Call it a case of overconfidence. Apartment developers, optimistic about the long-term health of the sector, continue to build new units at a robust clip despite a vacancy rate that has doubled in the past three years. Analysts say their exuberance may be warranted over the long haul, but it will hurt the sector in the short term by causing vacancy rates to spike further in 2004.

“The construction levels are merely going to exacerbate the existing oversupply situation for the short term,” says Andrew Wright, a senior consultant at Reis Inc., a New York-based research firm. A total of 106,647 units are expected to come on line in the top 50 markets this year followed by 103,358 units in 2004, the company reports.

Although the projected rate of construction is substantially lower than the 163,069 completions in 1999, that's still too much new supply for a market that experienced two straight years of negative absorption in 2001 and 2002, Wright says.

The number of vacant units in the top 50 markets has more than doubled in the past three years, from a total of 226,815 at the end of 2000 to 514,707 as of the third quarter of this year, according to Reis.

“You've got so much new supply coming on line, it's just flooding markets that are already saturated,” Wright says. “We don't see a level of demand that is going to meet or exceed the level of construction.”

Due to the combination of soft demand and a growing apartment stock, Reis predicts the national vacancy rate will grow to 7% by the end of 2004, up from 6.8% at the end of this year, and then decrease slightly in the following three years as declining construction levels give markets an opportunity to absorb the vacant space.

Colliding Forces

Economic trends have converged to erode demand for apartment units. The pool of prospective renters has shrunk considerably due to the loss of 2.7 million jobs since March 2001. At the same time, historically low interest rates have enticed renters to become first-time homebuyers.

Despite rising vacancy rates over the past few years, developers eager to capitalize on the cheap cost of capital have rushed to obtain construction loans before interest rates rise. Although their goal is to capitalize on the next upturn, analysts and company executives say their timing may be premature, if their apartments open as early as next year.

“The large inventory out there is going to be challenging,” says Stan Harrelson, CEO and president of Seattle-based Pinnacle Realty Management Co. “I think there will be a series of small steps in 2004 rather than a full recovery.”

Linwood Thompson, managing director in the Atlanta office of Marcus & Millichap, emphasizes that owners and developers have reason for optimism. They're willing to build and acquire apartment properties during the downturn because of the industry's strong track record. Long-term demographic trends are in the industry's favor because the number of households 25 to 34 years old, considered the prime rental prospects, is expected to rise by 584,000 between 2006 and 2010, according to Boston-based Property & Portfolio Research. “Owners are saying, ‘Now is the time to buy in and get myself in position for the next bull run,’” says Thompson.

Financial Crunch

The long-term outlook may be promising, but many apartment owners today face declining revenues. Chicago-based Equity Residential, which owns 990 properties nationwide, reported a 1.9% decrease in net operating income (NOI) in the third quarter vs. the same quarter last year, with income plummeting 7.4% at its properties in Phoenix and 5.6% in Atlanta.

Denver-based United Dominion Realty Trust, which owns 260 apartments in the U.S., sustained revenue declines in eight out of its 10 top markets in the third quarter, including a 4% decline in NOI in Richmond, Va. However, the stock prices of both companies have increased since the start of the year.

On a national level, there have been some encouraging developments this year. After two consecutive years of negative absorption, there was positive absorption in both the second and third quarters of this year, and Reis forecasts 57,062 sq. ft. of absorption by the end of the year.

In addition, the national vacancy rate declined by one-tenth of a percentage point to 6.6% in the third quarter compared with the previous quarter, Reis reports, marking the first time that the vacancy rate has decreased since the third quarter of 2000.

The trends, Thompson notes, indicate there may be modest improvement in 2004 followed by steady increases in rental rates and occupancies in 2005 as an improving economy generates job growth.

“I'm not bullish on 2004,” Thompson says. “But I'm optimistic about the next bull run, and I think we're getting closer to it.”