Earnings Call Transcript - ELME Q3 2021

Operator, Operator

Welcome to the Washington Real Estate Investment Trust Third Quarter Earnings Conference Call. As a reminder, today's call is being recorded. Before turning the call to the company's President and Chief Executive Officer, Paul McDermott, Amy Hopkins, Vice President of Investor Relations will provide some introductory information. Amy, please go ahead.

Amy Hopkins, Vice President of Investor Relations

Thank you and good morning, everyone. Before we begin, please note that forward-looking statements may be made during this discussion. Such statements involve known and unknown risks and uncertainties, which may cause actual results to differ materially and we undertake no duty to update them as actual events unfold. We refer to certain of these risks in our SEC filings. Reconciliations of the GAAP and non-GAAP financial measures discussed on this call are available on our most recent earnings press release and financial supplement, which were distributed yesterday and can be found in the Investor Relations page of our website. Participating in today's call with me will be Paul McDermott, President and Chief Executive Officer; Steve Riffee, Executive Vice President and Chief Financial Officer; Drew Hammond, Vice President, Chief Accounting Officer and Treasurer; and Grant Montgomery, Vice President and Head of Research. Now, I'd like to turn the call over to Paul.

Paul McDermott, President and Chief Executive Officer

Thank you, Amy. Good morning, everyone, and thanks for joining us today. I'd like to start off with an update on the progress of our Southeastern market expansion, following our commercial asset sales. I will also discuss the efforts that are underway to transform our operating model and current market conditions in the DC Metro and Atlanta, where we are actively growing our footprint. Steve will then update you on our portfolio performance and trends, and we'll discuss our third quarter results and outlook as we execute our transformation. Starting with our geographic expansion. We are pleased to report that in just over four months since our transformation announcement, we have already deployed or tied up over 55% of our $450 million target. We have deployed or are under binding contract to deploy approximately $154 million and we have been awarded another $97 million that is moving toward a binding contract. We also have other opportunities that we are pursuing, all of which align with our strategies and offer very strong NOI growth prospects. We have a very active pipeline and remain confident that we will meet our target over the balance of this year and perhaps into early next year. During the quarter, we closed the sales of our office and retail portfolios as planned. We closed our first Southeastern multifamily acquisition, The Oxford, on August 10th for $48 million. We have three additional acquisitions in process, including two communities that are under binding contracts of $106 million and the $97 million property that is moving towards a binding contract. We expect all three to close during the fourth quarter. We have and will remain disciplined, and we are only underwriting assets that fit our strategy and provide stronger NOI growth. Three of our initial properties aligned with our B Class portfolio strategy, with price points that target the deepest demand segments in their respective sub-markets, and the other property aligns with our Class B value-add strategy and offers a near-term value-add renovation pipeline. Our first acquisition, The Oxford, is a 240-unit garden-style community in the city of Conyers, Georgia. The area is primarily comprised of family households who want the benefits of living in the suburbs, combined with connectivity with downtown, midtown, and the South Atlanta business districts, along with the proximity to local employment nodes, including the Interstate 20 corridor, which is experiencing significant investment as employers expand into the area. The Oxford was built in 1999, and over the past five years, same-store rent growth for the submarkets' 1999 product has outperformed the average for all 90s vintage apartments in the Atlanta market and significantly outperformed the overall Atlanta market rent growth for all apartments. Over the past three years, the submarket has widened its outperformance versus the region's 90s vintage rent growth by over 3%. The Oxford has performed very well during the first two-and-a-half months we've operated it, with very strong new lease rate growth of 25% during September and increasing to 26% in October. Occupancy is tracking above our expectations, driven by very high retention rates and new leasing activity. We acquired The Oxford at a cap rate of 4.7%, and we expect an NOI growth rate that will be very high for the next three years. Two of the properties that we currently expect to close in the fourth quarter are located in Henry County in the southern suburbs of Atlanta, where rent growth has outperformed the overall Atlanta market on a trailing five and three-year basis and is projected to continue to outperform over the next several years. These properties are a strategic fit, aligning with our Class B portfolio strategy. We will provide more details after we close. In terms of our plans for our remaining capital and growth beyond, we are underwriting opportunities to acquire Southeastern communities, with low double-digit NOI growth prospects, which is stronger than our initial expectations when we decided to enter these markets. While the Southeastern markets are competitive, we have several advantages that appeal to sellers and are helping us to succeed. We have a 55-year track record of owning and operating multifamily properties and a strong track record of execution, which allows for a smooth and efficient due diligence process. We have well-established relationships in the multifamily industry that transcend into our new Southeastern growth markets that we are profiting from. Additionally, we are an all cash buyer with no financing contingencies, which sets us apart and adds a greater level of certainty of execution to the seller. While cap rates have tightened further since June, we are keying in on opportunities that will yield outsized rent and NOI growth and align with our strategic goals. Investment discipline is critical for us, and we spend a lot of time and effort researching and selecting our target markets and strategies for each market. Our research tells us that the industrial mix of an economy can determine what rent growth will look like over the long term. Our current target markets of Atlanta, Raleigh-Durham, and Charlotte have outsized exposure to industry that drive productivity growth, which creates a virtual feedback loop of job and income growth in migration and increasing education levels. Year-over-year effective rents for Atlanta, Raleigh/Durham, and Charlotte grew by 19.8%, 19%, and 17.6% respectively in September as reported by RealPage. New lease trade-outs were even stronger, averaging 22.7% across the three markets and a 580 basis point inflection between June and September. Annual demand also surged across these markets as in-migration and household formation drove record-setting absorption. Reported first quarter annual demand had already exceeded the five-year average in each target market, yet it climbed over 23% higher from the first to the third quarters. Raleigh/Durham posted a second quarter annual demand at 142% of its five-year average, while Charlotte and Atlanta's second quarter annual demand topped 162% and 161% of their five-year averages respectively. In order to maintain a disciplined approach and invest in these economies without competing with new supply, we're evaluating acquisition opportunities at the submarket level and targeting vintages with price points located at the deepest section of the demand curve. We are targeting renters who are benefiting from economic and wage growth, but remain underserved by new supply, which provides us the opportunity to create a quality living experience while also growing rents without competing with new supply. We remain in active negotiations, pursuing additional opportunities and would like to tie up another $200 million in multifamily assets that we expect can now be completed by early 2022. Again, we remain disciplined and are committed to allocating capital according to our strategy. We have passed on opportunities that did not meet our criteria or would not generate accretive growth. While we believe diversifying and expanding our footprint makes sense, we will also continue to explore acquisition opportunities in Northern Virginia, should they create greater value. The Washington apartment market is exhibiting some of the same positive trends that we are seeing in our Southeastern target markets. Year-over-year effective rents climbed 640 basis points from June to September. Suburban Virginia's performance followed a similar pattern, but with even stronger growth, with year-over-year effective rent growth accelerating to 9.7% in September. Our DC portfolio is positioned well with 80% of our portfolio in Northern Virginia, where the rapidly expanding consumer technology sector continues to drive job and income growth. Furthermore, our value-oriented price points offer favorable supply and demand fundamentals over the long term as the regional housing shortage worsens and the cost of ownership and new apartment supply remains unaffordable for mid-market renters. Before I turn it over to Steve, I'd like to discuss the efforts that are underway to transform and expand our operating model. As many of you know, we have been planning this transformation for several years and our transformation plan includes bringing property-level management in-house while building a new operating platform for the future. Over the past year, we have worked with a consultant to map out a plan to optimize our operational design as we scale our multifamily portfolio. We are now in phase one of this project, which includes three phases in total. We're making steady progress against the roadmap that we laid out and we anticipate that by the time of our year-end call, we will have selected all technology, established the elements required to support our operations including a comprehensive human capital program and established a new brand that best defines our approach for investors, residents, and employees. At that time, we expect to be able to give guidance on G&A and transformation costs as we will be actively building out the platform. We hope to execute phase two, which includes core platform implementation in 2022 and phase three, which incorporates the onboarding of our property management functions to our internal systems starting in late 2022 into mid-2023. While we control our revenue strategy and do all capital planning internally, day-to-day marketing, maintenance, and property management staffing have been outsourced. Following the complete internalization of property management and enhancements to our operational platform, we expect to realize significant operational benefits from streamlining our business processes through the use of technology to establish a closer connection with our residents to operational design efficiencies as we scale the business and optimize G&A expenses. At the property level, we believe that there are operating efficiencies ahead of us from internalizing property management because we are designing an operating platform aligned with our strategies for resident experience and employee satisfaction and growth. By utilizing corporate functions in a centralized model, we can be highly scalable, which will allow us to grow NOI at a much higher rate than G&A expenses. By designing and implementing our operating platform from scratch, we are not limited by existing infrastructure and will offer value and opportunity to all our stakeholders. Now I'd like to turn the call over to Steve to discuss our performance and trends, the status of our value creation opportunities, our third quarter results, and our near-term outlook as we execute our transformation.

Steve Riffee, Executive Vice President and Chief Financial Officer

Thank you, Paul, and good morning, everyone. The lease rate momentum that we experienced during the summer months has continued into the fall, and we are positioned well heading into the winter months with low double-digit lease rate growth on our most recent new lease executions. New lease rate growth was 9% for leases signed in September and 11% for leases signed thus far in October on an effective basis. On the renewal side, there has been very strong demand and the renewal lease rate growth was over 6% for September renewals and over 7% for October renewals on an effective basis. Concessions declined dramatically from June through September and are nearing pre-COVID levels. Total concessions for September move-ins declined over 95% compared to June move-ins driven by both a decline in the number of new leases with concessions and a decline in the average concession amount per lease. The percentage of new leases with concessions declined from an average level of 60% during the first half of the year to only 9% of new leases for September move-ins. The average concession value for new leases where concessions were granted, declined by 60% from $1,300 for June move-ins to approximately $560 per home for September move-ins. Occupancy remains strong, with a forward trend that will allow us to continue to increase rents. Same-store average occupancy grew 40 basis points in October, compared to the third quarter. Our suburban lease rates continue to outperform our urban lease rates, although the gap has narrowed due to the strong rebound we're experiencing in our urban portfolio. Blended lease rate growth was 7% for leases signed in September and over 8% for leases signed in October on an effective basis, which represents a significant increase from the third quarter average. For move-ins that took place during the third quarter, blended lease rate growth was 3.5% on average on an effective basis, representing a 620 basis point increase from the second quarter. Lease rate growth for September and October move-ins and lease executions with November and December move-in dates indicates steady and consistent improvement through year-end. We expect strong lease rate growth through the winter months and into the spring and summer leasing seasons in 2022. Rents have shown a swift recovery. The inflection as indicated by the rapid weekly improvement in lease rate growth, began towards the end of June, and rental rates improved rapidly through the summer. In August, we started signing new leases that were above pre-COVID levels for the majority of our portfolio. Specifically, the average effective rent for new leases in the third quarter was above the same month in 2019 for 17 of our 21 same-store properties. In fact, new leases for our suburban portfolio were 10% above the 2019 level on average in the third quarter, highlighting how well our suburban properties performed during the pandemic. We expect to see steady growth in average portfolio-wide rent levels, as the market recovery works its way into our rent roll over the next year. Our ability to capture this embedded growth will be slower during the winter months, as less than 25% of our leases expire between November and December. During this time, we will be focused on balancing rent growth with retention, as maintaining a balance in fundamentals heading into 2022 will set us up for an exceptionally strong spring and summer leasing season. Trove lease-up momentum continues, and it is now over 85% occupied. We expect Trove to be a key growth driver adding approximately $7 million of NOI in 2022 and $7.6 million of NOI in 2023. We also continued to monitor demand levels at Riverside, where we have a shovel-ready opportunity to add 767 units which we put on hold when COVID hit. While lease executions of Riverside are on a positive trend, we're currently monitoring projected lease rate growth to support this development. Our renovation programs are actively ramping up, after they were temporarily paused during the pandemic. We have a pipeline of approximately 2,700 units in our same-store portfolio. As expected, the pace of renovations picked up through the summer months, while unit turnover is seasonally high. In many cases, we preserve the renovation opportunity for the next turn, as we're achieving strong effective rent growth without currently having to make a capital investment. Year-to-date, we have fully renovated over 130 units and have invested capital in upgrading 110 additional units. We are securing low to mid double-digit cash-on-cash returns year-to-date. We expect to spend $3 million in our renovation program this year ramping up to approximately $7.5 million to $8 million next year for the current same-store portfolio. In the spirit of our transformation into a multifamily REIT, we have made changes to our earnings materials and non-GAAP financial metrics to be more in line with and comparable to other multifamily REITs. We believe that our new presentation makes comparisons of our operating results more meaningful and provides additional insight into our operating performance and trends. First, we provided a more detailed expense breakdown of both controllable and non-controllable expenses including property operating, taxes and insurance, and property management. Second, we've included detail of our same-store operating results by geographic region as we continue executing our strategic plan to diversify in multiple geographic regions. Third, we modified our calculation of NOI to exclude property management expense which is more consistent with the multifamily industry standard and better presents the impact of our trends in occupancy rates, rental rates, and operating costs and our operating performance. We retrospectively adjusted our previously reported multifamily NOI for comparability. Overall, this adjustment has increased our NOI margin by 300 to 400 basis points. Fourth, we updated our definition of NOI for residential communities to exclude NOI from ground-level retail tenants. The separation of non-residential NOI from residential NOI provides a better representation of our core performance by distinguishing between the core operations of the business and ancillary NOI. Fifth, we changed the name of the non-GAAP measure funds available for distribution or FAD to AFFO because we believe that AFFO is the more common term in the multifamily sector. We do not make any change to the calculation and there is no difference in the definition of AFFO and FAD as previously labeled. Sixth, we expanded our disclosure of same-store metrics, adding operating margin and effective lease rate growth. Finally, we combined our earnings release and financial supplement into one earnings package. All of these adjustments are described in detail on Page 14 of the third quarter earnings package. Now turning to financial performance. Net income for the third quarter of 2021 was approximately $31 million or $0.37 per diluted share compared to a net loss of $1 million or $0.01 per diluted share in the prior year. Core FFO was $0.20 per diluted share reflecting a year-over-year decline of $0.16 due to the impact of our commercial asset sales. Multifamily same-store NOI declined 40 basis points compared to the prior year driven by the impact of leases signed during the pandemic. As expected, the rapid rebound in core multifamily operating trends that began towards the end of the second quarter is and will continue to have a more gradual impact on our financial performance. While new lease executions began to improve rapidly starting in June and into July, those movements started to impact our results in late August, and we expect the inflection in lease rates to have a greater impact on our fourth-quarter results. Furthermore, the impact of the concession amortization peaked during the third quarter driven by the timing of the peak in concessions which occurred towards the very end of 2020 and into the first quarter of 2021. The impact of concessions and amortization peaked in August and began to decline on a monthly basis in September. Excluding the impact of amortization related to concessions granted in prior periods, same-store multifamily NOI increased 2% on a year-over-year basis during the third quarter. Our resident credit continues to be excellent. For the small amount of delinquent rents that we have, local rent assistance programs have helped us on the margin today. We collected 99% of multifamily rents during the third quarter and received $400,000 of local government rent assistance from residents. Year-to-date, residents have received over $1.4 million of rental assistance. Other NOI, which represents Watergate 600, declined 4.9% in the third quarter compared to the prior year primarily due to higher taxes and payroll expenses and a favorable bad debt recovery in the prior year period. Leasing activity at Watergate 600 has been steady, despite the challenging environment of the DC office market. We signed an 8,200 square foot new lease with a credit tenant during the quarter and two renewals and one expansion post quarter-end. Our percentage leased has increased to 92%, and we have activity to allow us to create further value in the asset. This one remaining office asset is an iconic building with Riverfront and monument views, high-quality institutional tenants and a weighted average lease term of eight years, and we continue to see the opportunity to create value by owning and leasing Watergate 600. Now touching on our outlook for the balance of the year. We are reinstating full-year 2021 guidance with a core FFO range of $1.05 per share to $1.08 per share. We estimate that our same-store multifamily portfolio will contribute between $90 million and $90.5 million of NOI for the year. At the midpoint, this implies an approximate 4.5% multifamily growth rate for the fourth quarter compared to the prior year period. We expect healthy same-store NOI growth in the fourth quarter and further growth in 2022. Trove and The Oxford are expected to contribute between $3.75 million and $4.25 million of 2021 NOI. Watergate 600 is expected to contribute approximately $12.75 million of NOI. We completed the sale of the office portfolio on July 26th for gross proceeds of $766 million and completed the sale of the retail portfolio on September 22nd for gross proceeds of $168.3 million. We acquired The Oxford on August 10th, which as Paul highlighted has performed very well thus far and is tracking ahead of underwriting based on rents. As we've discussed, we entered into binding agreements to acquire two communities in the Atlanta market for $106 million and are moving towards an additional binding agreement for another property for $97 million. All three of these transactions are expected to close during the fourth quarter. We redeemed all $300 million of senior unsecured notes that were previously scheduled to mature in 2022 on August 26 and repaid $150 million of amounts outstanding under the term loan maturing in 2023 on September 27. We ended the quarter with a very low net debt to EBITDA ratio of 1.4 times. While we may be in the mid to high five times net debt to adjusted EBITDA range in the first year after executing these transactions, as we progress through the second and third years of multifamily NOI growth, we would aspire to operate in the lower half of the five times to six times range. We have very little debt maturing in the near term, none earlier than 2023, and our equity versus debt ratio is expected to get close to 80% to 20%, which will be very strong. We have no secured debt in our capital structure, which provides us with flexibility to take on some agency debt or other secured debt as we acquire apartments. Moreover, we believe we will continue to have most of our line available, so strong liquidity will be maintained. We currently have approximately $1 billion of liquidity including the full availability of our $700 million line of credit, which we further extended another four years this quarter. Before I turn the call back to Paul, I am pleased to share that earlier this month we published our 2021 ESG report, which outlines our ESG vision and objectives as a multifamily company. With this report, we are proud to be among the first multifamily REITs to commit to achieving net-zero carbon operations. We detail a number of exciting ESG projects underway including the pursuit of green building certifications for multifamily Class B assets, growing our pipeline on-site solar projects, and the integration of climate risk into the company's overall enterprise risk management framework including evaluating climate risk and asset resilience as part of our underwriting process. And with that, I will now turn the call back to Paul.

Paul McDermott, President and Chief Executive Officer

Thank you, Steve. Overall, we are off to a very good start progressing on our geographic expansion and have executed most of our transformation to a multifamily company. We have completed the sale of our commercial segments and we have closed on one asset, have two others under contract and as we said have been awarded one more asset in Atlanta. We have an active pipeline of opportunities that align with our strategies and we remain confident, we can allocate this capital appropriately over the balance of this year and into early next year. For the balance of 2021, we remain focused on investing our remaining capital and firming up our plan to transform and expand our operating model. We expect to achieve operating efficiencies as we scale the business and execute our plan to bring property-level operations back in-house. We look forward to keeping you updated on our progress as we expand our geographic footprint and transform our operating platform. Now the team and I would like to open the call to answer your questions.

Operator, Operator

Thank you. And our first question today is coming from Jim Sullivan at BTIG. Your line is live. You may begin.

Jim Sullivan, Analyst

Yeah. Thank you. Couple of questions. First of all, in terms of the acquisition activity. I believe on the initial acquisition The Oxford, you indicated a cap rate of 4.7%. And I was unclear whether that 4.7% was based on the underwriting you did at the time of the acquisition or whether it was based on kind of the current run rates that you're achieving?

Paul McDermott, President and Chief Executive Officer

It was based on our underwriting. At the time of the acquisition, taking into account, yes, what's happening on a trailing basis, but not necessarily projecting the exact same rental growth that they've achieved over the last six months for the prolonged underwritten period.

Jim Sullivan, Analyst

Now that cap rate, I believe, is somewhat higher than you've been talking about in conversations before you started actually closing acquisitions. And I guess, given the liquidity and given your ambitions in terms of acquisitions in the coming couple of months here, is that 4.7% indicative of where you think you're going to be? I think you have been talking about rates maybe closer to 4% earlier.

Steve Riffee, Executive Vice President and Chief Financial Officer

Good question, Jim. There's no doubt that since we've rolled this out in June, cap rates have compressed further competitively in the Southeast markets. With about 55% of our target in terms of what we wanted to get out from a capital allocation standpoint, now tied up or in sight. We're averaging a 4%. And we would go a little under that. But the other thing that I want to point out is we talked about what we thought NOI would be like over the first three years when we set that target based on our research. What we're actually finding in our underwriting is that the NOI growth that we have for the first three or four years or multiples is a multiple of what we had originally assumed when we had our initial cap rate target. So we are identifying assets that are right on strategy. We see some cap rate compression, but we're actually seeing NOI growth that's much greater than we originally assumed. So we're happy that this is going to create the growth that we wanted through geographic diversification so far.

Jim Sullivan, Analyst

And talking about the assets that you have kind of under agreement or heading for agreement on, I think you indicated that one of them is B Value-Add. And I wonder in that respect, if you could kind of share with us what the expected spend per unit would be? I know, it's early days. You might not have finalized this, but whatever indications you could give would be helpful.

Paul McDermott, President and Chief Executive Officer

Jim, hi, it's Paul. We're still in negotiations on that asset, and so we're happy to talk about that once the deal is closed. But since we're still in negotiations with the seller, I'd prefer to defer that for now. Thank you.

Jim Sullivan, Analyst

Okay. Fair enough. And then finally for me, the operating platform rollout that you described, and it was helpful to get that detail into the phasing and timing. I'd be curious if you have established the budget for that. And of that cost, if you could share with us what you project that cost to be. What percentage of, if any, you can provide for that cost that would be capitalized versus expensed?

Paul McDermott, President and Chief Executive Officer

Jim, we have a preliminary estimate of that. We really would like to give that detail after we finish phase 1, which should conclude here near year-end. And we do expect a portion of that to be capitalized. And it is just we're in phase 1, which is scoping out really the technology platform, the whole human capital plan for integrating this at the operational level, and branding, and then the web technology. And we're going through a process and the actual amount that we would spend depends on the selections we make here in phase 1. I have a preliminary estimate. I don't really want to put it out to the February call when we have a budget that I'm very confident in. But there’s almost half of it that would be capitalized on the preliminary budget that I looked at. But we really look forward to giving clarity. The team is working very hard right now, and we're trying to target to have it done before our February year-end call so that we can speak to that and talk about the timing, and the phase-in, and kind of what our goals are in terms of what we might be able to achieve as a result of implementing it.

Jim Sullivan, Analyst

Okay. Fair enough. Thanks, guys.

Operator, Operator

Thank you. Our next question today is coming from John Pawlowski at Green Street. Your line is live. You may begin.

John Pawlowski, Analyst

Great. Thank you for taking the question. Maybe just one follow-up clarifying question on the cap rates. Steve, the 4% cap rates, is that on a forward 12-month basis or an in-place NOI concept?

Steve Riffee, Executive Vice President and Chief Financial Officer

It's on a forward underwriting, looking at what we believe we're going to be doing at each of the properties, and that's a blended cap rate across to 5%. The first one was higher. The last one was a little lower to blend to a 4% so far.

John Pawlowski, Analyst

Okay. Makes sense. Paul, could you understand we'll wait for actual quantification as the rollout of the operating platform, but the intensive human capital program you alluded to, can you just give us some more details of what that actually entails, the number of senior executives you have to bring on, overall headcount expansion, just a bit more context on the human capital program will be helpful?

Paul McDermott, President and Chief Executive Officer

Well, John, I'd be happy to discuss that once it’s finalized, but as Steve mentioned, we are currently in the early stages of developing it. Since you cover many multifamily REITs, you know that we are essentially bringing property-level operations in-house. You’re likely familiar with what it takes to staff an asset, and we are working on that now. We should have a clearer idea of what it will entail by the year-end earnings call in February. For now, that work is still ongoing, John.

Steve Riffee, Executive Vice President and Chief Financial Officer

And Paul, the only thing I would add, because I think you were commenting kind of at the more senior leadership levels and all as he was asking. We do expect from our preliminary work when we put the initial road map together working with consultants, we expect to achieve efficiencies very much operationally and at the property management level, we believe they would be staffed tighter. We believe that there will be some functions that are centralized. And so we do see an opportunity to create some of those efficiencies once it fully integrated.

John Pawlowski, Analyst

Okay. Appreciate it. Last question, months and months keep rolling by and the world is getting back to normal particularly in the apartment rental side, but there's still some narrowing in terms of a rebound in office utilization. So now that you've got a little bit more leasing done at Watergate, does the lack of resurgence in office utilization make you want to accelerate the sale of Watergate?

Paul McDermott, President and Chief Executive Officer

I think we’ve consistently stated that there is still potential to create value at the Watergate. As Steve mentioned, we signed one lease and extended another. Our hold on that property is now eight years. We’re currently seeing positive activity and aim to achieve more leasing, while closely monitoring the DC market. When we believe it’s the right time to bring it to market for maximum value, we will proceed.

John Pawlowski, Analyst

All right. Thank you. Makes sense.

Operator, Operator

Thank you. Our next question today is coming from Anthony Paolone at JPMorgan. Your line is live. You may begin.

Anthony Paolone, Analyst

Thanks. Just first, I guess, further on the cap rate discussion just to make sure we have our definitions right here. So you said forward 12 months NOI and is that before or after property management cost that you seem to be taking out these days about 3.5% and then also any CapEx reserves?

Steve Riffee, Executive Vice President and Chief Financial Officer

Yes. Our net operating income relative to our purchase price is how we calculate that. We have accounted for our internal costs within our property management expenses in the structure. When we assessed the initial cap rate, we considered what our cost structure will be at the property level. For capital expenditures, we are planning year-by-year what we want to do with the building. If we decide to make additional capital investments, we do not include that in the initial cap rate, similar to our other assessments, but we do report it. Regarding the renovation opportunities included in that capital expenditure, we view them as separate return on investment opportunities that generate their own returns.

Anthony Paolone, Analyst

Okay. But that 4% then is before the property management expense number?

Steve Riffee, Executive Vice President and Chief Financial Officer

I think the way we had written it, it actually did take into account the property management expenses. The redefining of it for financial reporting to be comparable to other companies did not change the way we've been looking at it traditionally in our acquisition models, Tony.

Anthony Paolone, Analyst

Got it. Understand. Just trying to make sure we're talking about the same thing. And then I think I caught, I think you mentioned maybe a 10% suburban rents that are above 2019 levels. But I don't know if you had given a number, if you can give a number just on the overall portfolio loss to lease right now.

Steve Riffee, Executive Vice President and Chief Financial Officer

The loss to lease in the portfolio, we did put out an updated investor deck last night also. And we do have a loss to lease slide on there. So our urban loss to lease right now is around 17%. Suburban is actually a little lower. Blended loss to lease is around 14%.

Anthony Paolone, Analyst

Okay. Got it. All right. And then just on this property management platform building out the organization I guess the question is, if you show up this $450 million that you set out to do, is that enough to really have the scale you need to do better than using third parties?

Paul McDermott, President and Chief Executive Officer

Tony, I think we're, it's Paul, we're going to obviously continue to scale the platform. That's the whole reason we're going through this exercise. And we have many ways to do that. But we would expect to be continuing to draft off the momentum of the $450 million initially. For example, I mean we still have the Watergate to monetize. We've been approached about JVs. As you know, we have Riverside that is shovel-ready, where we could also repatriate capital into other markets. So I think we've got a lot of opportunity in front of us, but the whole point here is to build this up to gain some of those efficiencies that we've alluded to that we're trying to create by redoing the platform.

Anthony Paolone, Analyst

Can you – with the stock in the $25, $26 range, can you make sense of using the equity here to do these deals?

Steve Riffee, Executive Vice President and Chief Financial Officer

Tony, initially, we recognized that with all the moving parts, it would take some time for everyone to fully understand the multiples. Currently, our trading implies a cap rate that is broader than other multifamily REITs. We have a solid balance sheet, good leverage, and a lot of flexibility, but we know we need to get capital out. We wanted to give ourselves time to utilize the capital we raised from the transformation and continue reinvesting. We also have at least two other capital sources that could be viable before we have to explore other markets. Our goal is to establish a capital structure that provides access to various markets as conditions change regarding optimal funding strategies. Additionally, we still have Watergate as a potential source of capital for growth, along with significant development opportunities on a large asset in Riverside, where many investors are interested in partnering for expansion. We have no joint ventures or secured debt, which results in a clean structure that seeks different capital sources. If we engage in a joint venture while retaining an interest, that could generate significant funds for further geographical expansion. We aim to simplify our company’s structure to present a clearer investment opportunity for equity investors, ensuring they understand our asset class without concerns about other classes. We are confident that our clean balance sheet allows us to explore various debt options, including secured debt, if that aligns with our apartment deal strategy. We have sufficient capital to initiate our plans and flexibility for several steps before needing to raise equity. Strategically, we hope this approach works, and so far, we believe we are executing it effectively.

Anthony Paolone, Analyst

Got it. Okay. That’s helpful. Thank you.

Operator, Operator

Thank you. Our next question today is coming from Blaine Heck at Wells Fargo. Your line is live. You may begin.

Blaine Heck, Analyst

Great. Thanks. Most of my questions have been asked. But one for Steve. How should we think about the potential dividend growth going forward? Now that your payout and portfolio have been reset is it kind of fair to assume it should follow closely with AFFO growth from here?

Steve Riffee, Executive Vice President and Chief Financial Officer

Yes, I believe so. When we adjusted the dividend level, we aimed for a payout ratio of around 75% of AFFO to monitor our progress. We are confident that once we redeploy the $450 million, we can operate within this framework. One of the aspects we are pleased about, and a key reason for geographic diversification, is our expansion into markets with stronger growth. Currently, we are experiencing some of the best economic conditions we've seen in our own market in quite a while. Regarding lease losses, we've observed a positive shift in net effective rents for new leases. In October, we recorded an increase of 11%, and in the past two weeks, that has risen to 12% and 13%. Everything is moving in a favorable direction. Additionally, we are witnessing improved underwriting and NOI growth, which we are optimistic about as we focus our new capital allocation. Diversification is essential. If we look at current AFFO growth, our recurring CapEx to NOI is now around 5%, which is a significant change compared to when our commercial portfolio was weighing us down. We are being strategic in capital allocation to maximize NOI growth, which in turn will enhance AFFO growth. We believe there will be opportunities for AFFO to increase as we continue our efforts, and ideally, this will also lead to future dividend growth.

Blaine Heck, Analyst

Very different from office. Thanks, guys.

Steve Riffee, Executive Vice President and Chief Financial Officer

Yes.

Operator, Operator

Thank you. Our next question today is coming from Michael Lewis at Trust Securities. Your line is live. You may begin.

Michael Lewis, Analyst

Great. Thank you. Appreciate all the detail as you're doing this kind of meaningful repositioning. And along those lines, you talked about this opportunity to build when you want. Kind of a big picture question on what that means in terms of the portfolio. You mentioned buying dispersed assets at a 4.7% cap. It sounds like maybe you could do some better sub-4%. Do you envision kind of value-add opportunities? Could you do redevelopment down the line? Is it quality in locations or is it suburban strategy? How do you kind of think about it as you have this opportunity to kind of build this portfolio up?

Paul McDermott, President and Chief Executive Officer

Michael, it's Paul. I would say all of the above because we have allocations to each of those areas. If you remember our strategy from June 15 regarding this transformation, we discussed the B strategy and how we would implement it. I'm going to ask Grant to elaborate on that shortly. Additionally, we have a renovation pipeline of 2,700 units and a development opportunity for 767 units that is ready to go, along with other development prospects already included in our existing portfolio in this region. But before I go further, let me hand it over to Grant to discuss those three areas.

Grant Montgomery, Vice President and Head of Research

Sure. Well, really the core of our focus is on the renter. And then we're really following the mid-market renter. Those mid-market renters can be found in a variety of locations both suburban and urban. Our Class B strategy really targets areas that have this outsized submarket growth with future innovation potential that might not make sense today, but those submarkets that we've really identified have the underlying strength to really point to that future opportunity while harvesting strong rent growth today. Secondly is the B Value-Add, which we have significant experience with here in the Washington D.C. area and are finding opportunities in the Southeast as well. Those are ones where we have the immediate opportunity to do full-scale unit renovations. And we're really focusing on properties in submarkets where the rent gap between those properties and the Class A product gives plenty of room to renovate and not compete directly against those well serving that underserved renter that may be in a more expensive submarket and is underserved by the current product there. And then finally, with our existing portfolio, we have some Class A minus properties which are higher quality slightly different renter, but still a mid-market renter but really focused on the value orientation of that. And those we're being really careful about in terms of our operations so that we try to stay below about 110% of the market median rent, because what we found from our research is that typically new developments in these markets including Washington D.C. delivered about 120% to 130% of the market median. And if we can stay below that 110% rate on the Class A properties, we really miss a lot of the direct head-to-head competition and so we can be successful in that upper-end of the mid-market strata as well. So we think we'll build that portfolio out both in suburban locations, urbanizing locations across these markets. But just as a sort of predicated upon where we're going in many of these markets, a large volume of will be suburban because these markets are highly suburban in nature. So, hopefully, that answers your question.

Michael Lewis, Analyst

Thank you. I wanted to ask about the platform setup and technology investments. I understand that there was a cost estimate mentioned, which included some debt repayment that may have already occurred. How should we consider the layering of those costs over time? Will you be separating transition costs from your core FFO for several quarters, or will there be significant upfront costs? How will that be structured?

Grant Montgomery, Vice President and Head of Research

That's a great question. We aim to be as transparent as possible regarding our costs. Initially, we had transaction costs associated with all our execution, which were reflected in various line items, including asset sales and debt breakage costs. The transformation costs will likely continue throughout this project's phase. Currently, the costs for 2021 are higher because of this execution. We expect G&A to start normalizing in 2022, and we plan to delineate the transformation investments we'll be making in that year. We'll provide guidance about those costs and the phasing of this transformation in February. The first phase is not a major investment, but it is currently embedded in our cost structure for the fourth quarter. The more significant costs will be estimated and shared in February, particularly concerning 2022. Some of these costs will be capitalized while others will be expensed, as we implement a fully integrated technology platform. This involves creating a human capital structure that includes job subscriptions, incentive programs, and operational staffing for each location. Additionally, we'll invest in web design and branding, utilizing technology for overnight pricing, all of which will be integrated and may have some capitalized costs. Our goal is to have most of this investment in place before we bring back the first property in an integrated manner, targeting late 2022 and continuing through mid-2023. We intend to track these separately, allowing us to start normalizing. We expect operating efficiencies to appear in various areas, particularly in the NOI of the property and property management expenses going forward. We also anticipate that G&A will normalize and scale as we phase out of commercial operations and make these investments. Strategically, as Paul mentioned, scaling the business makes the most sense. G&A is scalable at this company, meaning we won't need to add significant G&A as we grow. We will strive to clarify that the only ongoing costs after completing the final parts of the transactions will be those related to the integration of the platform, which we expect to extend into late 2022.

Michael Lewis, Analyst

Thank you.

Operator, Operator

Our final question today is coming from Bill Crow at Raymond James. Your line is live. You may begin.

Bill Crow, Analyst

Thanks. Good morning, guys. Paul, our team always does some great macro work. So a little amount of focus there. I think arguably your current and target renter cohort might be relatively more sensitive to the inflationary pressures, on say the gasoline utilities rental rate increases that are going into effect right now. And I'm just curious, as you look out a year and you think about lapping the increases that are being pushed today, do you think the Class B, of course, we're big proponents of workforce housing, do you think you'll be able to get the same rental rate increases a year from now as say Class A?

Paul McDermott, President and Chief Executive Officer

Bill. Hi, it's Paul. I'm going to ask Grant to jump in here real quick and then I'll follow-up.

Grant Montgomery, Vice President and Head of Research

Sure. So I think part of it is that we don't expect rental rate increases in 20% a year from now. So there will be some sort of tailing down of that going forward. But we are heartened by the strong income growth that we've actually seen. ADP came out with a report yesterday showing that wages have grown 3.3% across the US and for those that were changing jobs has actually doubled that at 6.6%. But as it relates to what we're trying to do in our portfolio the strongest growth was actually in the Southeast, which was 3.8%. And in some of the industries that our residents are likely to be employed in such as trade, transportation, and utilities for example, our locations that we are acquiring in Henry County is really sort of the nexus of logistics for the Atlanta area. Trade, transportation, and utilities wages were up 6.7%, and construction wages are up 5%. So these are the type of people that will be residing in our properties. So I think we're really heartened by that. I think the news came out yesterday that Costco was increasing their wages as well. So unlike other times in our recoveries, we're actually seeing strong wage growth at the bottom of the strata to the mid-level of the strata. And so I think we're heartened by that in terms of the ability of our renters to be able to absorb some of the growing costs in terms of their rent budget moving forward into 2022.

Paul McDermott, President and Chief Executive Officer

Bill, I want to emphasize how thorough Grant is in his responses, but I also want to note that our experience during COVID, with job losses and current inflation concerns, has shown that Class B properties have become stronger. We've noticed people moving from A to A-minus properties. When I examined our suburban B performance during COVID, I remember many questioned our suburban strategy, but we've really seen both growth and resilience in that income demographic. It's the only affordable product type situated in areas with good infrastructure, schools, and retail services. Although there may be continued pressures that impact our renters, we believe there will still be significant demand for this type of product moving forward, Bill.

Bill Crow, Analyst

All right. Appreciate the thoughts.

Operator, Operator

Thank you. We have no further questions in the queue at this time.

Paul McDermott, President and Chief Executive Officer

I'd like to thank everyone again for your time and interest today. We will continue to update you as we progress on our multifamily transformation and we look forward to speaking with many of you over the next several weeks. Thank you.

Operator, Operator

Thank you ladies and gentlemen. This does conclude today's event. You may disconnect at this time and have a wonderful day. Thank you for your participation.