Check out MFE's quick look at AvalonBay's Evolution AVA of H St. in Washington D.C.

Tim Naughton holds court comfortably at a boardroom table on an unseasonably warm February day, and it’s not just because he’s lived and breathed the Northern Virginia environs of AvalonBay Communities’ Arlington headquarters nearly all his life. Less than two months earlier, he stepped into the position he’d been preparing for since he started at AvalonBay (AVB) as a Washington-area development partner in 1989—two years after Harvard Business School. When longtime company leader Bryce Blair executed his plan to ­depart as head of the REIT last June, Naughton’s moment suddenly­—but not unexpectedly—had come.

“Bryce was a young man [when he joined the company], so the only question was, would he work longer than me?” says Naughton, who was made president of the firm in 2005 and has been on the board ever since. With Blair’s exit at the end of 2011, Naughton stepped up, and, so far, it’s been business as usual at AVB.

“I’ve been involved in the development of strategy [at AVB] for the last decade,” Naughton says. “[So] I wouldn’t expect a lot of shifts over night as they relate to strategy or key areas of focus [just because I became CEO].”

Others agree.

“I wouldn’t expect AVB to suddenly become a radically different company [with Naughton in charge],” says Alexander Goldfarb, managing director of equity research of REITs for New York–based Sandler O’Neill + Partners, which covers AVB. “I think it’s good for Avalon to have a change at the top. Bryce stepped down when he could have kept the reins for a long time.”

After leading AVB 11 years and positioning it to be poised to take advantage of the tailwinds in housing for the next few years, Blair thought it was a good time to move on. But the presence of Naughton also played a huge role.

“I didn’t step aside to let Tim take the reins,” Blair says. “But it certainly was a factor. I felt it was the right time for me personally, the right time for the company, and the right time for Tim. If any one of those three was out of sorts, I might not have made the decision.”

Other than minor shifting of roles, Naughton has made tweaks while in charge. But just as Naughton was taking the helm, the company announced an initiative that has a chance to change the way both it and, possibly, the industry function.

Building on a Strong Platform

Over the past 15 years (which is about the amount of time Naughton has been developing corporate strategy), AvalonBay has been one of the leaders in the institutional flow of capital from a smattering of markets across the country into a select group of “high-barrier” locations along both coasts. It used sophisticated revenue-management and portfolio-allocation strategies, as well as a stout development and redevelopment platform, to become a best-in-class operator and builder.

Naughton played a big role in this strategy, including orchestrating a nine-property trade with Denver-based REIT UDR in 2011.

“Over the 11-year period [when Blair served as CEO], Tim was critical in the development of strategy and operation of the company,” Blair says. “He served as president and a board member. At every level of the organization, he was a key leader and partner, whether it was interfacing with the board or working with the executive team on the implementation of strategy.”

Avalon had pruned its portfolio into the markets where it saw a structural advantage, from either a supply or demand standpoint. It moved out of places like Portland, Ore., and Minneapolis and bolstered its presence in high-barrier regions with high-tech and ­financial-services concentrations, like its backyard of the Washington, D.C., metro; the New York metro; Boston; Southern California; the Bay Area; and Seattle.

“We think we’re already in the right markets,” Naughton says. “The returns come with picking the right markets and, increasingly, picking the right submarkets and positioning appropriately within the submarkets based on the demand factors.”

Wall Street certainly doesn’t have an issue with this strategy. Despite its being a developer, which inherently carries more risk, analysts and investors put AVB on a pedestal. Goldfarb says the company has a “conservative culture, and they truly understand what it means to be stewards of capital.

“During the credit crisis, they had a $6 billion development pipeline and, despite being over their skis in the development program, in the depths of the financial crisis, they did not have to issue equity. They were prudent heading into the credit crisis.”

No one expects this approach to change under Naughton’s leadership. “They have a common belief in having low leverage and a very flexible capital structure,” says Andrew J. McCulloch, a managing director for Newport Beach, Calif.–based Green Street Advisors. “Tim is likely to continue to run AVB with a best-in-class balance sheet.”

Tightening the Focus

Every four or five years, AVB engages in strategic planning, looking at its capabilities versus where the market opportunities are. That’s led to discussions about whether to enter student or senior housing or even expand internationally. With only about 1 percent market share in its best markets, the company decided to drill down farther in the markets where it already had a foothold.

“When you look at returns and what our current market share is, there’s still plenty of opportunity in what we’re doing,” Naughton says. “It’s less risky and builds more on capabilities and strategic advantages that we have.”

In an effort to get to know its customers better in these core markets, AVB engaged McKinsey & Co. in 2008 to learn more about consumers’ apartment preferences. The research was enlightening. It showed that some customers cared solely about the cost of rent. Others want amenities. And others care mainly about the neighborhood that they’re in.

“We found out there are different kinds of segments of customers, and just having one offering doesn’t necessarily meet every segment’s needs,” says Kurt Conway, senior vice president of brand strategy and marketing at AvalonBay. “In order to more deeply penetrate our markets, we realized that we could come up with different offerings, thus attracting a broader segment of renters.”

Offering different product from its core brand could also help Avalon find a home for the aging assets it built decades ago that no longer fall under the high-end Avalon umbrella.

With the new branding, Avalon may have found a solution: The firm keeps the assets (many of which were in quality submarkets) without having to overinvest in them to make them Avalon-quality properties (or pull the Avalon branding altogether).

“A lot of our portfolio that was self-built is starting to age,” Naughton says. “These are great assets in great locations, but it’s not the same as a brand-new Avalon asset. You can redevelop it and bring it up and keep it up to a certain spec for only so long.”

One Company, Three Entities

The results of Avalon’s consumer study came to light on Dec. 21—just before Naughton was to eventually take the reins on Jan. 1—when the company put out a press release announcing two new apartment community brands, AVA and eaves.

“Tim and I were equal advocates for [the various brands] and were both deeply involved,” Blair says. “It will be a major part of his leadership to make it happen.”

Avalon remains the company’s core brand (and growth vehicle), with a focus on upscale living and high-end amenities in urban centers, first-run suburbs, and pricey employment centers. With the AVA brand, Avalon wants to attract the Gen Y segment, living in or near urban neighborhoods. AVA units, which will have smaller one-bedrooms or be engineered for roommate living, will be close to restaurants, nightlife, shopping, and public transportation.

“Part of the concept behind the product is to appeal more to roommates who may want to share space and be in edgier, transitional locations in order to be in an urban environment,” Naughton says.

Since AVA residents will be giving up space, AVB plans to offer more common areas. The AVA brand will grow primarily through new development and redevelopment.

So far, AVA communities have opened in the Nob Hill neighborhood of San Francisco and the Queen Anne and Belltown sections of Seattle, and construction has begun in Manhattan’s Chelsea neighborhood; Washington, D.C.’s, H Street district, and Seattle’s Ballard area.

Naughton says the company has nine AVA projects in the redevelopment pipeline and another 10 properties in development over the next two years. The brand could open up development and acquisition in new submarkets for AVB. For instance, the company probably wouldn’t have built a concrete Avalon deal along D.C.’s up-and-coming H Street corridor, but with AVA, it’s working on AVA H Street, a wood-frame project in an urban location.

“We wouldn’t have considered that for Avalon,” Naughton says. “That’s an incremental opportunity that we’re developing by virtue of having a different product coming to market.”

The eaves brand looks to hit a different segment of renters—those who want a quality apartment with functional amenities and services, like a washer and dryer in every unit.

“The service model is focused on their desire to save,” Naughton says. “It’s more of a casual, friendly, respectful service model as opposed to the professional, uniformed, ‘consider-it-done’ service model.”

Eaves properties, generally older than AVA redevelopments, will be located in suburban markets, like Gaithersburg and Columbia, Md., and will grow the brand through acquisition and redevelopment. This year, Naughton plans to reflag as eaves about 30 suburban B or B-plus communities from Avalon. It will add approximately 15 more to that total over the next couple of years.

Naughton says that the total per unit investment cost for an eaves community averages about $200,000, including redevelopment. The focus of the redevelopment is on upgrading kitchens, bathrooms, and select community amenities.

“A lot of our existing portfolio is already eaves, but we weren’t calling it anything,” Naughton says. “We didn’t feel comfortable putting the Avalon moniker on it.”

An Organizational Shift

Sure, renovating almost 50 properties to get them up to AVA and eaves standards will put some internal pressure on Naughton’s team, but building those two brands throughout the organization will pose other challenges, as well.

None could be bigger than the shift in organizational mind-set. Naughton says Avalon’s regional leaders are accustomed to being relatively autonomous by deciding (often with an assist from market research) what finishes and features may work for a particular property. Now, the brand may dictate those things.

“[The branding] will put more pressure on [the regional leaders] to navigate all of the information being thrown at them, including market research and consumer insight and how to incorporate that into putting together a good business plan for their region and how to execute on that and make investment decisions,” Naughton says.

But there are also a lot of internal advantages. For instance, having three distinct brands can help the company figure out how to best focus its spending from both a physical plant and marketing standpoint. “It helps organize our thinking and approach to business internally as much as how it gets expressed externally into the marketplace,” Naughton says. “In terms of the kind of features they start thinking about and positioning the property, some of these things are already settled, in a sense.”

Green Street’s McCulloch thinks this could ultimately be the biggest advantage of the program. “It helps you identify what you’re going to do under these three flagship brands and how you’re going to staff, outfit, and market the different products,” he says. “When you define the brands and everything is clearly delineated, it helps you get organized internally and better pinpoint strategic goals.”

Naughton hopes the distinct segments will help cure Avalon of an industry affliction he calls “feature creep.” The problem is essentially trying to be too many things to too many people and, ultimately, spending a lot of money on amenities and services that many residents don’t use.

“With this notion of being able to deliver a community of 500 units that appeals to 10 different segments, you end up investing more capital than you probably should,” Naughton says. “There are plenty of segments that don’t value a feature that you’re providing to 100 percent of the units.”

The Consumer Challenge

The apartment industry has never branded itself as well as other commercial sectors such as hotels, where Westin, Sheraton, W Hotels, and others are household names. Even some analysts who give AvalonBay strong marks wonder how much of a difference the branding will make. Though McCulloch says branding is a “net-net” win because it helps the company organize internally, he has a hard time believing that it will drive meaningful traffic to AVB’s communities.

“When it comes to overall branding in the apartment space, I still believe that the average renter cares about location above all else,” McCulloch says. “It’s hard to think a national branding campaign will change that.”

Others think AVB may be on to something that can work for its portfolio. “I think branding will be helpful, with AVA for upscale urban properties and eaves for good-value suburban properties,” Goldfarb says. “Some people may think AVB is out of their price range. But the eaves brand makes it a little more accessible.”

Even if it works, AvalonBay has to be disciplined. It can’t let the brands run together. “We keep asking ourselves how we make sure these brands remain distinct,” Naughton says. “If they start bleeding into each other, you’ve sort of lost the benefit of having multiple brands.”

Analysts are confident Naughton is up to the task. “I’ve always found Tim to be forthright and plain-talking, focused, and 100 percent engaged,” says Paula Poskon, a senior research analyst with Robert W. Baird & Co., a Milwaukee-based firm.

Naughton knows there’s more for the company to accomplish in its home base of Washington, D.C., and other core markets. In these places, where the company’s lucky if it has a 1 percent to 2 percent market share despite being a dominant national player, there’s a vast opportunity for growth.

That’s the main reason Naughton will leave the decision of whether to look at international markets and the senior and student sectors for later. Ultimately, new segments may evolve within the three major brands, and eventually the company may develop a Park Hyatt–type ultra-luxury brand. But first, Naughton wants to build the competency to serve AVB’s three new segments. “There’s more opportunity within the core business,” he says. “We need to do that first before fishing in another pond.”

His boss for over two decades thinks he’s up for the challenge. “Tim is a really good listener,” Blair says. “He’s open-minded. He listens to other viewpoints. He’s got a very strong [sense of] self-­confidence, but it doesn’t get in the way of him being a good listener and being open-minded and making the appropriate decision.

“That’s more unique in leadership than maybe people think. You have self-confident guys who don’t want to listen to others. Then you have people who just want to listen but don’t have the confidence to act. Tim is a nice blend of [both].”