Sometimes averages are a lousy performance indicator. That's particularly true of the national apartment sector, where a 5.8% vacancy rate and rental growth that is outpacing the rate of inflation suggest investors are well positioned for healthy returns.

That's little solace for investors in Palm Beach, Fla., where sales of multifamily assets have fallen 82% over the past year and landlords have lowered asking rents to woo tenants. Apartment owners in Florida and a few other markets across the nation have watched with dismay this year as strong tenant demand and rent growth gave way to mounting vacancy rates.

The culprit? Investors unable to achieve desired sale prices for excess single-family homes and condominiums are offering those units for rent. This shadow space is stealing tenants from professionally managed apartment complexes. Vacancies in Palm Beach, for example, have skyrocketed a whopping 280 basis points in the past year to 7%. In Orlando, the drain of tenants pushed the vacancy rate to 6.2% in the second quarter, up 140 basis points from a year ago, according to data researcher Reis.

It's a stark contrast from the explosive rental growth occurring in New York, Minneapolis and many West Coast markets, where the supply of apartments lags demand and rents are up more than 7% over the last year. As individual metros respond differently to the slowing economy and the slumping single-family home market, some investors are enjoying higher demand for apartments while others watch rent rolls dwindle.

Balanced between these performance extremes, the national vacancy rate offers little insight into the drama unfolding in individual markets. “Vacancies at the national level are at the lowest point in over five years,” says Michael Cohen, research strategist at New York-based Property & Portfolio Research. “But when you peel the onion back a little bit, you begin to see how it is a metro-by-metro story at this point.”

For investors trying to identify apartment buying opportunities or decide the ideal time to sell, the variety of indicators can be confusing. “There's not a lot of consistency of theme as to which markets look really good and which don't,” says Ron Witten, president of Dallas-based multifamily advisory firm Witten Advisors LLC. “Investors need to have a realistic understanding of how their particular markets are going to perform because not all markets are following the same pattern, or are subject to the same problems.”

Under the shadow

The problem causing the most pain right now is shadow space. This quasi-rental inventory doesn't affect all markets and is difficult to track, but it is likely the single most under-appreciated driver of multifamily fundamentals today, Witten says.

There are approximately 1 million to 1.5 million excess empty residences in the U.S. today beyond what is typically carried in the market, including everything from single-family homes and condos to multifamily rentals, Witten estimates. It is unclear how many of those residences are contributing to shadow rentals.

In addition to depleting the pool of renters for mainstream apartments, the shadow market also inhibits rental growth. That's because investors may only charge enough rent to cover their own holding costs while waiting for the sales market to revive. For apartment managers, it's difficult to raise rents on new leases with so many residences available below market rates.

That explains why asking rents dropped from the first to second quarters in several Florida markets, falling 0.5% to $1,110 per unit in Palm Beach, and dropping 0.1% to average $1,106 in Fort Lauderdale, according to Reis. Asking rents nationally in the second quarter rose 1.1% over the first quarter and climbed 4.2% over the past year.

It's no surprise that problems arising from the excess condominiums are concentrated where their development was most prolific. In nearly every Florida market, vacancy rates rose by a full percentage point or more at mid-year over the same period in 2006. “The shadow inventory is able to compete very aggressively and is constraining rent growth in Fort Lauderdale, Palm Beach, Orlando, Jacksonville,” says Sam Chandan, chief economist at Reis.

Orlando suffered the most rapid change as its vacancy rate rocketed 90 basis points to 5.2% in the second quarter from 4.3% in the first quarter, according to Property & Portfolio Research, which tracks different properties than Reis.

“The poster child for a market that has seen a precipitous change in fundamentals is Orlando,” Cohen says. Property & Portfolio says Orlando's vacancy rate has climbed 160 basis points in the past six months and will likely exceed 6% by the end of this year.

No sale

In Florida, spiking vacancy rates have crippled multifamily sales. In Miami,second-quarter sales by dollar volume fell 63% from a year ago to $340 million, according to Real Capital Analytics, which tracks deals $5 million and higher. Meanwhile, in Orlando the sales volume dropped 64% to $457 million during the same period.

Vacant apartment units lead to reduced cash flows for owners and ultimately lower sale prices and transaction volume. The volume of apartments trading in Tampa registered $442 million in the first half of 2007, down 59% from the first half of 2006, according to Real Capital Analytics. In Miami's Broward County, volume was $315 million for the first half of the year, down 60% from a year earlier.

Brokerage Marcus & Millichap has noticed a sharp decline in Florida deal volume, even though the company's sales activity at the national level is slightly ahead of last year. The firm's big-ticket transactions of $20 million or more in Florida amounted to about $100 million during the first seven months of 2007 compared with roughly $300 million during the same period last year, according to Linwood Thompson, managing director of the national multihousing group at Marcus & Millichap.

“Our business in Florida this year compared to last year is off about 60%,” Thompson says. “But not all of that is due to the shadow market.”

Rising operating costs have compounded vacancy problems in Florida. Those higher costs include increased taxes and property insurance rates that have more than tripled in the wake of recent hurricanes from about $450 per apartment unit to as much as $1,800.

By comparison, Marcus & Millichap's volume of deals valued at $20 million or more in Southern California totaled about $970 million for the first seven months of 2007, 3% less than the $1 billion volume the company racked up in the same period last year, Thompson says. The company's overall deal volume is up due to accelerating deal volume in Texas, Arizona and Midwestern markets.

And in the other corner…

Shadow space is only a concern in markets that experienced overbuilding of single-family homes and condos, or extensive conversions of apartments to condos. Fundamentals in many markets unaffected by shadow inventory are still improving, and in some cases, dramatically. Denver's vacancy rate fell 60 basis points to 7.8% in the second quarter. In California's Bay Area, which is experiencing strong demand amid a resurgence of information technology jobs, vacancy rates fell 50 basis points from the first to the second quarters to tally 3.9% in San Jose and 4.4% in San Francisco.

Dwindling vacancy rates are empowering managers to boost rents in the Bay Area. San Jose's asking rent climbed 2.4% to average $1,473 per unit in the second quarter, while asking rents in San Francisco climbed 3% to average $1,757, Reis reports.

Sales volume in San Francisco of $390 million in the first half of 2007 was down 15% from a year ago, although the total number of deals was up 27% with 28 properties trading, reports Real Capital Analytics.

Extremes in Florida aside, individual market performance seems to defy logic. Houston's vacancy rate of 7.6% at midyear was up 160 basis points from a year ago, while Dallas' 7.7% vacancy showed marked improvement of 30 basis points from a year earlier, and a decline of 50 basis points from the first quarter this year, Reis found. “Depending on what's going on with the demand side and the supply side in each of these markets, the [economic] transition is playing out in very different ways,” says Chandan, the Reis economist.

Against this backdrop of conflicting performance indicators, vacancy at the national level is trending upward even in markets without exposure to shadow space. In the second quarter, vacancy rates climbed in 29 of the 54 U.S. markets tracked by Property & Portfolio Research. The data provider expects that trend to push the national multifamily vacancy rate upward in the second half of 2007.

Meanwhile, the demise of subprime mortgages will help to increase the number of renters by removing the means for some households to buy a home, according to Mark Obrinsky, chief economist at the National Multi Housing Council.

On the negative side, sliding home values contribute to shadow space. Job losses in the housing industry and a slower economy in general may also discourage the formation of renter households as people cut spending by taking in roommates or live with family members.

Construction is the wildcard for the multifamily industry in the near term. Conversion of apartments to condos removed enough apartments from the national inventory to more than offset new construction in 2005, according to Reis. In 2006, the net increase in apartments was a modest 11,000 units.

Census Bureau data suggests apartment construction is slowing, but without condo conversions to remove inventory, the number of apartments in the U.S. will swell by 100,000 this year, researchers say. That's one of the reasons Reis has projected vacancy rates will increase from the current 5.8% to about 6.2% in 2008 and 2009. With increasing demand, vacancy rates will trend downward in 2010 and 2011, Reis predicts.

Indicators positive in long run

Beyond the short term, demographic trends bode well for apartment demand, says Hessam Nadji, managing director of research services at Marcus & Millichap. Echo Boomers are entering their 30s between now and 2015, boosting the renting-age population by 5.5 million. Immigration is expected to add another 12 million potential renters.

That should translate into an additional 4.3 million rental households, creating demand for about 430,000 new rental units each year for the next 10 years, Nadji says. “We're going to see a normalization of the market from a frenzied peak in 2006. That's going to be driven by the quality of product and the quality of individual markets, rather than the tide rising all boats. That's a good thing,” Nadji says.

When will this increasing demand begin to firm up apartment fundamentals? It's already happening in some markets where shadow space isn't a problem and new construction is limited. In Portland, for example, slow but positive job growth is lowering vacancy rates and boosting rents. In cities struggling with shadow rentals, it will take one to two years for buyers to absorb excess homes and relieve the upward pressure on vacancy rates.

The key for investors is to understand that individual markets will perform differently — sometimes radically differently — than national trends. Responsible investors will match their expectations to changing conditions at the local level, says Cohen of Property & Portfolio Research. “Investors need to understand where these markets are going and underwrite appropriately.”

Matt Hudgins is based in Austin.

MULTIFAMILY'S OPPOSITE EXTREMES

The healthiest apartment markets enjoy strong fundamentals, rent growth and job formation. The most challenged markets currently suffer from a glut of shadow space slow to burn off.

Top Five Healthiest Markets

  1. New York
  2. Seattle
  3. San Francisco
  4. Oakland
  5. Orange County

Top Five Most Challenged Markets

  1. Palm Beach
  2. Jacksonville
  3. Houston
  4. Phoenix
  5. Orlando

Source: Marcus & Millichap