Call it the Perfect Storm — excess supply collides with weak demand, growing unemployment and low interest rates that turn renters into homeowners. Still, despite falling occupancy rates and rising concessions, investors continue to chase apartment deals. Why? Beyond the short-term difficulties lies a demographic bonanza: a huge wave of new renters — young adults from the ranks of Echo Boomers — who will be looking for apartments and creating stronger demand in the next four to five years.

For now, however, that perfect storm rages. Spurred by falling interest rates, developers are building new projects, even though existing complexes are not fully rented. And, industry executives agree, the multifamily sector will remain under pressure until the economic recovery takes hold. “The apartment sector really needs to see a sustained pick-up of jobs,” says Mark Obrinsky, chief economist for the National Multi Housing Council. “Until that happens, we can expect softness all around.”

Many apartment executives fear that unemployment will either remain flat or possibly rise in 2003. This gloomy employment picture has lowered the national occupancy rate by 1.2%, from 95.5% in the third quarter of 2001 to 94.3% this year, according to Dallas-based M/PF Research. The vacancy rate has nearly doubled from its year 2000 trough of 3.8%.

What makes this recession different is the lowest interest rates in 40 years. The October unemployment rate of 5.7% is still below the peak of 7% during the 1991 recession. As interest rates put home ownership within reach of more renters, vacancies rose.

“The interest rate reduction has been cataclysmic to the apartment industry,” says Douglas Crocker, president and CEO of Equity Residential Properties Trust.“For the past two years the cost to own has been less than to rent, and owners of rental units didn't adjust their rents down accordingly.”

To fill apartments, many owners are also offering major concessions. In Dallas and Atlanta, for example, apartments are plentiful and months of free rent and other inducements are common. Encino, Calif-based Marcus & Millichap's Multi Housing Group predicts that both markets will experience 8% to 10% vacancy rates in 2003.

Still, across the country, average asking rents rose slightly from $895 at the close of the third quarter of 2001 to $901 in the third quarter of this year, according to the Multi Housing Group.

Investors Drive Demand

Against this backdrop, however, investors have bid up prices to record levels in places such as Las Vegas, Los Angeles and Orlando, Fla.

“Investor demand far exceeds the supply of apartment properties for sale. The longer-term outlook for apartment investments continues to be strong,” says Linwood Thompson, senior vice president and managing director for Marcus & Millichap's National Multi Housing Group. He says investors are targeting Class-B and Class-C properties with renovation and development potential, largely because renter demand for high-end units has dropped considerably over the past few quarters.

“I still see a lot of money going after multifamily right now. The biggest challenge for the investor is knowing which market to target,” says Jeff Goldstein, director of real estate at Boston Capital.

New York-based Real Capital Analytics found that investors have shown more caution in markets such as Phoenix, Dallas and Atlanta, where there is a lot of new construction. But New York, Boston and other markets in the Northeast continue to draw investor interest. “No matter what the fundamentals, if you can buy in these cities, you will,” says Edward Midgley, director of Insignia/ESG's Capital Advisor's Group.

The multifamily sector also remains a popular property type among lenders because they consider it a lower-risk investment than other property sectors. In 2003, multifamily loans are expected to account for about 50% of the origination volume for lending giant GMAC Commercial Mortgage Corp. of Horsham, Pa.

“From my perspective, I'm going to do a lot of business next year,” says John Cannon, senior vice president and managing director at GMAC. The firm expects to close approximately $11 billion worth of multifamily loans this year, and predicts a rise to $13 billion next year.

“With Fannie Mae and Freddie Mac offering such competitive financing, the price for capital for this product will continue to be the lowest [of the five major real estate sectors] in 2003,” he says.

Which Markets Will Recover the Fastest?

When the U.S economy rebounds, some markets are poised to recover more quickly than others. Supply-constrained markets such as New York, Boston, Los Angeles and Washington, D.C., are likely to improve before Atlanta, Phoenix and Dallas. The latter three have few barriers to development, which has led to an oversupply of new apartment complexes within the past year.

For example, Atlanta led the nation in new apartment supply at the end of September with 13,095 new units. Runner-up Dallas/Fort Worth created 9,405 new units, reports M/PF Research (see chart below). Markets that enjoyed the technology and telecom boom of the 1990s, such as San Francisco and Atlanta, have seen the steepest occupancy declines. The strongest multifamily market in the nation, according to many observers, is Southern California. Buoyed by a strong job market and healthy rental demand, vacancies are below 5%, according to Marcus & Millichap.

Demographic Boost

What lies beyond 2003? Those Echo Boomers, who are finishing college, landing their first jobs and starting families. The number of people ages 20 to 29 (typically the peak apartment-renting ages) is expected to increase over the next few years, leveling out at an annual increase of roughly 400,000 to 600,000 over the next decade, according to the U.S. Census Bureau.

“From a demographics standpoint, multifamily is in great shape,” says Crocker of Equity Residential.

Add to that the prospect of economic recovery, renewed job creation and rising interest rates, and the outlook begins to look bright for multifamily.