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Shadow Space Hurts Apartment Market

Apartment building sales braked in the first quarter of 2007, and analysts predict that after a dizzying climb in investment activity over the last six years, the total dollar value of transactions in 2007 will dip. The so-called shadow market of unsold condos and houses competing for renters is having a strong effect, slashing demand for traditional apartments, say some experts.

The shadow market's impact has already been dramatic, asserts Ron Witten, president of Dallas-based Witten Advisors LLC, a multifamily consulting firm. “It would appear to us that rental demand is probably less than half of what it would normally be given the pace of the growth of the economy. It looks like this other housing competition is draining at least half the demand,” Witten says.

Nationally, the number of excess housing units outside the apartment market totals more than one million, including 300,000 excess single-family homes for rent, and an inventory of 600,000 excess houses for sale, which could become rentals, as well as 150,000 additional condos languishing unsold on the residential market, Witten says. While many available houses and condos were owner-occupied, others were bought by investors specifically to be rented, he adds.

In the first quarter of 2007, about $20 billion in apartment transactions were recorded in the U.S. compared with $26 billion in first-quarter 2006, according to data researcher Real Capital Analytics. That's a 23% drop year over year. The U.S. Census Bureau reports that the 196,000 privately owned housing units completed in May 2007 represented a 22.5% drop over the 253,000 completed in May 2006.

“It looks like we'll see transactions decline from 2006,” when annual volume reached $90 billion, says Mark Obrinsky, chief economist for the National Multi Housing Council, but the number of deals will still be high compared with five years ago.

To say that the last five years have been a seller's market would be a gross understatement. The total value of apartment transactions has nearly quadruped over that stretch, rising from $23 billion in 2002 to $51 billion in 2004 and $90 billion last year.

“The big wild card is what people call the ‘shadow’ rental market, the for-sale housing units that might come into the rental market,” Obrinsky observes.

NMHC's ranking of the Top Multifamily Owners reflects changes in the marketplace, though the leaders remain familiar. AIMCO, based in Denver, is still ranked No. 1, but Baltimore-based MMA Financial LLC moved up from third to second place. Equity Residential dropped a notch to third in the rankings. The list contains a few surprises. American Management Services of Seattle, doing business as Pinnacle, climbed from 21st place in last year's survey to 14th this year.

Occupancy climbs

Meanwhile, the apartment industry's 18 million investment-grade units, mainly properties containing at least 50 units, are 95% occupied, Witten says, indicating a healthy market. He expects further industry adjustment for the rest of 2007, as competition from non-apartment housing stays intense.

National figures available from Reis, a real estate research and consulting firm, show that about 545,000 of the nation's investment-grade apartment units were vacant in 2006, while 8.7 million were occupied. For 2007, the projected number of vacant units is about 578,000, while the number of occupied units is expected to climb to 8.8 million units. Effective rents have been climbing from $930 in 2006 to a projected $967 in 2007, according to Reis.

As for sales, the NMHC index, which tracks apartment property sales, dropped to a score of 38 in April, down from 41 in January and a robust 66 in July 2005. An index reading above 50 indicates increasing multifamily sales; an index below 50 indicates decreasing sales volume. NMHC economists anticipate high, though not record, sales and improving demand for apartment rentals later in 2007.

Encroachment from the shadow market is hard to gauge, says Paul Emrath, an economist at the National Association of Home Builders in Washington, D.C. “You don't see the breakdown right away.”

A recent rise in interest rates could cause cap rates on apartment properties to climb after years of compression. The benchmark 10-year Treasury yield rose to 5.25% in early June, far above May levels, before dipping again. Sustained interest rates of 5.5% or higher could have a negative effect, Obrinsky anticipates.

Still, Hessam Nadji, research director at Marcus & Millichap, a real estate investment services firm in Encino, Calif., isn't worried. The market is transitioning after a period of robust rental growth to a more normal market, he says. “We're still seeing a pretty healthy supply and demand.”

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