Archstone-Smith’s Transformation Over the Past Decade Has Been Fueled by a Single Vision for Success.

By Lynn Novelli

Studio City, CA

R. Scot Sellers, chairman and CEO of Archstone-Smith (NYSE: ASN), has a simple formula for success in the apartment business: “Be in long-term growth markets, in the best neighborhoods, in the best locations, close to jobs and shopping and provide a notably higher level of service to customers.”

That may be easier said than done, but this formula has propelled Archstone-Smith from a regional apartment REIT with a $378.5 million equity market capitalization 10 years ago to its position today as a nationally focused company with a $4.3 billion equity market cap and 289 high-rise and garden apartments located in the nation’s top markets.

This radical repositioning is the direct result of Sellers’ personal vision. When he joined the company in 1993 after 10 years with Lincoln Mortgage, he began transforming the company’s portfolio. He surrounded himself with a like-minded management team and in 1996 the company began disposing of less-desirable properties and redeploying capital from the sales to acquire assets in target markets.

Herndon, VA

During the early and mid-1990s, the company changed names several times and was involved in several mergers. By 1998, the company was Archstone Communities Trust, owner of some 200+ garden-style apartments in major metropolitan areas. In October 2001, Archstone finalized the $3.6 billion purchase of Arlington, VA-based Charles E. Smith Residential Realty, which specialized in high-rise apartments in Washington, D.C., Chicago, Boston and southeast Florida. The merger boosted the company’s portfolio by 62 percent in number of units and created the Archstone-Smith name.

Archstone–Smith now owns and manages a national platform of more than 100,000 units concentrated in northern and southern California, Seattle, Chicago, Boston, New York City, Washington, D.C. (where 35 percent of its portfolio is located) and southeast Florida. However, the company has no plans to rest on its laurels and Sellers says it will continue its aggressive asset disposition and capital recycling.

By the end of the first quarter, the company had disposed of $190.8 million in assets in 2003 and plans to use those proceeds (and additional disposition sales) to acquire $200 million to $300 million in properties in target markets, according to accompany spokesperson.

San Diego, CA

“We now have 84 percent of our portfolio in core, protected markets, and we continue to pursue our goal of having 100 percent of our portfolio in these markets,” Sellers says.

Strength of Market Positioning

Archstone-Smith’s market positioning is one of its biggest strengths, says Paul Puryear, managing director of real estate research at Raymond James Associates. “They are located in supply constrained markets where it is much tougher for the competition to come in against them,” he says.

“They have made it a deliberate strategy to be in those markets, and it has taken them years to get there by buying, selling and trading assets. But now they have an excellent market position.”

In an economic environment characterized by no employment growth, a strong housing market and strong apartment construction, almost all apartment REITs are taking a beating. However, the strength of Archstone-Smith’s portfolio has buoyed results in the face of current market challenges, says A.G. Edwards & Sons analyst John Sheehan. In 2002 and so far in 2003, Washington, D.C., Southern California and Southeast Florida have been the company’s strongest markets, posting gains in revenue, according to the company. On the other end of the spectrum, revenues have continued to decline in Chicago and the San Francisco Bay area.

Boston, MA

A.G. Edwards’ current “hold” investment rating on Archstone-Smith is more of a reflection of market fundamentals than the quality of the company, he says. “Archstone-Smith’s operating performance has not been any worse than that of its peers. Overall, my view of the company is favorable. With its strong management team and strong portfolio, it is well positioned for when the market recovers,” Sheehan says.

Adds Puryear, “Archstone Smith is one of our top picks in the apartment sector. We like Archstone-Smith and believe it is very well positioned. We are benign on the sector, pending [economic recovery]. At these stock prices, there is no need for investors to run from the sector. If the prices were higher, maybe so.”

Performance in a Tough Market

The impact of a difficult apartment market was reflected in Archstone-Smith’s performance in late 2002 with same-store revenue decline, and NOI and FFO growth flattening. The third and fourth quarters were the first two quarters in more than 12 years that the company reported a decline in same-store revenue growth, and overall same-store revenue growth was off 0.4 percent for all of 2002.

However, first quarter 2003 results hinted at signs of a return to form. Archstone-Smith posted a 1.1 percent growth in sequential (fourth quarter 2002 to first quarter 2003) net operating income (NOI). “Archstone-Smith is the first in its sector to post a positive same-store NOI growth for the quarter, and it has maintained occupancy,” says Brian Legg, vice president, REIT research, Merrill Lynch & Co. “Most companies in its sector have posted negative NOI for the quarter because their market fundamentals have not bottomed yet.”

Archstone-Smith Headquarters: 9200 East Panorama Circle, Suite 400, Englewood, CO 80112 Phone: 303-708-5959 Web Site: www.archstone-smith.com Chairman & CEO: R. Scot Sellers CFO: Charles E. Mueller Core Markets: Archstone-Smith’s largest positions are in Washington, D.C., Southern California, San Francisco and Chicago. Ticker Symbol: ASN (NYSE) 52-Week High: $27.57 (5/31/02) 52-Week Low: $20.94 (2/14/03)

Archstone-Smith continues to outperform its peers, notes Legg. Year-over-year NOI growth in the first quarter was down by 3.9 percent, “but this performance was significantly better than most of its peers,” he says.

Archstone-Smith reported first quarter FFO per share of $0.48, slightly ahead of what analysts were predicting, although down from fourth quarter 2002 FFO per share of $0.56. The better-than-expected first quarter FFO, coupled with the positive first quarter NOI news, has led Merrill Lynch to revise its 2003 dividend estimate from $1.79 per common share to $1.85 and its 2004 dividend estimate from $1.80 to $1.88. Merrill Lynch also has revised its NOI forecast from a 4 percent to a 1 percent sequential decline for the rest of 2003.

Amid concerns among some analysts that a continued sluggish economy could cause some REITs to cut their dividends, Archstone-Smith paid a dividend of $0.4275 per common share on May 30. On an annualized basis, this represents a dividend of $1.71 per common share, slightly ahead of 2002’s $1.70. The first quarter also marked 110 consecutive quarters of dividend payments, and 2003 will make the 11th consecutive year of increases in common share dividends. Over the past 10 years, the average total annual return is 13.3 percent, and the company’s common share dividend has increased 151 percent over that period.

In addition, Archstone-Smith properties are well occupied in virtually all markets, says Lindsay Freeman, chief operating officer. “During a time such as the present of no revenue growth or a decline in effective rents, Archstone-Smith believes in maintaining high occupancy rates. Our outlook is being as thoughtfully aggressive as we need to be in a market that doesn’t lend itself to market rent growth.” At the end of the first quarter, the company’s occupancy rate was 94.8 percent.

In the short term, the company says it will continue to focus on maintaining occupancy by being willing to back off on rents at the time of leasing in favor of keeping units filled, going after the renewal long before a lease expires and offering flexible lease terms.

The High-Tech Edge

Technology also plays an important part in Archstone-Smith’s strategy for attracting and maintaining tenants. The company views technology as a tool to be used to improve customer service and reduce operating costs—customers enjoy the benefits and convenience of online bill paying and apartment rental and faster credit approval at the time of application through an online credit scoring system, the industry’s first.

In 2002, Archstone-Smith completed the rollout of its Lease Rent Optimizer (LRO) program, the first revenue management program designed for the apartment industry. In developing LRO, Sellers says he studied systems used by companies such as Hertz and Marriott, in search of best practices. His goal: streamline operations so that Archstone-Smith associates could spend more time meeting tenants’ needs and give them greater flexibility in lease terms and pricing. LRO calculates the optimal rent to charge for each lease based on several factors including availability, turnover costs and expected lease downtime.

Archstone-Smith’s Top Eight Markets
Market	Percentage of Portfolio
Washington, D.C.	35%
Southern California	13%
San Francisco Bay area	9%
Chicago	9%
Southeast Florida	7%
Boston	5%
Seattle	3%
New York City area	2%

In fourth quarter 2002, with LRO fully operational, same-store revenue growth ranked first or second among all public apartment companies in 16 of its markets, which accounts for 82 percent of Archstone-Smith’s portfolio. The company adds that customer satisfaction for the year hit an all-time high of 91 percent.

This year, Archstone-Smith will spend some $2 million to roll out a Web-based property management software program to all locations, another first in the industry. Archstone-Smith’s information systems group has been working with MRI Real Estate Solutions to develop the system, which will integrate LRO, automated leasing and record keeping.

The concept is customer-centered instead of unit-centered, explains Freeman. “We tend to have long-term relationships with customers who may move around to different units or even different properties,” he says. “The software is designed so that we can understand customer patterns and stay in contact with them.”

The company’s aggressive use of technology, especially at a time when many companies are shying away from it, puts them at an advantage, according to Sheehan.

“Archstone-Smith’s innovative use of technology sets it apart from its peers,” A.G. Edwards’ Sheehan says. “As LRO becomes integrated into operations it will lead to revenue growth which leads to dividend growth and earnings growth for shareholders.”

Encouraging Creativity

Sellers welcomes new ideas as the gateway to quality improvement. He encourages risk-taking among his staff, and what he calls “freedom to fail” is ingrained in the corporate culture. “We encourage ingenuity and creativity from the ranks,” he says. “We try to filter up new ideas, test them and roll them out. That’s how you get better.”

One example of a successful idea born from this approach is the standardization of the company’s maintenance shops and inclusion of the maintenance shop on its tours for prospective residents, Sellers adds. An example of an intriguing idea that has yet to work is an Archstone-Smith-branded credit card.

“We’ve looked at this several times, have done a fair amount of research on it and tested the idea and we haven’t yet found it to be viable,” Sellers says. “We continue to believe that this is an idea that may just be a matter of time before it works. But at this time, it’s something that we tested that hasn’t been viable.”

Archstone-Smith’s executive team: Back row, from left: Lindsay Freeman, COO; Scot Sellers, chairman and CEO; Charles Mueller, CFO. Front row, from left: Carrie Brower, general counsel; Dana Hamilton, EVP-national operations.

Whether it is a new operations practice or a corporate-branded credit card, the key to successful innovation is testing of new ideas in a scientific fashion, Sellers says. Within the company, new technology or techniques are implemented in a limited fashion at a few properties so that management can compare performance there with that of properties that are not testing the new idea. The standardized maintenance operations began in the company’s West Region before being rolled out across the country.

This approach limits the downside and allows management to tweak new ideas and techniques before rolling them out nationwide. And, Sellers readily admits, to discard those ideas that aren’t going to make it.

This somewhat maverick approach to the business has earned Sellers and his team a reputation among industry analysts for being bright, innovative and committed. “They believe in what they are doing,” A.G. Edwards’ Sheehan says. “That’s true even when their plans and strategies go against accepted ways. The interesting thing is their time horizon is longer than that of investors. They are not afraid of changes that may dilute short-term earnings. The hallmark of their business philosophy definitely is to take the long view.”

Developing the Future

If there is any caveat to Archstone-Smith’s investment potential, analysts believe it is the company’s development exposure. With some $480 million in the pipeline and $150 million in unfunded development commitments, the company faces some short-term challenges, Sheehan says. “Unleased property is a drag on FFO, and they are faced with having to lease up new units in a challenging environment,” he adds. “Plus, this is a challenging time to be constructing.”

On the positive side, however, the company’s strategy of selling less-desirable assets and redeploying the capital allows Archstone-Smith to engage in development activities without excessively leveraging the company, according to Sheehan. The debt ratio is modest and maturities are balanced so that analysts give the company’s balance sheet high marks. “Chief financial officer Charles Mueller manages the balance sheet very well for future growth,” Sheehan says.

Sellers and Freeman are confident that the company is not overburdened by the amount of development in the pipeline. While not negligible, Archstone-Smith’s development exposure is “not significant” for a company with a $10 billion asset base, Sellers says. Development is low as a percentage of assets compared to other companies, he notes.

By carefully selecting markets for development, working with local developers who know their markets and creating high quality properties, Archstone-Smith historically has been able to deliver value for investors, Sellers says. For example, a 700+ unit property in San Diego that Archstone-Smith developed at a cost of $100 million three years ago now is valued at $165 million.

Sheehan agrees that this track record of value creation through development somewhat temporizes the risk. He forecasts that Archstone-Smith’s yield on development will grow from the current 8.5 percent to 10 percent over the next 18 to 24 months. As market fundamentals improve, the company’s development program will be less of an issue, he adds.

However, the analysts remain cautious and stress that sustained improvement in market fundamentals—particularly job growth—is still likely a year away.

“The apartment industry as a whole has yet to see the turn,” Legg says. “We will not see any employment growth until 2004. Archstone’s performance in the first quarter of 2003 suggests it may have bottomed out and could be starting to turn, but it is too early to say. One good quarter doesn’t make a trend.”

Upside-Downside Samplings of what analysts are saying about Archstone-Smith: Banc of America Securities LLC Rating: NEUTRAL (5/1/03) “We are cautious about the outlook for the multifamily sector as a result of the limited employment growth, significant levels of new construction, and availability of credit that has helped the single-family housing industry at the expense of the multifamily rental industry. As a result, we rate Archstone-Smith ‘Neutral’ with a 12-month target price of $22 based on our 2003 adjusted funds from operations (AFFO) estimates of $1.64 and a target multiple of 13.2x.” Bear, Stearns & Co. Inc. Rating: PEER PERFORM (5/02/03) “As the company outlined on its fourth quarter 2002 conference call and reiterated on its first quarter 2003 conference call, dispositions will provide ample cash proceeds to cover any dividend shortfalls before earnings growth returns. We project a long-term dividend growth rate of about 3 percent, as the company should grow dividends modestly until more significant earnings growth returns in 2005, and then return to its policy of growing dividends close to the rate of earnings growth. Given Archstone’s size, attractive dividend yield, and relatively solid property level results, the stock could continue to receive support despite an overall unfavorable multifamily environment.” Lehman Brothers Rating: EQUAL WEIGHT (5/02/03) “ASN’s operating performance should continue to reflect the benefit of owning a portfolio half weighted toward Washington, D.C. and Southern California which we expect will continue to be among the better performing apartment markets in the country. The company’s development capacity remains a long term positive. The positive attributes of ASN are reflected in the stock’s premium valuation. Our target price represents 11.7 times our 2003 estimate of FFO per share.” Merrill Lynch & Co., Inc. Rating: NEUTRAL (5/02/03) “We are maintaining our ‘Neutral’ rating on ASN because apartment fundamentals remain weak and we do not expect a meaningful turnaround until early to mid-2004 at the earliest. The positives for ASN include the fact that the stock has a high 7.3 percent dividend yield and it is trading at an implied value of only $121,000 per unit, which is only 6 percent above ASN’s invested cost of $114,343 per unit. ASN has been selling assets at prices significantly above its gross asset cost. In [first quarter 2003], ASN recorded gains that were about 24 percent higher than the gross book value of the assets.”