Apartment REIT stung by rate-spurred exodus. (Who's Who in Real Estate: The Ins and Outs of L.A. Homebuilders).

AVALONBAY Communities Inc. Chairman Bryce Blair expected renters would stay put during the recession out of fear they would lose their jobs, so the developer kept building apartments.

Things didn't work out that way.

Mortgage interest rates as low as 5.2 percent induced tenants to become homeowners, leaving developers with too many empty apartments. "The economy eroded more than anyone expected and the recovery continues to be pushed out," said Blair. The Alexandria. Va.-based developer is starting half as many new apartment buildings this year as last.

The record low rates and an apartment glut are cutting profits for developers, from the biggest publicly traded apartment owner, Equity Residential, to one of the smallest, Associated Estates Realty Corp.

U.S. rental vacancies rose to 6.8 percent in the first quarter, the highest since 1989, and rents were unchanged, according to researcher Reis Inc.

Developers built apartments on the assumption that jobless renters would put off house purchases as they did in the 1990-91 recession. With monthly payments cheaper than some rents, 2002 home sales rose to a record 5.56 million last year.

Apartment developers will complete more than 208,000 units this year in 60 major U.S. markets, 1.4 percent more than the 205,000 built last year, Torto Wheaton Research estimates. Permits fell 3 percent to 327,000 units in May on a three-month trailing average, according to Citigroup's Smith Barney division.

While the market for apartment leasing in L.A. remains quite strong -- the county had a first quarter vacancy rate of 5.1 percent -- AvalonBay's local efforts have been stymied.

The developer has been mired in fights for two properties it wanted to acquire for large projects. Its desire to buy a Valencia golf course for a 216-unit project ran into community opposition in 2000. It also suffered a setback last year when an L.A. Superior Court judge ruled the city should not have rezoned land in the Del Rey Business Park in Marina del Rey for residential use. AvalonBay had proposed building a 309-unit apartment complex on 4.5 acres, a plan opposed by businesses in the 150-acre industrial area.

AvalonBay is under contract to buy a Ventura Boulevard site just east of Hayvenhurst Avenue, working on entitlements for a 170-apartment mixed-use facility with ground floor retail at the site.

Home sales rise

"It's a really, really difficult environment for multifamily housing," said Michael Torres, chief executive of Lend Lease Rosen, which manages $1.5 billion, including shares of real estate investment trusts devoted to apartments.

Demand for houses has been one of the few bright spots in the economy. The lowest interest rates in more than four decades boosted existing home sales 21 percent since 1999 -- as consumer sentiment measured by the Conference Board plunged 43 percent.

Employment last year fell 0.9 percent and will increase 0.4 percent this year, according to RBC Capital Markets. A slower-growing economy will delay the apartment industry's recovery to the second quarter of next year from the fourth quarter of this year, RBC said.

For the rental market to remain in balance, the economy needs to create five to seven new U.S. jobs for every apartment unit built. Instead, three jobs are being lost for every unit built, said Christopher Hartung, a real estate analyst at WR Hambrecht + Co. U.S. employers have eliminated 289,000 jobs in the past four months and the unemployment rate climbed to 6.1 percent in May, the highest in almost nine years.

"If you look at multifamily housing supply we're getting now, it's in line with what we got in the late '90s, when we had meaningful job growth," said Andrew Rosivach, an analyst at US Bancorp Piper Jaffray. "We're getting new supply while job growth is lower."

Demand has been hurt further by renters who can't afford to buy and are sharing apartments with roommates or moving back home. Publicly traded developers build about 10 percent of new rental units, while the rest comes from closely held companies such as JPI, Trammell Crow Residential and Irvine Co.

Lower earnings

Earnings for apartment real estate investment trusts fell 14 percent in the first quarter, the weakest performance of all real estate investment trust types, according to Smith Barney.

Earnings for 2003 will slide 11 percent, Smith Barney projects. AvalonBay's first-quarter earnings declined 17 percent to $57.5 million from the year-earlier quarter. Equity Residential's earnings slid 12 percent, to $168.6 million, and Associated Estates fell 46 percent to $3 million.

The companies' shares have lagged the market. Associated Estates shares have fallen 4 percent this year, AvalonBay's shares have risen almost 11 percent and Equity Residential 10 percent, all behind the 15 percent climb in the Standard & Poor's 500 Index in that time.

Apartment developers must contend with the growing appeal of home ownership. U.S. housing affordability rose to the highest level in three decades during the first quarter, according to the National Association of Realtors. A family with the national median income makes 44 percent more than needed to buy a median priced home, which was $161,500 in the first quarter.

The national home ownership rate has risen almost 4 percentage points to 68 percent since 1993, according to the U.S. Census Bureau. Home ownership may climb to 70 percent in the next five years, said Douglas Duncan, an economist at the Mortgage Bankers Association.

Landlords are reducing rents or offering one month or more free to draw renters. Equity Residential increased spending on such concessions by $3.7 million, or 42 percent, in the first quarter from the year before. Concessions were offered in about 33 percent of apartment markets at the end of last year, up from 28 percent of markets a year earlier, according to RBC.

"The biggest negative is we've not been able to increase rents," said Glade Knight, chairman and chief executive of Cornerstone Realty Income Trust Inc. That stands in stark contrast to declining home sales in the recession of 1990-91, said Banc of America analyst Lee Schalop.

"I've never seen a cycle like this," said Jeffrey Friedman, chairman and chief executive of Richmond Heights, Ohio-based Associated Estates, who has been in the business for 25 years.

Lower rents haven't persuaded some renters to stay put. Dau-Fan Wang and her husband are buying a three-bedroom condominium in Palo Alto, California, after renting a one-bedroom apartment in the city for the past three years. The timing was right because interest rates probably won't go any lower, Wang said. "It doesn't make sense to rent anymore," said Wang, 27, a pharmacy technician.

As renters buy houses, publicly traded developers such as AvalonBay are building fewer apartments, and are more careful about which areas they choose, Blair said. Associated Estates has no plans to start building as it wraps up development of apartments in Atlanta and Orlando, Friedman said.

Closely held Trammell Crow Residential plans to build about 4,000 units this year, about half the level in 2001, said Kenneth Valach, an executive managing director. "We're suffering in almost all markets across the country," he said.

For developers like AvalonBay, that's meant dropping old assumptions. Typically in a recession, "people want to save and not buy homes," Blair said. "This time, they've gone out and bought cars and houses."

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