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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Hello, and welcome to the AIR Communities Third Quarter 2022 Earnings Conference Call. My name is Alex, and I'll be coordinating the call today. [Operator Instructions]
I will now hand over to your host, Lisa Cohn. Please go ahead, Lisa.
Thank you, Alex, and good day. My name is Lisa Cohn, and I am President and General Counsel of AIR Communities.
During this conference call, forward-looking statements we make are based on management's judgment, including projections related to 2022 and 2023 expectations. These statements are subject to certain risks and uncertainties, a description of which can be found in our SEC filings.
Actual results may differ materially from what may be discussed today. We will also discuss certain non-GAAP financial measures such as funds from operations. These are defined and are reconciled to the most comparable GAAP measures in the supplemental information that is part of the full earnings release published on AIR's website.
Prepared remarks today come from Terry Considine, our CEO; Keith Kimmel, our President of Property Operations; John McGrath, our co-CIO and Chairman of our Investment Committee; and Paul Beldin, our Chief Financial Officer.
Other members of management are also present. All of us will be available during the question-and-answer session, which will follow our prepared remarks.
I will now turn the call to Terry Considine. Terry?
Thank you, Lisa, and my thanks to all of you for your interest in AIR. We live in interesting times. As an executive at a department REIT, this year has been a great success. As the REIT shareholder, it's been a pretty tough year.
When I talk to other investors, they tell me they've already put this year in the past and instead are interested to talk about next year. I want to help, but I'm also mindful of the wisdom of Yogi Berra, It's tough to make predictions, especially about the future.
In preparing for this call, I was impressed by the wide range of estimates for AIR FFO, 12% from high to low or $0.28 per share. I was also struck by the thought that any one of them might be right depending on the economy.
So here's how I look at it and where I can speak with conviction. AIR is in good shape, great shape and executing well. Keith and his team will do an excellent job in leasing apartments and controlling costs next year no matter the economy.
But how their work translates into FFO will be unusually dependent on macroeconomic conditions. So with that in mind, we set out to structure the earnings release and this call to provide you information about the effectiveness of the AIR business model and also about how we're prepared for different economic scenarios.
Most of the call will focus on the execution of the AIR business. For example, John's continuing transformation of the AIR portfolio with average rents up 19% in two years and intentional diversification by geography and price point to target economic growth and reduce volatility.
Or Keith's remarkable success managing two distinct portfolios, same-store, where revenues were up year-over-year by almost 10% and up 3.8% sequentially, continuing strong through the end of the year and managing also the acquisition portfolio where the class of '21 and sequential revenue growth of 9.2%, more than twice the growth rate of the same-store portfolio.
In both portfolios, Keith's gifts for innovation and productivity are such that costs are almost flat, no matter the highest inflation in 40 years. Or might it might be Paul's Midwestern caution on display in our balance sheet, we're allowing for a few smallish closings in the next few weeks. There is no debt maturing before mid-2025 and no exposure to higher interest rates for the next three years, except for a $70 million piece in mid-2024, and $285 million in the second half of 2025.
Paul is similarly conservative in accounting where, for example, we have almost no exposure to rent that is owed but not yet collected. Each of Keith, John and Paul will provide other interesting facts that are proofs of the AIR business model. It's above planned results in 2022 and its excellent prospects for next year.
Mindful of conversations with other investors, the earnings release also addresses such questions as, what is the outcome if inflation proves stubborn and is higher for longer. While the AIR answer is inflation is good news for apartment owners that can raise rents annually and AIR leads all peers in conversion of rent growth to free cash flow because of our ability to control operating expenses and G&A costs.
Second question might be what if interest rates continue to increase. The answer, interest rates next year will make little difference to AIR. After completion of a small refunding already underway that I mentioned just a minute ago, we had no maturities for the next two or three years until mid-2025. And outside our revolver, which will be paid down to $150 million from property sales later this month.
Our interest rates are fixed for even longer. And then there's a third question, but what if the Fed succeeds in causing a recession? Well, the AIR answer is recessions are always tough, but AIR is ready. Our current highly occupied apartments have rent rolls with stable cash flows backed by the high income and lofty credit ratings of our customers.
Our high-quality portfolio is diversified across markets. There's a recession focused on tech companies, Philadelphia students and Washington's national government are likely to be affected differently.
And finally, our high-quality portfolio is about 1.5B and so benefits when customers become more price sensitive. So, we're not giving guidance today. But even when Paul gives guidance in January, the best estimates will be subject to subsequent macro events.
What we are attempting today is to show how AIR is managed through the macro events of the third quarter and the full year of 2022 and how AIR is designed to manage through whatever may await us. It is all in 2023 and beyond.
My optimism, and I'm optimistic is based on my confidence in my AIR teammates, who sense of mission attracts and retains residents and in the AIR culture of collaboration and then an engaged Board whose directors have joined me and many of you in the investor meetings and spent an energetic two days here in Denver earlier this week.
We operate as a team working together, collaborating, ready for whatever the future may bring. And I thank each and every one of them. With no more, I'd like to turn the call over to Keith Kimmel, Head of AIR. Keith?
Thanks, Terry. The third quarter was another good quarter for AIR, with well over 90% of our leasing volume now complete for the year. I'd like to share four takeaways from the past three months.
First, as anticipated, revenue growth was exceptional. Sequential revenue was up 3.8%, triple our typical third quarter growth. We achieved peer-leading rate growth with blended rates up 14.5% during the quarter with our peak transaction volume.
In line with expectations noted on our last call, occupancy increased each month from 95.5% in July to 96.3% in September as frictional vacancy faded. In October, occupancy was 96.7% and has grown to 97% today. Our lease percentage and sales pipeline point towards continued strength throughout the fourth quarter.
My second take away is AIR continues to be the most efficient operator of multifamily real estate. And we are offsetting inflation pressures through superior team productivity and relentless innovation. Expenses grew just 10 basis points from last year.
More importantly, full year controllable operating expenses are anticipated to be roughly flat with 2021. Our expense performance starts with resident quality and customer satisfaction, leading to low turnover. Our trailing 12-month turnover of 38.5% represents a 320 basis point improvement from one year ago.
We recognize that our service team plays a critical role in customer satisfaction and expense control. With that in mind, we continue to invest in compensation for this team, including a 10% increase this year. This has led to low employee turnover and record satisfaction and result in a highly productive team. Ultimately, our efficiency is demonstrated by net operating margin. AIR's margin of 74.3% represents a 240 basis point expansion from the third quarter of 2021.
Third, the year-end continues to be impactful. We think of the AIR Edge is a combination of enhancements to our physical communities, our team and staffing model, our technology and our business processes, which resulted in revenue and margin outperformance.
Our impact is most notable when applied to new acquisitions. Our five communities in the Class of 2021 had sequential revenue growth more than doubled that of our same-store portfolio. And our Class of 2022 acquisitions, revenue was on plan and rates are ahead of our initial projections.
Fourth, AIR is well positioned for the balance of 2022, 2023 and beyond and are prepared for whatever the market brings. This fall has brought normal seasonal patterns back from a two-year hiatus, a predictable change for which AIR is well equipped.
Despite the seasonality, blended rates in October are up 11.8% and all while AIR occupancy remains strong. 2023 starts with an earn-in of 5%, an exceptional foundation to begin the year. And while there's some broader uncertainty around market trends at AIR we anticipate above average rate growth in the year ahead.
AIR's built to navigate any choppy waters that may come with our focus on floating residence, who have rent-to-income ratios of 18% and high credit scores and will be resilient during any economic challenges with our innovative and efficient platform, which continues to offset the headwinds of inflation and with our seasoned and talented team, the most important element of the AIR Edge.
My thanks to all our team members, your dedication to serving our residents and your drive to continuously improve our business have made this quarter a great success.
And with that, I'll now turn the call over to John McGrath, the Chairman of our Investment Committee. John?
Thank you, Keith. The economy is unusually turbulent. And the transaction markets are showing signs of uncertainty and stress. I can't speak to what others are experiencing. We have acted in the market, and by year-end, we will have closed approximately $2.1 billion of transactions of another $298 million set to close at the beginning of January.
This is coupled with another $5 billion or so of underwritten deals provides me insight into the current market environment. On average, we are seeing valuations down about 10%. That said, prices continue to hold for the best assets in the best locations.
However, the risk of the downside is increasing. We think that the stock market may be too pessimistic about property values, perhaps not considering this substantial increase in property rents and income, which offset about 1/2 the increase in cap rates.
We think that any further decline in property values will more likely be due to reduced liquidity, and we see this as an opportunity for AIR to be a buyer. As for cap rates, across the board, we are seeing expansion of approximately 50 to 100 bps from the beginning of the year.
As I mentioned previously, this expansion continues to be largely absorbed by robust NOI growth. I do not have a crystal ball, I expect this dynamic to continue, and a cap rate expansion decelerates perhaps early next year, pricing will reset.
Given current market conditions, we remain cautious. However, experience has taught that periods of economic turbulence are ripe with opportunity. We feel our prospects for growth in 2023 are terrific. Match funding allows us to be relatively agnostic to changing market conditions by locking in our cost of equity capital.
As market conditions fluctuate, we simply adjust our target return threshold. Certainty of execution is top of mind for many sellers, and AIR has a demonstrable track record of closing. This gives us a competitive advantage and shallow fire pools provide an opportunity for us to buy at discount to peak values and acquire high-quality assets with lower competition. We are beginning to see signs of distress in the market.
However, it is not yet systematic. If and when opportunities arise, we are ready to strike. Finally and perhaps most importantly, as Keith described earlier, through the AIR Edge, properties are worth more in our hands than they are to someone else. The transformative work we have completed since the separation with Aimco in regards to our operations, balance sheet, culture and portfolio, position us well to execute our disciplined capital allocation strategy.
We have no fixed goal for future transaction activity. However, we expect to grow through accretive acquisitions, while at the same time, optimizing our capital allocation, including diversification by market and price point, and continuing to improve the quality of the AIR portfolio as measured by such criteria as expected rent growth, average rents, median household income, customer credit asset age, physical condition and regulatory and political risk.
Our future portfolio growth will be driven primarily through opportunities we identify within our core markets. However, we will also look to invest in top-rated submarkets that exhibit high growth due to normal demand drivers and are landlord friendly. We will look for accretive acquisitions in Western Florida, the Front Range of Colorado and in the Research Triangle.
Turning to recent transaction activity. During the quarter, we acquired one property in Fort Lauderdale, Florida for $173 million. Property has 350 apartment homes and was newly constructed in 2021. We also canceled existing master leases at four properties owned by AIR and leased to Aimco for development. AIR paid $200 million to Aimco for the added improvements.
Additionally, during the quarter, we committed to purchase Southgate Towers for $298 million. Southgate is located in South Beach and has 495 apartment homes and approximately 30,000 square feet of retail space. The acquisition is expected to close in early January 2023.
Southgate is being funded by a paired trade and consistent with our recent Soft Florida acquisitions, will be enhanced through the AIR Edge and is expected to earn an unlevered IRR greater than 10% with a spread of more than 200 basis points over the cost of capital.
In addition to property acquisitions, year-to-date, we have bought back approximately 7.2 million shares or 4.3% of shares outstanding at the beginning of the year at an average price per share of just under $40 representing a long-term IRR greater than 10%.
We evaluate share buybacks as part of our broad capital allocation strategy and analyze the opportunity as I look through to real estate. As with any of our investments, we are in the spread business, and we'll utilize our paired trade framework to lock in an attractive cost of equity capital.
Going forward, we will continue to evaluate the opportunity to buy additional shares and would expect to deploy a balanced portion of any incremental new capital and share buybacks, consistent with our allocation to date.
On the disposition front, we completed no sales in the third quarter. However, later this month, we anticipate closing the sale of six properties located in New England for approximately $500 million, representing a trailing 12-month NOI cap rate of 4.4%.
We are bullish about the future and our ability to deploy capital externally. We remain firmly committed to disciplined capital allocation and are confident in our ability to execute highly accretive traits even in trying times.
With that, I'll turn the call over to Paul Beldin, Chief Financial Officer. Paul?
Thank you, John. Today I will discuss our strong and flexible balance sheet, third quarter results and our expectations for the balance of the year and conclude with a brief comment on our dividend.
AIR's balance sheet is well positioned for a period of elevated interest rates and potential economic uncertainty. First, leverage is low, reduced by the repayment of the remaining Aimco note balance in July and reduced further by this month's anticipated sale of New England area properties just discussed by John.
Pro forma the closing of the sale, third quarter leveraged EBITDA is 5.9x to 1x within our target range of 5x to 6x. Looking forward to year-end, I now anticipate leveraged EBITDA to be approximately 6:1, slightly above our previous expectation of 5.5x.
The increase in year-end leverage is primarily a result of our opportunistic third quarter and fourth quarter share repurchases. Consistent with AIR's investment policies, the share repurchases will be funded on a paired-trade basis keeping our sources and uses in balance and maintaining our leverage levels.
Second, we have little or no exposure to higher interest rates. Other than short-term borrowings on our revolving credit facility 97% of our debt is already fixed or subject to an interest rate cap. We are working to fix the interest rates on the 3% that remains floating. Borrowings on our revolving credit facility are expected to be largely repaid from the proceeds of property sales later this month.
Third, we have little or no exposure to near-term debt repayment. We expect in the next few weeks to pose loans extending $170 million of maturities. Once completed, we will have no maturities before mid-2025.
Fourth, we have abundant liquidity with $510 million available on our revolving credit facility, $460 million of proceeds expected to be received from the November property sales, $100 million of cash and properties unencumbered by debt of an estimated fair value of about $8 billion.
Fifth, to supplement our BBB flat credit rating from S&P., in October, we applied for an issuer credit rating for Moody's. We anticipate receiving their rating later this month. The ratings from S&P and Moody's will make fully available both private and public debentures.
And turning to third quarter results and our expectations for the balance of 2022. Third quarter FFO was $0.58 per share, $0.02 above the midpoint of guidance due to timing of transactions originally anticipated to occur in the fourth quarter. For the third time this year, we are raising same-store NOI guidance.
At the midpoint, we now expect NOI growth of 13.9%, 90 basis points higher than the high end of our beginning of year expectations. Our improved NOI outlook is a result of Keith's superb cost control were controllable operating expenses are negative year-to-date. Total operating expenses are now expected to grow between 50 and 150 basis points.
At the midpoint, we expect such costs to be 125 basis points lower than the low end of our beginning of year expectations. We are narrowing our expectations for full year FFO to be between $2.39 and $2.43 per share, maintaining the $2.41 midpoint and incremental same-store NOI and being offset by higher-than-anticipated G&A costs.
While G&A costs are increasing, these costs are expected to remain equal to or lower than our 15 basis points of GAV commitment. Similarly, our expectations for run rate FFO are unchanged at the midpoint. Lastly, the AIR Board of Directors declared a quarterly cash dividend of $0.45 per share.
We believe the tax characteristics of our dividend makes our stock compared to our peers more attractive to taxable investors, such as foreign investors, taxable individuals and corporations. Further detail can be found in our earnings release.
With that, we will now open the call for questions. Alex, and I'll turn it over to you for the first question.
[Operator Instructions] Our first question for today comes from Chandni Luthra from Goldman Sachs. Chandni, your line is now open.
Guys, if you could please understand -- help us understand controls of expenses next year. I mean, obviously, controllable expenses have been extremely well controlled this year. What are the drivers that you think would also be applicable next year, especially as you know, this inflationary environment continues? And then how should we think about non-controllable expenses going into 2023, particularly property taxes.
Chandni, this is Keith. I'll start and then I'll give you some insight to property operations, and then I'll turn it to Paul to tie it together.
Chandni, one of the things we think about is that -- when we think about expenses, it really starts with resident quality. And the reason it starts with resident quality, it then follows with customer satisfaction and the quality of our team. Because ultimately, that -- where you find that is in our low turnover numbers.
And so, in my prepared remarks, I talked about 38.5% as our turnover number. The more we have residents to stay with us longer, and therefore, team members that stay with us longer, giving exceptional customer service. We think that's really the big driver to expense control.
Now what will happen in inflation will the can a paint costs will be more next year than it does this year. It may or may not, but that's not where our emphasis comes in. Our track record over the past 10 years plus, I think it demonstrates that this is an area of focus for us, and we believe that we will continue to put up superior numbers. Those will be peer-leading particularly when we think about controllable expenses on site. Paul?
Thank you, Keith. Outside the controllable expenses, we have three categories of non-controllable items. First is insurance costs, as you all know, the insurance market has been difficult, and prices are increasing.
And so we'll provide specific guidance around our expectations of cost of insurance in January, but I think you can assume they'll be higher than where we were in 2022. Utility costs would be the second category. And those costs, while I anticipate them also to be higher next year.
About 75% of our costs are reimbursed to us by our residents. So there will be a net effect, but the bottom line impact will be muted. And the last piece you asked about, in particular, Chandni, is around real estate taxes.
And so we're in the midst of our planning process. So I'm not going to give specifics, but I would ask you to think about two different factors. One, about 40% of our portfolio is located in California, and so it's subject to Prop 13, which limits property tax increases to about 2% per year.
So that provides an important offset to increases in value of our portfolio. And then for the remaining 60% of the portfolio, property taxes usually increased at a pace similar to NOI growth, although often at a lag. And so we'll provide more particulars, but we've had very strong NOI growth this year, and so that will likely put a little bit of pressure on that 60% of the portfolio next year.
That's all very helpful. And for my follow-up question, so you guys noted in your prepared remarks that there is opportunity or air communities to be a buyer in that you're seeing or beginning to see signs of the stress in the market. How much have prices come down at what point would it make sense for you to pivot into buying those assets? And how would you think about funding those opportunities in that regard? How should we think about capital allocation between buybacks where your focus obviously has been a bit more aggressive lately?
Chandni, this is John. Thank you for your question. First, I'd say I am very bullish on our opportunities when we look to 2023 for buying. Some of the distress in the market again, not systematic, but across things will provide opportunities for us, such as lever buyers are on the sidelines because they are worried about negative leverage and other dynamics like that.
AIR, we don't have that same problem. First of all, our par trade philosophy makes us relatively agnostic to those changing conditions. Second, we look at all our deals on an unlevered basis. And so as long as I can look at and I have my match trade and I see my cost of capital is locked in and I have an appropriate spread above it, I have an opportunity to continue to improve the quality of our portfolio.
As to where we'll be looking and how we'll be looking at deals, I would say that -- as I said in my remarks, we look primarily to our existing core markets. But we'll look to other markets that exhibit high growth due primarily to durable demand drivers and landlord-friendly regulations. As far as the buybacks to acquisition of real estate, I would say, we run all of it through our capital allocation model.
And I would expect as we look to the future and things, of course, could change. But I would say that we'll be looking at an allocation similar to what we've seen recently where we've bought about 80% real estate and about 20% shares. And at the end of the day, everything gets run through our pair trade model and we will look to what the most accretive use of our cash will be.
Thank you. Our next question comes from Rich Anderson of SMBC. Rich, your line is now open.
So Paul, I want to go to the leverage going up to 6.1%, I think you said. I don't fully understand the math. I mean if you're funding the repurchase with asset sales at a four-ish type cap rate, your implied cap rate is much higher than that on the stock. So why would you have an uptick in leverage? Or is it that the 5.9% ending point of September already assumes those sales. And so, the impact is purely from the stock buyback that gets you to 6.1%. Is that correct?
Rich, yes, I believe you have it correct. But let me walk through the moving parts. So as of the end of September, we had acquired, in addition to the $125 million of stock that we acquired in the second quarter, we also acquired another just under $50 million of stock in September.
That has been supplemented by about another $120 million of shares repurchased through October. So September 30 cutoff, it doesn't reflect the full share repurchases, but our calculation of leverage -- that does include the benefit from the sale of the New England area assets that are expected to close in the next few weeks. So that is what brings us to 5.9 at 9.30.
And then looking forward at year-end without any additional property sales, but incremental share repurchases, that's expected to bump leverage up by about 1/10 of a turn, but we are committed to maintaining our leverage in that 5x to 6x range. And as John mentioned, this is all the payer trade -- but at this particular moment in time, we haven't completed the sales leg of that pair trade, and that will be something that we'll look to accomplish in 2023.
I mean I guess my question would be in this environment. You ultimately want to see leverage trending down, not up, right? And I presume that's -- that will be the game plan for 2023.
Our views on leverage are unchanged, where we see it as a range, and we see it in that 5x to 6x area.
Okay. Second question, we did an exercise at some point a month or two ago comparing REIT rent levels to your competition, and that includes all of your competition in all of your markets. It turns out that AIR ran about 15% to 20% above your market rent. And that I think is by design. You've obviously upgraded your portfolio through your pair trade and so on. First of all, do you are with that estimate?
And second, do you feel as though that might put you at a in a vulnerable spot if people are looking for a cheaper alternative to their living arrangements that are already at the top of the market on average with you guys. And so, the only thing they might do is leave you and go to a cheaper place that perhaps you don't offer as much as some of your peers. What do you think about that observation, if you agree or disagree, any color would be great.
Rich, it's Keith. I'll start and then I'll turn it over to John. I'll speak to it particularly when we think about the residents and those living in our communities. And I think the emphasis here really comes down to the quality of the residents that are in those higher prices. But first of all, we have 50-50 in the Bs and the As and the price points, but the incomes that are at those place, at the higher rent places are quite good.
And in fact, the averages are over $250,000. And so when we look at their ability to be able to pay the rents, we don't have any concern with that. They have high credits and so we feel like we're well positioned in very -- in a very good spot on the As. And then, of course, our Bs are the nice blend to go along with that, should there be something that comes into the economy. John?
Yes. And what I'd add from an investment perspective is that, I don't believe that people are pricing in today, the substantial increase in property rents and incomes, the little more bearish on what the future may look like. My opinion is that will prove to be wrong and what we'll see is rents will continue to increase and valuations will reset to appropriate levels.
Okay. Great.
Yes, Rich, Rich, this is Terry. And I just -- it's so good to hear your voice. I just want -- I want to chime in, too, that it really is Keith's point about customers. If we're dealing with sort of a more common customer who's younger, lower income, less settled, then you're right, there's more activity, there's more trading down that sort of thing.
But we have older settled customers, high incomes, good jobs, high credit scores. And they are both less likely to be affected in a recession and also better prepared to deal with it without undertaking the dislocation of moving.
Terry, the first word you ever said to me in the mid-90s where business is good. So, I was happy to see that resurrect itself in this press release.
It is pretty good.
Thank you. Our next question comes from Nick Joseph of Citi. Nick, your line is now open.
You're obviously seeing the normal seasonal sequential slowdown in October, maybe a little less pronounced than others. Are there any markets that you're experiencing some pushback on pricing or where you're introducing concessions relative to kind of the strength you're seeing across the other markets?
Hi, Nick, good to hear you. We're not seeing anything in particular. First, just when we hear about -- whenever I hear concessions, I -- it's really a marketing tool. Whether someone lowers the rent by $100 and say that's the new space rent or whether they put a two weeks free on it, it's a marketing tool that really is applied.
What we're seeing seasonally is really what we saw in 2018, 2019, what you would have seen pre-pandemic, which is when you get to the colder months, places like Philadelphia and Boston slow down more, where people move less. And then when you get past Halloween, you start getting into Thanksgiving and Christmas, there's also less activity. Nothing to what I would call out that looks anything unusual to us.
In fact, exactly what we would have anticipated. And we're feeling quite good of where our October is and where we'll finish the year up.
And then just on the $500 million of asset sales, what are you expecting those to close? How much hard money is down? And is there any kind of execution risk that you see still associated with those.
Hi, Nick, this is John. First, I expect the sale to close in the next couple of weeks. And they are -- they have substantial hard money down about $10 million on that deal. And as far as I seeing a lot of risk to closing, while anything is possible, I'd say at this point, the risk is very low.
Thank you. Our next question comes from Haendel St. Juste from Mizuho. Haendel, your line is now open.
So Keith, I guess a question for you. You just met you feel good about October. Expect that to continue into year-end. So maybe can you add some more color around that, where are you standing in November renewals today? And what do you expect near term for new and renewals into year-end?
Sure. Haendel, when we look forward, here's what we've seen historically. We usually see somewhere around a 200 basis points melt that will happen between October and the end of the year. And then, of course, what happens is that you work through January, February and then the spring starts to pick back up, which is what we would expect in, call it, March going into April. When we look at renewals, we think you're going to see renewal numbers that are comparable to what we've seen. They're going out in around the 10% range.
Okay. Any distinction in the recent or expected near-term rental trends between the As and Bs between your urban and suburban assets?
Haendel, I would say no different changes. And what we're seeing is that it really becomes market-specific. And the example I'd give you -- the two examples I give you is that maybe two of our more urbans would be our Miami South Beach and then Los Angeles, both of which are two office markets we have in the country.
We're seeing the highest rental rate achievement, the highest increases that are being achieved and those markets are doing quite well. And then, of course, when we look in places like DC and Denver other places that are more sort of suburban there is as solid as well. So, nothing, that's changed and nothing that seems unusual to us at this point.
Great. And then maybe my second question on bad debt and near term expectations. In the press release, I think you mentioned I expect to have no net bad debt by next year. I assume that means you're fully reserved and that any incremental payback is additive to earnings. And then secondly, curious how you're thinking about potential new bad debt as we enter and go further into a recession here?
Thanks, Haendel. I appreciate the question. This is Paul. And really since the onset of COVID, we've taken a very conservative approach to our past due rent. We've basically been on a cash basis of accounting that whole time.
And so what has ended up happening in the day of September is our AR balance, our gross AR balance has continued to come down because our collections are improving for those 99% or so of our residents that are paying rent timely.
And so our AR is primarily comprised of the 1%, give or take, of folks that are non-timely payers of rent. That balance is almost essentially fully reserved $200,000 under reserve. So I feel really good about that. And Keith and his team are working hard to collect all that amount and to the extent that we're successful in doing so, that will be additive to future period results.
And on the question of trends around bad debt, what we have seen is gross bad debt, which is our bad debt before consideration of any government assistance payments has trended down through the year. It was 240 basis points in Q1. It came down to 210 bps in the second quarter and was 190 bps in the third quarter.
I mean we believe that trend will likely continue. And so that absent a recessionary type environment in 2023, and I would expect things to continue to improve further from there. And then if there is a recession, I would go back and look at our previous experience. And what we saw during the GFC is that our bad debt expense increased from roughly 60 basis points of revenue at that time to about 110 basis points.
And so, it stayed that way through the duration of the recession but came back down. And so, it was really a much more muted impact than what has happened during COVID.
[Operator Instructions] Our next question comes from John Kim of BMO Capital Markets. John, your line is now open.
On your paired trade model, what came first, acquisitions or dispositions? I'm just wondering why you decided to pursue with South Beach acquisition when there's a lot of price discovery in the markets right now.
John, this is John. I guess the way I would answer that is the chicken and egg a little bit, but the dispositions, we've been out in the market, we've been looking at ways where we can lock in our cost of capital so that we can continue to improve the quality of our portfolio.
And so when I look back from the separation to now about the transformation work we've done to the portfolio, we've done this through a number of different initiatives, including our property sales. And the results have been quite stunning. Our average age has decreased by 25%. Our median incomes have increased by 33% and our average rents increased by 20%.
So, any new business that we look to do, we want to continue that trend. We want to continue to improve the quality of our portfolio. And so by chicken and egg, it means that if I can have an opportunity to acquire and improve the quality of the portfolio, I'll do a trade. If I don't have that same opportunity under no distress and I won't do a trade.
Have you disclosed the cap rate on the acquisition?
No. And I can't -- at this point, but what all I can tell you is that we expected -- we do have the pair trade identified. We expect it to be an that is going to be greater than 10%. And again, we're in a spread business, so we'll be about 200 bps or more on an IRR that cost of capital.
Okay. And my follow-up is I'm assuming the dispositions are in your assets up for sale on balance sheet, which is only $129 million. And I would have thought you'd had to mark that up to market on the split with Aimco. And also, it's out of the same-store pool. So, I was wondering how much that impacted or maybe even benefited your same-store results, taking them out?
John, this is Paul. On the -- you are correct that the Boston or the New England area of properties in our held-for-sale population about all the criteria under the accounting rules to do so. And that $127 million is accurate because with the separation of Aimco, from Aimco the basis of our assets do not reset. So it's our historical basis from when Aimco purchased those assets originally. Then in regards to the same-store pool, this disposition was in our models and in our expectations since about March of this year. So it's been part of our same-store expectations since that time.
Sorry, on that held for sale. So you took it up on a tax basis, but not on an accounting basis?
Yes. The treatment was different for tax and accounting purposes.
Thank you. Our final question for today comes from John Pawlowski from Green Street. John, your line is now open.
Paul, a follow-up on property taxes. I appreciate the color on just the lag of NOI and what potential increases we could see in non-California markets. I'm curious because the decline in property taxes year-to-date 2.5% down and the timing of appeals, does that blur the math for next year? Like could we see incremental growth next year because property taxes are down this year, any comments there would be great.
Well, John, I think if we did not have the benefit of some appeals in the core year numbers, our growth rate next year would be smaller. But what I don't want to get particular around guidance at this point. But what I think you'll see is our property tax growth will not be abnormally large because of current year appeals.
And then a few transaction market questions for John. I apologize if I misheard this. I heard Research Triangle. Are you looking at assets in Raleigh right now? And if so, what type of exposure are you looking to get in the Carolinas?
Thanks, John, for the question. The answer is that, yes, we're looking in the -- your submarkets, Central Raleigh, Chapel Hill and Kerry. We don't have an identified at this point in time, but we're out there looking at it. From a total exposure, part of that will come down to what kind of opportunities we find that are attractive.
Okay. But do you have something close to being under contract? Should we expect an entrance in the Raleigh press release or update in the coming quarters?
I can't talk to the coming quarters too far out, but as of today, no. I don't have anything under contract.
Okay. And last one for me, and I'm very sorry if John can just ask this, I just got distracted. But -- could you provide the initial cap rate on Southgate and the cap rate on the New England assets and what month those deals priced?
Yes. So on the South Gate, the answer is no. I can't provide that to you at this point in time. I can tell you, once again, like I told John, that we expect to have our IRRs greater than 10% and about 200 basis points or more on a spread. On the Boston sales, we're looking at the cap rate on trailing 12 of 4.4%. These deals priced at in the early third quarter.
We have no further questions for today. So I'll hand back to the management team for any further remarks.
Well, thank you, Alex, and thank all of you on the call for your interest in Air. Please call any one of us with questions. We look forward to seeing many of you in about 10 or 12 days at Mary.
Thanks so much. Have a good weekend.
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