At the beginning of this year, rental apartment owners and developers were relishing a market that, after some four years of playing ugly stepsister to the condo market's Cinderella, had emerged as the belle of the ball.

Amid growing demand, occupancy levels had climbed. Due to a supply-constrained market and the conversion of thousands of rental units to for-sale units, annual rent increases were reaching 5%. Add to that low and surprisingly stable cap rates and abundant capital looking for a place to land, and it was about as good as it ever gets for rental apartment developers.

Yet a shadow hung over the multifamily market. All those empty for-sale units in markets that either were overbuilt or where investors had driven a significant portion of condo sales were about to flood back into the market as rentals. The end result is a shadow market that is dampening the outlook for the rental apartment sector through the end of this year.

According to analyst Ron Witten, president of Witten Advisors, who provides regular updates to NAHB's Multifamily Leadership Board, there are a record number of empty residential units — an estimated 1 to 1.5 million — on the market. Accompanied by sluggish job growth, demand for rental apartments softened significantly in the fourth quarter of 2006 and declined even further in the first two quarters of this year.

Land prices not falling yet

Before the hot for-sale housing market cooled, however, it created a frenzy for land in many markets that sent prices soaring. Although no tracking measure exists for volatile land prices, insights from members of NAHB's Multifamily Leadership Board suggest that developers of rental apartments were virtually shut out by the deep pockets of publicly traded home builders and condo developers at the peak of the housing boom.

Another problem has been a steep rise in construction costs. The multifamily component of the Producer Price Index (PPI) showed a 9% rise from May 2005 to May 2006. Higher costs for land and materials haven't yet receded to the point where the numbers justify development of non-luxury market-rate rentals.

Consequently, multifamily rental apartment starts are at a 14-year low. While the rate of job growth is off by a third from early 2006, other indicators that determine growth in rental demand — household formation and immigration — remain strong, making it unlikely that developers will have to cut rents or offer serious concessions.

As of late July, multifamily starts were predicted to continue to drop: 16% in 2007, followed by a 2% decline in 2008. The good news is that as fewer units are built, those that remain will see their bottom lines improve.