The condo market is hot. Sales of condos and co-ops have reached record levels, and prices continue to climb. Traditionally, rental providers have viewed condos as competition since condos have historically offered a lower-cost alternative for renters to become owners. But the recent surge in condo demand has caused many apartment firms to take a new look at this sector and adjust their business plans to take advantage of it.

Some firms are analyzing their portfolios to find prime candidates for condo conversions. Some are starting for-sale divisions to develop new condo properties from the ground up. With condo converters paying more for apartment properties than rental firms, many are actively marketing properties to converters. All this activity has apartment firms wondering just how big the condo market is.

A National Phenomenon

One might expect condo demand to have dropped as lower mortgage rates and low down payment requirements made single-family homes more affordable in recent years. But the reverse has happened. Condo demand is up, at least when measured by the number of condo purchases.

According to the National Association of Realtors, condo purchases averaged less than 200,000 annually in the 1980s. That figure increased to 500,000 per year in the 1990s, and over the last three years it has escalated to more than 800,000. In the second quarter of 2004, annual condo sales reached nearly 1 million. To put this in perspective, condo sales, which accounted for 6% of home sales in the 1980s, now comprise 13% of home sales.

Unlike prior condo booms, which were more geographically concentrated, this time the increased demand is occurring nationwide. Over the last three years, all regions have reported increases in condo purchases of 55% to 75%.

As a result of this increasing demand, condo supply also is on the rise. Between 1993 and 2003, the condo stock increased 17%; it is up 75% since 1983. Condos now comprise 12% of all multifamily stock, up from 9% two decades ago. That said, they still remain a niche sector of the multifamily industry. There are just under 2 million owner-occupied units in multifamily buildings with five or more units, compared with 14.5 million renter-occupied units in properties with five or more units.

Condo Conversions on the Rise

The new condo demand is being met, in large part, by the conversion of rental apartments (as well as hotels and other non-residential real estate) instead of new construction. Unfortunately, there are no comprehensive national statistics on condo conversions, much less a long historical record.

Some recent data, however, does point to a pickup in conversion activity. For example, Real Capital Analytics reports that of the investment-grade apartments it tracks, the number sold to condo converters has risen from 6,000 in 2002 to 16,000 in 2003. Current trends for 2004 could put that number at 42,000 units. Through August 2004, more than 28,000 units were bought for conversion.

That means that conversion activity is adding at least as many units to the condo supply as new construction, and possibly more since the figures do not include all conversions (for example, conversions of small properties, non-investment grade apartments and non-residential real estate are excluded).

Supply-Demand Imbalance

By any measure, the increase in condo purchases has outstripped the increase in condo supply — both new construction and conversion. It is hardly surprising, then, that condo prices have been on the upswing in recent years. As the chart above shows, condos hardly looked like a good investment in the early 1990s. The median condo sales price in 1995 was 2% higher than the 1989 price.

Between 1995 and 2000, condo prices recovered enough to keep pace with single-family home price appreciation. In the last three years, however, condo prices have soared, substantially exceeding even the rapid increase in single-family home prices. Between 2000 and 2003, the median price of single-family homes rose by 22%. Over the same time period, condo prices rose by 47%.

What is driving condo demand and how long will it last? Condos are hot because of demographic changes, lifestyle choices and economics. The first two factors are likely to persist for some time. More people are deciding that they prefer the convenience of multifamily life. The groups drawn to urban condo living are the groups growing the fastest in the U.S. — young and old childless households and immigrants.

But the third factor already is changing. The more expensive condos get, the better renting looks, particularly since apartment rents have been relatively flat recently. For today's condo buyers, the economics make sense only if prices continue to rise rapidly, which seems unlikely. The other motives should keep demand from cratering, however, which is good news for apartment firms who have incorporated the for-sale market into their business strategies.

Mark Obrinsky is the chief economist and vice president of research for the Washington, D.C.-based National Multi Housing Council.