVERVIEW NORTH, NY: 15.0% 10.0% % 8 . 2 1 5.0% 0% % 5 . 6 % 4 . 5 % 6 . 2 3-Year 10 Year AVB Multifamily Sector Avg. Source: SNL Financial See page 12 for notes, page 61 for deﬁ ned terms, and page 65 for 5 year stock perfomance graph. AVALONBAY CORPORATE INFORMATION H EA D QUA RTERS Washington, DC 2900 Eisenhower Avenue Suite 300 Alexandria, VA 22314 Phone: Fax: (703) 329-6300 (703) 329-1459 REGIONA L OFF ICES Boston, MA 51 Sleeper Street Suite 750 Boston, MA 02210 Phone: Fax: (617) 654-9500 (617) 426-1610 Chicago, IL 200 North Arlington Heights Road Suite 15 Arlington Heights, IL 60004 Phone: Fax: (847) 342-0065 (847) 342-0075 Fairﬁ eld-New Haven, CT 1000 Bridgeport Ave Suite 258 Shelton, CT 06484 Phone: Fax: (203) 926-2300 (203) 926-9744 Long Island, NY 135 Pinelawn Road Suite 130 South Melville, NY 11747 Phone: Fax: (631) 843-0736 (631) 843-0737 Los Angeles, CA 16255 Ventura Boulevard Suite 950 Encino, CA 91436 Phone: Fax: (818) 784-2800 (818) 784-2810 Newport Beach, CA 4440 Von Karman Avenue Suite 300 Newport Beach, CA 92660 (949) 955-6200 Phone: (949) 724-9208 Fax: New York, NY 275 Seventh Avenue 25th Floor New York, NY 10001 Phone: Fax: (212) 370-9269 (212) 370-1511 San Francisco, CA 185 Berry Street Suite 3500 San Francisco, CA 94107 Phone: Fax: (415) 284-9080 (415) 546-4138 San Jose, CA 400 Race Street Suite 200 San Jose, CA 95126 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 Virginia Beach, VA 2901 Sabre Street Suite 100 Virginia Beach, VA 23452 (757) 631-5000 Phone: (757) 486-1063 Fax: Woodbridge, NJ Woodbridge Place 517 Route One South Suite 5500 Iselin, NJ 08830 Phone: Fax: (732) 404-4800 (732) 283-9101 INV ESTOR REL ATIONS Investor Relations AvalonBay Communities, Inc. 2900 Eisenhower Avenue Suite 300 Alexandria, VA 22314 Phone: ir@avalonbay.com (703) 329-6300 ext. 4747 WE BSITE www.avalonbay.com TRA NS FER AGE NT The Bank of New York Mellon Shareholder Relations Department–12E P.O. Box 11258 Church Street Station New York, NY 10286 Phone: (800) 524-4458 O C S I C N A R F N A S , . C N I , G I A R C & Y E N I E H : N G I S E D INDEP E NDEN T AUDI TO RS Ernst & Young, LLP 8484 Westpark Drive McLean, VA 22102 Phone: (703) 747-1000 F ORM 10-K A copy of the Company’s annual report on Form 10-K as ﬁ led with the Securities and Exchange Commission may be obtained without charge by contacting Investor Relations. CE O AN D CFO CE RT IFICATI ON S In 2007, the Company’s Chief Executive Ofﬁ cer provided to the New York Stock Exchange the Annual CEO Certiﬁ cation regarding the Company’s compliance with the New York Stock Exchange’s corporate governance listing standards. In addition, the Company’s CEO and CFO ﬁ led with the Securities and Exchange Commission the certiﬁ cations required by Sections 302 and 404 of the Sarbanes-Oxley Act of 2002 regarding the quality of the Company’s public disclosures in its 2007 annual report on Form 10-K. STOCK LISTI NG S NYSE–AVB This Annual Report, including the Letter to Shareholders, 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-Looking Statements” on page 32 of this report for a discussion regarding risks associated with these statements. Non-GAAP ﬁ nancial measures and other terms as used in this report are deﬁ ned and reconciled beginning on page 61 in the section titled, “Deﬁ nitions and Reconciliations of Non-GAAP Financial Measures and Other Terms.” For Our Shareholders and Our Customers Excellent Execution Excellent Execution For Our Shareholders Avalon Chrystie Place, NY TO OUR SHAREHOLDERS We enjoyed a number of accomplishments in 2007, accomplishments that became more meaningful and noteworthy during the year as the public real estate and capital markets adjusted to reﬂ ect increased uncertainty in the economic outlook. The year began on a positive note with our entry into the S&P 500 Index and completion of an opportunistic equity offering. By mid-year, market volatility sparked by the sub-prime crisis became the tipping point for a global re-pricing of risk. Although our operating funda- mentals remained solid throughout the year, the impact of this re-pricing was felt by all asset classes, including public valuation of our apartment assets. At a time of increased volatility in the ﬁ nancial markets, we remain committed to building value through Excellent Execution, adjusting our plans to optimize performance in an uncer- tain market climate. In this letter, we’ll look back at 2007 and forward to 2008 and beyond, discussing the economic outlook and its impact on the fundamentals of our business that sup- port earnings growth and mitigate risk. We’ll also highlight Excellent Execution in several areas of our business which over time have supported a business model that consistently delivers sector leading operating and investment returns to investors. 2007 IN REVIEW In last year’s report, Building Value was the theme we established to recognize the multiple growth platforms – new development, redevelopment, operations, and investment management – that create value for shareholders. Much was accomplished in 2007 through these platforms: 30.0% 25.0% 15.0% 5.0% e t a R h t w o r G l a u n n A d n u o p m o C TOTA L SHAREH OLDE R RET URN (1 ) % 1 . 4 2 % 1 . 1 1 % 6 . 6 % 1 . 4 % 1 . 2 1 % 8 . 0 1 % 7 . 4 1 % 0 . 0 1 % 2 . 4 3 year 5 year 10 year AVB Multifamily Sector Avg. S&P Source: SNL Financial • Net Operating Income (NOI) from our Same Store portfolio increased 7.2%, driven by revenue growth of 5.5% and modest expense growth of 2.1%. • Funds from Operations (FFO) increased 8.7% or 13.4% after adjusting for land sales. This was our third consecutive year of 10%+ growth in FFO after adjusting for land sales. • We delivered eight communities containing over 1,700 apartment homes with a Total Capital Cost of $440 million. Development underway and in planning grew to $6 billion. • We selectively sold $275 million in assets, generating an Economic Gain of $145 million and an 18% Unleveraged IRR on our invest- ment, conﬁ rming the value created through our investment activities. 2 AvalonBay Communities, Inc. • We acquired $325 million in new communities, and expanded our redevelopment activity, completing the renovation of ﬁ ve communities and starting redevelopment of four communities. • We completed the initial investment of capital sourced from our discretionary institutional investment management fund. These results provide the support for our actions aimed at returning value to our shareholders: • In 2007, our Board of Directors raised the dividend 9.0% and in February of this year approved an increase of 5.0% in our dividend. Over the last ten years, our dividend has increased over 100%, more than twice the Multifamily Sector Average. • We opportunistically expanded our share repurchasing program, acquiring $300 million in the latter half of 2007 and early 2008. Avalon Del Rey, CA h t w o r G e s n e p x E g n i t a r e p O l a u n n A 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% CO N TROLL ING E XPE NSES (4) % 3 4 . % 9 3 . % 5 2 . % 3 2 . % 7 3 . % 8 1 . . % 8 % 2 2 2 . 2004 2005 2006 2007 AVB Multifamily Sector Avg. Source: Green Street Advisors, SNL Financial • The strong headwinds faced by the REIT sector in 2007 were reﬂ ected in our returns for 2007. We experienced the ﬁ rst decline in Total Shareholder Return since 2002: -25%. Longer term, Total Shareholder Return has been outstanding, with average annual returns of 11%, 24% and 15% over a 3, 5 and 10 year period, respectively. These returns reﬂ ect the value and dura- bility of a business model that has delivered outsized risk adjusted returns over an entire business cycle. And ﬁ nally, AvalonBay was recognized for its success in taking care of the residents who call our communities their home. We were honored with the “Property Management Company of the Year” award by the National Association of Home Builders. This award recognizes that ﬁ nancial success in our industry is built on well managed properties tended by ﬁ rst-class associates pro- viding an outstanding living experience to our residents. Turning to the economy and capital markets, weakness in the for-sale housing market is impact- ing economic growth. Unsold inventory reached record levels and home prices are declining in most markets. As expected, job growth - a key driver of renter demand - slowed steadily during 2007, driven by the loss of 400,000 jobs in housing related industries. Avalon Danvers, MA AvalonBay Communities, Inc. 3 Excellent Execution Finding Extraordinary Opportunities to Create Unique Communities The redevelopment of a prominent historic landmark on Boston’s North Shore showcased our develop- ment talents. By adaptively reusing the historic build- ing and adding a variety of building and apartment styles targeted to different demographic segments, we created both an attractive community and an attractive investment. Since comple- tion, Avalon Danvers has garnered considerable local, regional and national atten- tion and added to our repu- tation as a market leader. 4 AvalonBay Communities, Inc. The weakness in housing spread to the capital markets, as rising delinquencies in lower qual- ity mortgage loans led to a broad re-pricing of risk among many asset classes. The “sub-prime mortgage” was a new term for many of us - a little known but large segment of the mort- gage market that became the big story in 2007. Credit markets contracted, liquidity became constrained and the cost of credit as measured by spreads widened. Our ﬁ nancial ﬂ exibility enabled us to respond to tightening capital markets by expanding our existing unsecured credit facility by $350 million to $1 billion, providing additional cost effective capital. THE APARTMENT MARKET: CURRENT FUNDAMENTALS AND OUTLOOK Going into 2008, third party forecasts suggest that GDP and job growth will be at levels below long-term averages. While a slower economy merits caution in our outlook for 2008, other factors work in favor of apartment demand in our markets: • We expect the economics of renting vs. buying will continue to favor rental apartments for the next several years. While falling home prices should marginally improve affordabil- ity, the cost of home ownership will remain higher in our markets compared to elsewhere in the U.S. Further, tighter lending restrictions are likely to limit the number of current renters that are able to qualify for a mortgage and purchase a home. rent • Demographic changes will ensure a steady increase in new renters, as the age segments with the greatest are to propensity expected to grow. According the National Multi- Housing Council, demo- should graphic add 150,000 renters annu- ally over the next ﬁ ve years. changes to ACCELERATING RENTER POPU LATI ON(5) 5 . 6 6 7 . 6 6 7 . 6 6 0 . 6 6 4 . 5 6 6 . 4 6 7 . 3 6 9 . 2 6 2 . 2 6 6 . 1 6 . 3 1 6 ) s n o i l l i m ( 4 3 - 0 2 e g A s n o i t a l u p o P S U 68 67 66 65 64 63 62 60 59 58 • Apartment construction levels will remain at or below 2005 2006 2007 2008E 2009E 2010E 2011E 2012E 2013E 2014E 2015E Source: National Multi-Housing Council historic levels in most of our markets in 2008. Some unsold housing inventory is being converted to rental housing by their owners. However, this ‘shadow’ supply is less of a factor in our markets compared to overbuilt markets in the Southwest and Florida, supporting our strategy of choosing supply-constrained markets. WILSHIRE LOS ANGEL ES, CA AvalonBay Communities, Inc. 5 LYNDHURST LY NDH URST, NJ 6 AvalonBay Communities, Inc. DE C LI NI NG H OM E OW N E RSH I P (6) e t a R p i h s r e n w o e m o H . S . U ) 7 0 0 2 Q 4 h g u o r h T a t a D ( 69.5% 69.0% 68.5% 68.0% 67.5% 67.0% 2000 2001 2002 2003 2004 2005 2006 2007 Source: Census Bureau • Over the last 24 months, the homeownership rate has declined from over 69% to approximately 68% and is predicted to continue falling. For in every 1% decline home ownership, an estimated 500,000 rent- ers emerge. RESPONDING TO CHALLENGES AND OPPORTUNITIES: EXCELLENT EXECUTION Embedded in our continuous focus on Excellent Execution is the practical reality that what we do is hard. What follows are examples of value creation through Excellent Execution by AvalonBay: in our high barrier-to-entry markets, in the diversity of the product we deliver, in our intense focus on our customer and in our ﬂ exible capital structure, all of which create, preserve and enhance value. Excellent Execution in Our High Barrier-to-Entry Markets The markets in which we operate are very competitive markets to secure land, difﬁ cult markets to secure entitlements and expensive markets in which to build. Here are a few examples of how our development teams around the country respond to the challenges imposed by our markets: • In New York City, we acquired a development site with spectacular views along the East River. The site required a clean-up plan to remove contaminated soil. Executed under the direction of AvalonBay’s construction division, all excavation and soil removal was carried out under a tent that covered an area bigger than a football ﬁ eld. Recently completed, our Avalon Riverview North high-rise community is leasing at rental rates well above projected levels. • In the San Francisco Bay Area, we agreed to manage construction of a 1,500-car, $45 million parking structure for the BART transit agency to secure approval for our Avalon at Dublin Station apartment community located adjacent to a key BART station. The challenges imposed by this construction effectively eliminated most of our competitors, and our efforts directly resulted in our winning control of development opportunities adjacent to two other BART stations. In total, these three sites represent $469 million of development opportunities at three of the region’s key transit nodes. Excellent Execution 2007 Property Management Company of the Year Over the years, we’ve implemented a series of initiatives to build a “culture of service” within both our communities and the orga- nization: customer research, full-service call centers, advance training for associ- ates and innovative recruit- ing. We’re proud AvalonBay was cited for our ability to employ “strategic cutting edge technologies to control operating expenses”, while at the same time providing an unparalleled living expe- rience for our residents. AvalonBay Communities, Inc. 7 Excellent Execution Focusing on our Customer To ensure that we continue delivering great service to our residents, we have opened a new, state-of-the- art Customer Care Center (CCC). Certain accounting and administrative func- tions, once the responsibility of the Community Manager at each of our 184 communi- ties, are being centralized and transferred to special- ists at the CCC. This frees up more time for associates at our communities to focus on leasing and meeting the needs of our residents. Functions are being trans- ferred by region and we expect the CCC to be fully operational by mid-2009. 8 AvalonBay Communities, Inc. • Over the years, we’ve built entire utility infrastructures (roads, water treatment plants), redeveloped hospitals into apartments and built a golf course, marina and ball ﬁ elds as part of the approval process. Through Excellent Execution, challenges become opportunities. Excellent Execution in the Product We Deliver To meet the needs of our customers, we’ve developed an expertise in both building and oper- ating a broad range of apartment communities. • From garden apartments to 50-story high rise buildings, our integrated in-house construction and development platform allows us to achieve better control over quality, cost and schedule. Centralized support for design, estimating and purchasing, and established processes help optimize value creation while mitigating risk. It’s why we have delivered over $3 billion of new construction within ± 3% of the original budgets over the past ten years. $600 $300 $450 s n o i l l i PROV EN TRACK R EC ORD (7) • A retail component is often required for new develop- ment to compete success- fully in urban markets. By into our incorporating communities quality gro- cers such as Whole Foods® and Safeway®, and other retailers such as Starbucks® and Panera®, we create convenience for our resi- dents and add value to our the communities. Over years, we’ve added experienced retail professionals and new systems to support retail. ($150) ($300) M n $150 i $ $0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Development Completed Total Capital Cost Over/(Under) Budgeted Cost 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% Excellent Execution through Focus on Our Customer Our residents pay the highest average rent in our sector and they expect great service. We con- tinuously seek to improve the way we do business on-site, minimizing administrative effort and providing more time for customer focused activities: • Our new Customer Care Center in Virginia Beach, VA is the result of a major initiative to centralize on-site operations such as processing lease applications, rent checks, invoices, lease renewals and resident inquiries. Adding other corporate functions in accounting, payroll and accounts payable adds critical mass in a lower cost location. BOWERY PLACE NEW YORK, NY AvalonBay Communities, Inc. 9 • Using new technology, we implemented an online survey process to gauge resident satisfaction. We receive real-time feedback from residents at three critical touchpoints - move-in, renewal and move-out - allowing our onsite teams to address customer concerns and promptly make changes to our daily operations. Excellent Execution in Our Capital Structure Our balance sheet provides ﬂ exibility to match the most attractive source of capital with our investment activity, as evidenced by these impressive metrics (as of December 31, 2007): • A Fixed Charge Ratio of 4.1 supports our ability to service debt obligations. Avalon Centerpoint, MD • Unencumbered assets exceed 80%, providing ﬁ nancial ﬂ exibility for uncertain capital market conditions. • Debt to Total Market Capitalization is just 30%. • Floating rate debt makes up just 10% of our capital structure, providing modest interest rate risk while better matching interest rate trends with revenue trends. • A Dividend Payout Ratio of 74% supports a safe and growing dividend. Whether through our $1 billion credit facility, selling assets at attractive prices, or harvesting value through the sale of partnership interests, ﬁ nancial ﬂ exibility allows us to access a variety of capital sources at a time when the capital markets are volatile and liquidity is constrained. FL EXIBLE CAPITAL STR UCTURE (8) Total Fixed-Rate Debt 20% Total Variable-Rate Debt 10% LOOKING FORWARD Equity 70% Excellent Execution is both a timely and timeless element of our successful strategy of more deeply penetrating our chosen markets with a broad range of products and services and with an intense focus on our customer. In a time of increased economic volatility, our plan for 2008 provides us with the ﬂ exibility to create value from several growth platforms: Avalon Wilshire, CA 10 AvalonBay Communities, Inc. • We add value through development. We have $6 billion either under construction or in planning. With our recent initial development yields approximately 150 basis points above market Cap Rates, the implied initial proﬁ t margin on our new investment activity is attractive. • We add value by redeveloping existing assets. We reorganized our investments and construc- tion groups to create a team of associates solely dedicated to redeveloping existing assets. We anticipate 19 communities will be in redevelopment during 2008. • We add value through our existing portfolio of operating apartments. We anticipate NOI growth of 3.0% to 4.5% in 2008, providing cash ﬂ ow and value growth from a large base of stabilized assets. L ONG - TERM OU TPE RFORMA N CE (1,2,3) e t a R h t w o r G l a u n n A d n u o p m o C r a e Y - 0 1 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% % 5 . 9 1 % 5 . 6 % 6 . 2 % 1 . 6 FFO NAV % 7 . 4 1 % 0 . 0 1 Total Shareholder Return AVB Multifamily Sector Avg. Source: SNL Financial, Green Street Advisors Our extended track record of out-performance in such key metrics as NAV, FFO and dividend growth could only be accomplished through a sustained level of Excellent Execution. We have a seasoned management team that understands how to maximize value during all phases of a real estate cycle. Our time tested strategy has delivered long- term performance near the top of the sector in the most important attributes investors value – earn- ings growth, NAV, dividends and Total Shareholder Return. A durable strategy that, through Excellent Execution, will support value creation for years to come. As always, we thank our shareholders for their continued support, our associates for their out- standing results and our residents for making an AvalonBay community their home. BRYCE BLAIR CHAIRMAN & CHIEF EXECUTIVE OFFICER Avalon Shrewsbury, MA Avalon on the Sound East, NY AvalonBay Communities, Inc. 11 NOTES & NON-GAAP FINANCIAL MEASURES AND OTHER TERMS NOTES NON-GAAP FINANCIAL MEASURES AND OTHER TERMS 1. Total Shareholder Return: The change in value over the period stated with all dividends reinvested. Total Shareholder Return is sometimes presented as the compound annual growth rate. The Total Shareholder Return for each year within the time- frame presented may vary. The following non-GAAP ﬁ nancial measures and other terms, as used in this Annual Report, including the Letter to Sharehold- ers, are deﬁ ned and further explained herein on pages 61-65 in the section titled “Deﬁ nitions and Reconciliations of Non-GAAP Financial Measures and Other Terms” and in the notes above: 2. Estimated NAV per Share Growth: The compound annual growth rate of Estimated NAV per Share as estimated 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. 4. Operating Expense Growth: Operating expense growth for the same-unit pool was compiled from individual company documents and published by Green Street Advisors, Inc. Full year change is based on the average of the four quarters for each year, to reﬂ ect the changes in properties included in same-unit results. 5. Accelerating Renter Population: Assumes 60% renter pro- pensity within 20-34 year old age cohort, per National Multi-Housing Council estimates. 6. Homeownership Rate: Deﬁ ned as percentage of total occu- pied U.S. households that are owner-occupied. Latest data as of Fourth Quarter 2007. 7. Development Completed represents Total Capital Cost of annual completions. 8. Percentages for Equity and Fixed and Variable Rate Debt represent the dollar amounts for each as a percentage of the Company’s Total Market Capitalization at December 31, 2007 (see “Leverage”). • Net Asset Value (NAV) • Fixed Charge Coverage (Interest Coverage) • Funds from Operations (FFO) • Initial Year Market Capitalization Rate (Cap Rate) • Leverage • Multifamily REIT Sector Average • Net Operating Income (NOI) • Projected NOI • Total Capital Cost • Economic Gain • Same Store (Established) Communities • Stabilized/Restabilized Operations • Dividend Payout Ratio • Unleveraged IRR • Stock Performance Graph FORWARD-LOOKING STATEMENTS This Annual Report, including the Letter to Shareholders, con- tains “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-Looking Statements” on page 28 of this report for a discussion regarding risks associated with these statements. 12 AvalonBay Communities, Inc. 2007 FINANCIAL REVIEW 14 16 31 32 33 34 35 37 58 60 61 Selected Financial Data Management’s Discussion and Analysis of Financial Condition and Results of Operations Quantitative and Qualitative Disclosures About Market Risk Consolidated Balance Sheets Consolidated Statements of Operations and Other Comprehesive Income Consolidated Statements of Stockholders’ Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Report of Independent Registered Public Accounting Firm Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Deﬁ nitions and Reconciliations of Non-GAAP Financial Measures and Other Terms 66 AvalonBay Corporate Information AvalonBay Communities, Inc. 13 AvalonBay Communities, Inc. 13 SELECTED FINANCIAL DATA The following table provides historical consolidated ﬁ nancial, 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) 12-31-07 12-31-06 12-31-05 12-31-04 12-31-03 Revenue: Rental and other income Management, development and other fees $ 806,599 6,142 $ 715,170 6,259 $ 650,907 4,304 $ 598,656 604 $ 545,794 896 Total revenue 812,741 721,429 655,211 599,260 546,690 For the year ended Expenses: Operating expenses, excluding property taxes Property taxes Interest expense, net Depreciation expense General and administrative expense Total expenses Equity in income of unconsolidated entities Venture partner interest in proﬁ t-sharing Minority interest in consolidated partnerships Gain on sale of communities Income from continuing operations before cumulative effect of change in accounting principle Discontinued operations: Income from discontinued operations Gain on sale of communities Total discontinued operations Income before cumulative effect of change in accounting principle 242,702 74,912 97,545 179,549 28,494 623,202 59,169 — (1,585) 545 217,134 66,786 109,184 160,442 24,767 578,313 7,455 — (573) 13,519 197,990 63,975 125,171 156,455 25,761 569,352 7,198 — (1,481) 4,479 187,804 57,907 129,106 149,721 18,074 542,612 1,100 (1,178) (150) 1,138 169,039 52,215 128,183 137,311 14,830 501,578 25,535 (1,688) (950) 1,234 247,668 163,517 96,055 57,558 69,243 4,005 106,487 110,492 5,618 97,411 103,029 19,126 195,287 214,413 24,387 121,287 145,674 33,504 159,756 193,260 358,160 266,546 310,468 203,232 262,503 Cumulative effect of change in accounting principle — — — 4,547 — Net income Dividends attributable to preferred stock 358,160 (8,700) 266,546 (8,700) 310,468 (8,700) 207,779 (8,700) 262,503 (10,744) Net income available to common stockholders $ 349,460 $ 257,846 $ 301,768 $ 199,079 $ 251,759 Per Common Share and Share Information: Earnings per common share—basic: Income from continuing operations (net of dividends attributable to preferred stock) Discontinued operations $ 3.04 1.40 $ 2.09 1.39 $ 1.20 2.94 $ 0.75 2.03 $ 0.85 2.82 Net income available to common stockholders $ 4.44 $ 3.48 $ 4.14 $ 2.78 $ 3.67 Weighted average common shares outstanding—basic Earnings per common share—diluted: Income from continuing operations (net of dividends attributable to preferred stock) Discontinued operations 78,680,043 74,125,795 72,952,492 71,564,202 68,559,657 $ 3.00 1.38 $ 2.06 1.36 $ 1.18 2.87 $ 0.75 2.00 $ 0.84 2.76 Net income available to common stockholders $ 4.38 $ 3.42 $ 4.05 $ 2.75 $ 3.60 Weighted average common shares outstanding—diluted 79,856,927 75,586,898 74,759,318 73,354,956 70,203,467 Cash dividends declared $ 3.40 $ 3.12 $ 2.84 $ 2.80 $ 2.80 14 AvalonBay Communities, Inc. For the year ended (Dollars in thousands, except per share information) 12-31-07 12-31-06 12-31-05 12-31-04 12-31-03 Other Information: Net income Depreciation—continuing operations Depreciation—discontinued operations Interest expense, net—continuing operations Interest expense, net—discontinued operations $ 358,160 179,549 2,176 97,545 687 $ 266,546 160,442 3,687 109,184 1,862 $ 310,468 156,455 6,842 125,171 1,927 $ 207,779 149,721 14,179 129,106 2,522 $ 262,503 137,311 17,414 128,183 4,394 EBITDA(1) $ 638,117 $ 541,721 $ 600,863 $ 503,307 $ 549,805 Funds from Operations(2) Number of Current Communities(3) Number of apartment homes $ 368,057 163 45,932 $ 320,199 150 43,141 $ 271,096 143 41,412 $ 235,514 138 40,142 $ 222,473 131 38,504 Balance Sheet Information: Real estate, before accumulated depreciation Total assets Notes payable and unsecured credit facilities Cash Flow Information: Net cash ﬂ ows provided by operating activities Net cash ﬂ ows provided by (used in) investing activities Net cash ﬂ ows provided by (used in) ﬁ nancing activities Notes to Selected Financial Data $7,556,740 $6,736,484 $3,208,202 $6,615,593 $5,848,507 $2,866,433 $5,940,146 $5,198,598 $2,334,017 $5,734,122 $5,116,019 $2,451,354 $5,468,735 $4,945,585 $2,337,817 $ 455,825 $ 351,660 $ 306,248 $ 275,617 $ 239,677 $ (809,247) $ (511,371) $ (19,761) $ (251,683) $ 33,935 $ 366,360 $ 162,280 $ (282,293) $ (29,471) $ (279,465) (1) EBITDA is deﬁ ned as net income before interest income and expense, income taxes, depreciation and amortization from both continuing and discontinued operations. Under this deﬁ nition, EBITDA includes gains on sale of assets and gain on sale of partnership interests. Management generally considers 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 alternative to net income (as determined in accordance with generally accepted accounting principles, or “GAAP”), as an indicator of our operating performance, or to cash ﬂ ows from operating activities (as determined in accordance with GAAP) as a measure of liquidity. Our calculation of EBITDA may not be comparable to EBITDA as calculated by other companies. (2) We generally consider Funds from Operations, or “FFO,” as deﬁ ned below, to be an appropriate supplemental measure of our operating and ﬁ nancial performance because, by excluding gains or losses related to dispositions of previously depreciated property and excluding real estate depreciation, which can vary 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 the Consolidated Statements of Operations and Other Comprehensive Income included elsewhere in this report. (3) Current Communities consist of all communities other than those which are still under construction and have not received a certiﬁ cate of occupancy. Consistent with the deﬁ nition 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 ventures. FFO does not represent net income in accordance with GAAP, and therefore it should not be considered an alternative to net income, which remains the primary measure, as an indication of our performance. In addition, FFO as calculated by other REITs may not be comparable to our calculation of FFO. FFO also does not represent cash generated from operating activities in accordance with GAAP, and therefore should not be considered an alternative to net cash ﬂ ows from operating activities, as determined by GAAP, as a measure of liquidity. Additionally, it is not necessarily indicative of cash available to fund cash needs. A presentation of GAAP based cash ﬂ ow metrics is provided in “Cash Flow Information” in the table above. The following is a reconciliation of net income to FFO (dollars in thousands, except per share data) For the year ended (Dollars in thousands, except per share data) 12-31-07 12-31-06 12-31-05 12-31-04 12-31-03 Net income Dividends attributable to preferred stock Depreciation—real estate assets, including discontinued operations and joint venture adjustments Minority interest expense, including discontinued operations Gain on sale of unconsolidated entities holding previously depreciated real estate assets 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 $358,160 (8,700) $266,546 (8,700) $310,468 (8,700) $207,779 (8,700) $262,503 (10,744) 184,731 165,982 163,252 159,221 129,207 280 391 1,363 3,048 1,263 (59,927) — (6,609) — — — — (4,547) — — (106,487) (97,411) (195,287) (121,287) (159,756) $368,057 $320,199 $271,096 $235,514 $222,473 79,856,927 $ 4.61 75,586,898 $ 4.24 74,759,318 $ 3.63 73,354,956 $ 3.21 70,203,467 $ 3.17 AvalonBay Communities, Inc. 15 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help provide an understanding of our business and results of operations. This MD&A should be read in conjunction with our Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this report. This report, including the following MD&A, contains forward-looking statements regarding future events or trends as described more fully under “Forward-Looking Statements” included in this report. Actual results or developments could differ materially from those projected in such statements. Executive Overview Business Description We are primarily engaged in developing, acquiring, owning and operating apartment communities in high barrier- to-entry markets of the United States. We believe that apartment communities are 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. However, throughout the real estate cycle, apartment market fundamentals, and therefore operating cash ﬂ ows, are affected by overall economic conditions. We seek to create long-term shareholder value by accessing capital on cost effective terms; deploying that capital to develop, redevelop and acquire apartment communities in high barrier-to-entry markets; operating apartment communities; and selling communities when they no longer meet our long-term investment strategy or when pricing is attractive. Barriers-to-entry in our markets generally include a difﬁ cult 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, Paciﬁ c Northwest, and Northern and Southern California regions of the United States. Our strategy is to more deeply penetrate these markets with a broad range of products and services and an intense focus on our customer. Our communities are predominately 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 services. Financial Highlights and Outlook Net income available to common stockholders for the quarter ended December 31, 2007 was $129,644,000, as compared to $44,138,000 for the quarter ended December 31, 2006, an increase of 193.7%. For the year ended December 31, 2007, net income available to common stockholders was $349,460,000 compared to $257,846,000 for 2006, an increase of 35.5%. These increases are primarily attributable to an increase in gains from the sale of communities and joint venture real estate investments in 2007 as compared to 2006 and growth in income from existing and newly developed communities in 2007. Apartment fundamentals remained positive in 2007 as evidenced by full year-over-year rental revenue growth of 5.5% achieved within our Established Community portfolio (as deﬁ ned later in this report), comprised of an increase in rental rates of 5.8% and a decrease in occupancy of 0.3%. This revenue growth combined with constrained expense growth contributed to our Established Community portfolio achieving year-over-year growth in net operating income (“NOI”) of 7.2% in 2007. For the fourth quarter of 2007, our Established Communities experienced an increase in rental revenue of 4.4% and a corresponding increase in NOI of 4.9% over the prior year period, evidencing the moderating, but continued growth in operations. Projected growth in earnings per share – diluted (“EPS”) in our current ﬁ nancial outlook is expected to be between 48.4% and 94.1% driven primarily by gains on the sale of communities that may occur under our expanded disposition program. In addition, we expect that our Established Communities will continue to show revenue and net operating income growth in 2008, but at a lesser rate relative to growth levels in 2007. Despite third party forecasts of a weaker economic environment, we anticipate positive renter demand resulting from a continued reduction in homeownership rates and a general increase in the propensity to rent. Declining home ownership rates are the result of a number of factors, including concerns regarding home prices and economic growth, demographic growth in those age groups that have historically demonstrated a higher propensity to rent as well as tighter underwriting standards for mortgages. Management expects the level of new rental completions in the Company’s markets will decline modestly during 2008 from 2007 levels and competition from unsold housing inventory made available for rent will remain modest relative to more oversupplied residential markets in the U.S. Overall we expect apartment market fundamentals will be balanced in our markets, supporting moderate growth in earnings. Our current ﬁ nancial outlook provides for 2008 rental growth of 2.5% to 4.0% in our established community portfolio and projected NOI growth of 3.0% to 4.5% We expect that our development activity will continue to create long-term value. We currently have approximately $2,162,500,000 under construction (measured by total projected capitalized cost of the communities at completion, including the portions in which joint venture partners hold an equity or economic interest). For 2008, we expect new development starts in the range of $900,000,000 to $1,100,000,000 measured at projected cost of completion, including projects that may be developed through joint ventures. This is a decrease in new 16 AvalonBay Communities, Inc. activity from 2007 reﬂ ecting the current economic and capital market conditions. We continue to be selective in pursuing new development opportunities. Land prices generally have not re-set in most of our markets, but we are seeing construction cost increases stabilizing. Construction costs for certain materials have begun to decline while prices for other materials remain high given strong global demand. There is also greater availability of experienced subcontractors and trade professionals as a result of slowing construction in both the condominium and single-family housing markets. We continue to selectively secure new Development Rights, including the acquisition of land for future development. We currently have Development Rights for construction of new apartment communities that would, if developed as expected, total approximately $3,918,000,000 based on total projected capitalized costs at December 31, 2007. We also expect to increase our redevelopment activities in 2008, for both wholly owned and Fund (as deﬁ ned below) related assets. While current market conditions with respect to liquidity may impact the types of funding sources used, we believe that our current level of indebtedness, our current ability to service interest and other ﬁ xed charges and our current limited use of ﬁ nancial encumbrances (such as secured ﬁ nancing) on our assets provide us with the ﬁ nancial position and ﬁ nancial ﬂ exibility to access the capital necessary to fund our development and redevelopment activities. We expect to meet these needs from both secured and unsecured debt, as well as asset sales and retained cash. AvalonBay Value Added Fund, L.P. (the “Fund”) is a discretionary investment fund in which we hold a 15% interest. The Fund has been our principal vehicle for acquiring apartment communities subject to certain exceptions, since its formation in March 2005. The Fund acquired seven communities for an aggregate purchase price of $305,450,000 during 2007. As of January 31, 2008, the total amount invested by the Fund is $779,318,000. Management of the Fund expects to invest approximately $39,000,000 of additional funds to redevelop the assets acquired, at which time, the Fund will become fully invested. We are exploring various potential sources and vehicles for funding future acquisitions after the Fund is fully invested. We continue to see real estate capital ﬂ ows from income investors. In 2007, we completed the disposition of four communities and one partnership interest for an aggregate gross sales price of $268,096,000. Given the current levels of demand from investors for high quality multifamily real estate assets, we anticipate increasing our level of disposition activity to a range of $700,000,000 to $1,000,000,000 in 2008. Actual disposition activity will depend on various factors including market and economic conditions. Communities Overview 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 options to purchase land held for development). Our current operating communities are further distinguished as Established Communities, Other Stabilized Communities, Lease-Up Communities and Redevelopment Communities. Established Communities are generally operating communities that are consolidated for ﬁ nancial 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 consolidated operating communities that have stabilized occupancy and operating expenses during the current year, but had not achieved stabilization as of the beginning of the prior year. Lease-Up Communities consist of communities where construction is complete but stabilization has not been achieved. Redevelopment Communities consist of communities where substantial redevelopment is in progress or is planned to begin during the current year. A more detailed description of our reportable segments and other related operating information can be found in Note 9, “Segment Reporting,” of our Consolidated Financial Statements. Although each of these categories is important to our business, we generally evaluate overall operating, industry and market trends 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 current and future cash needs and future operating potential based on acquisition, disposition, development, redevelopment and ﬁ nancing activities within Other Stabilized, Redevelopment and Development Communities, and discussions related to these segments of our business can be found in “Liquidity and Capital Resources.” The net operating income of our current operating communities, as deﬁ ned 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 ﬁ nancial performance is also impacted by the general availability and cost of capital and the performance of newly developed and acquired apartment communities. As of December 31, 2007, we owned or held a direct or indirect ownership interest in 184 apartment communities containing 52,748 apartment homes in ten states and the District of Columbia, of which 21 communities were under construction and eight communities were under reconstruction. Of these communities, 23 were owned by entities that were not consolidated for ﬁ nancial reporting purposes, including 20 owned by the Fund. In addition, we owned a direct or indirect ownership interest in Development Rights to develop an additional 48 communities that, if developed in the manner expected, will contain an estimated 13,656 apartment homes. AvalonBay Communities, Inc. 17 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Results of Operations Our year-over-year operating performance is primarily affected by individual geographic market conditions and apartment fundamentals as measured by changes in net operating income of our Established Communities; net operating income derived from acquisitions and development completions; the loss of net operating income related to disposed communities; and capital market, disposition and ﬁ nancing activity. A comparison of our operating results for the years 2007, 2006 and 2005 follows: Change Change (Dollars in thousands) 2007 2006 $ % 2006 2005 $ % Revenue: Rental and other income Management, development and other fees $806,599 $715,170 $91,429 12.8% $715,170 $650,907 $ 64,263 9.9% 6,142 6,259 (117) (1.9%) 6,259 4,304 1,955 45.4% Total revenue 812,741 721,429 91,312 12.7% 721,429 655,211 66,218 10.1% Expenses: Direct property operating expenses, excluding property taxes Property taxes 192,338 74,912 175,927 66,786 16,411 8,126 9.3% 12.2% 175,927 66,786 161,913 63,975 14,014 2,811 Total community operating expenses 267,250 242,713 24,537 10.1% 242,713 225,888 16,825 8.7% 4.4% 7.4% Corporate-level property management and other indirect operating expenses Investments and investment management Interest expense, net Depreciation expense General and administrative expense 38,627 34,177 4,450 13.0% 34,177 31,243 2,934 9.4% 11,737 97,545 179,549 28,494 7,030 109,184 160,442 24,767 4,707 (11,639) 19,107 3,727 67.0% (10.7%) 11.9% 15.0% 7,030 109,184 160,442 24,767 4,834 125,171 156,455 25,761 2,196 (15,987) 3,987 (994) 45.4% (12.8%) 2.5% (3.9%) Total other expenses 355,952 335,600 20,352 6.1% 335,600 343,464 (7,864) (2.3%) Equity in income of unconsolidated entities Minority interest in consolidated partnerships Gain on sale of land Income from continuing operations Discontinued operations: Income from discontinued operations Gain on sale of communities 59,169 7,455 51,714 693.7% 7,455 7,198 257 3.6% (1,585) 545 (573) 13,519 (1,012) 176.6% (96.0%) (12,974) (573) 13,519 (1,481) 4,479 908 (61.3%) 9,040 201.8% 247,668 163,517 84,151 51.5% 163,517 96,055 67,462 70.2% 4,005 106,487 5,618 97,411 (1,613) 9,076 (28.7%) 9.3% 5,618 97,411 19,126 195,287 (13,508) (97,876) (70.6%) (50.1%) Total discontinued operations 110,492 103,029 7,463 7.2% 103,029 214,413 (111,384) (51.9%) Net income Dividends attributable to preferred stock Net income available to common stockholders 358,160 266,546 91,614 34.4% 266,546 310,468 (43,922) (14.1%) (8,700) (8,700) — — (8,700) (8,700) — — $349,460 $257,846 $91,614 35.5% $257,846 $301,768 $(43,922) (14.6%) Net income available to common stockholders increased $91,614,000 or 35.5%, to $349,460,000 in 2007 due primarily to sales of consolidated operating communities and investments in unconsolidated entities and related gains occurring in 2007 combined with growth in net operating income from Established Communities and contributions to net operating income from newly developed communities in 2007. Net income available to common stockholders decreased $43,922,000, or 14.6%, to $257,846,000 in 2006, primarily attributable to reduced asset sales and the related gains, partially offset by growth in net operating income from Established Communities and contributions to net operating income from newly developed communities. Net operating income (“NOI”) is considered by management to be an important and appropriate supplemental performance measure to net income because it helps both investors and management to understand the core operations of a community or communities prior to the allocation of any corporate-level or ﬁ nancing-related costs. NOI reﬂ ects the operating performance of a community and allows for an easy comparison of the operating performance of individual assets or groups of assets. In addition, because prospective buyers of real estate have different ﬁ nancing and overhead structures, with varying marginal impacts to overhead by acquiring real estate, NOI is considered by many in the real estate industry to be a useful measure for determining the value of a real estate asset or group of assets. We deﬁ ne NOI as total property revenue less direct property operating expenses, including property taxes. 18 AvalonBay Communities, Inc. NOI does not represent cash generated from operating activities in accordance with U.S. generally accepted accounting principles (“GAAP”). Therefore, NOI should not be considered an alternative to net income as an indication of our performance. NOI should also not be considered an alternative to net cash ﬂ ow from operating activities, as determined 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, 2007, 2006 and 2005, along with reconciliation to net income for each year, is as follows: (Dollars in thousands) 12-31-07 12-31-06 12-31-05 For the year ended Net income Indirect operating expenses, net of corporate income Investments and investment management Interest expense, net General and administrative expense Equity in income of unconsolidated entities Minority interest in consolidated partnerships Depreciation expense Gain on sale of real estate assets Income from discontinued operations $358,160 31,285 11,737 97,545 28,494 (59,169) 1,585 179,549 (107,032) (4,005) $266,546 28,811 7,030 109,184 24,767 (7,455) 573 160,442 (110,930) (5,618) $310,468 26,675 4,834 125,171 25,761 (7,198) 1,481 156,455 (199,766) (19,126) Net operating income $538,149 $473,350 $424,755 The NOI increases in both 2007 and 2006, as compared to the prior year period, consist of changes in the following categories: (Dollars in thousands) Established Communities Other Stabilized Communities Development and Redevelopment Communities Total 2007 Increase $29,866 10,185 24,748 $64,799 2006 Increase $32,083 5,379 11,133 $48,595 The NOI increases in Established Communities in 2007 were largely due to continued favorable apartment market fundamentals. During 2007, we continued to focus on rental rate growth, while maintaining occupancy of at least 95% in all regions. We anticipate that increases in rental rates and overall rental revenue growth will moderate in 2008 as compared to 2007, as we expect a slower rate of job growth (demand) and a decline in new rental completions in our markets (supply). We expect revenue growth from our Established Communities of 2.5% to 4.0% in 2008 as compared to 2007. In addition, we continue to monitor and manage operating expenses to constrain expense growth. We expect operating expenses at our Established Communities to increase by 2.0% to 3.0% in 2008 as compared to 2007 from increasing property tax, labor and utility expenses. Overall, we anticipate growth in NOI from our Established Communities of 3.0% to 4.5% in 2008 as compared to 2007. The Company has given projected NOI growth in 2008 only for Established Communities and not on a company-wide basis. The Company believes that NOI growth of the Established Communities assists investors in understanding management’s estimate of the likely contribution to operations from Established Communities. However, the Company has not provided a projection of NOI growth on a company-wide basis due to the difﬁ culty in projecting the timing of new development starts, dispositions and acquisitions, as well as the complexities involved in projecting the allocation of corporate-level property management overhead, general and administrative costs and interest expense to communities not yet developed, disposed or acquired. NOI growth expected from Established Communities is not a projection of the Company’s projected consolidated ﬁ nancial performance or projected cash ﬂ ow. Rental and other income increased in 2007 as compared to the prior year due to increased rental rates for our Established Communities, coupled with additional rental income generated from newly developed communities. Overall Portfolio — The weighted average number of occupied apartment homes increased to 38,436 apartment homes for 2007 as compared to 37,716 apartment homes for 2006 and 36,520 apartment homes for 2005. This change is primarily the result of increased homes available from newly developed and acquired communities, partially offset by communities sold in 2007 and 2006. The weighted average monthly revenue per occupied apartment home increased to $1,767 in 2007 as compared to $1,610 in 2006 and $1,516 in 2005. Established Communities — Rental revenue increased $34,257,000, or 5.5%, for 2007 and increased $35,871,000, or 6.8% in 2006. These increases are due to increased average rental rates, partially offset by decreased economic occupancy. For 2007, the weighted average monthly revenue per occupied apartment home increased 5.8% to $1,795 compared to $1,697 in 2006, primarily due to increased market rents and the decrease in the amortization of concessions. The higher amortization recognized in 2006 was due to the higher levels of concessions granted in periods prior to 2006. The average economic occupancy decreased 0.3% to 96.3% in 2007. Economic occupancy takes into AvalonBay Communities, Inc. 19 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) account the fact that apartment homes of different sizes and locations within a community have different economic impacts on a community’s gross revenue. Economic occupancy is deﬁ ned as gross potential revenue less vacancy loss, as a percentage of gross potential revenue. Gross potential revenue is determined by valuing occupied homes at leased rates and vacant homes at market rents. We experienced increases in Established Communities’ rental revenue in all six of our regions in 2007 as compared to 2006. The largest increases in rental revenue were in the Paciﬁ c Northwest, Northern California and the Mid-Atlantic, with increases of 11.1%, 8.6% and 5.9%, respectively, between years. The Northeast and Northern California regions comprise the majority of our Established Community revenue, and therefore are discussed in more detail below. Northern California, which represented approximately 24.6% of Established Community rental revenue during 2007, experienced an increase in rental revenue of 8.6% in 2007 as compared to 2006. Average rental rates increased by 8.3% to $1,699, and economic occupancy increased 0.3% to 97.0% in 2007. Apartment fundamentals remain strong in Northern California. We expect Northern California to see continued but moderating revenue growth during 2008 at growth levels in excess of those expected in other markets. The Northeast region, which accounted for approximately 42.3% of Established Community rental revenue during 2007, experienced an increase in rental revenue of 3.2% in 2007 as compared to 2006. Average rental rates increased 3.5% to $2,129, and economic occupancy decreased 0.3% to 96.2% in 2007. We expect overall apartment fundamentals in the Northeast region will be balanced during 2008, with slower job growth and except in the Boston area, minimal net new rental supply. Supply-demand fundamentals for New York City and surrounding areas should remain healthy, although changes in employment levels in the ﬁ nancial services industry could cause economic growth to decelerate. Boston will continue to lag the region in revenue growth, as we expect the net new supply from apartment deliveries will outpace improvement in the region’s economy. These factors support our expectation for moderate rental rate growth in 2008. In accordance with GAAP, cash concessions are amortized as an offset to rental revenue over the approximate lease term, which is generally one year. As a supplemental measure, we also present rental revenue with concessions stated on a cash basis to help investors evaluate the impact of both current and historical concessions on GAAP based rental revenue and to more readily enable comparisons to revenue as reported 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 revenue in conformity with GAAP to total rental revenue adjusted to state concessions on a cash basis for our Established Communities for the years ended December 31, 2007 and 2006 (dollars in thousands). Information for the year ended December 31, 2005 is not presented, as Established Community classiﬁ cation is not comparable prior to January 1, 2006. 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 revenue For the year ended 12-31-07 12-31-06 $652,129 6,119 (6,234) $617,872 12,336 (6,236) $652,014 $623,972 5.5% 4.5% n/a n/a Management, development and other fees decreased $117,000, or 1.9% in 2007 and increased $1,955,000 or 45.4% in 2006. The decrease in 2007 was due to lower development and redevelopment management fees, coupled with the loss of fees due to the disposition of our interest in a joint venture, partially offset by increased property management fees from the Fund, as additional communities are acquired. The increase in 2006 over 2005 was due to a full year of management fees from the Fund, which was formed in March 2005. Direct property operating expenses, excluding property taxes increased $16,411,000 or 9.3% and $14,014,000 or 8.7% in 2007 and 2006, respectively, primarily due to the addition of recently developed and acquired apartment homes coupled with expense growth in our Established Communities. For Established Communities, direct property operating expenses, excluding property taxes, increased $1,661,000, or 1.1%, and $3,030,000, or 2.4%, to $148,628,000 and $131,106,000 in 2007 and 2006, respectively, due primarily to increases in other maintenance, marketing and landscaping expenses offset by lower utility and redecorating costs. Property taxes increased $8,126,000 or 12.2% and $2,811,000 or 4.4% in 2007 and 2006, respectively, due to overall higher assessments and the addition of newly developed and redeveloped apartment homes. Property taxes are impacted by the size and timing of successful tax appeals in both years. 20 AvalonBay Communities, Inc. For Established Communities, property taxes increased by $2,618,000, or 4.5%, and $721,000, or 1.4% in 2007 and 2006, respectively, due to higher assessments throughout all regions. Year over year changes are impacted by the size and timing of successful tax appeals. Overall, we expect property taxes in 2008 to increase from 2007 levels due to increased valuations and the addition of newly developed communities. Despite the potential decreases in real estate property values for tax purposes, there is generally a lag to the ultimate recognition of any savings in the real estate tax assessments. In addition, property tax increases are limited by law (Proposition 13) for communities in California. We evaluate property tax increases internally, as well as engage third-party consultants, and appeal increases when appropriate. Corporate-level property management and other indirect operating expenses increased by $4,450,000, or 13.0% and $2,934,000, or 9.4%, in 2007 and 2006, respectively, over the prior year periods due primarily to increased costs relating to corporate initiatives focused on increasing efﬁ ciency and enhancing controls at our operating communities, coupled with increased compensation and relocation costs. The 2007 expense includes the set up costs related to the ofﬁ ce in Virginia Beach, Virginia that we opened in 2007. This ofﬁ ce will be used to centralize certain community-related accounting, administrative and customer service functions. The transition began during the third quarter of 2007, when certain community-related accounting functions were relocated to our Virginia Beach ofﬁ ce and is expected to continue through the end of 2008. Expenses in this category increased in 2006, primarily due to the addition of recently developed and acquired apartment homes coupled with expense growth in our Established Communities. Investments and investment management reﬂ ects the costs incurred for investment acquisitions, investment management and abandoned pursuit costs, which include costs incurred for development pursuits not yet considered probable for development, as well as the abandonment or impairment of development pursuits, acquisition pursuits and disposition pursuits. Investments and investment management costs increased in 2007 as compared to 2006 due primarily to increased abandoned pursuit costs. Abandoned pursuit costs were $6,974,000 in 2007, $2,115,000 in 2006 and $816,000 in 2005. Abandoned pursuit costs can be volatile, and the costs incurred in any given period may vary signiﬁ cantly in future periods. Interest expense, net decreased $11,639,000 or 10.7% in 2007 and $15,987,000 or 12.8% in 2006 due primarily to higher levels of capitalized interest in connection with our increased development activity and increased interest income, partially offset by an increase in the average outstanding balance on our unsecured credit facility. Interest income increased in 2007 due to higher invested cash balances from our January 2007 equity offering as well as increases in the interest rate earned on cash deposits, offset partially by interest income in 2006 from an escrow funded from a disposition in 2005 that was used in a tax-deferred exchange. Depreciation expense increased $19,107,000 or 11.9% in 2007 and $3,987,000 or 2.5% in 2006 primarily due to the completion of development and redevelopment activities, primarily offset by the loss of depreciation from assets sold. General and administrative expense (“G&A”) increased $3,727,000 or 15.0% in 2007 primarily due to increased compensation costs. G&A expenses decreased $994,000 or 3.9% in 2006 primarily due to the incurrence in 2005 of the following: (i) separation costs of approximately $2,100,000 due to the departure of a senior executive; (ii) the accrual of costs related to various litigation matters of approximately $1,500,000; and (iii) increased board of director fees due to the acceleration of equity awards with the resignation of a director due to disability in 2005, partially offset by higher compensation costs in 2006. Gain on sale of land in 2007 decreased from 2006 due to the volume and size of land parcels sold in each year. The increase in 2006 from 2005 is due to larger gains on sales in 2006. Equity in income of unconsolidated entities in 2007 increased from 2006 due primarily to the recognition in 2007 of approximately $60,000,000 in gains from the disposition of two investments, partially offset by losses (after depreciation) associated with two unconsolidated investments and the consolidation in 2007 of a community that was not consolidated as of December 31, 2006. Minority interest in consolidated partnerships increased in 2007 as compared to 2006 due to the recognition of the sale of a 70% joint venture partner interest in one of our consolidated communities (See Note 6, “Investment in Real Estate Entities”). This increase was partially offset by the conversion and redemption of limited partnership units, thereby reducing outside ownership interests and the allocation of net income to outside ownership interests. The year over year decrease in 2006 was due to the conversion of limited partnership units, reducing the outside ownership interests. Income from discontinued operations represents the net income generated by communities sold or qualifying as discontinued operations during the period from January 1, 2006 through December 31, 2007. It decreased in 2007 and 2006 due to fewer communities sold or classiﬁ ed as discontinued operations. See Note 7, “Real Estate Disposition Activities,” of our Consolidated Financial Statements. Gain on sale of communities increased in 2007 due to the higher volume of dispositions in 2007. The decrease in 2006 as compared to 2005 is due to the volume and size of dispositions in the respective years relative to our basis in the assets. The amount of gain realized in any given reporting period depends on many factors, including the number of communities sold, the size and carrying value of those communities and the sales prices, which are driven by local and national market conditions. AvalonBay Communities, Inc. 21 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Funds from Operations Attributable to Common Stockholders (“FFO”) FFO is considered by management to be an appropriate supplemental measure of our operating and ﬁ nancial performance. In calculating FFO, we exclude gains or losses related to dispositions of previously depreciated property and exclude real estate depreciation, which can vary 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 included elsewhere this report. For a more detailed discussion and presentation of FFO, see “Selected Financial Data,” included elsewhere in this report. Liquidity and Capital Resources Factors affecting our liquidity and capital resources are our cash ﬂ ows from operations, ﬁ nancing activities and investing activities, as well as general economic and market conditions. Operating cash ﬂ ow has historically been determined by: (i) the number of apartment 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 ﬂ ows provided by ﬁ nancing 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 affected by changes in the capital markets environment, such as changes in interest rates or the availability of cost-effective capital. We regularly review our liquidity needs, the adequacy of cash ﬂ ows from operations, and other expected liquidity sources to meet these needs. We believe our principal short-term liquidity needs are to fund: • normal recurring operating expenses; • debt service and maturity payments; • preferred stock dividends and DownREIT partnership unit distributions; • the minimum dividend payments on our common stock required to maintain our REIT qualiﬁ cation under the Internal Revenue Code of 1986; • development and redevelopment activity in which we are currently engaged; and • capital calls for the Fund, as required. Increased capital market volatility in 2007 and constrained liquidity suggest that our liquidity needs may be met in 2008 from sources that differ from historical sources. Increased use of secured debt and increased asset sales relative to our recent activity are expected for 2008. Although general market liquidity is constrained, we anticipate that we can satisfy these needs from a combination of cash ﬂ ow provided by operating activities, proceeds from asset dispositions and borrowing capacity under our variable rate unsecured credit facility, as well as secured ﬁ nancings and other public or private sources of liquidity. Cash and cash equivalents totaled $21,222,000 at December 31, 2007, an increase of $12,938,000 from $8,284,000 at December 31, 2006. The following discussion relates to changes in cash due to operating, investing and ﬁ nancing activities, which are presented in our Consolidated Statements of Cash Flows included elsewhere in this report. Operating Activities — Net cash provided by operating activities increased to $455,825,000 in 2007 from $351,660,000 in 2006. The increase was driven primarily by the additional NOI from our Established Communities’ operations, as well as NOI from recently developed communities. Investing Activities — Net cash used in investing activities of $809,247,000 in 2007 related to investments in assets through the development and redevelopment of apartment communities, the acquisition of a community, and the acquisition of 17 land parcels, partially offset by proceeds from the disposition of a land parcel, four communities and a partnership interest in an unconsolidated real estate investment. During 2007, we invested $1,141,706,000 in the purchase and development of the following real estate and capital expenditures: • We completed the development of eight communities containing a total of 1,749 apartment homes for a total capitalized cost, including land acquisition cost, of $440,700,000. • We acquired 17 parcels of land in connection with Development Rights, for an aggregate purchase price of $311,691,000. • We had capital expenditures relating to current communities’ real estate assets of $13,851,000 and non-real estate capital expenditures of $1,424,000. • We commenced the development of 12 communities which are expected to contain a total of 3,412 apartment homes for an expected aggregate total capital cost of $1,279,800,000. 22 AvalonBay Communities, Inc. Financing Activities — Net cash provided by ﬁ nancing activities totaled $366,360,000 in 2007. The net cash inﬂ ow is due primarily to the proceeds from the issuance of 4,600,000 shares of the Company’s common stock at $129.30 per share, borrowings of $514,500,000 under our unsecured credit facility and the issuance of two mortgage notes for approximately $59,126,000, offset by the repurchase of 2,480,616 shares of our common stock at an average price of $103.95 per share, the repayment of mortgage notes of approximately $27,256,000, the repayment of unsecured notes at maturity of approximately $260,000,000 and dividend payments of $268,966,000. Variable Rate Unsecured Credit Facility In November 2007 we increased our borrowing capacity under our existing revolving variable rate unsecured credit facility from $650,000,000 to $1,000,000,000. The facility is with a syndicate of commercial banks, to whom we pay, in the aggregate, an annual facility fee of approximately $1,250,000. The unsecured credit facility bears interest at varying levels based on the London Interbank Offered Rate (“LIBOR”), our credit rating and on a maturity schedule selected by us. The current stated pricing is LIBOR plus 0.40% per annum (3.54% on January 31, 2008). The spread over LIBOR can vary from LIBOR plus 0.325% to LIBOR plus 1.00% based on our credit rating. In addition, a competitive bid option is available for borrowings of up to $422,500,000. This option allows banks that are part of the lender consortium to bid to provide 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 January 31, 2008. We are subject to and currently in compliance with certain customary covenants under the unsecured credit facility, including, but not limited to, maintaining certain maximum leverage ratios, a minimum ﬁ xed charges coverage ratio and minimum unencumbered assets and equity levels. The credit facility matures in November 2011, assuming our exercise of a one-year renewal option. At January 31, 2008, $733,500,000 was outstanding on the credit facility, $57,000,000 was used to provide letters of credit and $209,361,000 was available for borrowing under the unsecured 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 signiﬁ cant portion of the principal of these notes will be repaid prior to maturity. If we do not have funds on hand sufﬁ cient to repay our indebtedness as it becomes due, it will be necessary for us to reﬁ nance the debt. This reﬁ nancing may be accomplished by uncollateralized private or public debt offerings, additional debt ﬁ nancing that is collateralized by mortgages on individual communities or groups of communities, draws on our unsecured credit facility or by 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 satisfactory. The following ﬁ nancing activity occurred during the year ended December 31, 2007: • we issued $16,926,000 of variable rate mortgage debt for an operating community in June, maturing in May 2012; • we repaid $15,980,000 of mortgage debt, secured by the assets of an operating community in July; • we assumed $3,941,000 of ﬁ xed rate mortgage debt in conjunction with the acquisition of an operating community in July 2007 and subsequently defeased the note in December 2007; • we issued $100,000,000 of variable rate, tax-exempt debt for a development community in June, maturing in November 2040; • we repaid $150,000,000 in previously issued unsecured notes in August 2007, along with any unpaid interest, pursuant to their scheduled maturity; • we issued $42,200,000 of ﬁ xed rate, tax-exempt mortgage debt for an operating community in September 2007, maturing in June 2047; • we were relieved of our obligations associated with $8,116,000 in mortgage debt in conjunction with the disposition of the associated operating community in September 2007; • we repaid $110,000,000 in previously issued unsecured notes in December 2007, along with any unpaid interest, pursuant to their scheduled maturity; • we borrowed $514,500,000 under our unsecured credit facility; • we increased our borrowing capacity under our unsecured credit facility by $350,000,000, to $1,000,000,000; • we issued 4,600,000 shares of common stock at $129.30 per share for net proceeds of approximately $594,000,000 in conjunction with the inclusion of our common stock in the S&P 500 index in January 2007; and • we repurchased 2,480,616 shares of our common stock at an average price of $103.95 per share, for a total approximate purchase price of $257,854,000. In February 2008, the Board of Directors authorized a further increase of $200,000,000 in the common stock repurchase program, increasing the total amount the Company can acquire to $500,000,000, of which approximately $300,000,000 has been used to repurchase our common stock as of January 31, 2008. The decision to use the additional share repurchase authorization will depend on current capital market conditions and liquidity, our share price relative to the net asset value per share and other uses of capital, including development. AvalonBay Communities, Inc. 23 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) The table below details debt maturities for the next ﬁ ve years, excluding our unsecured credit facility, and amounts outstanding related to communities classiﬁ ed as held for sale, for debt outstanding at December 31, 2007 (dollars in thousands, except footnotes). Community Tax-exempt bonds Fixed rate CountryBrook Avalon at Symphony Glen Avalon at Lexington Avalon at Nob Hill Avalon Campbell Avalon Paciﬁ ca Avalon Knoll Avalon Landing Avalon Fields Avalon Oaks Avalon Oaks West Avalon at Chestnut Hill Variable rate(3) The Promenade Waterford Avalon at Mountain View Avalon at Foxchase I Avalon at Foxchase II Avalon at Mission Viejo Avalon at Nob Hill Avalon Campbell Avalon Paciﬁ ca Avalon at Fairway Hills I Bowery Place I Bowery Place II Avalon Acton Morningside Park Conventional loans(6) Fixed rate $150 million unsecured notes $110 million unsecured notes $50 million unsecured notes $150 million unsecured notes $150 million unsecured notes $200 million unsecured notes $300 million unsecured notes $50 million unsecured notes $250 million unsecured notes $250 million unsecured notes $100 million unsecured notes $150 million unsecured notes $250 million unsecured notes Wheaton Development Right 4600 Eisenhower Avenue Twinbrook Development Right Tysons West Development Right Avalon Orchards Variable rate(3) Avalon Ledges Avalon at Flanders Hill Avalon at Newton Highlands Avalon at Crane Brook Avalon at Bedford Center Total indebtedness—excluding unsecured credit facility All-In interest rate(1) Principal maturity date Balance outstanding 12-31-07 12-31-06 2008 2009 Scheduled maturities 2011 2010 2012 Thereafter 6.30% Mar-2012 Jul-2024 4.90% Feb-2025 6.55% Jun-2025 5.80% Jun-2025 6.48% Jun-2025 6.48% Jun-2026 6.95% 6.85% Jun-2026 7.55% May-2027 Jul-2041 7.45% Apr-2043 7.48% Oct-2047 5.82% 4.88% 3.50% 3.50% 3.50% 3.50% 3.98% 3.46% 3.46% 3.46% 4.33% 3.31% 3.34% 4.14% 6.63% Oct-2010 Jul-2014 Feb-2017 Nov-2017 Nov-2017 Jun-2025 Jun-2025 Jun-2025 Jun-2025 Jun-2026 Nov-2037 Nov-2039 Jul-2040 Nov-2040 Aug-2007 5.18% Dec-2007 7.13% Jan-2008 6.63% Jul-2008 8.38% Aug-2009 7.63% Dec-2010 7.66% Sep-2011 6.79% Sep-2011 6.31% Jan-2012 5.73% 6.26% Nov-2012 5.11% Mar-2013 Apr-2014 5.52% Sep-2016 5.89% Oct-2008 6.99% Apr-2009 8.08% Oct-2011 7.25% Jul-2028 5.55% Jul-2033 7.65% 5.68% May-2009 5.68% May-2009 5.62% Dec-2009 5.59% Mar-2011 5.62% May-2012 $ 15,990 $ 15,356 9,780 12,078 9,780 12,467 18,116 32,776 14,867 11,957 5,903 10,483 17,205 17,036 — $ 676 — 413 — — — 324 162 256 137 125 314 $ 719 — 439 — — — 347 173 275 147 133 331 $ 766 $ 816 $ 12,379 $ — 9,780 9,739 — 31,877 14,460 9,788 4,821 8,743 16,288 16,205 40,399 — 526 — — — 426 212 339 180 162 388 — 466 — — — 371 185 295 157 142 349 — 495 — — — 398 198 316 168 152 368 —(2) 31,877(2) 14,460(2) 11,654 5,751 10,224 17,077 16,919 42,149 166,580 187,325 2,407 2,564 2,731 2,911 14,612 162,100 31,495 33,100 18,300 16,800 9,600 7,635 2,684 6,024 2,733 11,500 93,800 48,500 45,000 — 30,844 33,100(4) 18,300(4) 16,800(4) 9,600(4) 7,635(4) 20,800(4) 6,923(2) 3,140(2) 11,500 93,800(5) 48,500(5) 45,000(5) 100,000 701 — — — — — — — — — 521 — — — 755 — — — — — — — — — 576 — — — 327,171 445,942 1,222 1,331 $ 150,000 $ — — 50,000(7) 146,000 150,000 200,000 300,000 50,000 250,000 250,000 100,000 150,000 250,000 4,432 4,293 8,007 6,381 19,612 110,000 50,000 146,000 150,000 200,000 300,000 50,000 250,000 250,000 100,000 150,000 250,000 4,514 4,402 8,200 6,535 19,883 $ — — 50,000 146,000 — — — — — — — — — 4,432 118 207 162 290 $ — — — — 150,000 — — — — — — — — — 4,175 222 173 311 29,388 — — — — — — — — — 636 270 — 138 30,432 — — — — — — — — — — 703 298 — 302 — — — — — — — — — — 777 329 — 340 — 33,100 18,300 16,800 9,600 7,635 20,800 6,923 3,140 11,500 90,587 47,603 45,000 99,220 1,303 1,446 410,208 $ — $ — $ — $ — — — — — — — — — — 100,000 150,000 250,000 — — — 5,466 17,939 — — — — 200,000 — — — — — — — — — 239 183 333 — — — — — 300,000 50,000 — — — — — — — 7,339 193 357 — — — — — — — 250,000 250,000 — — — — — — 204 382 2,199,534 1,938,725 201,209 154,881 200,755 357,889 500,586 523,405 18,635 21,245 37,650 33,535 — 111,065 17,990 20,510 36,335 32,560 16,816(4) 124,211 688 784 1,397 1,045 468 4,382 17,302 19,726 34,938 1,106 497 73,569 — — — 1,169 527 1,696 — — — 29,240 560 29,800 — — — — 14,764 14,764 — — — — — — $2,804,350 $2,696,203 $209,220 $232,345 $235,614 $391,903 $531,408 $1,095,713 (1) Includes credit enhancement fees, facility fees, trustees’ fees and other fees. (2) Financed by variable rate, tax-exempt debt, but the interest rate on a portion of this debt is effectively ﬁ xed at December 31, 2007 and December 31, 2006 through a swap agreement. The portion of the debt ﬁ xed through a swap agreement decreases (and therefore the variable portion of the debt increases) monthly as payments are made to a principal reserve fund. (3) Variable rates are given as of December 31, 2007. (4) Financed by variable rate debt, but interest rate is capped through an interest rate protection agreement. (5) Represents full amount of the debt as of December 31, 2007. Actual amounts drawn on the debt as of December 31, 2007 are $87,519,000 for Bowery Place I, $34,323,000 for Bowery Place II, $12,156,000 for Avalon Acton and $0 for Morningside Park. (6) Balances outstanding represent total amounts due at maturity, and are not net of $2,501 of debt discount as of December 31, 2007 and $2,922 of debt discount as of December 31, 2006, as reﬂ ected in unsecured notes on our Consolidated Balance Sheets included elsewhere in this report. (7) These notes were repaid at their scheduled maturity in January 2008. 24 AvalonBay Communities, Inc. Future Financing and Capital Needs — Portfolio and Other Activity As of December 31, 2007, we had 21 new communities under construction, for which a total estimated cost of $943,679,000 remained to be invested. In addition, we had eight communities which we own, or in which we have a direct or indirect interest, under reconstruction, for which a total estimated cost of $53,836,000 remained to be invested. Substantially all of the capital expenditures necessary to complete the communities currently under construction and reconstruction, as well as development costs related to pursuing Development Rights, will be funded from: • cash currently on hand invested in highly liquid overnight money market funds and repurchase agreements, and short-term investment vehicles; • the remaining capacity under our current $1,000,000,000 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 reconstruction activity related to communities acquired by the Fund as discussed below, or the construction of a Development Right begins, we intend to arrange adequate ﬁ nancing to complete these undertakings, although we cannot assure you that we will be able to obtain such ﬁ nancing. In the event that ﬁ nancing cannot be obtained, we may have to abandon Development Rights, write-off associated pre-development costs that were capitalized and/or forego reconstruction activity. In such instances, we will not realize the increased revenues and earnings that we expected from such Development Rights or reconstruction activity and signiﬁ cant losses could be incurred. We have invested in the Fund, a private, discretionary investment vehicle that acquires and operates apartment communities in our markets. The Fund has invested $777,568,000 as of December 31, 2007. Management of the Fund expects to invest approximately $46,000,000 of additional funds to redevelop the assets acquired, at which time the Fund will become fully invested. The Fund has nine institutional investors, including us, with a combined capital equity commitment of $330,000,000. A signiﬁ cant portion of the investments made in the Fund by its investors have been made through AvalonBay Value Added Fund, Inc., a Maryland corporation that qualiﬁ es as a REIT under the Internal 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 $32,035,000 has been invested as of January 31, 2008) representing a 15.2% combined general partner and limited partner equity interest. As of January 31, 2008, the Fund has committed to invest approximately $818,367,000. We are exploring various potential sources for funding future acquisitions after the Fund is fully invested. From time to time we use joint ventures to hold or develop individual real estate assets. We generally employ joint ventures primarily to mitigate asset concentration or market risk or 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 varying degrees depending on the terms of the joint venture or partnership agreement. We cannot assure you that we will achieve our objectives through joint ventures. In evaluating our allocation of capital within our markets, we sell assets that do not meet our long-term investment criteria or when capital and real estate markets allow us to realize a portion of the value created over the past business cycle and redeploy the proceeds from those sales to develop and redevelop communities. In response to real estate and capital markets conditions, we sold four communities and one partnership interest in an unconsolidated entitiy for an aggregate sales price of $268,096,000 from January 1, 2007 through January 31, 2008. Because the proceeds from the sale of communities may not be immediately redeployed into revenue generating assets, the immediate effect of a sale of a community for a gain is to increase net income, but reduce future total revenues, total expenses and NOI. However, we believe that the absence of future cash ﬂ ows from communities sold will have a minimal impact on our ability to fund future liquidity and capital resource needs. During 2008, we intend to dispose of between $700,000,000 and $1,000,000,000 in assets. However, actual disposition volume will depend on market conditions and other variables, which are subject to change in 2008. AvalonBay Communities, Inc. 25 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Off Balance Sheet Arrangements In addition to the investment interests in consolidated and unconsolidated real estate entities, we have certain off-balance sheet arrangements with the entities in which we invest. Additional discussion of these entities can be found in Note 6, “Investments in Real Estate Entities,” and Note 8, “Commitments and Contingencies,” of our Consolidated Financial Statements located elsewhere in this report. • CVP I, LLC has outstanding tax-exempt, variable rate bonds maturing in November 2036 in the amount of $117,000,000, which have permanent credit enhancement. We have agreed to guarantee, under limited circumstances, the repayment to the credit enhancer of any advances it may make in fulﬁ llment of CVP I, LLC’s repayment obligations under the bonds. We have also guaranteed to the credit enhancer that CVP I, LLC will obtain a ﬁ nal certiﬁ cate of occupancy for the project (Chrystie Place in New York City) overall once tenant improvements related to a retail tenant are complete, which is expected in the ﬁ rst half of 2008. Our 80% partner in this venture has agreed that it will reimburse us its pro rata share of any amounts paid relative to these guaranteed obligations. The estimated fair value of, and our obligation under these guarantees, both at inception and as of December 31, 2007 were not signiﬁ cant. As a result we have not recorded any obligation associated with these guarantees at December 31, 2007. • MVP I, LLC executed a construction loan in the amount of $94,000,000 to ﬁ nance the development of Avalon at Mission Bay North II. In conjunction with the construction management services that the Company provided to MVP I, LLC, the Company provided a construction completion guarantee to the construction loan lender in order to fulﬁ ll their standard ﬁ nancing requirements related to construction ﬁ nancing. In the fourth quarter of 2007, all of the lender’s standard completion requirements were satisﬁ ed and the obligation of the Company under this guarantee terminated. In December 2007, MVP I, LLC repaid the construction loan, concurrently executing a seven-year, ﬁ xed rate conventional loan. • The Fund has 20 loans secured by individual assets with amounts outstanding in the aggregate of $447,166,000. These mortgage loans have varying maturity dates (or dates after which the loans can be prepaid), ranging from October 2011 to September 2016. These mortgage loans are secured by the underlying real estate. In addition, the Fund had amounts outstanding of $47,400,000 as of December 31, 2007 under its credit facilities, all of which is under an unsecured facility maturing in December 2008. The Fund did not have any amounts outstanding at December 31, 2007 under the Fund's credit facility secured by uncalled capital commitments that matured in January 2008. The mortgage loans and the credit facility are payable by the Fund with operating cash ﬂ ow from the underlying real estate, and the credit facility is secured by capital commitments. We have not guaranteed the debt of the Fund, nor do we have any obligation to fund this debt should the Fund be unable to do so. • In addition, as part of the formation of the Fund, we have provided to one of the limited partners a guarantee. The guarantee provides that if, upon ﬁ nal liquidation of the Fund, the total amount of all distributions to that partner during the life of the Fund (whether from operating cash ﬂ ow or property sales) does not equal a minimum of the total capital contributions made by that partner, then we will pay the partner an amount equal to the shortfall, but in no event more than 10% of the total capital contributions made by the partner (maximum of approximately $6,510,000 as of December 31, 2007). As of December 31, 2007, the fair value of the real estate assets owned by the Fund is considered adequate to cover such potential payment to that partner under a liquidation scenario. The estimated fair value of, and our obligation under this guarantee, both at inception and as of December 31, 2007 was not signiﬁ cant and therefore we have not recorded any obligation for this guarantee as of December 31, 2007. • In connection with the pursuit of a Development Right in Pleasant Hill, California, $125,000,000 in bond ﬁ nancing was issued by the Contra Costa County Redevelopment Agency (the “Agency”) in connection with the possible future construction of a multifamily rental community by PHVP I, LLC. The bond proceeds were immediately invested in their entirety in a guaranteed investment contract (“GIC”) administered by a trustee. This Development Right is planned as a mixed-use development, with residential, for- sale, retail and ofﬁ ce components. The bond proceeds will remain in the GIC until August 2008, at which time a loan will be made to PHVP I, LLC to fund construction of the multifamily portion of the development, or the bonds will be redeemed by the Agency. We are currently in discussions to extend both the term until the bond ﬁ nancing proceeds must be used for development of the multifamily portion of the project, and the GIC until August 2008, when construction of the multifamily portion of the development is now expected to begin. Although we do not have any equity or economic interest in PHVP I, LLC at this time, we do have an option to make a capital contribution to PHVP I, LLC in exchange for a 99% general partner interest in the entity. Should we decide not to exercise this option, bond proceeds will be released from escrow, the bonds will be redeemed without penalty and a loan will not be made to PHVP I, LLC. The bonds are payable from the proceeds of the GIC and are non-recourse to both PHVP I, LLC and to us. There is no loan payable outstanding by PHVP I, LLC as of December 31, 2007. 26 AvalonBay Communities, Inc. • In addition, as part of providing construction management services to PHVP I, LLC for the construction of a public garage, we have provided a construction completion guarantee to the related lender in order to fulﬁ ll their standard ﬁ nancing requirements related to the garage construction ﬁ nancing. Our obligations under this guarantee will terminate following construction completion of the garage once all of the lender’s standard completion requirements have been satisﬁ ed, which we currently expect to occur in the ﬁ rst half of 2008. In the third quarter of 2006, signiﬁ cant modiﬁ cations were requested by the local transit authority to change the garage structure design. We do not believe that the requested design changes impact the construction schedule. However, it is expected that these changes will increase the original budget by an amount up to $5,000,000. We believe that substantially all potential additional amounts are reimbursable from unrelated third parties. At this time we do not believe that it is probable that we will incur any additional costs. The estimated fair value of, and our obligation under this guarantee, both at inception and as of December 31, 2007 was not signiﬁ cant and therefore we have not recorded any obligation for this guarantee as of December 31, 2007. • In the fourth quarter of 2006, we admitted a 70% venture partner to the Avalon Del Rey Apartments, LLC for an investment of $49,000,000, including the assumption of debt. In conjunction with this investment, we provided an operating guarantee to the joint venture partner which stated that if the initial year return earned by the joint venture partner was less than a threshold return of 7% on its initial equity investment, we would pay the joint venture partner an amount equal to the shortfall, up to the 7% threshold return required. In the fourth quarter of 2007, the initial year return earned by the joint venture partner was determined to be in excess of the guarantee threshold thereby satisfying all provisions of the Company under this guarantee. There are no other lines of credit, side agreements, ﬁ nancial guarantees or any other derivative ﬁ nancial instruments related to or between our unconsolidated real estate entities and us. In evaluating our capital structure and overall leverage, management takes into consideration our proportionate share of this unconsolidated debt. Contractual Obligations We currently have contractual obligations consisting primarily of long-term debt obligations and lease obligations for certain land parcels and regional and administrative ofﬁ ce space. During the second quarter of 2007, we entered into an operating lease for 20,000 square feet of ofﬁ ce space in Virginia Beach, Virginia. We began to utilize this space for certain of our community-related accounting and customer service functions in the third quarter of 2007. There have not been any other material changes outside the ordinary course of business to our contractual obligations during 2007. Scheduled contractual obligations required for the next ﬁ ve years and thereafter are as follows as of December 31, 2007 (dollars in thousands): Total Less than 1 Year 1–3 Years 3–5 Years More than 5 Years Payments due by period Debt Obligations(1) Operating Lease Obligations(2) $3,210,703 2,142,739 $723,720 14,412 $467,959 29,108 $923,311 29,268 $1,095,713 2,069,951 Total $5,353,442 $738,132 $497,067 $952,579 $3,165,664 (1) Includes $514,500 outstanding under our variable rate unsecured credit facility as of December 31, 2007. The table of contractual obligations assumes repayment of this amount in 2008 - See “Liquidity and Capital Resources.” Amounts exclude interest payable as of December 31, 2007. (2) Includes land leases expiring between November 2028 and March 2142. Amounts do not include any adjustment for purchase options available under the land leases. Inﬂ ation and Deﬂ ation Substantially all of our apartment leases are for a term of one year or less. In an inﬂ ationary 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 inﬂ ation, 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 deﬂ ationary rent environment, we may be exposed to declining rents more quickly under these shorter-term leases. AvalonBay Communities, Inc. 27 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Forward-Looking Statements This Annual Report contains “forward-looking statements” as that term is deﬁ ned under the Private Securities Litigation Reform 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 trends 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; • the timing and cost of completion of apartment communities under construction, reconstruction, development or redevelopment; • the timing of lease-up, occupancy and stabilization of apartment communities; • the pursuit of land on which we are considering future development; • the anticipated operating performance 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 qualiﬁ cation as a REIT under the Internal Revenue Code; • the real estate markets in Northern and Southern California and markets in selected states in the Mid-Atlantic, Northeast, Midwest and Paciﬁ c Northwest regions of the United States and in general; • the availability of debt and equity ﬁ nancing; • interest rates; • general economic conditions; and • trends affecting our ﬁ nancial condition or results of operations. We cannot assure the future results or outcome of the matters described in these statements; rather, these statements merely reﬂ ect our current expectations of the approximate outcomes of the matters discussed. You should not rely on forward-looking statements because they involve known and unknown risks, uncertainties and other factors, some of which are beyond our control. These risks, uncertainties and other factors may cause our actual results, performance or achievements to differ materially from the anticipated future results, performance or achievements expressed or implied by these forward-looking statements. These risks, uncertainties and other factors are discussed in our Annual Report on Form 10-K for 2007 in the section titled “Risk Factors” and in other reports and documents ﬁ led with the Securities and Exchange Commission. In addition, these forward-looking statements represent our estimates and assumptions only as of the date of this report. We do not undertake a duty to update these forward-looking statements, and therefore they may not represent our estimates and assumptions after the date of this report. Some of the factors that could cause our actual results, performance or achievements to differ materially from those expressed or implied by these forward-looking statements include, but are not limited to, the following: • we may fail to secure development opportunities due to an inability to reach agreements with third parties to obtain land at attractive prices or to obtain desired zoning and other local approvals; • we may abandon or defer development opportunities for a number of reasons, including changes in local market conditions which make development less desirable, increases in costs of development and increases in the cost of capital, resulting in losses; • construction costs of a community may exceed our original estimates; • we may not complete construction and lease-up of communities under development or redevelopment on schedule, resulting in increased interest costs and construction costs and a decrease in our expected rental revenues; • occupancy rates and market rents may be adversely affected by competition and local economic and market conditions which are beyond our control; • ﬁ nancing may not be available on favorable terms or at all, and our cash ﬂ ows from operations and access to cost effective capital may be insufﬁ cient for the development of our pipeline which could limit our pursuit of opportunities; • our cash ﬂ ows may be insufﬁ cient to meet required payments of principal and interest, and we may be unable to reﬁ nance existing indebtedness or the terms of such reﬁ nancing may not be as favorable as the terms of existing indebtedness; • we may be unsuccessful in our management of the Fund and the Fund REIT; and • we may be unsuccessful in managing changes in our portfolio composition. 28 AvalonBay Communities, Inc. Critical Accounting Policies The preparation of ﬁ nancial statements in conformity with 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 assumptions were made, it is possible that different accounting policies would have been applied, resulting in different ﬁ nancial results or a different presentation of our ﬁ nancial statements. Below is a discussion of the accounting policies that we consider critical to an understanding of our ﬁ nancial condition and operating results that may require complex or signiﬁ cant judgment in their application or require estimates about matters which are inherently uncertain. A discussion of our signiﬁ cant accounting policies, including further discussion of the accounting policies described below, can be found in Note 1, “Organization and Signiﬁ cant Accounting Policies” of our Consolidated Financial Statements. Principles of Consolidation We may enter into various joint venture agreements with unrelated third parties to hold or develop real estate assets. We must determine for each of these ventures, whether to consolidate the entity or account for our investment under the equity or cost basis of accounting. We determine whether to consolidate certain entities based on our rights and obligations under the joint venture agreements, applying the guidance of FIN 46(R), “Consolidation of Variable Interest Entities” (as revised) and Emerging Issues Task Force 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.” For investment interests that we do not consolidate, we look to the guidance in AICPA Statement of Position 78-9, “Accounting for Investments in Real Estate Ventures”, Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock”, and Emerging Issues Task Force Topic D-46, “Accounting for Limited Partnership Investments”, to determine the accounting framework to apply. The application of these rules in evaluating the accounting treatment for each joint venture is complex and requires substantial management judgment. Therefore, we believe the decision to choose an appropriate accounting framework is a critical accounting estimate. If we were to consolidate the joint ventures that we accounted for using the equity method at December 31, 2007, our assets would have increased by $1,029,093,000 and our liabilities would have increased by $739,806,000. We would be required to consolidate those joint ventures currently not consolidated for ﬁ nancial reporting purposes if the facts and circumstances changed, including but not limited to the following reasons, none of which are currently expected to occur: • For entities not considered to be variable interest entities under FIN 46(R), the nature of the entity changed such that it would be considered a variable interest entity. • For entities in which we do not hold a controlling voting and/or variable interest, the contractual arrangement changes resulting in our investment interest being either a controlling voting and/or variable interest. We evaluate our accounting for investments on a quarterly basis or when a signiﬁ cant change in the design of an entity occurs. Cost Capitalization We capitalize costs during the development of assets beginning when we determine that development of a future asset is probable until the asset, or a portion of the asset, is delivered and is ready for its intended use. For redevelopment efforts, we capitalize costs beginning either (i) in advance of taking homes out of service when signiﬁ cant renovation of the common area has begun until the redevelopment is completed, or (ii) when an apartment home is taken out of service for redevelopment until the 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. During the development and redevelopment efforts we capitalize all direct and those indirect costs which have been incurred as a result of the development and redevelopment activities. These costs include interest and related loan fees, property taxes as well as other direct and indirect costs. Interest is capitalized for any project speciﬁ c ﬁ nancing, as well as for general corporate ﬁ nancing to the extent of our aggregate investment in the projects. Indirect project costs, which include personnel and ofﬁ ce and administrative costs, that are clearly associated with our development and redevelopment efforts are also capitalized. The estimation of the direct and indirect costs to capitalize as part of our development and redevelopment activities requires judgment, and as such, we believe cost capitalization to be a critical accounting estimate. There may be a change in our operating expenses in the event that there are changes in accounting guidance governing capitalization or changes to development or redevelopment activity. If changes in the accounting guidance limit our ability to capitalize costs or if we reduce our development and redevelopment activities without a corresponding decrease in indirect project costs, there may be an increase in our operating expenses. For example, if in 2007 our development activities decreased by 10%, and there were no corresponding decrease in our indirect project costs, our operating expenses would have increased by $2,748,000. We capitalize pre-development costs incurred in pursuit of Development Rights for which we currently believe future development is probable. These costs include legal fees, design fees and related overhead costs. Future development of these pursuits is dependent upon various factors, including zoning and regulatory approval, rental market conditions, construction costs and availability of capital. Pre-development costs AvalonBay Communities, Inc. 29 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) 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, making future development no longer probable, any capitalized pre-development costs are written-off with a charge to expense. Due to the subjectivity in determining whether a pursuit will result in the acquisition or development of an apartment community, and therefore should be capitalized, the accounting for pursuit costs is a critical accounting estimate. If it were determined that 10% of our capitalized pursuits were no longer probable of occurring, net income for the year ended December 31, 2007 would have decreased by $6,100,000. Asset Impairment Evaluation We apply the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, to determine the need for performing impairment analyses, as well as to measure the loss if an impairment has occurred on a regular basis, considering qualitative economic factors. Because each asset is unique, requiring signiﬁ cant management judgment, we believe that the asset impairment evaluation is a critical accounting estimate. Management judgment is required both to determine if a signiﬁ cant event has occurred, such that an impairment analysis is necessary, as well as for the assessment and measurement of any potential impairment. To perform the impairment analysis, we must estimate the undiscounted future cash ﬂ ows associated with the asset, which in the case of an apartment community would be the NOI, as well as potential disposition proceeds for a given asset. Forecasting cash ﬂ ows requires assumptions about such variables as the estimated holding period, rental rates, occupancy and operating expenses during the holding period as well as disposition proceeds. In addition, when an impairment has occurred, we must estimate the discount factor, or market capitalization rate to apply to the undiscounted cash ﬂ ows to derive the fair value of the position. The market capitalization rate is inﬂ uenced by many factors, including national and local economic conditions, as well as the location and quality of the asset. Changes in the future cash ﬂ ows associated with an asset have a direct, linear relationship to the fair value of the position. For example, if there is a 10% decline in the estimated NOI for a community, there would be a corresponding decrease in the fair value of that asset of 10%. Changes in the market capitalization rate have an inverse relationship with the fair value of an asset, with a decrease in the market capitalization rate resulting in an increase in the fair value of the asset. For example, an asset that is valued at $80,000,000 when using a ﬁ ve percent market capitalization rate will increase in value to $100,000,000 if the market capitalization rate decreases by one percent to four percent, and to $133,000,000 if the market capitalization rate decreases by two percent, to a three percent market capitalization rate. For the year ended December 31, 2007, we did not recognize any impairment in value associated with our investments or long-lived assets. We cannot predict the occurrence of future events that may cause an impairment assessment to be performed. REIT Status We are a Maryland 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 (“the Code”), 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 requirements, 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 if we distribute 100% of taxable income to our stockholders over time periods allowed under the Code. If we fail to qualify as a REIT in any taxable year, we will be subject to federal and state 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. For example, if we failed to qualify as a REIT in 2007, our net income would have decreased by approximately $119,800,000. Our qualiﬁ cation as a REIT requires management to exercise signiﬁ cant judgment and consideration with respect to operational matters and accounting treatment. Therefore, we believe our REIT status is a critical accounting estimate. 30 AvalonBay Communities, Inc. Quantitative and Qualitative Disclosures About Market Risk We are exposed to certain ﬁ nancial market risks, the most predominant being interest rate risk. We monitor interest rate risk 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 interest rate ﬂ uctuations historically has been small relative to other factors affecting operating results, such as rental rates and occupancy. The speciﬁ c market risks and the potential impact on our operating results are described below. Our operating results are affected 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, primarily associated with short-term interest rates such as LIBOR. We had $1,084,653,000 and $426,795,000 in variable rate debt outstanding (excluding variable rate debt effectively ﬁ xed through swap agreements) as of December 31, 2007 and 2006, respectively. If interest rates on the variable rate debt had been 100 basis points higher throughout 2007 and 2006, our annual interest costs would have increased by approximately $6,417,000 and $3,027,000, respectively, based on balances outstanding during the applicable years. We currently use interest rate protection agreements (consisting of interest rate swap and interest rate cap agreements) to reduce the impact of interest rate ﬂ uctuations on certain variable rate indebtedness, not for trading or speculative purposes. Under swap agreements: • we agree to pay to a counterparty the interest that would have been incurred on a ﬁ xed principal amount at a ﬁ xed interest rate (generally, the interest rate on a particular treasury bond on the date the agreement is entered into, plus a ﬁ xed increment); and • the counterparty agrees to pay to us the interest that would have been incurred on the same principal amount at an assumed ﬂ oating interest rate tied to a particular market index. As of December 31, 2007, the effect of interest rate swap agreements is to ﬁ x the interest rate on approximately $46,340,000 of our variable rate, tax-exempt debt. The interest rate protection provided by certain swap agreements on the consolidated variable rate, tax-exempt debt was not electively entered into by us but, rather, was a requirement of either the bond issuer or the credit enhancement provider related to certain tax-exempt bond ﬁ nancings. Had these swap agreements not been in place during 2007 and 2006, our annual interest costs would have been approximately $931,000 and $1,182,000 lower, respectively, based on balances outstanding and reported interest rates during the applicable years. Additionally, if the variable interest rates on this debt had been 100 basis points higher throughout 2007 and 2006 and these swap agreements had not been in place, our annual interest costs would have been approximately $248,000 lower in 2007 and $37,000 higher in 2006. Because the counterparties providing the swap agreements are major ﬁ nancial institutions which have an A+ or better credit rating by the Standard & Poor’s Ratings Group and the interest rates ﬁ xed by the swap agreements are signiﬁ cantly higher than current market rates for such agreements, we do not believe there is exposure at this time to a default by a counterparty provider. In addition, changes in interest rates affect the fair value of our ﬁ xed rate debt, computed using a discounted cash ﬂ ow model considering our current market yields, which impacts the fair value of our aggregate indebtedness. Debt securities and notes payable (excluding amounts outstanding under our variable rate unsecured credit facility) with an aggregate carrying value of $2,696,203,000 at December 31, 2007 had an estimated aggregate fair value of $2,756,890,000 at December 31, 2007. Fixed rate debt (excluding our variable rate debt effectively ﬁ xed through swap agreements) represented $2,079,713,000 of the carrying value and $2,140,400,000 of the fair value at December 31, 2007. If interest rates had been 100 basis points higher as of December 31, 2007, the fair value of this ﬁ xed rate debt would have decreased by $84,459,000. We do not have any exposure to foreign currency or equity price risk, and our exposure to commodity price risk is insigniﬁ cant. AvalonBay Communities, Inc. 31 CONSOLIDATED BALANCE SHEETS (Dollars in thousands, except per share data) 12-31-07 12-31-06 ASSETS Real estate: Land Buildings and improvements Furniture, ﬁ xtures and equipment Less accumulated depreciation Net operating real estate Construction 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 real estate entities Deferred ﬁ nancing costs, net Deferred development costs Prepaid expenses and other assets Total assets LIABILITIES AND STOCKHOLDERS’ EQUITY Unsecured notes, net 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 Minority interest of unitholders in consolidated partnerships Commitments and contingencies Stockholders’ equity: Preferred stock, $0.01 par value; $25 liquidation preference; 50,000,000 shares authorized at both December 31, 2007 and 2006; 4,000,000 shares issued and outstanding at both December 31, 2007 and 2006 Common stock, $0.01 par value; 140,000,000 shares authorized at both December 31, 2007 and 2006; 77,318,611 and 74,668,372 shares issued and outstanding at December 31, 2007 and 2006, respectively Additional paid-in capital Accumulated earnings less dividends Accumulated other comprehensive loss Total stockholders’ equity Total liabilities and stockholders’ equity See accompanying notes to Consolidated Financial Statements. $1,024,111 5,130,872 160,330 6,315,313 (1,259,558) 5,055,755 953,004 288,423 — $ 943,724 4,501,494 141,303 5,586,521 (1,080,313) 4,506,208 641,781 202,314 160,059 6,297,182 5,510,362 21,222 189,171 29,542 57,990 28,177 60,996 52,204 8,284 135,917 26,429 42,724 26,140 39,365 59,286 $6,736,484 $5,848,507 $1,893,499 514,500 800,203 67,909 91,580 237,932 38,578 42,477 — $2,153,078 — 648,350 60,417 59,232 192,022 37,189 37,654 69,100 3,686,678 3,257,042 23,152 — 18,311 — 40 40 773 3,026,708 2,499 (3,366) 747 2,482,516 93,430 (3,579) 3,026,654 2,573,154 $6,736,484 $5,848,507 32 AvalonBay Communities, Inc. CONSOLIDATED STATEMENTS OF OPERATIONS AND OTHER COMPREHENSIVE INCOME (Dollars in thousands, except per share data) 12-31-07 12-31-06 12-31-05 For the year ended Revenue: Rental and other income Management, development and other fees Total revenue Expenses: Operating expenses, excluding property taxes Property taxes Interest expense, net Depreciation expense General and administrative expense Total expenses Equity in income of unconsolidated entities Minority interest in consolidated partnerships Gain on sale of land Income from continuing operations Discontinued operations: Income from discontinued operations Gain on sale of communities Total discontinued operations Net income Dividends attributable to preferred stock $806,599 6,142 812,741 $715,170 6,259 721,429 $650,907 4,304 655,211 242,702 74,912 97,545 179,549 28,494 623,202 59,169 (1,585) 545 217,134 66,786 109,184 160,442 24,767 578,313 7,455 (573) 13,519 247,668 163,517 4,005 106,487 110,492 358,160 (8,700) 5,618 97,411 103,029 266,546 (8,700) 197,990 63,975 125,171 156,455 25,761 569,352 7,198 (1,481) 4,479 96,055 19,126 195,287 214,413 310,468 (8,700) Net income available to common stockholders $349,460 $257,846 $301,768 Other comprehensive income: Unrealized gain on cash ﬂ ow hedges Comprehensive income Earnings per common share—basic: Income from continuing operations (net of dividends attributable to preferred stock) Discontinued operations Net income available to common stockholders Earnings per common share—diluted: Income from continuing operations (net of dividends attributable to preferred stock) Discontinued operations Net income available to common stockholders See accompanying notes to Consolidated Financial Statements. 213 891 2,626 $349,673 $258,737 $304,394 $ 3.04 1.40 $ 4.44 $ 3.00 1.38 $ 4.38 $ 2.09 1.39 $ 3.48 $ 2.06 1.36 $ 3.42 $ 1.20 2.94 $ 4.14 $ 1.18 2.87 $ 4.05 AvalonBay Communities, Inc. 33 CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY Shares issued Preferred stock Common stock Preferred stock Common stock Additional paid-in capital Accumulated earnings less dividends Accumulated other comprehensive loss Total stockholders’ equity 4,000,000 — 72,582,076 — $40 — $726 — $2,380,852 — $(21,159) 310,468 $(7,096) — $2,353,363 310,468 (Dollars in thousands) Balance at December 31, 2004 Net income Unrealized gain on cash ﬂ ow hedges Change in redemption value of minority interest Dividends declared to common and preferred stockholders Issuance of common stock Amortization of deferred compensation — — — — — — — — 1,080,972 — Balance at December 31, 2005 4,000,000 73,663,048 Net income Unrealized gain on cash ﬂ ow hedges Change in redemption value of minority interest Dividends declared to common and preferred stockholders Issuance of common stock Amortization of deferred compensation — — — — — — — — — — 1,005,324 — Balance at December 31, 2006 4,000,000 74,668,372 Net income Unrealized gain on cash ﬂ ow hedges Change in redemption value of minority interest Dividends declared to common and preferred stockholders Issuance of common stock Purchase of common stock Amortization of deferred compensation — — — — — — — — — — — — 5,130,855 — (2,480,616) — — — — — — 40 — — — — — — 40 — — — — — — 11 — — — — — — 40,378 (216,982) (377) 8,338 — 2,626 2,626 — — — — — (216,982) 40,012 8,338 737 2,429,568 71,950 (4,470) 2,497,825 — 266,546 — 266,546 — 891 891 (2,593) — 38,839 (241,155) (1,318) 14,109 — — — — — (2,593) (241,155) 37,531 14,109 747 2,482,516 93,430 (3,579) 2,573,154 — 358,160 — 358,160 — 213 213 — — — — (6,124) — 619,359 (93,501) (276,823) (1,741) (164,403) — — — — — (6,124) (276,823) 617,669 (257,929) 18,334 — — — — 10 — — — — — 51 (25) — — — 18,334 — Balance at December 31, 2007 4,000,000 77,318,611 $40 $773 $3,026,708 $ 2,499 $(3,366) $3,026,654 See accompanying notes to Consolidated Financial Statements. 34 AvalonBay Communities, Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) 12-31-07 12-31-06 12-31-05 For the year ended Cash ﬂ ows 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 ﬁ nancing costs and debt premium/discount Amortization of stock-based compensation Income allocated to minority interest in consolidated partnerships Equity in income of unconsolidated entities, net of eliminations Return on investment of unconsolidated entities Gain on sale of real estate assets Increase in cash in operating escrows Decrease (increase) in resident security deposits, prepaid expenses and other assets Increase in accrued expenses, other liabilities and accrued interest payable Net cash provided by operating activities Cash ﬂ ows from investing activities: Development/redevelopment of real estate assets including land acquisitions and deferred development costs Acquisition of real estate assets, including partner equity interest Capital expenditures—existing real estate assets Capital expenditures—non-real estate assets Proceeds from sale of real estate and technology investments, including reimbursement for Fund communities, net of selling costs Increase in payables for construction Decrease (increase) in cash in construction escrows Increase in investments in unconsolidated real estate entities $358,160 $266,546 $310,468 179,549 2,176 4,934 14,353 1,585 (58,122) 130 (107,032) (7,403) 160,442 3,687 4,474 10,095 573 (6,480) 298 (110,930) (844) 156,454 6,842 4,022 4,292 1,481 (6,565) 330 (199,766) (4,344) 8,747 (4,381) 8,547 58,748 455,825 28,180 351,660 24,487 306,248 (1,112,590) (13,841) (13,851) (1,424) 261,089 32,348 54,149 (15,127) (735,167) (74,924) (21,289) (957) 272,223 34,542 19,572 (5,371) Net cash used in investing activities (809,247) (511,371) Cash ﬂ ows from ﬁ nancing activities: Issuance of common stock Repurchase of common stock Dividends paid Net borrowings (repayments) under unsecured credit facility Issuance of mortgage notes payable and draws on construction loans Repayments of mortgage notes payable Issuance (repayment) of unsecured notes Payment of deferred ﬁ nancing costs Redemption of units for cash by minority partners Contributions from minority and proﬁ t-sharing partners Distributions to DownREIT partnership unitholders Distributions to joint venture and proﬁ t-sharing partners 621,029 (257,929) (268,966) 514,500 59,126 (27,256) (260,000) (6,550) (6,851) 1,333 (280) (1,796) 26,551 — (234,958) (66,800) 113,849 (6,827) 343,743 (12,698) (80) — (392) (108) Net cash provided by (used in) ﬁ nancing activities 366,360 162,280 Net increase 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. 12,938 8,284 $ 21,222 $ 98,594 2,569 5,715 $ 8,284 $102,640 (382,871) (57,415) (17,570) (1,520) 469,292 5,198 (21,784) (13,091) (19,761) 36,611 — (215,391) (35,200) 26,269 (41,932) (50,000) (1,292) (50) — (1,194) (114) (282,293) 4,194 1,521 $ 5,715 $121,526 AvalonBay Communities, Inc. 35 CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) Supplemental disclosures of non-cash investing and ﬁ nancing activities (dollars in thousands): During the year ended December 31, 2007: • As described in Note 4, “Stockholders’ Equity,” 75,231 shares of common stock valued at $10,971 were issued in connection with stock grants, 2,929 shares valued at $365 were issued through the Company’s dividend reinvestment plan, 41,000 shares valued at $4,381 were withheld to satisfy employees’ tax withholding and other liabilities and 8,609 shares valued at $231 were forfeited, for a net value of $6,724. In addition, the Company granted 331,356 options for common stock, net of forfeitures, at a value of $7,518. • 19,231 units of limited partnership, valued at $887, 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 recorded a decrease to other liabilities and a corresponding gain to other comprehensive income of $213 to adjust the Company’s Hedging Derivatives (as deﬁ ned in Note 5, “Derivative Instruments and Hedging Activities”) to their fair value. • The Company issued $100,000 of variable-rate tax-exempt debt relating to Avalon Morningside Park. The proceeds were placed in an escrow account until requisitioned for construction funding, none of which has been drawn for use in the development of the community. • Common and preferred dividends declared but not paid totaled $67,909. • The Company recorded an increase of $6,124 to minority interest with a corresponding decrease to accumulated earnings less dividends to adjust the redemption value associated with a put option held by a joint venture partner. This put option allows our partner to put their interest in the investment to the Company at the future fair market value. During the year ended December 31, 2006: • As described in Note 4, “Stockholders’ Equity,” 122,172 shares of common stock valued at $12,568 were issued in connection with stock grants, 2,306 shares valued at $256 were issued through the Company’s dividend reinvestment plan, 47,111 shares valued at $3,449 were withheld to satisfy employees’ tax withholding and other liabilities and 5,910 shares valued at $193 were forfeited, for a net value of $9,182. In addition, the Company granted 849,769 options for common stock, net of forfeitures, at a value of $9,946. • 308,345 units of limited partnership, valued at $14,166, 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 issued $187,300 of variable rate, tax-exempt debt, of which $107,451 in proceeds were not received, but placed in an escrow until requisitioned for construction funding. • The Company recorded a decrease to other liabilities and a corresponding gain to other comprehensive income of $891 to adjust the Company’s Hedging Derivatives (as deﬁ ned in Note 5, “Derivative Instruments and Hedging Activities”) to their fair value. • The Company recorded an increase of $2,593 to minority interest with a corresponding decrease to accumulated earnings less dividends to adjust the redemption value associated with a put option held by a joint venture partner. This put option allows our partner to put their interest in the investment to the Company at the future fair market value. • Common and preferred dividends declared but not paid totaled $60,417. During the year ended December 31, 2005: • 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 were 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 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 deconsolidated mortgage notes payable in the aggregate amount of $24,869 upon admittance of outside investors into the Fund (as deﬁ ned in Note 6, “Investments in Unconsolidated Entities”). • The Company assumed ﬁ xed rate debt of $4,566 as part of the acquisition of an improved land parcel. • The Company recorded a decrease to other liabilities and a corresponding gain to other comprehensive income of $2,626 to adjust the Company’s Hedging Derivatives to their fair value. • Common and preferred dividends declared but not paid totaled $54,476. 36 AvalonBay Communities, Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, except per share data) 1. Organization and Signiﬁ cant Accounting Policies Organization AvalonBay Communities, Inc. (the “Company,” which term, unless the context otherwise requires, 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 Internal Revenue Code of 1986 (“the Code”), as amended. The Company focuses on the ownership and operation of apartment communities in high barrier-to-entry markets of the United States. These markets are located in the Northeast, Mid-Atlantic, Midwest, Paciﬁ c Northwest, and Northern and Southern California regions of the country. At December 31, 2007, the Company owned or held a direct or indirect ownership interest in 163 operating apartment communities containing 45,932 apartment homes in ten states and the District of Columbia, of which eight communities containing 2,231 apartment homes were under reconstruction. The operations of 139 of these communities, containing 40,509 apartment homes are consolidated for ﬁ nancial reporting purposes. In addition, the Company owned or held a direct or indirect ownership interest in 21 communities under construction that are expected to contain an aggregate of 6,816 apartment homes when completed. The Company also owned or held a direct or indirect ownership interest in rights to develop an additional 48 communities that, if developed as expected, will contain an estimated 13,656 apartment homes. Principles of Consolidation The Company is the surviving corporation from the merger (the “Merger”) of Bay Apartment Communities, Inc. (“Bay”) and Avalon Properties, 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 ﬁ nancial statements for Avalon presented prior to the Merger. At that time, Avalon ceased to legally exist, and Bay as the surviving legal entity adopted the historical ﬁ nancial statements of Avalon. Consequently, Bay’s assets were recorded in the historical ﬁ nancial 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. The accompanying Consolidated Financial Statements include the accounts of the Company and its wholly-owned partnerships, certain joint venture partnerships, subsidiary partnerships structured as DownREITs and any variable interest entities consolidated under FASB Interpretation No. 46 (“FIN 46(R)”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,” as revised in December 2003. All signiﬁ cant intercompany balances and transactions have been eliminated in consolidation. The Company assesses consolidation of variable interest entities under the guidance of FIN 46(R). The Company accounts for joint venture entities and subsidiary partnerships, including those structured as DownREITs, that are not variable interest entities, 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,” Statement of Position (“SOP”) 78-9, “Accounting for Investments in Real Estate Ventures,” Accounting Principles Board (“APB”) Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” and EITF Topic D-46, “Accounting for Limited Partnership Investments.” The Company uses EITF Issue No. 04-5 to evaluate the partnership of each joint venture entity and determine whether control over the partnership, as deﬁ ned by the EITF, lies with the general partner, or the limited partners, when the limited partners have certain rights. The general partner in a limited partnership is presumed to control that limited partnership, unless that presumption is overcome by the limited partners having either: (i) the substantive ability, either by a single limited partner or through a simple majority vote, to dissolve the limited partnership or otherwise remove the general partner without cause; or (ii) substantive participating rights. If the Company is the general partner and has control over the partnership, or if the Company’s limited partnership ownership includes the ability to dissolve the partnership, or has substantive participating rights, as discussed above, the Company consolidates the investments. If the Company is not the general partner, or the Company’s partnership interest does not contain either of the above terms which overcome the presumption of control in a limited partnership residing with the general partner, the Company then looks to the guidance in SOP 78-9, APB No. 18 and EITF Topic D-46 to determine the accounting framework to apply. The Company generally uses the equity method to account for these investments unless its ownership interest is so minor that it has virtually no inﬂ uence over the partnership’s operating and ﬁ nancial policies. Investments in which the Company has little or no inﬂ uence are accounted for using the cost method. In each of the partnerships structured as DownREITs, either the Company or one of the Company’s wholly owned subsidiaries is the general partner, and there are one or more limited partners whose interest in the partnership is represented by units of limited partnership interest. For each DownREIT partnership, limited partners are entitled to receive an initial distribution of current cash ﬂ ow before any distribution is made to the general partner. Although the partnership agreements for each of the DownREITs are different, generally the distributions per unit paid to the holders of units of limited partnership interests have approximated the Company’s current common stock dividend per share. The holders of units of limited partnership interests have the right to present all or some of their units for redemption for a cash amount as determined by the applicable partnership agreement and based on the fair value of the Company’s common stock. In lieu of cash redemption, the Company may elect to exchange such units for an equal number of shares of the Company’s common stock. AvalonBay Communities, Inc. 37 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) In conjunction with the acquisition and development of investments in unconsolidated entities, the Company may incur costs in excess of its equity in the underlying assets. These costs are capitalized and depreciated over the life of the underlying assets to the extent that the Company expects to recover the costs. 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 carrying value of the investment or if the investee could not sustain an earnings capacity that would justify the carrying amount of the investment. The Company did not recognize an impairment loss on any of its investments in unconsolidated entities during the years ended December 31, 2007, 2006 or 2005. Revenue and Gain Recognition Rental income related to leases is recognized on an accrual basis when due from residents in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition,” and Statement of Financial Accounting Standards (“SFAS”) No. 13, “Accounting for Leases.” In accordance with the Company’s 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. The Company accounts for sales of real estate assets and the related gain recognition in accordance with SFAS No. 66, “Accounting for Sales of Real Estate.” Real Estate Operating real estate assets are 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. Signiﬁ cant expenditures which improve or extend the life of an asset are capitalized. Expenditures for maintenance and repairs are charged to operations as incurred. The Company’s policy with respect to capital expenditures is generally to capitalize only non-recurring 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 apartment 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. The capitalization of costs during the development of assets (including interest and related loan fees, property taxes and other direct and indirect costs) begins when the Company has determined that development of the future asset is probable and ends when the asset, or a portion of an asset, is delivered and is ready for its intended use. For redevelopment efforts, we capitalize costs beginning either (i) in advance of taking homes out of service when signiﬁ cant renovation of the common area has begun until the redevelopment is completed, or (ii) when an apartment home is taken out-of-service for redevelopment until the redevelopment is completed and the apartment home is available for a new resident. Rental income and operating costs incurred during the initial lease-up or post-redevelopment lease-up period are recognized as they accrue. 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 currently believes future development is probable (“Development Rights”). Future development of these Development Rights is dependent upon various factors, including zoning and regulatory 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, making future development by the Company 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 and disposition pursuits, in the amounts of $6,974 in 2007, $2,115 in 2006 and $816 in 2005. These costs are included in operating expenses, excluding property taxes on the accompanying Consolidated Statements of Operations and Other Comprehensive Income. Abandoned pursuit costs can vary greatly, and the costs incurred in any given period may be signiﬁ cantly different in future years. The Company owns land improved with ofﬁ ce buildings and industrial space occupied by unrelated third parties in connection with ﬁ ve Development Rights. The Company intends to manage the current improvements until such time as all tenant obligations have been satisﬁ ed or eliminated through negotiation, and construction of new apartment communities is ready to begin. As provided under the guidance of SFAS No. 67, the revenue from incidental operations received from 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, allocating to each asset and liability acquired in such transaction, 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, ﬁ xtures and equipment, are reﬂ 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 on the accompanying Consolidated Balance Sheets 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 ﬂ ow of acquired leases with leased rents above or below current market rents. 38 AvalonBay Communities, Inc. Depreciation is calculated on buildings and improvements using the straight-line method over their estimated useful lives, which range from seven to thirty years. Furniture, ﬁ xtures and equipment are generally depreciated using the straight-line method over their estimated useful lives, which range from three years (primarily computer-related equipment) to seven years. It is the Company’s policy to perform a quarterly qualitative analysis to determine if there are changes in circumstances that suggest the carrying value of a long-lived asset may not be recoverable. If there is an event or change in circumstance that indicates an impairment in the value of an operating community, the Company compares the current and projected operating cash ﬂ ow of the community over its remaining useful life, on an undiscounted basis, to the carrying amount of the community. If the carrying amount is in excess of the estimated projected operating cash ﬂ ow of the community, the Company would recognize an impairment loss equivalent to an amount required to adjust the carrying amount to its estimated fair market value. The Company did not recognize an impairment loss on any of its operating communities during the years ended December 31, 2007, 2006 or 2005. Income Taxes The Company elected to be taxed as a REIT under the Code, as amended, for the year ended December 31, 1994 and has 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 requirements, including a requirement that it currently 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 if it distributes 100% of the taxable income over the time period allowed under the Code to its stockholders. Management believes that all such conditions for the avoidance of income taxes have been met for the periods presented. Accordingly, 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 qualiﬁ es 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. The following reconciles net income available to common stockholders to taxable net income for the years ended December 31, 2007, 2006 and 2005: (Unaudited) Net income available to common stockholders Dividends attributable to preferred stock, not deductible for tax GAAP gain on sale of communities less than tax gain Depreciation/Amortization timing differences on real estate Tax compensation expense in excess of GAAP Other adjustments Taxable net income 2007 Estimate 2006 Actual 2005 Actual $349,460 $257,846 $301,768 8,700 11,808 (49,971) (29,067) 12,259 8,700 7,242 (21,974) (26,540) 13,335 8,700 9,345 (13,503) (18,969) 8,423 $303,189 $238,609 $295,764 The following summarizes the tax components of the Company’s common and preferred dividends declared for the years ended December 31, 2007, 2006 and 2005: (Unaudited) Ordinary income 15% capital gain Unrecaptured §1250 gain 2007 35% 54% 11% 2006 48% 43% 9% 2005 9% 77% 14% Deferred Financing Costs Deferred ﬁ nancing costs include fees and other expenditures necessary to obtain debt ﬁ nancing and are amortized on a straight-line basis, which approximates the effective interest method, over the shorter of the term of the loan or the related credit enhancement facility, if applicable. Unamortized ﬁ nancing costs are written-off when debt is retired before the maturity date. Accumulated amortization of deferred ﬁ nancing costs was $19,368 at December 31, 2007 and was $16,179 at December 31, 2006. 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. Cash in escrow consists primarily of construction ﬁ nancing proceeds that are restricted for use in the construction of a speciﬁ c community. The majority of the Company’s cash, cash equivalents and cash in escrows are held at major commercial banks. Interest Rate Contracts The Company utilizes derivative ﬁ nancial instruments to manage interest rate risk and generally designates these ﬁ nancial instruments as cash ﬂ ow hedges under the guidance of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended. This statement requires that derivatives be recorded on the balance sheet as either an asset or liability measured at its AvalonBay Communities, Inc. 39 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) fair value, with changes in fair value recognized currently in earnings unless speciﬁ c hedge accounting criteria are met. For cash ﬂ ow hedge relationships, changes in the fair value of the derivative instrument that are deemed effective at offsetting the risk being hedged are reported in other comprehensive income. For cash ﬂ ow hedges where the cumulative changes in the fair value of the derivative exceed the cumulative changes in fair value of the hedged item, the ineffective portion is recognized in current period earnings. As of December 31, 2007 and December 31, 2006, the Company had approximately $213,108 and $262,000, respectively, in variable rate debt subject to cash ﬂ ow hedges. As of December 31, 2007, the Company did not apply hedge accounting for an additional $92,400 in variable rate debt which is subject to interest rate caps. See Note 5, “Derivative Instruments and Hedging Activities,” for further discussion of derivative ﬁ nancial instruments. Comprehensive Income Comprehensive income, as reﬂ ected on the Consolidated Statements of Operations and Other Comprehensive Income, is deﬁ ned as all changes in equity during each period except for those resulting from investments by or distributions to shareholders. Accumulated other comprehensive loss as reﬂ ected on the Consolidated Statements of Stockholders’ Equity reﬂ ects the effective portion of the cumulative changes in the fair value of derivatives in qualifying cash ﬂ ow hedge relationships. Earnings per Common Share In accordance with the provisions of SFAS No. 128, “Earnings per Share,” basic earnings per share is computed by dividing earnings available to common stockholders by the weighted average number of shares outstanding during the period. Other potentially dilutive common shares, and the related impact to earnings, are considered when calculating earnings per share on a diluted basis. The Company’s earnings per common share are determined as follows: Basic and diluted shares outstanding Weighted average common shares—basic Weighted average DownREIT units outstanding Effect of dilutive securities Weighted average common shares—diluted Calculation of Earnings per Share—basic Net income available to common stockholders Weighted average common shares—basic Earnings per common share—basic Calculation of Earnings per Share—diluted Net income available to common stockholders Add: Minority interest of DownREIT unitholders in consolidated partnerships, including discontinued operations For the year ended 12-31-07 12-31-06 12-31-05 78,680,043 105,859 1,071,025 74,125,795 172,255 1,288,848 72,952,492 474,440 1,332,386 79,856,927 75,586,898 74,759,318 $ 349,460 $ 257,846 $ 301,768 78,680,043 74,125,795 72,952,492 $ 4.44 $ 3.48 $ 4.14 $ 349,460 $ 257,846 $ 301,768 280 391 1,363 Adjusted net income available to common stockholders $ 349,740 $ 258,237 $ 303,131 Weighted average common shares—diluted Earnings per common share—diluted 79,856,927 75,586,898 74,759,318 $ 4.38 $ 3.42 $ 4.05 Certain options to purchase shares of common stock in the amounts of 335,856 and 3,000 were outstanding during the years ended December 31, 2007 and December 31, 2006, respectively, but were not included in the computation of diluted earnings per share because in applying the treasury stock method under the provisions of SFAS No. 123(R), “Share Based Payments,” as discussed below, such options are anti-dilutive. Employee options to purchase shares of common stock of 4,500 were outstanding during the year ended December 31, 2005, but were not included in the computation of diluted earnings per share 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 Effective January 1, 2003, the Company adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of FASB Statement No. 123,” prospectively to all employee awards granted, modiﬁ ed, or settled on or after January 1, 2003. Awards under the Company’s stock option plans vest over a three-year period. Therefore, the cost related to stock-based employee compensation for employee stock options included in the determination of net income for the years ended December 31, 2007 and 2006 is the same as the cost that would have been recognized if the fair value based method had been applied to all awards since the original effective date of SFAS No. 123. However, the cost related to stock-based employee compensation for employee stock options included in the determination of net income for the year ended December 31, 2005 is less than that which would have been recognized if the fair value based method had been applied to all awards granted since the original effective date of SFAS No. 123. If the fair value based method had been applied to all outstanding and unvested awards in the year ended December 31, 2005, net income would have been $112 lower for the year ended December 31, 2005. There would not have been any material impact on earnings per common share – diluted for the year ended December 31, 2005. 40 AvalonBay Communities, Inc. The Company adopted the provisions of SFAS No. 123(R) using the modiﬁ ed prospective transition method on January 1, 2006. The adoption of SFAS No. 123(R) did not have a material impact on the Company’s ﬁ nancial position or results of operations. However, the adoption of SFAS No. 123(R) changed the service period for, and timing of, the recognition of compensation cost related to retirement eligibility, which will generally result in accelerated expense recognition by the Company for its stock-based compensation programs. For the year ended December 31, 2005, the Company recorded compensation cost over the vesting period, regardless of eligibility for retirement (see Note 8, “Commitments and Contingencies,” for a discussion of the Company’s retirement plan). If the Company had recorded compensation cost based on retirement eligibility, the increase to compensation cost during the year ended December 31, 2005 would not have been material. Under the provisions of SFAS No. 123(R), the Company is required to estimate the forfeiture of stock options and recognize compensation cost net of the estimated forfeitures. The estimated forfeitures included in compensation cost are adjusted to reﬂ ect actual forfeitures at the end of the vesting period. Prior to the adoption of SFAS No. 123(R), option forfeitures were recognized as they occurred. The forfeiture rate at December 31, 2007 was 2.3%. The application of estimated forfeitures did not materially impact compensation expense for the year ended December 31, 2007 or 2006. Assets Held for Sale & Discontinued Operations The Company follows SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”) which requires that the assets and liabilities of any communities which have been sold, or otherwise qualify as held for sale, be presented separately in the Consolidated Balance Sheets. In addition, the results of operations for those assets that meet the deﬁ nition of discontinued operations are presented as such in the Company’s Consolidated Statements of Operations and Other Comprehensive Income. Held for sale and discontinued operations classiﬁ cations are provided in both the current and prior periods presented. Real estate assets held for sale are measured at the lower of the carrying amount or the fair value less the cost to sell. Both the real estate assets and corresponding liabilities are presented separately in the accompanying Consolidated Balance Sheets. Subsequent to classiﬁ cation of a community as held for sale, no further depreciation is recorded. For those assets qualifying for classiﬁ cation as discontinued operations, the community speciﬁ c components of net income presented as discontinued operations include net operating income, minority interest expense, depreciation expense and interest expense, net. For periods prior to the asset qualifying for discontinued operations under SFAS 144, the Company reclassiﬁ ed the results of operations to discontinued operations in accordance with SFAS 144. Subsequent to the reclassiﬁ cation to discontinued operations, the impact of assets classiﬁ ed as discontinued operations on the Consolidated Statements of Operations and Other Comprehensive Income will include depreciation. 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 presentation for held for sale or discontinued operations will not have any impact on the Company’s ﬁ nancial condition or results of operations. The Company combines the operating, investing and ﬁ nancing portions of cash ﬂ ows attributable to discontinued operations with the respective cash ﬂ ows from continuing operations on the accompanying Consolidated Statements of Cash Flows. Use of Estimates The preparation of ﬁ nancial statements in conformity with GAAP requires management to make certain estimates and assumptions. These estimates and assumptions affect the reported 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 revenue and expenses during the reporting periods. Actual results could differ from those estimates. Reclassiﬁ cations Certain reclassiﬁ cations have been made to amounts in prior years’ ﬁ nancial statements to conform to current year presentations. Recently Issued Accounting Standards The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109,” (“FIN 48”), on January 1, 2007. The Company did not have any unrecognized tax beneﬁ ts and there was no material effect on either the ﬁ nancial condition or results of operations of the Company as a result of implementing FIN 48. We do not believe that there will be any material changes in our unrecognized tax positions over the next 12 months. The Company is subject to examination by the respective taxing authorities for the tax years 2004 through 2006. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which standardizes the deﬁ nition of fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements, and accordingly, this statement does not require any new fair value measurements. SFAS No. 157 is effective for all ﬁ scal years beginning after November 15, 2007. The Company does not believe that the adoption of SFAS No. 157 will have any material impact on its ﬁ nancial position or results of operations. In December 2007, the FASB issued Statement No. 141(R), “Business Combinations.” This statement changes the accounting for acquisitions speciﬁ cally eliminating the step acquisition model, changing the recognition of contingent consideration from being recognized when it is probable to being recognized at the time of acquisition, disallowing the capitalization of transaction costs and delays when restructurings related to acquisitions can be recognized. The standard is effective for ﬁ scal years ending after December 15, 2008 and will only impact the accounting for acquisitions subsequent to adoption of the standard. In December 2007, the FASB issued Statement No. 160, “Accounting and Reporting of Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51.” Under this statement, noncontrolling interests are considered equity and thus our practice of AvalonBay Communities, Inc. 41 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) reporting minority interests in the mezzanine section of the consolidated balance sheet will be eliminated. Also, under the new standard, net income will encompass the total income of all consolidated subsidiaries and there will be separate disclosure on the face of the consolidated statement of operations and other comprehensive income of the attribution of that income between controlling and noncontrolling interests. Last, increases and decreases in noncontrolling interests will be treated as equity transactions. The standard is effective for ﬁ scal years ending after December 15, 2008. In December 2007, the FASB ratiﬁ ed the consensus of Emerging Issues Task Force on Issue 07-6 “Accounting for the Sale of Real Estate Subject to the Requirements of FASB Statement No. 66 (“SFAS 66”) When the Agreement Includes a Buy-Sell Clause” (“EITF 07-6”). EITF 07-6 addresses the impact of a buy-sell clause contained within a joint venture agreement on a seller’s continuing involvement in the entity and corresponding ability to recognize proﬁ t on a sale of real estate to the joint venture, in which they retain a partial ownership interest. In EITF 07-6, the Task Force reached a consensus that a buy-sell clause, in and of itself, does not constitute a prohibited form of continuing involvement that would preclude partial sales treatment under SFAS 66. However, a buy-sell clause may constitute a prohibited form of continuing involvement that precludes partial sales treatment if the buyer cannot act independently from the seller or if the seller is economically compelled to reacquire the other partner’s interest in the jointly owned entity. EITF 07-6 is effective for new arrangements entered into in ﬁ scal years beginning after December 15, 2007 and interim periods within those ﬁ scal years. 2. Interest Capitalized The Company capitalizes interest during the development and redevelopment of real estate assets in accordance with SFAS No. 34, “Capitalization of Interest Cost.” Capitalized interest associated with communities under development or redevelopment totaled $73,118 for 2007, $46,388 for 2006 and $25,284 for 2005. 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, 2007 and December 31, 2006 are summarized below. The following amounts and discussion do not include the mortgage notes related to three communities classiﬁ ed as held for sale as of December 31, 2006 as shown in the Consolidated Balance Sheets (see Note 7, “Real Estate Disposition Activities”). 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 unsecured credit facility 12-31-07 12-31-06 $1,893,499 230,050 570,153 2,693,702 514,500 $2,153,078 210,114 438,236 2,801,428 — Total mortgage notes payable, unsecured notes and unsecured credit facility $3,208,202 $2,801,428 (1) Balances at December 31, 2007 and December 31, 2006 include $2,501 and $2,922 of debt discount, respectively. The following debt activity occurred during the year ended December 31, 2007: • we issued $16,926 of variable rate mortgage debt for an operating community in June, maturing in May 2012; • we repaid $15,980 of mortgage debt, secured by the assets of an operating community in July; • we assumed $3,941 of ﬁ xed rate mortgage debt in conjunction with the acquisition of an operating community in July 2007 and subsequently defeased the note in December 2007; • we issued $100,000 of variable rate, tax-exempt debt for a development community in September, maturing in November 2040; • we repaid $150,000 in previously issued unsecured notes in August 2007, along with any unpaid interest, pursuant to their scheduled maturity; • we issued $42,200 of ﬁ xed rate, tax-exempt mortgage debt for an operating community in September 2007, maturing in October 2047; • in conjunction with the sale of a community we were relieved of our obligation related to the mortgage note secured by the assets of the community in the amount of $8,116, as it was assumed by the purchaser in September; • we repaid $110,000 in previously issued unsecured notes in December 2007, along with any unpaid interest, pursuant to their scheduled maturity; • we borrowed $514,500 under our unsecured credit facility; and • we increased our borrowing capacity under our unsecured credit facility by $350,000, to $1,000,000. 42 AvalonBay Communities, Inc. In the aggregate, secured notes payable mature at various dates from October 2008 through April 2043 and are secured by certain apartment communities and improved land parcels (with a net carrying value of $1,202,135 as of December 31, 2007). As of December 31, 2007, the Company has guaranteed approximately $108,575 of mortgage notes payable held by wholly owned subsidiaries; all such mortgage notes payable are consolidated for ﬁ nancial reporting purposes. The weighted average interest rate of the Company’s ﬁ xed rate mortgage notes payable (conventional and tax-exempt) was 6.5% and 6.8% at December 31, 2007 and December 31, 2006, respectively. The weighted average interest rate of the Company’s variable rate mortgage notes payable and its unsecured credit facility, including the effect of certain ﬁ nancing related fees, was 5.4% at December 31, 2007 and 5.8% at December 31, 2006. Scheduled payments and maturities of mortgage notes payable and unsecured notes outstanding at December 31, 2007 are as follows: Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Thereafter Secured notes payments Secured notes maturities Unsecured notes maturities Stated interest rate of unsecured notes 8,788 6,204 6,226 5,324 4,265 4,610 4,988 5,396 5,838 6,328 253,707 $311,674 4,432 76,141 29,388 36,579 27,143 — 33,100 — — 44,700 237,046 $488,529 50,000 146,000 150,000 200,000 300,000 50,000 250,000 250,000 100,000 150,000 — 250,000 — — $1,896,000 6.625% 8.250% 7.500% 7.500% 6.625% 6.625% 6.125% 5.500% 4.950% 5.375% — 5.750% — — The Company’s unsecured notes contain a number of ﬁ nancial 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 service payments. In November 2007 we increased our borrowing capacity under our existing revolving variable rate unsecured credit facility from $650,000 to $1,000,000. The facility is with a syndicate of commercial banks, to whom we pay, in the aggregate, an annual facility fee of approximately $1,250. The Company had $514,500 outstanding under the current credit facility and $61,689 outstanding in letters of credit on December 31, 2007. At December 31, 2006 there were no amounts outstanding under the current facility and $38,713 outstanding in letters of credit. The unsecured credit facility bears interest at varying levels based on the London Interbank Offered Rate (“LIBOR”), rating levels achieved on the Company’s unsecured notes and on a maturity schedule selected by the Company. The current stated pricing is LIBOR plus 0.40% per annum (5.81% at December 31, 2007). The stated spread over LIBOR can vary from LIBOR plus 0.325% to LIBOR plus 1.00% based on the Company’s credit rating. In addition, the unsecured credit facility includes a competitive bid option, which allows banks that are part of the lender consortium to bid to make loans to the Company at a rate that is lower than the stated rate provided by the unsecured credit facility for up to $422,500. The competitive bid option may result in lower pricing than the stated rate if market conditions allow. The Company did not have any amounts outstanding under this competitive bid option as of December 31, 2007. The Company is in compliance with certain customary covenants under the unsecured credit facility, including, but not limited to, maintaining certain maximum leverage ratios, a minimum ﬁ xed charges coverage ratio and minimum unencumbered assets and equity levels. The credit facility matures in November 2011, assuming exercise of a one-year renewal option by the Company. 4. Stockholders’ Equity As of both December 31, 2007 and 2006, the Company had authorized for issuance 140,000,000 and 50,000,000 shares of common and preferred stock, respectively. As of December 31, 2007, the Company has the following series of redeemable preferred stock outstanding at a stated value of $100,000. This series has no stated maturity and is not subject to any sinking fund or mandatory redemptions. Series H Shares outstanding December 31, 2006 Payable quarterly 4,000,000 March, June, September, December Annual rate 8.70% Liquidation preference Non-redeemable prior to $25.00 October 15, 2008 AvalonBay Communities, Inc. 43 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) Dividends on the preferred stock are cumulative from the date of original issue and are payable quarterly in arrears on or before 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 accrued and unpaid dividends, if any. During the year ended December 31, 2007, the Company: (i) issued 4,600,000 shares of common stock in connection with an equity offering; (ii) issued 474,496 shares of common stock in connection with stock options exercised; (iii) issued 19,231 shares of common stock to acquire an equal number of DownREIT limited partnership units; (iv) issued 2,929 shares through the Company’s dividend reinvestment plan; (v) issued 75,231 common shares in connection with stock grants; (vi) issued 8,577 common shares through the Company’s employee stock purchase program; (vii) had 8,609 shares of restricted stock forfeited; (viii) withheld 41,000 shares to satisfy employees’ tax withholding and other liabilities; and (ix) purchased 2,480,616 shares through the Company’s stock repurchase program. In addition, the Company granted 344,429 options for common stock to employees. As required under SFAS No. 123(R), any deferred compensation related to the Company’s stock option and restricted stock grants during the year ended December 31, 2007 is not reﬂ ected on the Company’s Consolidated Balance Sheet as of December 31, 2007 and will not be reﬂ ected until earned as compensation cost. Dividends per common share were $3.40 for the year ended December 31, 2007, $3.12 for the year ended December 31, 2006 and $2.84 for the year ended December 31, 2005. The average dividend for all non-redeemed preferred shares during 2007, 2006 and 2005 was $2.18 per share. No preferred shares were redeemed in 2007, 2006 or 2005. 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 preferred stock to purchase shares of common stock through either reinvested 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. In January 2007, the Company ﬁ led a new shelf registration statement with the Securities and Exchange Commission, allowing the Company to sell an undetermined number or amount of certain debt and equity securities as deﬁ ned in the prospectus. In addition, in conjunction with its inclusion in the S&P 500 Index in January 2007, the Company issued 4,600,000 shares of its common stock at $129.30 per share, resulting in net proceeds in the amount of approximately $594,000. During 2007, the Company announced that its Board of Directors increased to $300,000 the Company’s common stock repurchase program for purchases of shares of its common stock in open market or negotiated transactions. From August 1, 2007 to December 31, 2007, the Company repurchased 2,480,616 shares at an average price of $103.95 per share through this program. The Company did not have any purchases under this program prior to August 1, 2007. 5. Derivative Instruments and Hedging Activities The Company enters into interest rate swap and interest rate cap agreements (collectively, the “Hedging Derivatives”) to reduce the impact of interest rate ﬂ uctuations on its variable rate, tax-exempt bonds and its variable rate conventional secured debt (collectively, the “Hedged Debt”). The Company has not entered into any interest rate hedge agreements for its conventional unsecured debt and does not enter into derivative transactions for trading or other speculative purposes. The following table summarizes the consolidated Hedging Derivatives at December 31, 2007: (Dollars in thousands) Notional balance Weighted average interest rate (1) Weighted average capped interest rate Earliest maturity date Latest maturity date Estimated fair value, asset/(liability) (1) For interest rate caps, this represents the weighted average interest rate on the debt. 44 AvalonBay Communities, Inc. Interest Rate Caps $235,973 5.0% 7.5% May-09 Mar-14 $ 115 Interest Rate Swaps $46,337 6.5% n/a Jun-10 Jul-10 $ (2,808) At December 31, 2007, the Company had nine derivatives designated as cash ﬂ ow hedges and four derivatives not designated as hedges. For the derivative positions that the Company has determined qualify as effective cash ﬂ ow hedges under SFAS No. 133, the Company has recorded the effective portion of cumulative changes in the fair value of the Hedging Derivatives in other comprehensive income. Amounts recorded in other comprehensive income will be reclassiﬁ ed into earnings in the periods in which earnings are affected by the hedged cash ﬂ ow. To adjust the Hedging Derivatives to their fair value, the Company recorded unrealized gains in other comprehensive income of $213, $891 and $2,626 during the years ended December 31, 2007, 2006 and 2005, respectively. These amounts will be reclassiﬁ ed into earnings in conjunction with the periodic adjustment of the ﬂ oating rates on the Hedged Debt, in interest expense, net. The amount reclassiﬁ ed into earnings in 2007, as well as the estimated amount included in accumulated other comprehensive income as of December 31, 2007, expected to be reclassiﬁ ed into earnings within the next twelve months to offset the variability of cash ﬂ ows of the hedged items during this period are not material. The Company assesses both at inception and on an on-going basis, the effectiveness of qualifying cash ﬂ ow hedges. Hedge ineffectiveness, reported as a component of general and administrative expenses, did not have a material impact on earnings of the Company for any prior period, and the Company does not anticipate that it will have a material effect in the future. The fair values of the Hedging Derivatives are included in accrued expenses and other liabilities on the accompanying Consolidated Balance Sheets. Derivative ﬁ nancial instruments expose the Company to credit risk in the event of nonperformance by the counterparties under the terms of the Hedging Derivatives. The Company minimizes its credit risk on these transactions by dealing with major, creditworthy ﬁ nancial institutions which have an A+ or better credit rating by the Standard & Poor’s Ratings Group. As part of its on-going control procedures, the Company monitors the credit ratings of counterparties and the exposure of the Company to any single entity, thus minimizing credit risk concentration. The Company believes the likelihood of realizing losses from counterparty non-performance is remote. 6. Investments in Real Estate Entities Investments in Unconsolidated Real Estate Entities The Company accounts for its investments in unconsolidated real estate entities in accordance with the literature as discussed in Note 1, “Organization and Signiﬁ cant Accounting Policies”, under Principles of Consolidation. In October 2007, the Company completed the sale of its partnership interest in Avalon Grove to its third–party venture partner for $63,446 with a gain in accordance with GAAP of $56,320 reported as a component of equity in income of unconsolidated entities on the Consolidated Statements of Operations and Other Comprehensive Income. Avalon Grove, located in the Fairﬁ eld-New Haven market of Connecticut, was previously reported as an unconsolidated real estate investment. The Company will continue to manage this community for a customary property management fee. As of December 31, 2007, the Company had investments in the following real estate entities: • Arna Valley View LP — In connection with the municipal approval process for the development of a consolidated community, the Company agreed to participate in the formation of a limited partnership in February 1999 to develop, ﬁ nance, own and operate Arna Valley View, a 101 apartment-home community located in Arlington, Virginia. This community has affordable rents for 100% of apartment homes related to the tax-exempt bond ﬁ nancing and tax credits used to ﬁ nance construction of the community. A subsidiary of the Company is the general partner of the partnership with a 0.01% ownership interest. The Company is responsible for the day-to-day operations of the community and is the management agent subject to the terms of a management agreement. As of December 31, 2007, Arna Valley View has $5,635 of variable rate, tax-exempt bonds outstanding, which mature in June 2032. In addition, Arna Valley View has $4,938 of 4% ﬁ xed rate county bonds outstanding that mature in December 2030. Arna Valley View’s debt is neither guaranteed by, nor recoursed to the Company. Due to the Company’s limited ownership in this venture and the terms of the management agreement regarding the rights of the limited partners, it is accounted for using the cost method. • CVP I, LLC — In February 2004, the Company entered into a joint venture agreement with an unrelated third-party for the development of Avalon Chrystie Place, a 361 apartment-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 achieved in 2007). The Company is the managing member of CVP I, LLC, however, property management services at the community are performed by an unrelated third party. In connection with the construction management services that the Company provided to CVP I, LLC during the development of Avalon Chrystie Place, the Company provided a construction completion guarantee to the construction loan lender in order to fulﬁ ll their standard ﬁ nancing requirements related to the construction ﬁ nancing. Upon completion of the construction of Avalon Chrystie Place in 2006, the Company was released from all obligations associated with this guarantee. • As of December 31, 2007, CVP I, LLC has tax-exempt variable rate bonds in the amount of $117,000 outstanding, which have a permanent credit enhancement and mature in February 2036. The Company has guaranteed, under limited circumstance, the repayment to the credit enhancer of any advance in fulﬁ llment of CVP I LLC’s repayment obligations under the bonds. The Company AvalonBay Communities, Inc. 45 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) has also guaranteed the credit enhancer that CVP I, LLC will obtain a ﬁ nal certiﬁ cate of occupancy for the project overall once tenant improvements related to a retail tenant are complete, which is expected in the ﬁ rst half of 2008. The Company’s maximum obligation under this guarantee at December 31, 2007 was $121,000. The Company’s 80% partner in this venture has agreed that it will reimburse the Company its pro rata share of any amounts paid relative to these guaranteed obligations. The Company does not currently expect to incur any liability under either of these guarantees. The estimated fair value of, and the Company’s obligation under these guarantees, both at inception and as of December 31, 2007 were not signiﬁ cant. As a result the Company has not recorded any obligation associated with these guarantees at December 31, 2007. This community is unconsolidated for ﬁ nancial reporting purposes and is accounted for under the equity method. • Avalon Del Rey Apartments, LLC — In March 2004, the Company entered into an agreement with an unrelated third party which provided that, upon construction completion, Avalon Del Rey would be owned and operated by a joint venture between the Company and the third-party. Avalon Del Rey is a 309 apartment-home community located in Los Angeles, California. Construction for Avalon Del Rey was completed during the third quarter of 2006. During the fourth quarter of 2006, the third-party venture partner invested $49,000 and was granted a 70% ownership interest in the venture, with the Company retaining a 30% equity interest (see Note 7, “Real Estate Disposition Activities”). The Company will continue to 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 Apartments, LLC has a variable rate $50,000 secured construction loan, of which $40,845 is outstanding as of December 31, 2007 and which matures in September 2009, subject to the exercise of an additional one-year extension option. In conjunction with the construction management services that the Company provided to Avalon Del Rey Apartments, LLC, the Company has provided a construction completion guarantee to the construction loan lender in order to fulﬁ ll their standard ﬁ nancing requirements related to construction ﬁ nancing. Although the obligation of the Company under this guarantee exists at December 31, 2007, the Company does not have any potential liability at December 31, 2007, as construction has been completed. This guarantee will terminate following satisfaction of the lender’s standard completion requirements, which the Company expects to occur in 2008. • In conjunction with the admittance of the joint venture partner to the LLC, the Company provided the third-party investor an operating guarantee. This guarantee, which extended for one year, provided that if the one-year return for the initial year of the joint venture partner’s investment is less than a threshold return of 7% on its initial equity investment, that the Company would pay the joint venture partner an amount equal to the shortfall, up to the 7% threshold return required. Over the guarantee period, the cash ﬂ ows and return on investment for Avalon Del Rey exceeded the initial year threshold return required by our joint venture partner, satisfying all obligations of the Company under this guarantee. • Concurrent with the satisfaction of the operating guarantee in the fourth quarter of 2007, the Company recognized the sale of the 70% ownership interest in the entity that owns Avalon Del Rey, reporting a gain of $3,607 as a component of equity in income of unconsolidated entities on the Consolidated Statements of Operations and Other Comprehensive Income. Therefore, in the fourth quarter of 2007, the Company began to account for its investment in the joint venture under the equity method of accounting. • Juanita Construction, Inc. — In April 2004, a taxable REIT subsidiary of the Company entered into an agreement to develop Avalon at Juanita Village, a 211 apartment-home community located in Kirkland, Washington, for which construction was completed in late 2005. Avalon at Juanita Village was developed through Juanita Construction, Inc., a wholly-owned taxable REIT subsidiary and was sold to a joint venture in the ﬁ rst quarter of 2006, at which point, the subsidiary was reimbursed for all the costs of construction and retained a promoted residual interest in the proﬁ ts of the joint venture. The third-party joint venture partner received a 100% equity interest in the joint venture and will control the joint venture. The Company was engaged to manage the community for a property management fee. This community is unconsolidated for ﬁ nancial reporting purposes effective with the sale to the joint venture. • Aria at Hathorne LLC — In the second quarter of 2007, a wholly owned taxable REIT subsidiary entered into an LLC agreement with a joint venture partner to develop 64 for-sale townhomes with a total capital cost of $23,636 in Danvers, Massachusetts. The homes will be developed during 2008 and 2009 on an outparcel adjacent to our Avalon Danvers rental apartment community. The outparcel was zoned for for-sale activity, and was contributed to the LLC by the subsidiary of the Company in exchange for a 50% ownership interest. The LLC has $726 outstanding on a variable rate $5,400 secured construction loan and $2,744 outstanding on a $3,200 variable rate development loan as of December 31, 2007. The Company’s joint venture partner has provided a payment and completion guarantee to both the acquisition and development and the construction loan lender. The Company accounts for this investment under the equity method. • MVP I, LLC — In December 2004, the Company entered into a joint venture agreement with an unrelated third-party for the development of Avalon at Mission Bay North II. Construction for Avalon at Mission Bay North II, a 313 apartment-home community located in San Francisco, California, was completed in December 2006. The Company has contributed $5,902 to this venture and holds a 25% equity interest. The Company is responsible for the day-to-day operations of the community and is the management agent subject to the terms of a management agreement. To fund the construction of Avalon at Mission Bay North II, MVP I, LLC executed a variable rate $94,400 secured construction loan. In conjunction with the construction management services that the Company provided to MVP I, LLC, the Company provided a construction completion guarantee to the construction loan lender in order to fulﬁ ll their standard ﬁ nancing requirements related to construction ﬁ nancing. In the fourth quarter of 2007, all of the 46 AvalonBay Communities, Inc. lender’s standard completion requirements have been satisﬁ ed and the obligation of the Company under this guarantee terminated. In December 2007, MVP I, LLC repaid the construction loan, concurrently executing a seven-year, ﬁ xed rate conventional loan. This community is unconsolidated for ﬁ nancial 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, discretionary investment vehicle, which will acquire and operate communities in the Company’s markets. The Fund will serve, until March 16, 2008 or until 80% of its committed capital is invested, as the principal vehicle through which the Company will acquire apartment communities, subject to certain exceptions. The Fund has nine institutional investors, including the Company, and a combined equity capital commitment of $330,000. A signiﬁ cant portion of the investments made in the Fund by its investors are being made through AvalonBay Value Added Fund, Inc., a Maryland corporation that qualiﬁ es as a REIT under the Internal Revenue Code (the “Fund REIT”). A wholly-owned subsidiary 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 $43,399 of this commitment funded as of December 31, 2007. The Fund has invested $777,568 as of December 31, 2007. Management of the Fund expects to invest approximately $46,000 of additional funds to redevelop the assets acquired, at which time the Fund will become fully invested. 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 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. The Company received net proceeds 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 interest if certain thresholds are met (which were not achieved in 2007). As of December 31, 2007, the Fund owns the following 20 communities, subject to certain mortgage debt. In addition, as of December 31, 2007, the Fund has $47,400 outstanding under its variable rate credit facility, which matures in January 2008. The Company has not guaranteed any of the Fund debt, nor does it have any obligation to fund this debt should the Fund be unable to do so. • Avalon at Redondo Beach, a 105 apartment-home community located in Los Angeles, California. As of December 31, 2007, Avalon at Redondo Beach has $16,765 in 4.8% ﬁ xed rate debt outstanding, which matures in October 2011; • Avalon Lakeside, a 204 apartment-home community located in Chicago, Illinois. As of December 31, 2007, Avalon Lakeside has $12,056 in 5.7% ﬁ xed rate debt outstanding which matures in March 2012; • Avalon Columbia, a 170 apartment-home community located in Baltimore, Maryland. As of December 31, 2007, Avalon Columbia has $22,275 in 5.5% ﬁ xed rate debt outstanding, which matures in April 2012; • Avalon Redmond, a 400 apartment-home community located in Seattle, Washington. As of December 31, 2007, Avalon Redmond has $36,500 in 5.0% ﬁ xed 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, 2007, Avalon at Poplar Creek has $16,500 in 4.8% ﬁ xed rate debt outstanding, which matures in October 2012; • Avalon Sunset, an 82 apartment-home community located in Los Angeles, California. As of December 31, 2007, Avalon Sunset has $12,750 in 5.4% ﬁ xed rate debt outstanding, which matures in February 2014; • Avalon at Civic Center, a 192 apartment-home community located in Norwalk, California. As of December 31, 2007, Avalon at Civic Center has $23,806 in 5.3% ﬁ xed rate debt outstanding, which matures in August 2013; • Avalon Paseo Place, a 134 apartment-home community located in Fremont, California. As of December 31, 2007, Avalon Paseo Place has $11,800 in 5.7% ﬁ xed rate debt outstanding, which matures in November 2013; • Avalon Yerba Buena, a 160 apartment-home community located in San Francisco, California. As of December 31, 2007, Avalon Yerba Buena has $41,500 in 5.9% ﬁ xed rate debt outstanding, which matures in March 2014; • Avalon at Aberdeen Station, a 290 apartment-home community located in Aberdeen, New Jersey. As of December 31, 2007, Avalon at Aberdeen Station has $34,456 in 5.7% ﬁ xed rate debt outstanding, which matures in September 2013; • The Springs, a 320 apartment-home community located in Corona, California. As of December 31, 2007, The Springs has $26,000 in 6.1% ﬁ xed rate debt outstanding, which matures in October 2014; • The Covington, a 256 apartment-home community located in Lombard, Illinois. As of December 31, 2007, The Covington has $17,243 in 5.4% ﬁ xed rate debt outstanding, which matures in January 2014; • Avalon Cedar Place, a 156 apartment-home community located in Columbia, Maryland. As of December 31, 2007, Avalon Cedar Place has $12,000 in 5.7% ﬁ xed rate debt outstanding, which matures in February 2014; AvalonBay Communities, Inc. 47 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) • Avalon Centerpoint, a 392 apartment-home community located in Baltimore, Maryland. As of December 31, 2007, Avalon Centerpoint has $45,000 in 5.7% ﬁ xed rate debt outstanding, which matures in December 2013; • Middlesex Crossing, a 252 apartment-home community located in Billerica, Massachusetts. As of December 31, 2007, Middlesex Crossing has $24,100 of 5.5% ﬁ xed rate debt outstanding, which matures in December 2013; • Avalon Crystal Hill, a 168 apartment-home community located in Ponoma, New York. As of December 31, 2007, Avalon Crystal Hill has $24,500 of 5.4% ﬁ xed rate debt outstanding, which matures in December 2013; • Skyway Terrace, a 348 apartment-home community located in San Jose, California. As of December 31, 2007, Skyway Terrace has $37,500 of 6.1% ﬁ xed rate debt outstanding, which matures in March 2014; • Avalon Rutherford Station, a 108 apartment-home community located in East Rutherford, New Jersey. As of December 31, 2007, Avalon Rutherford Station has $20,653 of 6.1% ﬁ xed rate debt outstanding, which matures in September 2016; • South Hills Apartments, an 85 apartment-home community located in West Covina, California. As of December 31, 2007, South Hills Apartments has $11,762 of 5.9% ﬁ xed rate debt outstanding, which matures in December 2013; and • Colonial Towers/South Shore Manor, a 211 apartment-home community located in Weymouth, Massachusetts. Colonial Towers/ South Shore Manor had no debt outstanding at December 31, 2007. In addition, as part of the formation of the Fund, the Company provided a guarantee to one of the limited partners. The guarantee provides that, if, upon ﬁ nal liquidation of the Fund, the total amount of all distributions to that partner during the life of the Fund (whether from operating cash ﬂ ow or property sales) does not equal the total capital contributions made by that partner, then the Company will pay the partner an amount equal to the shortfall, but in no event more than 10% of the total capital contributions made by the partner (maximum of approximately $6,510 as of December 31, 2007). As of December 31, 2007, the fair value of the real estate assets owned by the Fund is considered adequate to cover such potential payment under a liquidation scenario. The estimated fair value of and the Company’s obligation under this guarantee, both at inception and as of December 31, 2007 was not signiﬁ cant and therefore the Company has not recorded any obligation for this guarantee as of December 31, 2007. The following is a combined summary of the ﬁ nancial 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 partners’ capital: Mortgage notes payable and credit facility Other liabilities Partners’ capital Total liabilities and partners’ capital 12-31-07 (unaudited) 12-31-06 (unaudited) $ 997,319 31,774 $1,029,093 $ 719,310 20,496 289,287 $1,029,093 $724,795 55,716 $780,511 $510,784 51,108 218,619 $780,511 The following is a combined summary of the operating results of the entities accounted for using the equity method, for the years presented: For the year ended 12-31-07 (unaudited) 12-31-06 (unaudited) 12-31-05 (unaudited) $ 92,075 (40,090) — (40,791) (26,622) $(15,428) $67,207 (30,913) 26,661 (23,545) (18,054) $21,356 $35,826 (19,582) — (7,648) (8,482) $ 114 Rental income Operating and other expenses Gain on sale of communities Interest expense, net Depreciation expense Net income (loss) 48 AvalonBay Communities, Inc. In conjunction with the acquisition and development of the investments in unconsolidated entities, the Company incurred costs in excess of its equity in the underlying net assets of the respective investments. These costs represent $5,375 at December 31, 2007 and $7,491 at December 31, 2006 of the respective investment balances. Investments in Unconsolidated Non-Real Estate Entities In February 2005, the Company sold its interest in a technology venture that was accounted for under the cost method. 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. Under the terms of the sale, certain proceeds were escrowed to secure the purchaser’s rights to indemniﬁ cation. Any amounts not used for this purpose were distributed to the former investors in the venture in 2006. For the year ended December 31, 2006, the Company recognized $433 for the ﬁ nal installment of the gain on this sale upon release of this escrow. The following is a summary of the Company’s equity in income (loss) of unconsolidated entities for the years presented: Town Grove, LLC Avalon Del Rey, LLC CVP I, LLC Town Run Associates Avalon Terrace, LLC(1) MVP I, LLC AvalonBay Value Added Fund, L.P. AvalonBay Redevelopment LLC Rent.com Constellation Real Technologies Total(2) For the year ended 12-31-07 12-31-06 12-31-05 $57,821 3,616 567 107 22 (1,261) (1,775) — — 72 $59,169 $1,457 — (68) 298 6,736 (662) (799) — 433 60 $7,455 $1,286 — (339) 266 58 (57) (341) 73 6,252 — $7,198 (1) Equity in income from this entity for 2006 includes a gain of $6,609 for the Company’s 25% share of the gain from the fourth quarter disposition of Avalon Bedford, the sole asset held by Avalon Terrace, LLC. (2) This table does not include Aria at Hathorne. As a development community, all costs are being capitalized, resulting in no reportable income. 7. Real Estate Disposition Activities During the year ended December 31, 2007, the Company sold four communities: Avalon View, located in Wappingers Falls, New York, San Marino, located in San Jose, California, Avalon West, located in Westborough, Massachusetts and Avalon at Stevens Pond, located in Saugus, Massachusetts. These four communities contained a total of 982 apartment homes and were sold for an aggregate sales price of $204,650. The Company also sold its interest in Avalon Grove, which contained 402 apartment homes for a sales price of $63,446. The sale of these communities and partnership interest resulted in a gain in accordance with GAAP of $162,807. Details regarding the community asset sales are summarized in the following table: Community Name Location Wappingers Falls, NY San Jose, CA Westborough, MA Saugus, MA Stamford, CT Avalon View San Marino Avalon West Avalon at Stevens Pond Avalon Grove(1) Total of all 2007 asset sales Total of all 2006 asset sales Total of all 2005 asset sales Period of sale Q307 Q307 Q307 Q407 Q407 Apartment homes 288 248 120 326 402 1,384 1,036 1,305 Debt $ — — 8,116 — — $ 8,116 $37,200 $ — Gross sales price $ 54,000 55,000 18,000 77,650 63,446 $268,096 $261,850 $351,450 Net proceeds $ 53,293 54,333 9,585 76,784 63,401 $257,396 $218,492 $344,185 (1) The Company held and sold its 50% ownership interest in the LLC that developed, owned and operated Avalon Grove. The Company will continue to manage this community for a customary property management fee. AvalonBay Communities, Inc. 49 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) As of December 31, 2007, the Company had no communities that qualiﬁ ed as discontinued operations or held for sale under the provisions of SFAS No. 144. In accordance with the requirements of SFAS No. 144, the operations for any communities sold from January 1, 2005 through December 31, 2007 and the communities that qualiﬁ ed as discontinued operations as of December 31, 2007 have been presented as discontinued operations in the accompanying Consolidated Financial Statements. Accordingly, certain reclassiﬁ cations have been made in prior periods to reﬂ ect discontinued operations consistent with current period presentation. The following is a summary of income from discontinued operations for the periods presented: Rental income Operating and other expenses Interest expense, net Depreciation expense Income from discontinued operations For the year ended 12-31-07 12-31-06 12-31-05 $10,911 (4,043) (687) (2,176) $4,005 $17,658 (6,491) (1,862) (3,687) $5,618 $42,336 (14,441) (1,927) (6,842) $19,126 The Company’s Consolidated Balance Sheets include other assets (excluding net real estate) of $0 and $3,821 as of December 31, 2007 and December 31, 2006, respectively, and other liabilities of $0 as of December 31, 2007 and $69,100 as of December 31, 2006, relating to real estate assets sold or classiﬁ ed as held for sale. During the year ended December 31, 2007, the Company sold one parcel of land through a taxable REIT subsidiary, located in the Mid- Atlantic, for a sales price of $5,800, resulting in a gain of $545 under GAAP. The Company had gains on the sales of land parcels of $13,519 in 2006, and $4,479 in 2005. 8. Commitments and Contingencies Employment Agreements and Arrangements As of December 31, 2007, the Company had employment agreements with four executive ofﬁ cers. The employment agreements provide 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 voluntary termination by the employee). The current terms of these agreements end on dates that vary between November 2008 and June 2009. The employment agreements provide for one-year automatic renewals (two years in the case of the Chief Executive Ofﬁ cer (“CEO”)) after the initial term unless an advance notice of non-renewal is provided by either party. Upon a notice of non-renewal by the Company, each of the ofﬁ cers may terminate his employment and receive a severance payment. Upon a change in control, the agreements provide for an automatic extension of up to three years from the date of the change in control. The employment agreements provide for base salary and incentive compensation in the form of cash awards, stock options and stock grants subject to the discretion of, and attainment of performance goals established by the Compensation Committee of the Board of Directors. 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 termination 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 provides 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 Ofﬁ cer Severance Program (the “Program”) for the beneﬁ t of those ofﬁ cers of the Company who do not have employment agreements. Under the Program, in the event an ofﬁ cer who is not otherwise covered by a severance arrangement is terminated (other than for cause) within two years following a change in control (as deﬁ ned) of the Company, such ofﬁ cer will generally receive a cash lump sum payment equal to the sum of such ofﬁ cer’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 Program 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. Construction and Development Contingencies In connection with the pursuit of a Development Right in Pleasant Hill, California, $125,000 in bond ﬁ nancing was issued by the Contra Costa County Redevelopment Agency (the “Agency”) in connection with the possible 50 AvalonBay Communities, Inc. future construction of a multifamily rental community by PHVP I, LLC. The bond proceeds were immediately invested in their entirety in a guaranteed investment contract (“GIC”) administered by a trustee. This Development Right is planned as a mixed-use development, with residential, for-sale, retail and ofﬁ ce components. The bond proceeds will remain in the GIC until June 2008, at which time a loan will be made to PHVP I, LLC to fund construction of the multifamily portion of the development, or the bonds will be redeemed by the Agency. Although the Company does not have any equity or economic interest in PHVP I, LLC at this time, the Company holds an option to make a capital contribution to PHVP I, LLC in exchange for a 99% general partner interest in the entity. Should the Company decide not to exercise this option, the bonds will be redeemed, and a loan will not be made to PHVP I, LLC. The bonds are payable from the proceeds of the GIC and are non-recourse to both PHVP I, LLC and to the Company. There is no loan payable outstanding by PHVP I, LLC as of December 31, 2007. In addition, as part of providing construction management services to PHVP I, LLC for the construction of a public garage, the Company has provided a construction completion guarantee to the related lender in order to fulﬁ ll their standard ﬁ nancing requirements related to the garage construction ﬁ nancing. The Company’s obligations under this guarantee will terminate following construction completion of the garage once all of the lender’s standard completion requirements have been satisﬁ ed, which the Company currently expects to occur in 2008. In the third quarter of 2006, signiﬁ cant modiﬁ cations were requested by the local transit authority to change the garage structure design. The Company does not believe that the requested design changes will impact the construction schedule. However, it is expected that these changes will increase the original budget by an amount up to $5,000. The Company believes that substantially all potential additional amounts are reimbursable from unrelated third parties. At this time, the Company does not believe that it is probable that it will incur any additional costs. The estimated fair value of and the Company’s obligation under this guarantee, both at inception and as of December 31, 2007 was not signiﬁ cant and therefore the Company has not recorded any obligation for this guarantee as of December 31, 2007. Legal Contingencies The Company is currently involved in litigation alleging that 100 communities currently or formerly owned by the Company violated the accessibility requirements of the Fair Housing Act and the Americans with Disabilities Act. The lawsuit, Equal Rights Center v. AvalonBay Communities, Inc., was ﬁ led on September 23, 2005 in the federal district court in Maryland. The plaintiff seeks compensatory and punitive damages in unspeciﬁ ed amounts as well as injunctive relief (such as modiﬁ cation of existing communities), an award of attorneys’ fees, expenses and costs of suit. The Company has ﬁ led a motion to dismiss all or parts of the suit, which has not been ruled on yet by the court. The Company cannot predict or determine the outcome of this lawsuit, nor is it reasonably possible to estimate the amount of loss, if any, that would be associated with an adverse decision. During 2006, the Company determined that contaminated soil from imported ﬁ ll was delivered to its Avalon Lyndhurst development site by third parties. The contaminants exceeded allowable levels for residential use under New Jersey state and local regulations. The remediation effort is complete. The net cost associated with this remediation effort, after considering insurance proceeds received to date and including costs associated with construction delays, is approximately $6,000. The Company is pursuing the recovery of these additional net costs from the third parties involved, but no assurance can be given as to the amount or timing of reimbursements to the Company. The Company recorded these incremental costs as incurred, and is recording potential recoveries as they become certain or are received. Although the net costs to complete construction of this community exceeded the original construction budget, the Company has determined that there is not an impairment in the value of this asset which would require a write down in the carrying value. The Company will continue to review this assessment based on changes in circumstances or market conditions. In addition, the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. These matters are frequently covered by insurance. If it has been determined that a loss is probable to occur, the estimated amount of the loss is expensed in the ﬁ nancial statements. While the resolution of these matters cannot be predicted with certainty, management currently believes the ﬁ nal outcome of such matters will not have a material adverse effect on the ﬁ nancial position or results of operations of the Company. Lease Obligations The Company owns 11 apartment communities which are located on land subject to land leases expiring between November 2028 and March 2142. In addition, the Company leases certain ofﬁ ce space. These leases are accounted for as operating leases under SFAS No. 13, “Accounting for Leases.” These leases have varying escalation terms, and four of these leases have purchase options exercisable between 2008 and 2095. The Company incurred costs of $15,516, $14,850 and $15,163 in the years ended December 31, 2007, 2006 and 2005, respectively, related to these leases. The following table details the future minimum lease payments under the Company’s current leases: Payments due by period 2008 $14,412 2009 $14,537 2010 2011 2012 Thereafter $14,571 $14,613 $14,655 $2,069,951 AvalonBay Communities, Inc. 51 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 9. Segment Reporting The Company’s reportable operating segments include Established Communities, Other Stabilized Communities, and Development/ Redevelopment Communities. Annually as of January 1st, the Company determines which of its communities fall into each of these categories and maintains that classiﬁ cation, unless disposition plans regarding a community change, throughout the year for the purpose of reporting segment operations. • Established Communities (also known as Same Store Communities) are communities where a comparison of operating results from the prior year to the current year is meaningful, as these communities were owned and had stabilized occupancy and operating expenses as of the beginning of the prior year. For the year ended December 31, 2007, the Established Communities are communities that are consolidated for ﬁ nancial reporting purposes, had stabilized occupancy and operating expenses as of January 1, 2006, are not conducting or planning to conduct substantial redevelopment activities and are not held for sale or planned for disposition within the current year. A community is considered to have stabilized occupancy at the earlier of (i) attainment of 95% physical occupancy or (ii) the one-year anniversary of completion of development or redevelopment. • Other Stabilized Communities includes all other completed communities that have stabilized occupancy, as deﬁ ned above. Other Stabilized Communities do not include communities that are conducting or planning to conduct substantial redevelopment activities within the current year. • Development/Redevelopment Communities consists of communities that are under construction and have not received a ﬁ nal certiﬁ cate of occupancy, communities where substantial redevelopment is in progress or is planned to begin during the current year and communities under lease-up, that had not reached stabilized occupancy, as deﬁ ned above, as of January 1, 2007. 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, “Disclosures 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’ performance. 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 ﬁ nancial measure for Established Communities and Other Stabilized Communities. NOI is deﬁ ned by the Company as total revenue less direct property operating expenses. Although the Company considers NOI a useful measure of a community’s or communities’ operating performance, NOI should not be considered an alternative to net income or net cash ﬂ ow from operating activities, as determined in accordance with GAAP. NOI excludes a number of income and expense categories as detailed in the reconciliation of NOI to net income. A reconciliation of NOI to net income for the years ended December 31, 2007, 2006 and 2005 is as follows: Net income Indirect operating expenses, net of corporate income Investments and investment management Interest expense, net General and administrative expense Equity in income of unconsolidated entities Minority interest in consolidated partnerships Depreciation expense Gain on sale of real estate assets Income from discontinued operations For the year ended 12-31-07 12-31-06 12-31-05 $358,160 31,285 11,737 97,545 28,494 (59,169) 1,585 179,549 (107,032) (4,005) $266,546 28,811 7,030 109,184 24,767 (7,455) 573 160,442 (110,930) (5,618) $310,468 26,675 4,834 125,171 25,761 (7,198) 1,481 156,455 (199,766) (19,126) Net operating income $538,149 $473,350 $424,755 The primary performance measure for communities under development or redevelopment 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. 52 AvalonBay Communities, Inc. The table below provides details of the Company’s segment information as of the dates speciﬁ ed. The segments are classiﬁ ed based on the individual community’s status as of the beginning of the given calendar year. Therefore, each year the composition of communities within each business segment is adjusted. Accordingly, the amounts between years are not directly comparable. The accounting policies applicable to the operating segments described above are the same as those described in Note 1, “Organization and Signiﬁ cant Accounting Policies.” Segment information for the years ended December 31 2007, 2006 and 2005 has been adjusted for the communities that were sold from January 1, 2005 through December 31, 2007, or otherwise qualify as discontinued operations as of December 31, 2007, as described in Note 7, “Real Estate Disposition Activities.” For the year ended December 31, 2007 Established Northeast Mid-Atlantic Midwest Paciﬁ c Northwest Northern California Southern California 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) $276,423 114,144 12,070 33,594 160,442 56,091 652,764 47,857 106,013 n/a 6,107 $184,643 71,882 7,286 23,111 116,516 40,219 443,657 30,325 64,167 n/a n/a 3.7% 6.4% 2.3% 17.1% 12.6% 5.9% 7.2% n/a n/a n/a n/a $1,805,241 690,573 92,879 290,308 1,395,022 349,719 4,623,742 356,038 2,240,744 288,423 47,793 Total $812,741 $538,149 13.7% $7,556,740 For the year ended December 31, 2006 Established Northeast Mid-Atlantic Midwest Paciﬁ c Northwest Northern California Southern California Total Established Other Stabilized Development / Redevelopment Land Held for Future Development Non-allocated(2) $198,062 100,462 11,478 33,103 149,531 57,632 550,268 87,939 76,356 n/a 6,866 $134,001 61,870 7,121 21,819 104,588 41,115 370,514 55,337 47,499 n/a n/a 5.2% 14.9% 7.4% 13.0% 11.6% 9.3% 9.4% n/a n/a n/a n/a $1,232,590 627,789 92,408 316,089 1,406,401 374,606 4,049,883 811,053 1,324,929 202,314 42,437 Total $721,429 $473,350 11.4% $6,430,616 For the year ended December 31, 2005 Established Northeast Mid-Atlantic Midwest Paciﬁ c Northwest Northern California Southern California Total Established Other Stabilized Development / Redevelopment Land Held for Future Development Non-allocated(2) $161,399 68,575 11,113 30,080 143,070 48,800 463,037 71,682 116,144 n/a 4,348 $108,334 48,613 6,627 19,312 97,434 35,319 315,639 35,967 73,149 n/a n/a 3.8% 3.9% 7.1% 8.0% 3.5% 6.7% 4.4% n/a n/a n/a n/a $1,032,589 387,801 91,755 315,331 1,454,734 331,315 3,613,525 636,073 1,158,482 179,739 30,741 Total $655,211 $424,755 9.3% $5,618,560 (1) Does not include gross real estate assets held for sale of $0, $184,977 and $321,586 as of December 31, 2007, 2006 and 2005, respectively. (2) Revenue represents third-party management, accounting and developer fees and miscellaneous income which are not allocated to a reportable segment. AvalonBay Communities, Inc. 53 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 10. Stock-Based Compensation Plans The Company has a stock incentive plan (the “1994 Plan”), which was amended and restated on December 8, 2004, and amended on February 9, 2006, December 6, 2006 and September 19, 2007. Individuals who are eligible to participate in the 1994 Plan include ofﬁ cers, other associates, outside directors and other key persons of the Company and its subsidiaries who are responsible for or contribute to the management, growth or proﬁ tability of the Company and its subsidiaries. The 1994 Plan authorizes (i) the grant of stock options that qualify as incentive stock options (“ISOs”) under Section 422 of the Internal 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) performance share awards entitling the recipient to acquire shares of common stock and (vi) dividend equivalent rights. Shares of common stock of 2,160,738, 1,791,861 and 2,066,308 were available for future option or restricted stock grant awards under the 1994 Plan as of December 31, 2007, 2006 and 2005, respectively. Annually on January 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 Directors. Before the Merger, 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 shares 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 forfeited, canceled, reacquired by Avalon, satisﬁ ed without the issuance of common stock or otherwise terminated (other than by exercise). Options granted to ofﬁ cers, non-employee directors 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 reﬂ ect the equivalent Bay shares and exercise prices based on the 0.7683 share conversion ratio used in the Merger. Ofﬁ cers, 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 Merger, options and other awards ceased to be granted under the Avalon 1993 Plan or the Avalon 1995 Incentive Plan. Accordingly, there were no options to purchase shares of common stock available for grant under the Avalon 1995 Incentive Plan or the Avalon 1993 Plan at December 31, 2007, 2006 or 2005. Information with respect to stock options granted under the 1994 Plan, the Avalon 1995 Incentive Plan and the Avalon 1993 Plan is as follows: 1994 Plan shares 2,276,818 (743,524) 725,988 (29,504) 2,229,778 (592,308) 867,113 (17,344) 2,487,239 (471,024) 344,429 (38,929) 2,321,715 1,158,591 1,041,360 1,230,428 Weighted average exercise price per share Avalon 1995 and Avalon 1993 Plan shares Weighted average exercise price per share $42.39 41.89 70.09 55.66 $51.40 50.09 99.28 79.72 $69.65 56.57 147.39 110.28 $83.15 $42.45 $47.99 $60.84 186,262 (159,638) — — 26,624 (22,384) — — 4,240 (3,472) — — 768 26,624 4,240 768 $36.23 37.82 — — $37.09 37.15 — — $36.81 36.86 — — $36.61 $37.09 $36.81 $36.61 Options Outstanding, December 31, 2004 Exercised Granted Forfeited Options Outstanding, December 31, 2005 Exercised Granted Forfeited Options Outstanding, December 31, 2006 Exercised Granted Forfeited Options Outstanding, December 31, 2007 Options Exercisable: December 31, 2005 December 31, 2006 December 31, 2007 54 AvalonBay Communities, Inc. For options outstanding at December 31, 2007 under the 1994 Plan, 673,426 options had exercise prices ranging between $31.50 and $59.99 and a weighted average remaining contractual life of 4.2 years, 533,560 options had exercise prices ranging between $60.00 and $89.99 and a weighted average remaining contractual life of 7.1 years, 780,373 options had exercise prices between $90.00 and $119.99 and a weighted average remaining contractual life of 8.1 years and 334,356 options had exercise prices between $120.00 and $149.99 and a weighted average remaining contractual life of 9.1 years. Options outstanding and exercisable at December 31, 2007 for the Avalon 1993 and Avalon 1995 Plans had an exercise price of $36.61 and a weighted average contractual life of less than one year with an intrinsic value of $44. Options outstanding under the 1994 Plan at December 31, 2007 had an intrinsic value of $25,516. Options exercisable at December 31, 2007 under the 1994 plan had a weighted average contractual life of 5.7 years and an intrinsic value of $40,973. The intrinsic value of options exercised during 2007, 2006 and 2005 was $17,895, $49,440 and $80,271, respectively. The weighted average fair value of the options granted during the year ended December 31, 2007 is estimated at $21.83 per share on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: dividend yield of 4.0% over the expected life of the option, volatility of 17.32%, risk-free interest rates of 4.73% and an expected life of approximately seven years. The weighted average fair value of the options granted during 2006 is estimated at $11.47 per share on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions: dividend yield of 5.0% over the expected life of the option, volatility of 17.61%, risk-free interest rates of 4.55% and an expected life of approximately seven years. 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 interest rates of 3.91% and an expected life of approximately seven years. The cost related to stock-based employee compensation for employee stock options included in the determination of net income is based on estimated forfeitures for the given year. Estimated forfeitures are adjusted to reﬂ ect actual forfeitures at the end of the vesting period. The Company issued restricted stock as part of its stock-based compensation plan during the years ended December 31, 2007, 2006 and 2005. Compensation cost is recognized over the requisite service period, which varies, but does not exceed ﬁ ve years. The fair value of restricted stock is the closing stock price on the date of the grant. Provisions of SFAS No. 123(R) require the Company to recognize compensation cost taking into consideration retirement eligibility. The cost related to stock-based compensation for restricted stock included in the determination of net income is based on actual forfeitures for the given year. Restricted stock awards typically vest over a ﬁ ve-year period with the exception of accelerated vesting provisions. Restricted stock vesting during 2007 had fair values ranging from $36.66 to $147.75 per share. The total fair value of shares vested was $8,590, $7,655 and $8,932 for the years ended December 31, 2007, 2006 and 2005, respectively. Total stock-based compensation cost recognized in income was $13,502, $10,095 and $4,292 for the years ended December 31, 2007, 2006 and 2005, respectively, and total capitalized stock-based compensation cost was $5,106, $4,014 and $4,046 for the years ended December 31, 2007, 2006 and 2005, respectively. At December 31, 2007, there was a total of $8,480 and $10,850 in unrecognized compensation cost for unvested stock options and unvested restricted stock, respectively. The unrecognized compensation cost for stock options does not take into account estimated forfeitures. The unrecognized compensation cost for unvested stock options and restricted stock is expected to be recognized over a weighted average period of 1.6 years and 2.3 years, respectively. In October 1996, the Company adopted the 1996 Non-Qualiﬁ ed Employee Stock Purchase Plan (as amended, the “ESPP”). Initially 1,000,000 shares of common stock were reserved for issuance under this plan. There are currently 780,735 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 12 months. Under the ESPP, eligible employees are permitted to acquire shares of the Company’s common stock through payroll 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 ﬁ rst 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, if the change is announced prior to the beginning of the affected date or purchase period. The Company issued 8,577 shares, 10,830 shares and 13,372 shares and recognized compensation expense of $158, $173 and $134 under the ESPP for the years ended December 31, 2007, 2006 and 2005, respectively. The Company accounts for transactions under the ESPP using the fair value method prescribed under SFAS No. 123(R), as further discussed in Note 1, “Organization and Signiﬁ cant Accounting Policies.” AvalonBay Communities, Inc. 55 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) 11. Fair Value of Financial Instruments Cash and cash equivalent balances are held with various ﬁ nancial institutions and may at times exceed the applicable Federal Deposit Insurance Corporation limit. The Company monitors credit ratings of these ﬁ nancial institutions and the concentration of cash and cash equivalent balances with any one ﬁ nancial institution and believes the likelihood of realizing material losses from the excess of cash and cash equivalent balances over insurance limits is remote. The following estimated fair values of ﬁ nancial instruments were determined by management using available market information and established valuation methodologies, including discounted cash ﬂ ow. Accordingly, the estimates presented are not necessarily indicative of the amounts the Company could realize on disposition of the ﬁ nancial instruments. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. • Cash equivalents, rents receivable, accounts and construction payable and accrued expenses, and other liabilities are carried at their face amounts, which reasonably approximate their fair values. • Bond indebtedness and notes payable with an aggregate outstanding par amount of approximately $2,696,000 and $2,804,000 had an estimated aggregate fair value of $2,756,890 and $2,910,078 at December 31, 2007 and 2006, respectively. The Company reports all derivative instruments at fair value in accordance with SFAS No. 133, as amended. See Note 5, “Derivative Instruments and Hedging Activities,” for further discussion. 12. Related Party Arrangements Unconsolidated Entities The Company manages unconsolidated real estate entities for which it receives asset management, property management, development and redevelopment fee revenue. From these entities, the Company received fees of $6,142, $6,259 and $4,304 in the years ended December 31, 2007, 2006 and 2005, respectively. These fees are included in management, development and other fees on the accompanying Consolidated Statements of Operations and Other Comprehensive Income. In addition, in connection with the construction management services that the Company provided to MVP I, LLC, the entity that owns and developed Avalon at Mission Bay North II, the Company funds certain construction costs that are expected to be reimbursed through construction ﬁ nancing within 30 to 60 days. Although construction was completed in 2006, ﬁ nal payments to vendors are still being funded. The accompanying Consolidated Balance Sheets reﬂ ect a receivable in prepaid expenses and other assets in the amounts of $939 as of December 31, 2007 and $5,654 as of December 31, 2006, from MVP I, LLC. Director Compensation Directors of the Company who are also employees receive no additional compensation for their services as a director. Following each annual meeting of stockholders starting with the 2006 annual meeting, non-employee directors receive (i) a number of shares of restricted stock (or deferred stock awards) having a value of $100 and (ii) a cash payment of $40, payable in quarterly installments of $10. After September 20, 2007, the cash payment increased to $50, payable in quarterly installments of $12.5. The value of the restricted stock or deferred stock award will increase to $125 following the 2008 annual meeting. Until the 2007 annual meeting, the number of shares of restricted stock (or deferred stock awards) was calculated based on the last reported sale price of the common stock on the New York Stock Exchange (“NYSE”) on the ﬁ fth business day following the prior year’s annual meeting. Following the 2007 annual meeting, the number of shares of restricted stock (or deferred stock awards) is calculated based on the closing price on the day of the award. Non-employee directors may elect to receive all or a portion of cash payments 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 recorded non-employee director compensation expense relating to the restricted stock grants and deferred stock awards in the amount of $855, $1,013 and $966 for the years ended December 31, 2007, 2006 and 2005 as a component of general and administrative expense. Deferred compensation relating to these restricted stock grants and deferred stock awards was $766 and $778 on December 31, 2007 and December 31, 2006, respectively. 56 AvalonBay Communities, Inc. 13. Quarterly Financial Information (Unaudited) The following summary represents the quarterly results of operations for the years ended December 31, 2007 and 2006: Total revenue(1) Income from continuing operations(1) Income from discontinued operations(1) Net income available to common stockholders Net income per common share—basic(2) Net income per common share—diluted(2) Total revenue(1) Income from continuing operations(1) Income from discontinued operations(1) Net income available to common stockholders Net income per common share—basic Net income per common share—diluted For the three months ended 3-31-07 6-30-07 9-30-07 12-31-07 $192,735 $ 45,383 $ 1,137 $ 44,345 $ 0.57 $ 0.56 $199,498 $ 49,319 $ 1,733 $ 48,877 $ 0.62 $ 0.61 $208,123 $ 49,677 $ 79,092 $126,594 $ 1.60 $ 1.58 $212,385 $103,289 $ 28,530 $129,644 $ 1.66 $ 1.64 For the three months ended 3-31-06 6-30-06 9-30-06 12-31-06 $171,284 $ 43,586 $ 67,528 $108,939 $ 1.48 $ 1.45 $176,711 $ 33,833 $ 33,173 $ 64,831 $ 0.87 $ 0.86 $183,646 $ 40,963 $ 1,150 $ 39,938 $ 0.54 $ 0.53 $189,788 $ 45,135 $ 1,178 $ 44,138 $ 0.59 $ 0.58 (1) Amounts may not equal previously reported results due to reclassiﬁ cation between income from continuing operations and income from discontinued operations. (2) Amounts may not equal full year results due to rounding. 14. Subsequent Events In January 2008, the Company repaid $50,000 in previously issued unsecured notes, along with any unpaid interest, pursuant to their scheduled maturity. Also in January 2008, the Company purchased an additional 482,100 shares of its common stock in open market transactions under its share repurchase program at an average price of $87.42. In February 2008, the Board of Directors of the Company authorized an increase in the Company’s stock repurchase program. The increase extended the aggregate purchase price of shares acquired in open market or negotiated transactions up to $500,000, of which $200,000 remained available for future purchases as of February 22, 2008. The Company announced on February 5, 2008 that its Board of Directors declared a dividend for the ﬁ rst quarter of 2008 of $0.8925 per share of the Company’s common stock (par value $0.01 per share). The declared dividend is a 5.0% or $0.0425 per share increase over the Company’s prior quarterly dividend of $0.85 per share. AvalonBay Communities, Inc. 57 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders of AvalonBay Communities, Inc.: We have audited the accompanying consolidated balance sheets of AvalonBay Communities, Inc. as of December 31, 2007 and 2006, and the related consolidated statements of operations and other comprehensive income, stockholders’ equity, and cash ﬂ ows for each of the three years in the period ended December 31, 2007. Our audits also included the ﬁ nancial statement schedule listed in the Index at Item 15(a)(2). These ﬁ nancial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these ﬁ nancial 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 ﬁ nancial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the ﬁ nancial statements. An audit also includes assessing the accounting principles used and signiﬁ cant estimates made by management, as well as evaluating the overall ﬁ nancial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the ﬁ nancial statements referred to above present fairly, in all material respects, the consolidated ﬁ nancial position of AvalonBay Communities, Inc. at December 31, 2007 and 2006, and the consolidated results of its operations and its cash ﬂ ows for each of the three years in the period ended December 31, 2007 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 ﬁ nancial statements taken as a whole, presents fairly in all material respects, the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), AvalonBay Communities, Inc.’s internal control over ﬁ nancial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 25, 2008 expressed an unqualiﬁ ed opinion thereon. McLean, Virginia February 25, 2008 58 AvalonBay Communities, Inc. REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING The Board of Directors and Stockholders of AvalonBay Communities, Inc.: We have audited AvalonBay Communities, Inc.’s internal control over ﬁ nancial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). AvalonBay Communities, Inc.’s management is responsible for maintaining effective internal control over ﬁ nancial reporting, and for its assessment of the effectiveness of internal control over ﬁ nancial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting in Item 9a. Our responsibility is to express an opinion on the company’s internal control over ﬁ nancial 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 perform the audit to obtain reasonable assurance about whether effective internal control over ﬁ nancial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over ﬁ nancial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over ﬁ nancial reporting is a process designed to provide reasonable assurance regarding the reliability of ﬁ nancial reporting and the preparation of ﬁ nancial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over ﬁ nancial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reﬂ ect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of ﬁ nancial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance 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 ﬁ nancial statements. Because of its inherent limitations, internal control over ﬁ nancial 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 degree of compliance with the policies or procedures may deteriorate. In our opinion, AvalonBay Communities, Inc. maintained, in all material respects, effective internal control over ﬁ nancial reporting as of December 31, 2007 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, 2007 and 2006, and the related consolidated statements of operations and other comprehensive income, stockholders’ equity, and cash ﬂ ows for each of the three years in the period ended December 31, 2007 of AvalonBay Communities, Inc. and our report dated February 25, 2008 expressed an unqualiﬁ ed opinion thereon. McLean, Virginia February 25, 2008 AvalonBay Communities, Inc. 59 MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Our common stock is traded on the NYSE under the ticker symbol AVB. The following table sets forth the quarterly high and low sales prices per share of our common stock for the years 2007 and 2006, as reported by the NYSE. On January 31, 2008 there were 813 holders of record of an aggregate of 76,845,045 shares of our outstanding common stock. The number of holders does not include individuals or entities who beneﬁ cially own shares but whose shares are held of record by a broker or clearing agency, but does include each such broker or clearing agency as one record holder. 2007 2006 Sales Price High Low Dividends declared Sales Price High Low Dividends declared Quarter ended March 31 Quarter ended June 30 Quarter ended September 30 Quarter ended December 31 $149.94 $134.62 $128.46 $125.48 $125.30 $115.38 $105.91 $ 88.97 $0.85 $0.85 $0.85 $0.85 $110.45 $112.00 $125.21 $134.60 $ 88.95 $100.50 $110.27 $119.31 $0.78 $0.78 $0.78 $0.78 We expect to continue our policy of paying regular quarterly cash dividends. However, dividend distributions will be declared at the discretion of the Board of Directors and will depend on actual cash from operations, our ﬁ nancial condition, capital requirements, the annual distribution requirements under the REIT provisions of the Internal Revenue Code and other factors as the Board of Directors may consider relevant. The Board of Directors may modify our dividend policy from time to time. In February 2008, we announced that our Board of Directors declared a dividend on our common stock for the ﬁ rst quarter of 2008 of $0.8925 per share, a 5.0% increase over the previous quarterly dividend of $0.85 per share. The increased dividend will be payable on April 15, 2008 to all common stockholders of record as of April 1, 2008. Issuer Purchases of Equity Securities Period (a) Total Number of Shares Purchased (1) (b) Average Price Paid per Share (1) (c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs (2) (d) Maximum Dollar Amount that May Yet be Purchased Under the Plans or Programs (in thousands) (2) Month Ended October 31, 2007 Month Ended November 30, 2007 Month Ended December 31, 2007 Month Ended January 31, 2008 — 1,120,900 328,574 483,036 $ — $100.42 $ 92.88 $ 87.32 — 1,120,900 328,316 482,100 $385,197 $272,639 $242,145 $200,000 (1) Includes shares surrendered to the Company in connection with employee stock option exercises or vesting of restricted stock as payment of exercise price or as payment of taxes. (2) On August 8, 2007, we announced that our the Board of Directors voted to increase the aggregate limit of our common stock repurchase program to $300,000,000. On February 6, 2008, we disclosed that our Board of Directors voted to further increase the authorized limit to $500,000,000. All amounts presented in the table above include this further increase. In determining whether to repurchase shares, we consider a variety of factors, including our liquidity needs, the then current market price of our shares and the effect of the share repurchases on our per share earnings and FFO. There is no scheduled expiration date to this program. 60 AvalonBay Communities, Inc. DEFINITIONS AND RECONCILIATIONS OF NON-GAAP FINANCIAL MEASURES AND OTHER TERMS This Annual Report, including the Letter to Shareholders, contains certain non-GAAP ﬁ nancial measures and other terms. The deﬁ nition and calculation of these non-GAAP ﬁ nancial measures and other terms may differ from the deﬁ nitions and methodologies used by other REITs and, accordingly, may not be comparable. The non-GAAP ﬁ nancial measures referred to below should not be considered an alternative to net income as an indication of our performance. In addition, these non-GAAP ﬁ nancial measures do not represent cash generated from operating activities in accordance with GAAP and therefore should not be considered as an alternative measure of liquidity or as indicative of cash available to fund cash needs. 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 partnership units. Fixed Charge Coverage (Interest Coverage) EBITDA from continuing operations, excluding land gains and gain on the sale of investments in real estate joint ventures, divided by the sum of interest expense, net, and preferred dividends. Interest Coverage is presented by the Company because it provides rating agencies and investors an additional means of comparing our ability to service debt obligations to that of other companies. EBITDA is deﬁ ned by the Company as net income before interest income and expense, income taxes, depreciation and amortization. A reconciliation of EBITDA and a calculation of Interest Coverage for the fourth quarter of 2007 are as follows (dollars in thousands): Net income Interest expense, net Interest expense (discontinued operations) Depreciation expense Depreciation expense (discontinued operations) EBITDA EBITDA from continuing operations EBITDA from discontinued operations EBITDA EBITDA from continuing operations Land gains Gain on the sale of investments in real estate joint ventures EBITDA from continuing operations, excluding land gains and gain on sale of investments in real estate joint ventures Interest expense, net Dividends attributable to preferred stock Interest charges Interest coverage $131,819 26,262 — 47,179 — $205,260 $176,730 28,530 $205,260 $176,730 — (59,927) $116,803 26,262 2,175 28,437 4.1 Funds From Operations (FFO) FFO is determined based on a deﬁ nition adopted by the Board of Governors of the National Association of Real Estate Investment Trusts (“NAREIT”). FFO is calculated by the Company 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 a change in accounting principle and depreciation of real estate assets, including adjustments for unconsolidated partnerships and joint ventures. Management generally considers FFO to be an appropriate supplemental measure of operating performance because, by excluding gains or losses related to dispositions of previously depreciated operating communities and excluding real estate depreciation (which can vary among owners of identical assets in similar condition based on historical cost accounting and useful life estimates), FFO can help one compare the AvalonBay Communities, Inc. 61 operating performance of a company’s real estate between periods or as compared to different companies. A reconciliation of FFO to net income is as follows: (Dollars in thousands) 12-31-07 12-31-06 12-31-05 12-31-04 12-31-03 12-31-02 12-31-01 12-31-00 12-31-99 For the Year Ended Net income Dividends attributable to preferred 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 unconsolidated entities Gain on sale of operating communities Funds from Operations attributable to common stockholders Weighted average common shares outstanding—diluted EPS—diluted FFO per common share—diluted $358,160 (8,700) $266,546 (8,700) $310,468 (8,700) $207,779 (8,700) $262,503 (10,744) $173,125 (17,896) $248,997 (40,035) $210,604 (39,779) $172,276 (39,779) 184,731 165,982 163,252 159,221 129,207 143,026 128,086 120,208 108,679 280 391 1,363 3,048 1,263 1,601 1,559 1,759 1,975 — (59,927) (106,487) — (6,609) (97,411) — — (195,287) (4,547) — (121,287) — — (159,756) — — (48,893) — — (62,852) — — (40,779) — — (47,093) $368,057 $320,199 $271,096 $235,514 $222,473 $250,963 $275,755 $252,013 $196,058 79,856,927 75,586,898 74,759,318 73,354,956 70,203,467 70,674,211 69,781,719 68,140,998 66,110,664 $4.38 $4.61 $3.42 $4.24 $4.02 $3.63 $2.75 $3.21 $3.60 $3.17 $2.22 $3.55 $3.02 $3.95 $2.53 $3.70 $2.03 $2.97 Initial Year Market Capitalization Rate (Cap Rate) Projected NOI of a single community for the ﬁ rst 12 months of operations (assuming no repositioning), less estimates for non-routine allowance of approximately $200–$300 per apartment home, divided by the gross sales price for the community. Projected NOI, as referred to above, represents management’s estimate of projected rental revenue minus projected operating expenses before interest, income taxes (if any), depreciation, amortization and extraordinary items. For this purpose, management’s projection of operating expenses for the community includes a management fee of 3.0%–3.5%. The Initial Year Market Cap Rate, which may be determined in a different manner by others, is a measure frequently used in the real estate industry when determining the appropriate purchase price for a property or estimating the value for a property. Buyers may assign different Initial Year Market Cap Rates to different communities when determining the appropriate value because they (i) may project different rates of change in operating expenses and capital expenditure estimates and (ii) may project different rates of change in future rental revenue due to different estimates for changes in rent and occupancy levels. The weighted average Initial Year Market Cap Rate is weighted based on the gross sales price of each community. Leverage Total debt as a percentage of Total Market Capitalization. Total Market Capitalization represents the aggregate of the market value of the Company’s common stock, 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 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 current total market value of its assets based on the current price at which the Company’s common stock trades. Changes in Leverage also can inﬂ uence changes in per share results. A calculation of Leverage as of December 31, 2007 is as follows (dollars in thousands): Total debt Common stock Preferred stock Operating partnership units Total debt Total Market Capitalization Debt as % of capitalization $ 3,210,703 7,278,774 100,000 6,027 3,210,703 10,595,504 30.3% 62 AvalonBay Communities, Inc. Because Leverage changes with ﬂ uctuations in the Company’s stock price, which occur regularly, the Company’s Leverage may change even when the Company’s earnings, interest and debt levels remain stable. Investors should also note that the net realizable value of the Company’s assets in liquidation is not easily determinable and may differ substantially from the Company’s Total Market Capitalization. Multifamily Sector Average The multifamily sector average is a weighted average based on Total Capitalization per SNL Financial. The weighted average for Total Shareholder Return, FFO per Share, Operating Expenses and Common Dividend Growth per Share includes AEC, AIV, BRE, CPT, EQR, ESS, HME, MAA, PPS and UDR. The weighted average for Estimated NAV per Share Growth includes all companies under Green Street Advisors, Inc.’s coverage for which data is available during each of the time periods presented and includes AEC, BRE, CPT, EQR, PPS and UDR. Net Operating Income (NOI) Total property revenue less direct property operating expenses (including property taxes), and excludes corporate-level income (including management, development and other fees), corporate-level property management and other indirect operating expenses, investments and investment management, net interest expense, general and administrative expense, joint venture income, minority interest expense, depreciation expense, gain on sale of real estate assets and income from discontinued operations. The Company considers NOI to be an appropriate supplemental measure to net income of operating performance of a community or communities because it helps both investors and management to understand the core operations of a community or communities prior to the allocation of corporate-level property management overhead or general and administrative costs. This is more reﬂ ective of the operating performance of a community, and allows for an easier comparison of the operating performance of single assets or groups of assets. In addition, because prospective buyers of real estate have different overhead structures, with varying marginal impact to overhead by acquiring real estate, NOI is considered by many in the real estate industry to be a useful measure for determining the value of a real estate asset or groups of assets. A reconciliation of NOI (from continuing operations) to net income is as follows: (Dollars in thousands) 12-31-07 12-31-06 12-31-05 For the Year Ended Net income Indirect operating expenses, net of corporate income Investments and investment management Interest expense, net General and administrative expense Equity in income of unconsolidated entities Minority interest in consolidated partnerships Depreciation expense Gain on sale of real estate assets Income from discontinued operations $358,160 31,285 11,737 97,545 28,494 (59,169) 1,585 179,549 (107,032) (4,005) $266,546 28,811 7,030 109,184 24,767 (7,455) 573 160,442 (110,930) (5,618) $310,468 26,675 4,834 125,171 25,761 (7,198) 1,481 156,455 (199,766) (19,126) Net operating income $538,149 $473,350 $424,755 NOI as reported by the Company does not include the operating results from discontinued operations (i.e., assets sold during the period January 1, 2006 through December 31, 2007). A reconciliation of NOI from communities sold or classiﬁ ed as discontinued operations to net income for these communities is as follows: (Dollars in thousands) Income from discontinued operations Interest expense, net Depreciation expense NOI from discontinued operations NOI from assets sold NOI from assets held for sale NOI from discontinued operations For the Year Ended 12/31/2007 12/31/2006 $4,005 687 2,176 $6,868 $6,868 — $6,868 $ 5,618 1,862 3,687 $11,167 $11,167 — $11,167 AvalonBay Communities, Inc. 63 Projected NOI As used for certain Development and Redevelopment Communities and in calculating the Initial Year Market Cap Rate for dispositions, represents management’s estimate, as of the date of this annual report (or as of the date of the buyer’s valuation in the case of dispositions), of projected stabilized rental revenue minus projected stabilized operating expenses. For Development and Redevelopment Communities, Projected NOI is calculated based on the ﬁ rst year of Stabilized Operations, as deﬁ ned below, following the completion of construction. In calculating the Initial Year Market Cap Rate, Projected NOI for dispositions is calculated for the ﬁ rst twelve months following the date of the buyer’s valuation. Projected stabilized rental revenue represents management’s estimate of projected gross potential (based on leased rents for occupied homes and market rents for vacant homes) minus projected economic vacancy and adjusted for concessions. Projected stabilized operating expenses do not include interest, income taxes (if any), depreciation or amortization, or any allocation of corporate-level property management overhead or general and administrative costs. The weighted average Projected NOI as a percentage of Total Capital Cost is weighted based on the Company’s share of the Total Capital Cost of each community, based on its percentage ownership. Management believes that Projected NOI of the development and redevelopment communities, on an aggregated weighted average basis, assists investors in understanding management’s estimate of the likely impact on operations of the Development and Redevelopment Communities when the assets are complete and achieve stabilized occupancy (before allocation of any corporate-level property management overhead, general and administrative costs or interest expense). However, the Company does not provide a projection of NOI on a company-wide basis. Given the different dates and ﬁ scal years for which NOI is projected for these communities, the projected allocation of corporate-level property management overhead, general and administrative costs and interest expense to communities under development or redevelopment is complex, impractical to develop, and may not be meaningful. Projected NOI of these communities is not a projection of the Company’s overall ﬁ nancial performance or cash ﬂ ow. There can be no assurance that the communities under development or redevelopment will achieve the Projected NOI as described in this annual report. Total Capital Cost Includes all capitalized costs projected to be or actually incurred to develop the respective Development or Redevelopment 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 regulatory fees, all as determined in accordance with GAAP. For Redevelopment Communities, Total Capital Cost excludes costs incurred prior to the start of redevelopment when indicated. With respect to communities where development or redevelopment was completed in the current or a prior period, Total Capital Cost reﬂ ects the actual cost incurred, plus any contingency estimate made by management. Total Capital Cost for communities identiﬁ ed as having joint venture ownership, either during construction or upon construction completion, represents the total projected joint venture contribution amount. For joint ventures not in construction, Total Capital Cost is equal to gross real estate cost. 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 measure to gain on sale in accordance with GAAP because it helps investors understand the relationship between the cash proceeds from a sale and the cash invested in the sold community. A reconciliation of Economic Gain to gain on sale in accordance with GAAP for the full year 2007 is presented below: Number of Communities Sold(1) 5 Communities, 1 Land Parcel Gross Sales Price $273,896 GAAP Gain $163,352 Accumulated Depreciation and Other $17,588 Economic Gain $145,764 (1) Activity includes amounts related to the disposition of a partnership interest in which the Company held a 50% investment interest. Amounts exclude dispositions to joint venture entities in which the Company retains an economic interest. Same Store (Established) Communities Identiﬁ ed by the Company as communities where a comparison of operating results from the prior year to the current year is meaningful, as these communities were owned and had Stabilized Operations, as deﬁ ned below, as of the beginning of the prior year. Therefore, for 2007, Established Communities are consolidated communities that have Stabilized Operations as of January 1, 2006 and are not conducting or planning to conduct substantial redevelopment activities within the current year. Established Communities do not include communities that are currently held for sale or planned for disposition during the current year. 64 AvalonBay Communities, Inc. Stabilized/Restabilized Operations The earlier of (i) attainment of 95% physical occupancy or (ii) the one-year anniversary of completion of development or redevelopment. Dividend Payout Ratio The percentage of earnings paid to shareholders in dividends, calculated as the yearly dividend per share divided by FFO per share. The payout ratio provides an idea of how well earnings support the dividend payments. Unleveraged IRR Refers to the internal rate of return on sold communities 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 direct operating expenses during the period owned by the Company. Each of the items (i), (ii), (iii) and (iv) are calculated in accordance with GAAP. The calculation of Unleveraged IRR does not include an adjustment for the Company’s general and administrative expense, interest expense, or corporate-level property management and other indirect operating expenses. Therefore, Unleveraged IRR is not a substitute for net income as a measure of our performance. 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 a community, before the impact of indirect 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 gross value created with respect to other communities owned by the Company, and the Company does not represent 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 ﬂ ows over the holding period for each respective community, including net sales proceeds. Stock Performance Graph The stock performance graph provides a comparison, from December 2002 through December 2007, of the cumulative total shareholder return (assuming reinvestment of dividends) among the Company, the Standard & Poor’s (“S&P”) 500 Index, and a peer group index composed of 15 publicly-traded apartment REITs, including the Company (the “FTSE NAREIT Apartment REIT Index”) based on an initial purchase price of $100. The FTSE NAREIT Apartment REIT Index includes only REITs that invest directly or indirectly primarily in the equity ownership of multifamily residential apartment communities. Upon written request to the Company’s Secretary, the Company will provide any stockholder with a list of REITs included in the FTSE NAREIT Apartment REIT Index. The historical information set forth below is not necessarily indicative of future performance. Data for the FTSE NAREIT Apartment REIT Index and the S&P 500 Index were provided to the Company by NAREIT. STOCK PERFORMANCE $500 $400 $300 $200 $100 $0 2002 2003 2004 2005 2006 2007 AVB FTSE NAREIT Apartment REIT Index S&P 500 Index Source: NAREIT Benchmarked at 12/02=$100 Dec 2002 Dec 2003 Dec 2004 Dec 2005 Dec 2006 Dec 2007 S&P 500 Index FTSE NAREIT Apartment REIT Index AvalonBay $100 100 100 $129 125 130 $143 169 215 $150 194 264 $173 271 395 $183 202 295 AvalonBay Communities, Inc. 65 AVALONBAY CORPORATE INFORMATION BOARD OF DIRE CT OR S Bryce Blair (4) Chairman and CEO AvalonBay Communities, Inc. Bruce A. Choate (2,4,5) President and CEO Watson Land Company John J. Healy, Jr. (3,4) Founder and President 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 (1,5) Managing Partner Lance R. Primis and Partners, LLC Peter S. Rummel (3,4) Chairman and CEO The St. Joe Company 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 Chief Financial Ofﬁ cer Leo S. Horey Executive Vice President Property Operations Charlene Rothkopf Executive Vice President Human Resources David W. Bellman Senior Vice President Construction–East Coast, Midwest Danyell D. Alders Vice President Property Operations–Southern CA Ronald S. Ladell Vice President Development–NJ Sean J. Breslin Senior Vice President Redevelopment and Asset Management–National Deborah A. Coombs Senior Vice President Property Operations– Northern CA, Paciﬁ c NW Jonathan B. Cox Senior Vice President Development– Mid-Atlantic, Mid-West Lili F. Dunn Senior Vice President Investments–National Frederick S. Harris Senior Vice President Development–NY Tom A. Javits Senior Vice President Development–NY Joanne M. Lockridge Senior Vice President Finance, Assistant Treasurer and Assistant Secretary–National William M. McLaughlin Senior Vice President Development–MA, RI, CT, NJ J. Richard Morris Senior Vice President Construction–National Kevin P. O’Shea Senior Vice President Investment Management–National Edward M. Schulman Senior Vice President General Counsel and Secretary–National Bernard J. Ward Senior Vice President Property Operations– East Coast, Mid-Atlantic Stephen W. Wilson Senior Vice President Development–West Coast Trinity M. Blue Vice President Property Operations–Metro NY Richard A. Borowski Vice President Construction–Mid-Atlantic , NJ Shannon E. Brennan Vice President Property Operations– Mid-Atlantic Alfred Brockunier III Vice President Construction–NY Ishwar Lal Vice President Procurement Design and Estimating–National Lyn C. Lansdale Vice President Strategic Business Services–National Sarah K. Mathewson Vice President Property Operations–MA, RI Janice A. Miner Vice President Property Operations–CT, NY Duane W. Carlson Vice President Construction–Northern CA Mike F. Nootens Vice President Engineering–National Darren R. Carrington Vice President Investments–CA, Paciﬁ c NW Christopher L. Payne Vice President Development–Southern CA Sean M. Clark Vice President Development–Southern CA Walter A. Rebenson Vice President Development–Midwest Scott W. Dale Vice President Development–MA Michael J. Roberts Vice President Development–MA Tsippora Dingott Vice President Information Services–National Robert S. Salkovitz Vice President Construction–Southern CA Mark J. Forlenza Vice President Development–CT Brian E. Fritz Vice President Development–WA Keri A. Shea Vice President Finance and Treasurer–National Mona R. Stahling Vice President Operations–National Patrick J. Gniadek Vice President Investments–East Coast, Midwest B. Kevin Thompson Vice President Marketing–National Karen A. Hollinger Vice President Operations–National Matthew B. Whalen Vice President Development–Long Island Suzanne Jakstavich Vice President Human Resources–National Philip M. Wharton Vice President Development–NY Scott R. Kinter Vice President Construction–Northeast 66 AvalonBay Communities, Inc. F I N A N C I A L H I G H L I G H T S TOTAL SHAREHOLDER RETURN (1) e t a R h t w o r G l a u n n A d n u o p m o C 20.0% 15.0% 10.0% 5.0% 0% % 7 . 4 1 % 0 . 0 1 % 1 . 1 1 % 1 . 4 3-Year 10 Year AVB Multifamily Sector Avg. Source: SNL Financial e t a R h t w o r G l a u n n A d n u o p m o C e t a R h t w o r G l a u n n A d n u o p m o C NAV PER SHARE GROWTH (2) 30.0% 20.0% % 4 . 5 2 % 5 . 9 1 % 7 . 5 1 10.0% % 1 . 6 0% 3-Year 10 Year AVB Multifamily Sector Avg. Source: Green Street Advisors, SNL Financial AvalonBay Communities, Inc. is an equity Real Estate Investment Trust primarily engaged in developing, redeveloping, acquiring, and managing quality apartment communities in high barrier-to-entry markets within the United States. Our markets are located in the Northeast, Mid-Atlantic, Midwest, Paciﬁ c Northwest, and Northern and Southern California regions. At year-end 2007, our Total Market Capitalization was $10.6 billion. Over the last ten years, our Total Shareholder Return averaged 14.7% per year, and the growth rate of our dividend averaged 7.4% per year during the same time period. Our time-tested strategy is to more deeply penetrate our chosen markets with a broad range of products and services and an intense focus on our customer. AvalonBay Communities common shares are traded on the New York Stock Exchange under the ticker symbol AVB and were included in the S&P 500 Index in 2007. More information about AvalonBay may be found on our website at www.avalonbay.com. FFO PER SHARE GROWTH (3) PAGE 1, TOP: AVALON DEL REY, CA BOTTOM: AVALON GLEN COVE NORTH, NY COVER: AVALON RIVERVIEW NORTH, NY: 15.0% 10.0% % 8 . 2 1 5.0% 0% % 5 . 6 % 4 . 5 % 6 . 2 3-Year 10 Year AVB Multifamily Sector Avg. Source: SNL Financial See page 12 for notes, page 61 for deﬁ ned terms, and page 65 for 5 year stock perfomance graph. AVALONBAY CORPORATE INFORMATION H EA D QUA RTERS Washington, DC 2900 Eisenhower Avenue Suite 300 Alexandria, VA 22314 Phone: Fax: (703) 329-6300 (703) 329-1459 REGIONA L OFF ICES Boston, MA 51 Sleeper Street Suite 750 Boston, MA 02210 Phone: Fax: (617) 654-9500 (617) 426-1610 Chicago, IL 200 North Arlington Heights Road Suite 15 Arlington Heights, IL 60004 Phone: Fax: (847) 342-0065 (847) 342-0075 Fairﬁ eld-New Haven, CT 1000 Bridgeport Ave Suite 258 Shelton, CT 06484 Phone: Fax: (203) 926-2300 (203) 926-9744 Long Island, NY 135 Pinelawn Road Suite 130 South Melville, NY 11747 Phone: Fax: (631) 843-0736 (631) 843-0737 Los Angeles, CA 16255 Ventura Boulevard Suite 950 Encino, CA 91436 Phone: Fax: (818) 784-2800 (818) 784-2810 Newport Beach, CA 4440 Von Karman Avenue Suite 300 Newport Beach, CA 92660 (949) 955-6200 Phone: (949) 724-9208 Fax: New York, NY 275 Seventh Avenue 25th Floor New York, NY 10001 Phone: Fax: (212) 370-9269 (212) 370-1511 San Francisco, CA 185 Berry Street Suite 3500 San Francisco, CA 94107 Phone: Fax: (415) 284-9080 (415) 546-4138 San Jose, CA 400 Race Street Suite 200 San Jose, CA 95126 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 Virginia Beach, VA 2901 Sabre Street Suite 100 Virginia Beach, VA 23452 (757) 631-5000 Phone: (757) 486-1063 Fax: Woodbridge, NJ Woodbridge Place 517 Route One South Suite 5500 Iselin, NJ 08830 Phone: Fax: (732) 404-4800 (732) 283-9101 INV ESTOR REL ATIONS Investor Relations AvalonBay Communities, Inc. 2900 Eisenhower Avenue Suite 300 Alexandria, VA 22314 Phone: ir@avalonbay.com (703) 329-6300 ext. 4747 WE BSITE www.avalonbay.com TRA NS FER AGE NT The Bank of New York Mellon Shareholder Relations Department–12E P.O. Box 11258 Church Street Station New York, NY 10286 Phone: (800) 524-4458 O C S I C N A R F N A S , . C N I , G I A R C & Y E N I E H : N G I S E D INDEP E NDEN T AUDI TO RS Ernst & Young, LLP 8484 Westpark Drive McLean, VA 22102 Phone: (703) 747-1000 F ORM 10-K A copy of the Company’s annual report on Form 10-K as ﬁ led with the Securities and Exchange Commission may be obtained without charge by contacting Investor Relations. CE O AN D CFO CE RT IFICATI ON S In 2007, the Company’s Chief Executive Ofﬁ cer provided to the New York Stock Exchange the Annual CEO Certiﬁ cation regarding the Company’s compliance with the New York Stock Exchange’s corporate governance listing standards. In addition, the Company’s CEO and CFO ﬁ led with the Securities and Exchange Commission the certiﬁ cations required by Sections 302 and 404 of the Sarbanes-Oxley Act of 2002 regarding the quality of the Company’s public disclosures in its 2007 annual report on Form 10-K. STOCK LISTI NG S NYSE–AVB This Annual Report, including the Letter to Shareholders, 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-Looking Statements” on page 32 of this report for a discussion regarding risks associated with these statements. Non-GAAP ﬁ nancial measures and other terms as used in this report are deﬁ ned and reconciled beginning on page 61 in the section titled, “Deﬁ nitions and Reconciliations of Non-GAAP Financial Measures and Other Terms.” 2 0 0 7 A N N U A L R E P O R T A v a l o n B a y C o m m u n i t i e s , I n c . A N N U A L R E P O R T 2 0 0 7 2900 Eisenhower Avenue Suite 300 • Alexandria • VA • 22314 www.avalonbay.com Excellent Excellent Execution Execution

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