In 2005, owners of apartment properties experienced the kind of year that they may not see again for a while. Thanks largely to the continuing condo-conversion craze, sale prices of multifamily properties jumped 34% in the first 10 months of the year as $62 billion in apartment assets changed hands — compared with $49 billion for all of 2004. Thousands of units were removed from the rental inventory, which generated lower vacancies and higher rents.

For 2006, however, nobody expects a rerun. With interest rates rising, housing markets cooling and condo demand slowing, the condo-conversion party is expected to wind down. Condo converters, who accounted for more than half of the multifamily buying binge, will step back from the table. “We definitely believe that the condo converters will take a breather in 2006,” says Michael Cohen, senior real estate economist at Boston-based real estate consulting firm Property & Portfolio Research.

If so, that could cause the red-hot investment sales market to soften. It would also slow down the removal of units from the rental market. If there's any upside to a conversion pullback, however, Cohen sees it benefiting institutional investors who cannot outbid aggressive converters for deals. If the converters slow down, that could give less-leveraged institutions an advantage in snapping up properties.

This may already be panning out as several high-profile institutional apartment deals have closed this year. AMLI Residential, a luxury apartment REIT, was bought by a Morgan Stanley-managed fund for $2.1 billion in October. In June, ING Clarion snapped up apartment REIT Gables Properties Trust for $2.8 billion. Cohen expects more institutions to pursue single-asset or portfolio deals in 2006.

Still another factor that could dampen conversion activity is higher mortgage rates. Long-term fixed rates on home mortgages were hovering near 6.3% on Nov. 10, an 18-month high. As long-term rates climb, Cohen points out, affordability is becoming more of an issue; fewer consumers are able to finance a condo.

It's easy to see why, too. The median value of a single-family home hit $212,200 in September, or 14.3% above its 2004 level, reports the National Association of Realtors. And median condo values jumped to $213,600, which was a 9% increase over 2004.

Sharp drop in vacancy

Meanwhile, 2005 is going out with a boom. In addition to lofty sale prices, operating margins are beginning to show signs of life. Average asking rents increased by 1% to hit $950 in the third quarter, according to New York-based Reis. With some apartments falling out of the rental pool due to condo conversions and more renters priced out of the home buying market, the national apartment vacancy rate dropped from 6.4% to 5.8% between the second and third quarter, the largest quarterly drop that Reis has measured since it began tracking the apartment market in 1999.

“The combined impact of strong net absorption, the removal of competitive units through condo conversion and the limited addition of new inventory resulted in a large reduction in vacancy,” says Lloyd Lynford, CEO of Reis.

Some 38,200 vacant rental units were leased during the third quarter, according to Reis, well above the 9,200 units that were absorbed in the second quarter. But that third-quarter number may be understated by as much as 20% due to condo conversion activity that has removed units from the inventory, says Lynford.

Beneficiary of rising rates

Rick Campo, CEO of Houston-based Camden Properties Trust, anticipates that 2006 will be a moderately strong year. The REIT, which owns 66,446 units in the Sunbelt and Midwest regions, is expecting to rack up its first gains in net operating income per unit in three years.

Campo is encouraged by what he sees in the surrounding single-family home markets: Rising mortgage rates and inflated prices are preventing many tenants from becoming homeowners. About 24% of the Camden tenants who departed when their leases expired in June bought homes, he says. In October, that figure dipped to 17% — and Campo expects it to drop even more next year.

“The question is: Can the next few years be as good as the past year?” asks Campo. “Maybe not, but we expect 2006 to bring decent growth.”