The frenzied pace at which developers are converting apartments into condominiums is having a decidedly positive effect on apartment fundamentals in the short term, leading to lower vacancy rates and higher monthly rents. Yet, industry experts say that in the long run apartment owners may be forced to make significant capital expenditures to compete with luxury condos.

The national apartment vacancy rate registered 6.4% in the second quarter, after topping out at nearly 7% at the end of 2003, according to Manhattan-based real estate data firm Reis. During that same stretch, effective rents have climbed from $856 to $897.

The conversion craze, which shows no signs of abating, has helped prop up the apartment sector by reducing supply. In 2004 alone, some 64,258 apartment units were converted into condos. “The subtraction of rental units from the market has become as important as new construction to the equilibrium of the sector,” says Lloyd Lynford, CEO of Reis.

In hot condo markets such as Miami and Washington, D.C., developers are enticing condo buyers with top-shelf amenities like Subzero refrigerators and other expensive appliances. For owners of tired apartment buildings who have neglected to keep pace with the luxury condo market, the end game could include increased capital expenditures on amenity upgrades and marketing.

That's the conventional wisdom, but not everyone is ready to concede that point just yet. “I think it's very hard to predict how the condo conversions will ultimately affect the apartment market,” says Mark Obrinsky, chief economist at Washington, D.C.-based apartment trade group National Multifamily Housing Council.

If condo developers face softer demand in the next few years, Obrinsky believes that the condo units could revert back to rentals. If such a scenario were to unfold, that would increase the inventory of available apartments and offset the improved fundamentals of the last few years.

Under the worst-case scenario, individual speculators holding condo units could rent them out and compete directly with the apartment market.

The rise in conversion activity isn't expected to end anytime soon. Reis data shows that condos represented just 10% of all new multifamily projects started in 2003. That percentage jumped to 18% in 2004, and Reis projects that figure to nearly double by the end of this year (see cover story for more on the condo craze).

Despite the obvious challenges, Lynford is sanguine about prospects for the apartment market. He projects that 63,000 apartment units will be absorbed in 2005, up from only 39,300 units last year.

The combination of lower vacancy rates, robust absorption and the steady removal of competitive units by condo converters should drive rental increases of 3% and 3.5% in 2006 and 2007.

Still, Lynford says the apartment market isn't completely out of the woods just yet. “Scrutiny and vigilance will be required by investors as they strive to determine the long-term impact of the condominium onslaught on their apartment portfolios.”