Annual starts of multifamily buildings containing five or more units have not fallen significantly below 300,000 for a decade, but that will change this year. Multifamily starts in five-plus buildings will sink to 245,000 by the end of 2008, forecasts the National Association of Home Builders. That's the fewest number of starts since 1995, largely due to the condo market reeling from the housing downturn.

The forces behind these changes are generally the same ones affecting for-sale housing. After four years of a housing boom driven by low interest rates, the residential climate once marked by easy availability of credit and a proliferation of new mortgage instruments is experiencing a dramatic correction.

During four years of condo mania, sales were driven by first-time buyers who found multifamily for-sale units to be an affordable alternative to single-family homes. At the same time, second-home buyers and empty nesters were buying up luxury condos in both urban areas and resort locations.

Since multifamily projects have a two-to-three-year lead time, they are unable to respond quickly to changes in demand. As a result, completed condos began selling faster and at higher prices. The demand encouraged both new construction and conversions from rental to for-sale units. Builders tried to produce for-sale units whenever possible.

But developers stretched the concept of “whenever possible” to its limits. As a result, the built-for-sale share of total multifamily starts rose from about 20% in 2000 to nearly 50% at the market peak in 2005. As recently as the first quarter of this year, 39% of multifamily starts were planned for sale. Unfortunately, the fast sales and the quick appreciation not only encouraged production, it also attracted investors to the market.

It is never quite clear what ends a speculative spiral. In the case of the housing boom, the combination of higher housing prices and higher interest rates seems to have been the catalyst. Rising interest rates, together with the rapid rise of housing prices, were sufficient to reduce demand for housing.

As such, multifamily projects were particularly hard hit when housing demand weakened. Now as the inventory of condominium units remains high and the rental market has shown some strength, many condo projects are being recast as apartment projects.

There is no comprehensive measure of condo conversions, but Real Capital Analytics tabulates sales of a large percentage of rental properties to condo converters. Its monthly “Capital Trends” report for June 2007 showed more than $1 billion in condo conversion sales — sales of properties being converted into condos — involving 4,700 units so far this year.

However, there have been even more units involved in reversions, with 5,225 condos being converted back to apartments. Real Capital's tracking of reversion units since the end of the condo boom in 2006 shows that 75% of the projects were sold back to rental operators for the same or a higher price.

Still, even as the condo share of multifamily production subsides, a large number of condos are in the production pipeline. As recently as last year, multifamily condo starts exceeded multifamily condo completions, a situation that has prevailed since 2002. Given softness in condo prices and a rebound in apartment rents, it is hard to know whether supply is being constrained enough for the condo market to have bottomed out.