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Southern Comfort For Apartment Investors

Major cities like New York, Washington and Los Angeles have typically lured apartment investors for one simple reason: It costs so much to buy homes in these markets that demand for rental apartments is always strong.

But the same dynamic may be rippling across several Southeastern apartment markets, where it seems that news of the deflating real estate bubble has not reached and prices of single-family homes continue to rise at rates that outpace the national average. As a result, Merrill Lynch analyst Steve Sakwa believes that apartment REITs with core Southern portfolios should continue to outperform their peers.

“Many of the 19 markets [out of the 48 we track] that saw stable or rising single-family homes prices in the fourth quarter are located in the south, including markets such as Tampa, Orlando, Houston, Nashville and Raleigh,” says Sakwa, adding that monthly data from the National Association of Realtors (NAR) supports his opinion that southern states are exhibiting relative strength.

In February, for example, existing home sales in the region were up 3.1% year-over-year, versus a 0.3% drop in the national rate. The median sales price of existing single-family homes was up by 11.7% in the Southeast, higher than the 10.6% gain for the entire nation. At the same time, with 30-year mortgages reaching 6.53% last week (the highest level since July 2002), more southerners may choose to rent rather than buy.

One Southeastern market where this scenario is playing out is in Fort Lauderdale, which in the first quarter moved up from ninth to first place percentage gains in effective rents among the 69 markets that Reis Inc. tracks. The beachfront city, one of south Florida’s hot real estate markets, saw effective rent gains of 2.8%. Not surprisingly, Palm Beach, Miami and Tampa locked in second, third and fourth place respectively. Palm Beach and Tampa also saw their apartment vacancies fall by 40 basis points (second to only San Francisco and Seattle, which posted 50 basis point declines).

Investors are paying attention. For example, small-cap apartment REIT Mid-America Apartment Communities (MAA), which owns a Southeastern portfolio concentrated in Florida, got a big boost last week when it guided analysts to a higher range for the first quarter by a nickel (to between 82 cents and 85 cents per share). It cited higher property revenues and increased occupancy rates, particularly in its Florida holdings. On Wednesday, the day after MAA raised guidance, shares rose 5.8% to hit $54.30. MAA wasn’t alone, either. Apartment REITs posted an average gain of 1.9% last Wednesday versus a 1.3% gain for the Morgan Stanley REIT (RMZ) index. Apartment REITs also posted a strong weekly gain of 5.7% that outperformed the RMZ by 205 basis points. The group was up 18.05% (total return) for the year at the end of last week. United Dominion Realty Trust (UDR) posted same-store rental income and fee growth of 5.1% during February, according to Merrill Lynch, and strong gains in southern markets such as Orlando, Tampa, Houston, Austin and Atlanta helped drive that growth.

Parting Shot: Another trend line that apartment investors should watch closely is conversion activity, which has added strength to the rental market by eliminating inventory. If the first quarter was any indication, the conversion slowdown that began last October has carried into 2006: Reis Inc. reports that roughly 30,000 apartment properties were converted into condos during the fourth quarter of 2005, down from 50,000 in the third quarter.

Preliminary estimates for the first quarter suggest that the number of conversions dropped to the lowest level since 2004 — about 12,000 total conversions. “Whereas conversion activity reduced the overall stock of multifamily housing in 2005, investors should be mindful of how a shift in conversion patterns in 2006 might impact the supply of rental apartments,” says Lloyd Lynford, CEO at Reis Inc.

Now, there is another risk for apartment investors: so-called re-conversion. This is when units that were converted to condos go unsold, forcing converters to throw their properties back into the rental market. It’s impossible to find accurate figures on the number of condos that have reverted back into apartment buildings, but Lynford says that the phenomenon increases the risk that the rental unit supply will grow faster than construction pipeline levels suggest.

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