A long shadow hangs over the U.S. apartment market at the start of 2008. The combination of a potential supply glut fueled by a growing number of condominiums and single-family homes available for rent and the ongoing subprime mortgage crisis threatens the health of the sector.

The upshot? Some markets are bound to fare better than others. “There is a real divergence taking place right now in the apartment market between winners and losers,” says Michael Cohen, research strategist and head of multifamily research at Boston-based Property & Portfolio Research (PPR).

“Market selection for apartment investors is really very important at this point in time because there are some markets that are very clearly going to become laggards going forward over the next couple of years,” adds Cohen.

Winners include markets like San Francisco and Austin, which have high barriers to entry. Meanwhile, South Florida, Las Vegas and Phoenix continue to suffer from overbuilding and lackluster economic growth.

Time to build?

Real estate fundamentals for apartment properties across the country are generally strong. Effective rents increased 4.4% in the third quarter of 2007 over the same period a year earlier, according to New York-based data research firm Reis Inc. The national apartment vacancy rate declined 20 basis points to 5.6% during the same period.

But analysts say current vital signs mask some larger problems brewing in the industry. With strong economic indicators at their backs as little as 12 to 18 months ago, developers could not resist the temptation to build anew. As a result, new construction is on the rise just as the economy is slowing and competing condominium product is enticing renters.

Some 110,000 new apartment units were completed and brought to market among PPR's top 54 apartment markets in 2007, the vast majority of which were ground-up construction. But in 2008, PPR is forecasting another 130,000 new units to be completed, resulting in a 15% increase.

Significant cap-rate compression on existing assets over the past three years ultimately led many investors to develop rather than buy properties in order to realize higher returns, says Cohen. That dovetailed with readily available financing just prior to the subprime debacle.

On a brighter note, Cohen says the slowing economy and more expensive financing are blessings in disguise. “It could actually tamp down the delivery of new units longer term, out in 2009 and early 2010, which in the long run could be a positive for apartment fundamentals.”

Condos by the numbers

Overbuilding in the condo market has created a large supply of rental units, or “shadow space.” And the construction spigot is still wide open. Condo completions nationally rose 45% in 2007, increasing to 233,000 versus 160,000 in 2006, according to investment sales brokerage Marcus & Millichap.

Bernard Markstein, senior economist with the National Association of Homebuilders, says some 200,000 new condo units will be completed across the nation in 2008.

The phenomenon of shadow space is nothing new, but has never been easy to quantify. “None of us really have any idea how many homes and condos are becoming rentals,” says Mark Obrinsky, vice president of research and chief economist with the National Multi Housing Council (NMHC). “It's certainly more in some markets than in others. A lot of people feel Miami might be the city where you see this the most, but even there I don't think anyone has solid data.”

Even without hard numbers, the shadow factor is evident. “We had, and are going through, such a precipitous level of condo overbuilding in a number of those markets at the same time that demand has fallen off, and a good piece of that demand was from investors,” says Cohen.

While investors have stopped buying, many of them are left holding units that they were hoping to unload for a profit or flip. Their only options are to bear the cost of paying the monthly mortgage or try to generate whatever cash flow they can through renting.

The pace of condo sales continues to slow. Recent data from the National Association of Realtors reveals that existing condominium and co-op sales fell 9.1% to a seasonally adjusted annual rate of 600,000 units in October from 660,000 in September, but are 20.2% below the 752,000 pace reached in October 2006.

Because apartments and condos share many similarities, there is a higher degree of shadow space than ever before, says Sam Chandan, director of research for Reis. “The degree of substitutability between an apartment and a condo is much higher than between an apartment and a home. You're getting basically the same set of amenities that you would get if you were renting an apartment.”

In overbuilt condo markets such as South Florida, Phoenix, and Las Vegas, a growing number of condo owners are renting their units in direct competition with traditional or mainstream apartments, says Chandan.

The upshot is that the market for converting for-lease apartment properties into for-sale condos is officially dead. According to Reis, conversions all but dried up starting in early 2007. “If there are conversions that are being undertaken now, they are few and far between and they're idiosyncratic,” says Chandan.

With the condo sales market in the doldrums, several alternative strategies are in play — “reversions” where properties were initially converted from leasing to sales, but revert back to rental status, and “repurposing,” where a condo development is repurposed to rental apartments.

Fallout over falling prices

Whatever strategy is employed, the overall weak for-sale housing market is adouble-edged sword for the rental apartment market. On the surface, fewer homebuyers would seem to favor more demand for apartments. “That's why you're seeing a national vacancy rate at around a five-year low,” says Cohen.

But the reason there are fewer homebuyers has much to do with machinations in the broader economy. “The fact that home purchasing is down so precipitously from where we were in 2005 — and the value of homes and condos is falling and is expected to fall through 2008 — has implications for the larger economy, which has implications for job creation and shadow supply,” says Cohen. In some markets in South Florida, for example, prices have fallen more than 50% in the past year alone.

Home foreclosure filings nationally in October 2007 were 94% higher than a year earlier, according to data firm RealtyTrac. Such somber news does not automatically translate to a positive for the apartment industry. “You have folks who are now going to be less creditworthy because they've lost their homes and will possibly rent a house or may seek alternative household arrangements,” says Cohen.

Despite the challenges, some recent data indicates that apartment demand has been, and will remain, solid with little sign of falling off. NMHC's quarterly survey of members regarding apartment conditions focuses on a key figure, the “Market Tightness Index,” which indicates markets are tightening when the score is above 50. In October, the index scored just under 50, a slight change from the previous two quarters that registered just over 50.

REITs feel the heat

Investors and analysts are getting jittery about the perceived high valuations of public apartment REITs, which explains why UBS downgraded the largest players in the sector in November. UBS analysts cite concerns about additional single-family homes and condos entering the rental pool. They also note that yields on new development have dropped by 1% in the past year, and worry about overheating in apartment development pipelines.

Chicago-based Equity Residential Properties Trust (EQR), the largest apartment REIT ranked by market capitalization in the United States with 154,000 total units, was downgraded from neutral to sell.

Over the past few years, EQR has repositioned its portfolio to focus on markets with high barriers to entry and pulled out of Minneapolis, Chicago, Houston, Nashville, Charlotte and soon Dallas. With a modest $1.2 billion of new development underway, EQR is underwriting a return on development that is 1% higher than for acquisitions.

Ron Witten, president of Witten Advisors in Dallas, consults with apartment REITs who are trying to assess the impact of overbuilding in the condo and the single-family sectors. “They really want to know what their cost of capital is, and what is an attractive return on a development deal,” he says. “In the short term, there are some headwinds from the oversupply in the housing market.”

Ben Johnson is a Dallas-based writer.

South Florida's house of condo cards

Jack McCabe has been an astute observer of South Florida's apartment and condo markets for 20 years. As CEO of McCabe Research & Consulting in Deerfield Beach, Fla., he has witnessed several of the inevitable boom-and-bust building cycles, but this one is different.

“It was a real house of cards down here as it has been in many markets, heavily driven by speculative investment, not by end users,” says McCabe. “We have a five-and-a-half to six-year supply of condo units in Miami-Dade County. In my opinion, Florida is already in a recession.”

Welcome to condo-town USA, and the epicenter of a disaster in progress. In fact, the supply of overbuilt condo-driven “shadow” rental space is so large that many apartment landlords are offering up to two months of free rent on a 12-month lease just to compete.

Where some see chaos, others sense opportunity. To help owners unload some of their inventory, CB Richard Ellis executive vice president Robert Given and first vice president Gerard Yetming launched a website last August — www.blockcondounits.com — to market bulk sales of so-called “fractured condos.”

Up to half the units in these condo communities were sold, but the developers found themselves in financial straits and quickly needed to sell the remaining units, preferably in bulk.

By November, the site listed 43 projects with 5,000 units for sale, and CB Richard Ellis has teamed up with Miami-based Web site Condo.com to widen its reach in marketing the properties.

Surprisingly, according to McCabe, even in the midst of this chaos, apartment developers in South Florida are now competing for land in quality locations, banking on a perceived missed opportunity.

He points to a scarcity of new market-rate rental projects since 2005, primarily because much of the newer Class-A rental product had been converted to for-sale condos prior to the subprime debacle and condo bust taking hold.

Lenders are still willing to help developers build, as long as the word “condo” is not involved. “If you want to do an apartment project, a commercial lender is interested, but if you want to do a condo project you might as well be kissing your sister because there's nobody to listen to you,” says McCabe. “Condo projects are taboo in Florida right now.”

McCabe does see hope on the horizon. He predicts that when Baby Boomers begin retiring in 2010 and 2011, condo sales will pick up just when prices should become more affordable. “That's where I see the real turning point for this downward cycle, but not until then.”
— Ben Johnson