Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to help provide an understanding of our business and results of operations. This MD&A should be read in conjunction with our Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included elsewhere in this report. This report, including the following MD&A, contains forward-looking statements regarding future events or trends as described more fully under "Forward-Looking Statements" included in this report. Actual results or developments could differ materially from those projected in such statements as a result of the risk factors described in Item 1a, "Risk Factors," of this report. Executive Overview
Business Description
We are primarily engaged in developing, acquiring, owning and operating apartment communities in high barrier-to-entry markets of the United States. We believe that apartment communities are an attractive long-term investment opportunity compared to other real estate investments because a broad potential resident base should help reduce demand volatility over a real estate cycle. However, throughout the real estate cycle, apartment market fundamentals, and therefore operating cash flows, are affected by overall economic conditions. We seek to create long-term shareholder value by accessing capital on cost effective terms; deploying that capital to develop, redevelop and acquire apartment communities in high barrier-to-entry markets; operating apartment communities; and selling communities when they no longer meet our long-term investment strategy or when pricing is attractive. Barriers-to-entry in our markets generally include a difficult and lengthy entitlement process with local jurisdictions and dense urban or suburban areas where zoned and entitled land is in limited supply.
We regularly evaluate the allocation of our investments by the amount of invested capital and by product type within our individual markets, which are located in New England, the New York/New Jersey metro area, the Mid-Atlantic, the Midwest, the Pacific Northwest, and the Northern and Southern California regions of the United States. Our strategy is to penetrate these markets with a broad range of products and services and an intense focus on our customer. Our communities are predominately upscale, which generally command among the highest rents in their markets. However, we also pursue the ownership and operation of apartment communities that target a variety of customer segments and price points, consistent with our goal of offering a broad range of products and services.
Financial Highlights and Outlook
For the year ended December 31, 2008, net income available to common stockholders was $401,033,000 compared to $349,460,000 for 2007, an increase of 14.8%. The annual year-over-year increase is primarily attributable to an increase in gains from the sale of communities and joint venture real estate investments in 2008 as compared to 2007 and growth in income from existing and newly developed communities in 2008, partially offset by non-cash charges for land impairments, abandoned pursuit costs and other charges related to our reduction in our planned development activity and other items listed in the table below.

                                                     Net Income and EPS/FFO Decrease (Increase)
                                                                   Full Year 2008
                                                          Amount                      Per Share (1)
Land impairments                                $                57,899,000          $           0.75
Severance and related costs                                       3,400,000                      0.04
Federal excise tax                                                3,200,000                      0.04
Fund II organizational costs                                      1,209,000                      0.02
Gain on medium term notes repurchase                             (1,839,000 )                   (0.02 )

Preferred stock deferred offering expenses                        3,566,000                      0.05
Increase in abandoned pursuit costs                               5,537,000                      0.07

                                                $                72,972,000          $           0.94

(1) Per share amounts are computed using the weighted average common shares-diluted at December 31, 2008.

Apartment fundamentals, while in line with expectations, were challenged in the second half of 2008 as the recent economic downturn accelerated. We were able to achieve full year-over-year rental revenue growth of 3.1% for our Established Community portfolio, comprised entirely of an increase in rental rates of 3.1%, with no change in occupancy. This revenue growth, combined with constrained expense growth, contributed to our Established Community portfolio achieving year-over-year growth in net operating income ("NOI") of 3.6% in 2008. However, due to the decline in market fundamentals during the fourth quarter of 2008, rental revenue from Established Communities increased 1.7% and NOI increased 2.4% over the prior year period.
We expect a decrease in Earnings per share - diluted ("EPS") in 2009 from the prior year of approximately 50%, driven primarily by the decrease in expected dispositions for 2009. Contributing to these results will be an expected decline in the revenue and net operating income from our Established Communities in 2009. The recession, coupled with the short term nature of apartment leases, has adversely impacted current operating fundamentals. While certain apartment markets continue to exhibit positive trends, the negative impact on renter demand from net job losses is expected to result in year-over-year declines in NOI. We believe that the adverse impact of the recession will be somewhat offset by (i) the expected continued weakness in the for-sale housing market during 2009 and (ii) growth in those age groups that have historically demonstrated a higher propensity to rent. In addition, the level of new rental completions in the Company's markets is anticipated to decline during 2009 from 2008 levels. Our current financial outlook for 2009 provides for a decline in rental revenue of between 1.5% and 3.5% in our Established Community portfolio and a projected NOI decline of 4.25% to 6.25%.
While current capital market conditions continue to adversely affect access to liquidity, we were able to demonstrate the benefits of the financial flexibility that comes with a largely unencumbered capital structure. During the year ended December 31, 2008, we raised in excess of $1,900,000,000 of capital through the issuance of secured and unsecured debt, sales of assets, and joint venture partner capital commitments. During 2008 we sourced approximately $1,200,000,000 in debt at attractive prices from a variety of sources, including the Government Sponsored Enterprises, tax-exempt debt, money center banks and even a local bank for long term secured debt. In addition, we achieved a record level of dispositions during 2008, selling eleven communities (including one held by the Fund) for an aggregate gross sales price of $646,200,000. We anticipate our level of disposition activity to be in the range of gross sales of $100,000,000 to $200,000,000 in 2009. However, our actual disposition activity may differ significantly and will depend on various factors including market and economic conditions in 2009.
We used the proceeds from both the debt financing activity and community dispositions to fund our development and redevelopment activities, reduce amounts drawn under our unsecured line of credit, repay secured and unsecured debt, prepay certain secured debt with higher interest costs and repurchase common stock. Capital needs result primarily from development expenditures, maturing debt and dividend requirements. Our committed capital is sufficient to complete the development underway and meet other liquidity uses. See the discussion under Liquidity and Capital Resources.
While we believe that our development activity will continue to create long-term value, we reduced our expected level of development in response to the general deterioration in real estate and capital market conditions, the general

recessionary environment. As previously disclosed, we do not anticipate starting any new development during the first half of 2009. Development starts in the second half of 2009, if any, will be evaluated based on our assessment of economic and capital market conditions at that time. We do expect to increase redevelopment activity in 2009 for both wholly owned and Fund (as defined below) related assets. As a result of the reduction in our development activities, we incurred certain non-cash and other charges as discussed in the table above. During 2008 we completed 13 communities for an aggregate total capitalized cost of $1,044,300,000, while only starting six communities, which are expected to be completed for an estimated total capitalized cost of $491,000,000. During 2009, the Company expects to disburse approximately $650,000,000 related to the 14 communities under development at December 31, 2008 and expected acquisitions of land for future development. We expect approximately $100,000,000 of the projected 2009 disbursements will be funded from cash in escrow related to previously sourced tax-exempt debt.
Our 2009 financial plan anticipates a continuation of poor credit markets and constrained liquidity. However, we believe that our current level of indebtedness, our current ability to service interest and other fixed charges and our current limited use of financial encumbrances (such as secured financing) will provide adequate access to the capital necessary to fund our current development and redevelopment activities. We expect to meet our liquidity needs from the issuance of corporate securities (which could include unsecured debt and/or common and preferred equity) and secured debt, as well as from disposition proceeds, joint ventures or from retained cash. We believe that the current market provides for an opportunity to perform certain deferred maintenance and repositioning activities at attractive costs due to the continued decline in costs for construction materials and labor. During 2009, we expect to start 16 redevelopments of wholly owned communities, as well as five redevelopments of communities on behalf of the Fund, as defined below. AvalonBay Value Added Fund, L.P. (the "Fund") is a discretionary investment fund with nine institutional investors, including us. One of our wholly owned subsidiaries is the general partner of the Fund and has invested approximately $48,000,000 in the Fund, representing a 15.2% combined general partner and limited partner equity interest. The Fund was our principal vehicle for acquiring apartment communities through the close of its investment period in March 2008.
On September 2, 2008, we announced the formation of AvalonBay Value Added Fund II, L.P. ("Fund II"), a private, discretionary investment vehicle with commitments from four institutional investors including us totaling $333,000,000. We have committed $150,000,000 to Fund II, representing a 45% equity interest. At final closing, the aggregate investor commitments to Fund II and our commitment and percentage interest in Fund II may change. Fund II can employ leverage of up to 65%, allowing for a total investment capacity of approximately $950,000,000 and has a term of ten years plus two one-year extension options. Fund II will acquire and operate multifamily apartment communities primarily in our current markets with the objective of creating value through redevelopment, enhanced operations and/or improving market fundamentals. Fund II will serve as the exclusive vehicle through which we will acquire investments in apartment communities for a period of three years from the closing date or until 90% of its committed capital is invested, subject to limited exceptions. Fund II will not include or involve our development activities. We will receive, in addition to any returns on its invested equity, asset management fees, property management fees and redevelopment fees. We will also receive a promoted interest if certain return thresholds are met. As of December 31, 2008, there has been no capital contributed to Fund II and Fund II has made no investments. In the fourth quarter of 2008, Fund II entered into a $75,000,000 unsecured credit facility, with an option to increase the facility up to $200,000,000, subject to certain lender requirements. The credit facility bears interest at LIBOR plus 2.50% per annum, and matures in December 2011, assuming the exercise of a one-year extension option. At December 31, 2008, there was $760,000 outstanding under the Fund II credit facility. Communities Overview
Our real estate investments consist primarily of current operating apartment communities, communities in various stages of development ("Development Communities") and Development Rights (i.e., land or options to purchase land held for development), as further described in Item 2 of this report. Our current operating communities are further distinguished as Established Communities, Other Stabilized Communities, Lease-Up Communities and Redevelopment Communities. Established Communities are generally operating communities that are consolidated for financial reporting purposes and were owned and had stabilized occupancy and operating expenses as of the

beginning of the prior year, which allows the performance of these communities and the markets in which they are located to be compared and monitored between years. Other Stabilized Communities are generally all other consolidated operating communities that have stabilized occupancy and operating expenses during the current year, but had not achieved stabilization as of the beginning of the prior year. Lease-Up Communities consist of communities where construction is complete but stabilization has not been achieved. Redevelopment Communities consist of communities where substantial redevelopment is in progress or is planned to begin during the current year. A more detailed description of our reportable segments and other related operating information can be found in Note 9, "Segment Reporting," of our Consolidated Financial Statements.
Although each of these categories is important to our business, we generally evaluate overall operating, industry and market trends based on the operating results of Established Communities, for which a detailed discussion can be found in "Results of Operations" as part of our discussion of overall operating results. We evaluate our current and future cash needs and future operating potential based on acquisition, disposition, development, redevelopment and financing activities within Other Stabilized, Redevelopment and Development Communities. Discussions related to these segments of our business can be found in "Liquidity and Capital Resources."
NOI of our current operating communities, is one of the financial measures that we use to evaluate community performance. NOI is affected by the demand and supply dynamics within our markets, our rental rates and occupancy levels and our ability to control operating costs. Our overall financial performance is also impacted by the general availability and cost of capital and the performance of newly developed and acquired apartment communities. As of December 31, 2008, we owned or held a direct or indirect ownership interest in 178 apartment communities containing 50,292 apartment homes in ten states and the District of Columbia, of which 14 communities were under construction and nine communities were under reconstruction. Of these communities, 23 were owned by entities that were not consolidated for financial reporting purposes, including 19 owned by the Fund. In addition, we owned a direct or indirect ownership interest in Development Rights to develop an additional 27 communities that, if developed in the manner expected, will contain an estimated 7,304 apartment homes.

Results of Operations
Our year-over-year operating performance is primarily affected by both overall and individual geographic market conditions and apartment fundamentals and reflected in changes in NOI of our Established Communities; NOI derived from acquisitions and development completions; the loss of NOI related to disposed communities; and capital market and financing activity. A comparison of our operating results for 2008, 2007 and 2006 follows (dollars in thousands):

                               2008          2007         $ Change       % Change         2007          2006        $ Change      % Change
Revenue:
Rental and other income      $ 847,640     $ 760,521     $   87,119           11.5 %    $ 760,521     $ 671,382     $  89,139          13.3 %
Management, development
and other fees                   6,568         6,142            426            6.9 %        6,142         6,259          (117 )        (1.9 %)

Total revenue                  854,208       766,663         87,545           11.4 %      766,663       677,641        89,022          13.1 %


Expenses:
Direct property operating
expenses, excluding
property taxes                 200,990       181,324         19,666           10.8 %      181,324       164,852        16,472          10.0 %
Property taxes                  77,267        70,562          6,705            9.5 %       70,562        62,651         7,911          12.6 %

Total community operating
expenses                       278,257       251,886         26,371           10.5 %      251,886       227,503        24,383          10.7 %


Corporate-level property
management and other
indirect operating
expenses                        39,874        38,627          1,247            3.2 %       38,627        34,177         4,450          13.0 %
Investments and investment
management                      17,298        11,737          5,561           47.4 %       11,737         7,030         4,707          67.0 %
Interest expense, net          114,878        94,540         20,338           21.5 %       94,540       106,271       (11,731 )       (11.0 %)
Depreciation expense           194,150       168,324         25,826           15.3 %      168,324       149,352        18,972          12.7 %
General and administrative
expense                         42,781        28,494         14,287           50.1 %       28,494        24,767         3,727          15.0 %
Impairment loss                 57,899             -         57,899            N/A              -             -             -             -

Total other expenses           466,880       341,722        125,158           36.6 %      341,722       321,597        20,125           6.3 %


Equity in income of
unconsolidated entities          4,566        59,169        (54,603 )        (92.3 %)      59,169         7,455        51,714         693.7 %
Minority interest income
(expense) in consolidated
partnerships                       741        (1,585 )        2,326          146.8 %       (1,585 )        (573 )      (1,012 )      (176.6 %)
Gain on sale of land                 -           545           (545 )          N/A            545        13,519       (12,974 )       (96.0 %)


Income from continuing
operations                     114,378       231,184       (116,806 )        (50.5 %)     231,184       148,942        82,242          55.2 %

Discontinued operations:
Income from discontinued
operations                      12,208        20,489         (8,281 )        (40.4 %)      20,489        20,193           296           1.5 %
Gain on sale of
communities                    284,901       106,487        178,414          167.5 %      106,487        97,411         9,076           9.3 %

Total discontinued
operations                     297,109       126,976        170,133          134.0 %      126,976       117,604         9,372           8.0 %


Net income                     411,487       358,160         53,327           14.9 %      358,160       266,546        91,614          34.4 %
Dividends attributable to
preferred stock                (10,454 )      (8,700 )       (1,754 )         20.2 %       (8,700 )      (8,700 )           -             -

Net income available to
common stockholders          $ 401,033     $ 349,460     $   51,573           14.8 %    $ 349,460     $ 257,846     $  91,614          35.5 %

Net income available to common stockholders increased $51,573,000 or 14.8%, to $401,033,000 in 2008 due primarily to gains from the sale of communities and year-over-year increases in community operating performance, partially offset by charges associated with land impairments and abandoned pursuits as well as increased costs for interest and depreciation. Net income available to common stockholders increased $91,614,000 or 35.5% in 2007 over the prior year period due primarily to sales of consolidated operating communities and investments in unconsolidated entities and related gains combined with growth in NOI from Established Communities and contributions to net operating income from newly developed communities.
NOI is considered by management to be an important and appropriate supplemental performance measure to net income because it helps both investors and management to understand the core operations of a community or communities prior to the allocation of any corporate-level or financing-related costs. NOI reflects the operating performance of a community and allows for an easy comparison of the operating performance of individual assets or groups of assets. In addition, because prospective buyers of real estate have different financing and overhead structures, with varying marginal impacts to overhead by acquiring real estate, NOI is considered by many in the real estate industry to be a useful measure for determining the value of a real estate asset or group of assets. We define NOI as total property revenue less direct property operating expenses, including property taxes.
NOI does not represent cash generated from operating activities in accordance with U.S. generally accepted accounting principles ("GAAP"). Therefore, NOI should not be considered an alternative to net income as an indication of our performance. NOI should also not be considered an alternative to net cash flow from operating activities, as determined by GAAP, as a measure of liquidity, nor is NOI necessarily indicative of cash available to fund cash needs. Reconciliations of NOI for the years ended December 31, 2008, 2007 and 2006 to net income for each year, are as follows (dollars in thousands):

                                                                        For the year ended
                                                           12-31-08          12-31-07          12-31-06
Net income                                                $  411,487        $  358,160        $  266,546
Indirect operating expenses, net of corporate income          33,045            31,285            28,811
Investments and investment management                         17,298            11,737             7,030
Interest expense, net                                        114,878            94,540           106,271
General and administrative expense                            42,781            28,494            24,767
Equity in income of unconsolidated entities                   (4,566 )         (59,169 )          (7,455 )
Minority interest in consolidated partnerships                  (741 )           1,585               573
Depreciation expense                                         194,150           168,324           149,352
Impairment loss                                               57,899                 -                 -
Gain on sale of real estate assets                          (284,901 )        (107,032 )        (110,930 )
Income from discontinued operations                          (12,208 )         (20,489 )         (20,193 )

Net operating income                                      $  569,122        $  507,435        $  444,772

The NOI increases for both 2008 and 2007, as compared to the prior year period, consist of changes in the following categories (dollars in thousands):

                                                       2008          2007
                                                     Increase      Increase
         Established Communities                     $  14,257     $  27,665

         Other Stabilized Communities                   14,982        10,186

         Development and Redevelopment Communities      32,448        24,812


         Total                                       $  61,687     $  62,663

The NOI increases in Established Communities in 2008 were largely due to continued favorable but moderating apartment market fundamentals. During 2008, we continued to focus on rental rate growth, while maintaining occupancy of at least 95% in all regions.
We anticipate that rental rates and occupancy levels will decline in 2009 such that overall rental revenue will decline between 1.5% and 3.5% as compared to the 3.1% growth achieved in 2008. The expected revenue decline is due to the general decline in overall economic conditions and related employment levels. Expense growth also impacts growth in NOI and we continue to monitor and manage operating expenses to constrain expense growth. We expect operating expenses to increase between 3.0% and 4.0% in 2009 from prior year levels, attributable primarily to increases in property taxes, utilities, insurance and office operations. As a result, we expect NOI for our Established Communities to decline between 4.25% and 6.25%. These projections are based on our outlook for economic conditions in 2009, both nationally and in the markets where we operate. There can be no assurance that our outlook for economic conditions and/or their impact on our operating results will be accurate, and actual results could differ materially. Please see "Risk Factors," "Forward Looking Statements" and other discussions in this report on Form 10-K for a discussion of factors which could affect our results of operations.
Net operating income ("NOI") is considered by management to be an important and appropriate supplemental performance measure to net income because it helps both investors and management to understand the core operations of a community or communities prior to the allocation of any corporate-level or financing-related costs. NOI reflects the operating performance of a community and allows for an easy comparison of the operating performance of individual assets or groups of assets. In addition, because prospective buyers of real estate have different financing and overhead structures, with varying marginal impacts to overhead by acquiring real estate, NOI is considered by many in the real estate industry to be a useful measure for determining the value of a real estate asset or group of assets. We define NOI as total property revenue less direct property operating expenses, including property taxes.
Rental and other income increased in 2008 as compared to the prior year due to increased rental rates and occupancy for our Established Communities, coupled with additional rental income generated from newly developed communities. Overall Portfolio - The weighted average number of occupied apartment homes decreased to 37,886 apartment homes for 2008 as compared to 38,436 homes for 2007 and 37,716 homes for 2006. This change is primarily the result of communities sold during 2008 containing 3,459 apartment homes, as well as declining occupancy levels due to the economic slow down, partially offset by increased homes available from newly developed communities,. The weighted . . .