A market in recovery.

More signs of rental housing market recovery are appearing. Rental vacancy rates have dropped, and rent increases are more positive than in the previous years. Most important is that the renters' share of households appears to have bottomed out and house hold growth has strengthened, having increased by 1.6 million in the last five quarters versus 500,000 in the five quarters prior. And the labor markets have improved markedly.

Vacancy Rates Decline. The sharp declines in rental apartment vacancy rates ended in third quarter 2005, but this was in a series that is not seasonally adjusted. Same quarter to same quarter changes still show a downward trend. The rental apartment vacancy rate was 10.8 percent in the third quarter of this year versus 10.2 percent in the second quarter, but down from the 12 percent rate for third quarter 2004. The improved job market and household growth is supporting an increase in occupancies despite the record level in the homeownership rate. And both should support further improvement in occupancies in 2006. The apartment vacancy rate almost certainly will be less than 10 percent by the end of next year.

Net Effective Rents. Net effective rent increases have been flat. They have risen at a 3 percent annual rate for more than a year. The rate of increase, however, is up from the 2.5 percent rise experienced from 2002 until the middle of 2004. NOI's appear to be improving and this will reverse the six-year drop reported in NAA's Survey of Income and Expenses in Rental Apartment Communities.

Rental Households Increase. Homeownership rates may have peaked, evidenced by an increase in renters' share of households in the second and third quarters of this year. Renter households had fallen in the previous 10 years. The long period of declines in mortgage interest rates that reached 40-year lows in 2004 and unfavorable demographics for the rental market produced sharp increases in homeownership rates. Renters' share of total households in turn fell 5.5 percent from 1995 to 2004. It increased 0.7 percentage points over the second and third quarters of this year, and this translates into more than 700,000 additional rental households.

Shifting Demographics. Improvement in the apartment market will be aided by shifting demographic forces. Household growth has improved dramatically. Quarterly growth in households from the same quarter in the previous year jumped from the depressed average of less than 500,000 during the five-quarter period ending in the second quarter of last year. Households increased by an average of more than 1.6 million in the five quarters since then.

The principal reason for increased household growth was employment growth, which permitted unbundling of existing households. More young adults found jobs and were able to move from their parents' homes. Also more persons who had doubled-up with other singles in the tough labor market of 2001 through mid-2004 were able to move out as they found new or better jobs.

Also contributing to household growth is the increasing numbers of young adult Echo Boomers, a demographic that will continue to grow well into the next decade. About 2.1 million more households 25 to 34 years of age should exist in 2015 than exist currently, according to a forecast by the Harvard/MIT Joint Center for Housing Studies (JCHS).

Household growth, in turn, will be strong as long as the current economic upturn maintains strength. The current rate of household growth is not likely to be maintained. JCHS forecasts a strong average rate of increase of 1.5 million annually during the next 10 years.

Condo Conversions. Condo/co-op demand will be driven by the continued aging of Baby Boomer households 55 to 74 years of age, which will increase by more than 10 million during the next 10 years.

Much of the demand for condos/co-ops will have to be met by new construction. RealFacts reported that a survey it conducted found that just more than 100,000 units out of the 2.747 million units in its database are built to condo specs with condo maps in place.

The largest inventory of rental units that could be converted to condos is located in Northern California (nearly 33,000 units). Other large inventories of condo conversions are in Texas (26,600 units) and the region including Arizona and New Mexico (22,800 units.) In Southern California, where the trend toward condo conversion started, few units are left that could go condo quickly.

The combination of modest rent increases and rising home prices encourages owners and developers to convert rental units into condos. Investors, discouraged by weak apartment fundamentals, increasingly began to convert properties to condos to provide opportunities to cash out near the top of a housing boom. Tax policy and demographics are also contributing to condo/co-op demand. Homeowners saw their ability to trade down and avoid capital gains taxation upon sale of their principal residence. Tax laws regarding exemption of gains on the sale of a principal residence were changed effective in 1997. It permitted individuals to sell their principal residence and exempt $250,000 of the gains ($500,000 if married filing a joint return) from capital gains taxation.

An issue exists that threatens the condo market in the near term. Investors are becoming an increasing proportion of the buyers of condos as they see huge increases in values. Many of these investors are solely relying on equity increases to support their condos because rents often may not even cover debt service.

New Construction. Multifamily construction has been relatively stable for the past several years with a range of 328,000 to 345,000 units. A 352,000-unit total is anticipated for 2005. Significant changes have occurred within the multifamily construction sector. Rental unit starts have declined during the past three years while condo/co-op starts have jumped from 77,000 units in 2002 to an estimated 155,000 for this year. Total multifamily construction in 2006 should be little changed from this year.

A 6 percent rise in rental unit starts and a 6.5 percent decline in condo/co-op activity are expected. Condo/co-op starts will moderate as a result of rising mortgage interest rates and a distinct moderation in the increase in their values. An adjustment is inevitable, but it will be moderate in light of strong potential demand for the longer run. Rental unit construction will improve in response to a cooling of the for-sale market and a relatively strong labor market.

Robert J. Sheehan is NAA's consulting economist. He can be reached at 703/491-7377 or [e-mail].

Changes in Households from Same Quarter a Year Earlier

2003
1st             987
2nd             531
3rd             342
4th             518

2004
1st             463
2nd             591
3rd            1371
4th            1688

2005
1st             188
2nd            1784
3rd            1312

Source: U.S. Department of Labor

Note: Table made from bar graph.

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