As unsold homes and apartments invade the rental market, presenting fierce competition for the nation's 18 million units of traditional apartment stock, the industry is weathering the onslaught with the help of government-sponsored enterprises, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Corp. (Freddie Mac).

The agencies are aggressively buying apartment loans in the secondary market while other commercial real estate sectors experience a dearth of capital in the wake of the subprime mortgage crisis and moribund commercial mortgage-backed securities (CMBS) market.

“Occupancies are down a little bit, but it's nowhere near crisis mode,” says Robert White, founder and president of New York-based research firm Real Capital Analytics. “Relative to other property types, apartments are much more in demand by investors.”

Occupancy took a hit in the first quarter, tumbling a full percentage point from 95.2% in the fourth quarter to 94.2%, according to M/PF YieldStar, a research firm based in Carrollton, Texas. Average rents in the first quarter were 3.4% higher than the same period a year earlier.

The 5.8% vacancy rate in the first quarter for apartments marked a four-year high, reports M/PF YieldStar. U.S. Census Bureau figures showed an even higher vacancy rate of 10.7% for buildings with five or more units — a jump of 0.6% from the fourth quarter of 2007.

“That is a meaningful quarterly uptick,” says Greg Willett, vice president of research at M/PF YieldStar. The Census includes properties at the low end of the market, while M/PF YieldStar mainly samples Class-A and B properties.

The burgeoning shadow market of unsold houses and condos undoubtedly figures into the vacancy rate. Single-family homes and multifamily properties with fewer than five units now comprise 60% of the country's rental product, according to the Census Bureau.

Sandstorm in the West

Some parts of the country are hurting more than others. The so-called “sand states” — Florida, Arizona, Nevada and California — have been hit hardest, says White. Earlier, San Diego and Phoenix were among the hottest markets for apartment investors. “That has certainly changed dramatically over the past year.” Nationally, urban properties, those near transport hubs, and student housing have become safe havens for investors.

Meanwhile, property sales have plummeted. The $12 billion deal volume in the first quarter was 67.5% lower than in the fourth quarter of 2007, according to the National Multi-Housing Council.

Not only have sales dropped, but lending volume in some sectors also has been severely affected. The Mortgage Bankers Association reports that multifamily loan originations fell 27% in the first quarter. But loan originations on office and hotel properties fell 75% and 60% respectively.

More good news for multifamily investors: Total returns for apartment REITs year-to-date through June 19 were 13.2%, according to the National Association of Real Estate Investment Trusts, compared with just 2.9% for office REITs.

Further, apartment investors are consummating bigger deals than investors in most other sectors. In March, Denver-based UDR Inc., formerly United Dominion Realty, completed a $1.7 billion sale of more than 25,000 apartment units to DRA Fund VI of New York, in a joint venture with Steven D. Bell & Co. of Greensboro, N.C.

Sticker shock

But even little deals can be pricey. Some investors have been stunned by the soaring cost of agency-backed loans as spreads over the 10-year Treasury yield have risen from 140 basis points to more than 200 basis points.

Properties have held their value, however, because sellers refuse to drop their prices, emphasizes Linwood Thompson, senior vice president with brokerage Marcus & Millichap. “Fewer transactions are closing. But it is dangerous to equate that to a drop in value because that is not happening.”

RCA's White agrees that apartment prices and cap rates have not corrected as much as in other sectors. “Some of my clients are saying cap rates are as low as they've ever been.”

Through 2009, apartment market fundamentals in San Francisco, Salt Lake City, and Oakland are expected to remain strong, according to M/PF Yieldstar, while areas where condos were overbuilt — such as Phoenix, Las Vegas and Atlanta — have lagged.

Today's malaise differs from the devastating correction of the 1990s, Thompson says. “We had vacant buildings throughout Texas. We had the [savings and loan] crisis. Properties were being sold for 50 cents on the dollar.”

Some investors have raised vulture funds to gobble up distressed apartments, Thompson notes. “The reality is, not much of it is happening.”