5. Investments in Real Estate Entities

Investments in Unconsolidated Real Estate Entities

The Company accounts for its investments in unconsolidated real estate entities under the equity method of accounting, except as otherwise noted below, as discussed in Note 1, "Organization and Basis of Presentation," under Principles of Consolidation. The significant accounting policies of the Company's unconsolidated real estate entities are consistent with those of the Company in all material respects.

As of December 31, 2012, the Company had investments in the following real estate entities:

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CVP I, LLC—In February 2004, the Company entered into a joint venture agreement with an unrelated third-party for the development of Avalon Chrystie Place, a 361 apartment-home community located in New York, New York, for which construction was completed in 2005. The Company holds a 20% equity interest (with a right to 50% of distributions after achievement of a threshold return, which was achieved in 2011 and 2012). The Company is the managing member of CVP I, LLC, however, property management services at the community are performed by an unrelated third party.

- As of December 31, 2012, CVP I, LLC has outstanding tax-exempt, variable rate bonds maturing in November 2036 in the amount of $117,000,000 which have permanent credit enhancement. The Company guaranteed to the credit enhancer that CVP I, LLC will obtain a final certificate of occupancy for the project, which was received in 2012, satisfying the Company's obligations under the guarantee. The Company also agreed to guarantee, under limited circumstances, the repayment to the credit enhancer of any advances it may make in fulfillment of CVP I, LLC's repayment obligations under the bonds. Our 80% partner in this venture agreed that it will reimburse us its pro rata share of any amounts paid relative to the outstanding guaranteed obligation. The estimated fair value of and our obligation under the outstanding guarantee, both at inception and as of December 31, 2012, was not significant. As a result the Company has not recorded any obligation associated with the guarantee at December 31, 2012.
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MVP I, LLC—In December 2004, the Company entered into a joint venture agreement with an unrelated third-party for the development of Avalon at Mission Bay North II. Construction of Avalon at Mission Bay North II, a 313 apartment-home community located in San Francisco, California, was completed in December 2006. The Company holds a 25% equity interest in the venture. The Company is responsible for the day-to-day operations of the community and is the management agent subject to the terms of a management agreement. In December 2007, MVP I, LLC executed a fixed-rate conventional loan, which is secured by the underlying real estate assets of the community, for $105,000,000. The loan is an interest-only note bearing interest at 6.02%, maturing in December 2015. The Company has not guaranteed the debt of MVP I, LLC, nor does the Company have any obligation to fund this debt should MVP I, LLC be unable to do so.

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Arna Valley View LP—In connection with the municipal approval process to develop a consolidated community, the Company entered into a limited partnership in February 1999 to develop, finance, own and operate Arna Valley View, a 101 apartment-home community in Arlington, Virginia. This community has affordable rents for 100% of apartment homes related to the tax-exempt bond financing and tax credits used to finance construction of the community. A subsidiary of the Company is the general partner of the partnership with a 0.01% ownership interest. The Company manages the community and is subject to a management agreement. As of December 31, 2012, Arna Valley View has $5,678,000 of variable rate, tax-exempt bonds outstanding, which mature in June 2032. In addition, Arna Valley View has $5,963,000 of 4% fixed rate county bonds outstanding that mature in December 2030. Arna Valley View's debt is neither guaranteed by, nor recourse, to the Company. Due to the Company's limited ownership in this venture and the terms of the management agreement regarding the rights of the limited partners, it is accounted for using the cost method.

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Aria at Hathorne Hill, LLC—In the second quarter of 2007, a wholly-owned taxable REIT subsidiary of the Company entered into an LLC agreement with a joint venture partner to develop 64 for-sale town homes with a projected total capitalized cost of $23,621,000 in Danvers, Massachusetts on an out parcel adjacent to our Avalon Danvers rental apartment community. Approximately 30% of the homes have been built and sold. The out parcel was zoned for for-sale activity, and was contributed to the LLC by a subsidiary of the Company in exchange for a 50% ownership interest. During 2011, the Company concluded that because the market for for-sale housing development had not improved as expected, its investment in the venture was impaired and that impairment was other than temporary. As a result, the Company recognized a charge of $1,955,000 for the impairment of the investment in the unconsolidated joint venture, which holds nondepreciable real estate assets. In December 2011, the Company acquired the note that the venture had with a third party lender for $1,700,000.

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Fund I—In March 2005, the Company formed Fund I, a private, discretionary real estate investment vehicle, which acquired and operates communities in the Company's markets. Fund I served as the principal vehicle through which the Company acquired investments in apartment communities, subject to certain exceptions, until March 2008. Fund I has a term that expires in March 2013, plus two one-year extension options. Fund I has nine institutional investors, including the Company. A significant portion of the investments made in Fund I by its investors were made through AvalonBay Value Added Fund, Inc., a Maryland corporation that qualifies as a REIT under the Code (the "Fund I REIT"). A wholly-owned subsidiary of the Company is the general partner of Fund I and, excluding costs incurred in excess of our equity in the underlying net assets of Fund I, has an equity investment of $21,121,000 in Fund I and the Fund I REIT, net of distributions and excluding the purchase by the Company of a mortgage note secured by a Fund I community, representing a 15.2% combined general partner and limited partner equity interest. The Company receives asset management fees, property management fees and redevelopment fees, as well as a promoted interest if certain thresholds are met.

During 2012, Fund I sold six communities:

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Avalon Lakeside, located in Chicago, IL, for $20,500,000;

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Avalon at Poplar Creek, located in Chicago, IL, for $27,200,000;

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Avalon Lombard, located in Chicago, IL, for $35,450,000;

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Avalon Paseo Place, located in Fremont, CA, for $30,900,000;

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Avalon Skyway, located in San Jose, CA, for $90,000,000; and

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Avalon at Aberdeen Station, located in Aberdeen, NJ, for $66,250,000

The Company's proportionate share of the gain recognized on the sale of these six communities was $7,971,000.

- Subsidiaries of Fund I have 13 loans secured by individual assets (including a mortgage owned by the Company) with amounts outstanding in the aggregate of $254,354,000. Fund I subsidiary loans have varying maturity dates (or dates after which the loans can be prepaid without penalty), ranging from August 2013 to September 2016. These mortgage loans are secured by the underlying real estate. The mortgage loans are payable by the subsidiaries of Fund I with operating cash flow or disposition proceeds from the underlying real estate. The Company has not guaranteed the debt of Fund I, nor does the Company have any obligation to fund this debt should Fund I be unable to do so.
  
  In addition, as part of the formation of Fund I, the Company provided to one of the limited partners a guarantee. The guarantee provides that if, upon final liquidation of Fund I, the total amount of all distributions to that partner during the life of Fund I (whether from operating cash flow or property sales) does not equal a minimum of the total capital contributions made by that partner, then the Company will pay the partner an amount equal to the shortfall, but in no event more than 10% of the total capital contributions made by the partner (maximum of approximately $7,500,000 as of December 31, 2012). Under the expected Fund I liquidation scenario, as of December 31, 2012, the expected realizable value of the real estate assets owned by Fund I is considered adequate to avoid payment under such guarantee to that partner. The estimated fair value of, and the Company's obligation under this guarantee, both at inception and as of December 31, 2012, was not significant and therefore the Company has not recorded any obligation for this guarantee as of December 31, 2012.
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Fund II—In September 2008, the Company formed Fund II, a private, discretionary real estate investment vehicle which acquired and operates communities in the Company's markets. Fund II served as the exclusive vehicle through which the Company acquired investment interests in apartment communities, subject to certain exceptions, through the close of its investment period in August 2011. Fund II has six institutional investors, including the Company. One of the Company's wholly owned subsidiaries is the general partner of Fund II and excluding costs incurred in excess of our equity in the underlying net assets of Fund II, the Company has made an equity investment of $107,938,000 (net of distributions), representing a 31.3% combined general partner and limited partner equity interest.

- During the year ended December 31, 2012, a subsidiary of Fund II acquired Avalon Watchung, a 334 apartment home community located in Watchung, NJ, for $63,000,000. This was the final acquisition for Fund II.
  
  Subsidiaries of Fund II have 14 loans secured by individual assets with amounts outstanding in the aggregate of $490,078,000, with maturity dates that vary from November 2014 to September 2019. The mortgage loans are payable by the subsidiaries of Fund II with operating cash flow or disposition proceeds from the underlying real estate. The Company has not guaranteed repayment of this debt, nor does the Company have any obligation to fund this debt should Fund II be unable to do so.
  
  In addition, as part of the formation of Fund II, the Company provided to one of the limited partners a guarantee. The guarantee provides that if, upon final liquidation of Fund II, the total amount of all distributions to that partner during the life of Fund II (whether from operating cash flow or property sales) does not equal a minimum of the total capital contributions made by that partner, then the Company will pay the partner an amount equal to the shortfall, but in no event more than 10% of the total capital contributions made by the partner (maximum of approximately $8,910,000 as of December 31, 2012). Under the expected Fund II liquidation scenario, as of December 31, 2012, the expected realizable value of the real estate assets owned by Fund II is considered adequate to avoid payment under such guarantee to that partner. The estimated fair value of, and the Company's obligation under this guarantee, both at inception and as of December 31, 2012, was not significant and therefore the Company has not recorded any obligation for this guarantee as of December 31, 2012.

The following is a combined summary of the financial position of the entities accounted for using the equity method, as of the dates presented (dollars in thousands):

	12-31-12		12-31-11

	(unaudited)		(unaudited)
Assets:
Real estate, net	$	1,337,084	$	1,583,397
Other assets		73,252		70,233

Total assets	$	1,410,336	$	1,653,630

Liabilities and partners' capital:
Mortgage notes payable and credit facility	$	943,259	$	1,074,429
Other liabilities		20,405		27,335
Partners' capital		446,672		551,866

Total liabilities and partners' capital	$	1,410,336	$	1,653,630

The following is a combined summary of the operating results of the entities accounted for using the equity method, for the years presented (dollars in thousands):

	For the year ended (unaudited)

	12-31-12			12-31-11			12-31-10
Rental and other income	$	172,076		$	160,066		$	114,755
Operating and other expenses		(73,955	)		(71,926	)		(56,322	)
Gain on sale of communities(1)		106,195			22,246			—
Interest expense, net		(53,904	)		(50,530	)		(40,050	)
Depreciation expense		(47,748	)		(47,920	)		(36,631	)

Net income (loss)	$	102,664		$	11,936		$	(18,248	)

(1): Amount for the year ended December 31, 2012 includes $44,700 of gain recognized by the joint venture associated with the Company's acquisition of Avalon Del Rey from its joint venture partner.

In conjunction with the formation of Fund I and Fund II, as well as the acquisition and development of certain other investments in unconsolidated entities, the Company incurred costs in excess of its equity in the underlying net assets of the respective investments. These costs represent $7,342,000 at December 31, 2012 and $9,167,000 at December 31, 2011 of the respective investment balances.

The following is a summary of the Company's equity in income of unconsolidated entities for the years presented (dollars in thousands):

	For the year ended (unaudited)

	12-31-12		12-31-11			12-31-10
Avalon Del Rey, LLC(1)	$	4,000	$	102		$	1
CVP I, LLC(2)		5,394		4,493			4,368
MVP I, LLC		493		(626	)		(881	)
AvalonBay Value Added Fund, L.P.(3)		7,041		2,204			(1,653	)
AvalonBay Value Added Fund II, L.P.		2,130		(1,053	)		(1,073	)
Juanita Village(4)		1,856		—			—

Total	$	20,914	$	5,120		$	762

(1): During 2012, the Company purchased its joint venture partner's interest in this venture.
(2): Equity in income from this entity for 2012, 2011, and 2010 includes $2,865, $2,815, and $2,839, respectively, relating to the Company's recognition of its promoted interest.
(3): Equity in income for 2012 and 2011 includes the Company's proportionate share of the gain on the sale of Fund I assets of $7,971 and $3,063, respectively.
(4): The Company's equity in income for this entity represents its residual profits interest from the sale of the community.

Investments in Consolidated Real Estate Entities

In February 2012, the Company acquired The Mark Pasadena, located in Pasadena, CA. The Mark Pasadena contains 84 apartment homes and was acquired for a purchase price of $19,400,000. In conjunction with this acquisition, the Company assumed the existing 4.61% fixed-rate mortgage loan with an outstanding principal amount of $11,958,000 which matures in June 2018 and is secured by the community.

In June 2012, the Company acquired Eaves Cerritos, located in Artesia, CA. Eaves Cerritos contains 151 apartment homes and was acquired for a purchase price of $29,500,000.

In July 2012, the Company acquired Avalon Del Rey, a 309 apartment home community which was owned by a joint venture in which the Company held a 30% ownership interest. As part of this transaction, the venture repaid the $43,606,000 variable rate note secured by the community. The Company paid approximately $67,200,000 for its joint venture partner's 70% interest as well as contributing its proportionate share of the note repayment to the venture. Upon the acquisition of Avalon Del Rey, the Company consolidated the community, recognized income from its promoted interest of $4,055,000 included in equity in income of unconsolidated equities, and a gain of $14,194,000, as gain on acquisition of unconsolidated entity in the Consolidated Statements of Comprehensive Income. The gain recognized reflects the amount by which the fair value of the Company's previously owned investment interest exceeded its carrying value.

In December 2012, the Company acquired Eaves Burlington, located in Burlington, MA. Eaves Burlington contains 203 apartment homes and was acquired for a purchase price of $40,250,000.

The Company accounted for each of these acquisitions as a business combination and recorded the acquired assets and assumed liabilities, including identifiable intangibles, based on their fair values. The Company looked to third party pricing or internal models for the values of the land, and an internal model to determine the fair values of the real estate assets, in place leases and mortgage loan. Given the heterogeneous nature of multifamily real estate, the fair values for the land, real estate assets and in place leases incorporated significant unobservable inputs and therefore are considered to be Level 3 prices within the fair value hierarchy. For the Mark Pasadena, the Company used a discounted cash flow analysis to value the mortgage note, considering the contractual terms of the instrument and observable market-based inputs. The fair value of the mortgage loan is considered a Level 2 price as the majority of the inputs used fall within Level 2 of the fair value hierarchy.

The Company expenses transaction costs associated with acquisition activity as it is incurred. Expensed transaction costs associated with the acquisitions made by the Company in 2012 as well as costs associated with the Archstone Acquisition totaled $9,593,000, reported as a component of Operating expenses, excluding property taxes on the accompanying Consolidated Statements of Comprehensive Income. Acquisition costs in 2011 and 2010 were not significant.

In 2010, the Company purchased a non-recourse mortgage note secured by a Fund I operating community, on an arms length basis. Upon acquisition of the note, the Company determined that it had control of the Fund I subsidiary, as a result of its collective equity and debt investments, the relationship between the Company and Fund I, and the nature of the Company's operations being more similar to those of the Fund I subsidiary than those of Fund I. Therefore, the Company consolidates the results of operations and net assets of the Fund I subsidiary.