Love 'em or hate 'em, it's clear that condo converters and developers are making waves in the apartment industry. On the upside, condo converters are gobbling up existing apartments, and in turn driving up sale prices and reducing the supply of available rental housing. The downside is that condo developers also are making it difficult for apartment developers to compete for building sites by their willingness to pay up to three times more for land.

“The condo craze has taken from our supply and demand base, and made all of us change our business models,” says Jeff Franzen, a senior vice president at Dallas-based Lincoln Property Co. In fact, the stiff competition for land and buildings has prompted firms such as Lincoln to expand into the condo market. Currently, Lincoln has about 1,500 condo units in various stages of construction compared with about 6,000 apartment units that are under way.

Condo conversions are receiving at least partial credit for boosting occupancies and rental rates in the apartment sector. “We are getting a big lift from all the condo conversions taking place, which is taking inventory out of the marketplace,” says Bruce W. Duncan, CEO at Chicago-based Equity Residential Properties Trust, which owns about 200,000 apartment units nationally.

Equity Residential is experiencing positive revenue growth in almost every market. Among the 30,000 units Equity owns in Florida, for example, revenue growth is up 8% through May compared with the same period in 2004.

According to a ranking of firms by the National Multi Housing Council, CharterMac, Apartment Investment and Management Co., Equity Residential and MMA Financial continue to dominate the apartment ownership landscape as they did last year, with only minor changes. CharterMac leads the way with ownership interests in 324,711 apartments in the U.S. as of Jan. 1, up from 309,292 last year.

Many apartment owners are taking advantage of premium pricing to sell off non-core assets and improve portfolios. Equity Residential sold about $1 billion worth of apartments and bought about $1 billion worth of property, and the firm expects a similar transaction volume for 2005. “We think it's a great opportunity to sell out of smaller markets or locations that are physically challenged, and buy into better locations,” Duncan says.

Return of development

After sliding into a downturn a few years ago due to overbuilding and a flurry of record home sales, the apartment market has experienced four consecutive quarters of positive absorption, declining vacancies and rising effective rents. In the top 64 metropolitan markets tracked by Reis Inc., the average vacancy rate declined to 6.6% during the first quarter, a drop of 10 basis points compared to the fourth quarter.

Improving market conditions are starting to spark construction activity. The number of multifamily permits for the past 12 months ending March 31 reached 391,000, a rise of 3.9% over the same period a year ago, according to the National Multi Housing Council.

Yet, the condo boom also is raising costs for apartment developers. For example, Equity Residential paid about $56,000 per unit for a building site in Washington, D.C., and recently sold a portion of that site to a developer planning a high-rise condo for nearly three times the amount.

Higher land costs are prompting developers such as Equity Residential to be more creative in their approach to new construction. The REIT plans to spend between $300 million and $400 million on new development in 2005, primarily by maximizing density at existing properties. Equity Residential recently received city approval to build an additional 306 units at Charles River Park in Boston.

Sales frenzy

Apartment sales were strong in the first quarter with $15.4 billion in properties changing hands, nearly $4 billion of which went to buyers planning condo conversions, reports Real Capital Analytics.

In some cases, the offers are too good to resist. Richmond, Va.-based United Dominion Realty Trust recently received an unsolicited offer from a condo converter on a 20-year-old apartment property in Scottsdale, Ariz. for $220,000 per unit, or a cap rate of 2.9%. The trickle-down effect is that United Dominion can use the proceeds from that sale to aggressively target new acquisitions. Selling a property for a 2.9% cap in Scottsdale enables the REIT to compete for properties in major markets such as Los Angeles and San Diego, where caps are 5%, says CEO Tom Toomey of United Dominion.

However, United Dominion is still quite cautious in its approach to acquisitions. The company focuses on deals that are at or below replacement cost. “Every day we wake up and see new price highs and compression on spreads,” says Toomey. “So, it is a time where we have to go back to fundamentals and look at what the real estate is worth.”