Building on interest rates: as interest rates price potential homebuyers out of the market, apartment owners stands to gain new residents and higher rents.

Clearly, whether positive or negative, interest rates have always had an effect on apartment ownership and development. During the past 10 years, historically low interest rates have been the driving force behind the nation's real estate market, boosting single-family home ownership and strengthening the market as a whole.

Those rates, and resulting improvements, also played an important role in the status of apartment asset ownership, both for-sale and for-rent. Despite the previous low rates and surge of single-family ownership, the apartment industry did not completely drown. Rather, the rental market took a back seat and is now again rising above water.

Recent changes are also beginning to have an effect on the market. Increases in interest rates for a 30-year mortgage rate managed to reach an average level of 6.8 percent in mid-July, more than 1 percent higher than the 5.73 percent level at the same time last year. The Federal Home Mortgage Corp. said that the last time the rate was higher was in 2002. Although the bubble has not necessarily burst yet, the recent rise in interest rates has resulted in the housing affordability problem rising to a new level.

As such, the housing inventory is beginning to pile up while other vital changes within the real estate industry are also becoming noticeable. Rising market rates, increased inventory and dramatic hikes in construction costs have impacted and will continue to effect real estate litigation, condos and rentals.

Homebuyers Running Scared

Ownership and development of rental units will probably experience the greatest immediate impact of recent trends and downturns in the real estate community. As previously noted, the nation has encountered both rising interest rates and deteriorating housing affordability. Further, condominium conversions that have been carried to fruition have removed a significant portion of rental inventory from the rental market. The upshot is that those ingredients have blended to create a desperate demand for rental units.

At the outset, increasing interest rates have resulted in a huge detriment to potential buyers, especially first-time buyers. Now, not only are houses too expensive, but also interest rates are slowly becoming more and more unfriendly. As a result, most potential buyers are now weary of "getting in" with these seemingly hostile conditions. However, some claim that, relatively, interest rotes remain rather low, especially compared to the soaring rates of the early '90s, which topped 8 percent. Nonetheless, individuals always get comfortable with present conditions and most do not adjust well to change.

As such, potential buyers seem to be running scared from higher rates, as the housing inventory is piling up. As opposed to last year, when buyers were involved in a race to "open houses," now, houses, condos and townhomes are remaining on the market for much longer. Potential homebuyers are now more likely to sit on the sidelines and wait until the conditions fit their fancies and their finances.

What does this mean for apartment ownership and development?

In short, the apartment industry is booming. As an example, new multifamily housing development throughout the San Francisco area has sky-rocketed, including more than a 40 percent increase in new development from the same period last year in certain areas. Also, according to National Multi Housing Council (NMHC) market trends, multifamily permits, starts and completions all increased in first quarter 2006, and may continue to flourish throughout the year. However, other recent studies seem to negate those anticipated trends, as the U.S. Department of Commerce has noted a 15.4 percent decline in apartment construction in July. Nevertheless, increased construction is much needed, as less affordability breeds more renters. Without such development, an even more severe shortage of rental units may result.

Furthermore, existing owners of rental properties are in for some good times, as those who choose to "sit on the sidelines" will be those looking to rent. In short, those who already possess investments or ownership interests in apartment units stand to do well. With mortgage terms tightening, there is a renewed demand for middle-income, market-rate housing. Those owners, developers and builders who can serve people perched on the proverbial sidelines stand to do well in the short-term future.

Also, there is a national expectancy for growth in occupancy and rental rates per unit, clearly meaning expected increases in rental income for apartment owners. In particular, some projections point to expected increases in operating rents topping 3 percent throughout 2006 and into 2007. Therefore, rental properties are in high demand, with speculating investors or existing owners standing on solid ground.

Those areas projected to experience strong population and economic growths provide the best opportunities for investment in apartment assets. With shifting demographics, including immigration, more seniors and Baby Boomers, the future of the rental industry looks bright.

Condo Conversion Market Softens

The once red-hot area of condominium conversions is finally cooling. Only a few years ago, when real estate prices rose significantly, many apartment owners and developers took advantage of the condo conversion craze by converting already-owned apartment units into condominiums. Others bought, converted and "flipped" the same properties for huge profits. Whichever the process, those conversions provided an ample opportunity for the middle-class to "get in" the real estate arena. This trend continued and essentially exploded, with condo conversion being the ideal method for apartment property owners and developers to maximize their investments.

However, it seems as if condo conversion is now either nearing its peak or has already arrived at its plateau. NMHC's preliminary estimates indicate that the number of condo conversions has fallen to its lowest number since early 2004, and many industry researchers see further softening of the market throughout 2006 and into 2007. Furthermore, the market demonstrates a trend in which there is a reversion of those units that have already been converted. In other words, a growing number of apartment units that were planned for conversion are reverting to rentals with sales of the planned condos often coming to a screeching halt.

San Diego is encountering this issue. The conversion craze, initially inspired by motivated speculators or buyers seeking second homes, has taken a significant hit. This impact is evidenced by the fact that the average sale price for condos actually dropped between June and July for the first time in several years. Even more pertinent, city councils in some localities, including Los Angeles, have actually proposed temporary moratoriums on condo conversions to account for the shortage of apartment rentals.

Some markets, however, have not been as effected, and conversion plans remain on course. The degree of softening has shown to largely depend on the economic and population growths of each individual local market. As a result, the effect of these changes may depend on the local housing market. Nevertheless, each owner, developer and builder should be aware of all of these potential consequences.

Hitting the Wall

On a similar note, in certain areas of the country, the gradual shift in housing and interest rates recently have halted condominium construction altogether. For example, initially, a major developer in Portland, Ore., planned construction of a 230-room hotel, 92 luxury condominiums and 20,000 square feet of retail space. However, within the past month, the condominium aspect of the plan has been scaled back "significantly," with a principal from the developer citing the softening condo market and rising interest rates as two of its reasons for the substantial decrease in construction.

A similar scenario is unfolding in Las Vegas. With rising interest rates, construction costs rising through the roof and a softening of the condo market, condominium construction projects right and left are being scrapped in their entirety. Those developers and builders who pinpointed Las Vegas as a gold mine for condo construction have hit a wall, with buyers backing out at a considerable rate.

Those are just a couple of examples of the potential effects that the combination of a flattening housing market and increased interest rates may have on condo plans already in the works. The "NMHC Market Trends" echoes this concern by warning that the condo demand might have passed its peak, meaning that condo starts are likely to retreat in the near future. Many properties originally planned for condominiums, and that are still in the construction phase, are now being utilized as rentals as an answer to the slowing condo market.

However, in certain areas enjoying ongoing economic and population growth, including Tucson, Ariz.; Seattle; and Portland, Ore., condo construction has been relatively unaffected, with sales expected to remain headed in a positive direction. Once again, the potential effect might differ with respective market variances.

The information contained in this article is not to be considered legal advice, and does not constitute a complete review of all potential issues that might arise in these situations, The author strongly recommends that you consult with legal counsel regarding these issues before undertaking them.

By MORGAN A. STEWART, ESQ.

RELATED ARTICLE: Husing climate could increase litigation.

Historically, a softening real estate industry and increased interest rates have resulted in increasing litigation. Although seemingly counter-intuitive, a closer inspection reveals the obvious without reaping huge benefits of appreciating property, owners must find a new way to draw income from their homes.

One such manner of gaining income unfortunately results in more suits in which owners claim various construction defects. As stated, owners may now face a much more difficult challenge in drawing money from their properties through equity with a noticeable trend wherein homeowners are refinancing less often. Thus, owners have traditionally engaged in a detailed inspection of the property to detect potential defects. Those discovered defects result in claims against developers and builders, which, in turn, inevitably result in settlements or judgments in favor of owners.

Another effect of recent trends on litigation pertains to the rising interest rates. In particular, initial borrower-friendly mortgages and rates are beginning to go south. especially regarding those borrowers who entered into adjustable rate mortgage agreements. The fixed-rate periods are coming to an end, with borrowers left high and dry, unable to make the spiking payments. As a result, builders and owners alike are backing out of contracts because of the recent increase in rates and inventory. Additionally, for those involved in new construction and development, construction costs have skyrocketed and, as a result, contractors simply cannot afford to do the work.

Unless carefully planned, the result may include defaults and contract breaches which can result in a surge of litigation. Thus although it remains to be seen, current conditions have historically resulted in more lawsuits, in one way or another. A cautious player in this market needs to be aware of these matters and be ready to take proper remedial measures.--M.S.

Morgan A. Stewart is a Partner with Manly, McGuire & Stewart. He can be reached at 949/252-9990 or [e-mail].