Only the shadow knows: how will the increased condo inventory affect professionally managed apartment occupancy and pricing? A solid forecast of the "shadow" rental impact has proven elusive.

The professionally managed apartment market is expanding. Vacancies are down and approaching their long-term averages. Effective rents are above previous peaks in most areas. Capital flows into the sector are at a record pace, as are property prices.

Not surprisingly, new multifamily housing development is up, driven by projects in which units are expected to be sold, rather than rented. In fact, for the first time in many years (and perhaps ever), the number of condominiums underway exceeds rentals.

The shift toward condos is understandable; though a 3 percent rent growth reflects a much better market than a year ago, it pales in comparison to the double-digit appreciation that could be achieved by selling those units. What is puzzling is that this shift is occurring at the peak of the national housing cycle and at a time when single-family construction is soaring and mortgage rates are moving up.

In past cycles, slowing single-family home sales have been followed by slowing condominium sales. Some say "it will be different this time" because of demographic globalization. Still, even a large new source of demand, such as aging baby-boomers, is not infinite, and these boomers' ability to buy condos is often contingent on the sale of their existing homes.

As condo sales slow, incentive for condo conversions will also dissipate, affecting both the pricing and performance of rental properties. At best, the tail-wind of shrinking rental inventory will no longer provide additional occupancy boosts for remaining properties; at worst, thousands of units could be offered for rent in a relatively short period of time, causing havoc in the market.

Because a sizeable segment of the new condo supply is catering to income-property, second-home purchases and foreign buyers, it is reasonable to expect that at least some of these physically vacant units eventually could be offered as rentals. Such units are not part of the professionally managed universe; however, they potentially compete with professionally managed rentals and are subsequently termed "shadow" rentals.

Capturing the "shadow" effect on professionally managed apartments is a challenge for economists and industry executives because no timely surveys of such activities are conducted, and there are too many moving parts to allow a rigorous analysis.

Not only do the homeownership and rental segments of the housing market constantly influence each other, there is a lot of interaction within the two. Just five years ago, what is broadly defined today as the "professionally managed universe" was still in the "shadows" itself, with less than half of all renter-occupied stock in properties with five or more units in structure.

There is also some notable geographic variation in the structure of the rental universe, even among cities within the same U.S. Census region. For example, more than 70 percent of Minneapolis renters traditionally live in professionally managed properties, yet the comparable figure for Dayton, Ohio, is less than 40 percent. At the same time, cities with otherwise little in common can have similar renter distributions. For example, both in 1990 and 2000, Cincinnati and Miami each had about 55 percent of their renters occupying communities with five or more units in structure.

Despite its still-significant share of the overall rental market, non-professionally managed housing is not a perfect substitute for professionally managed units, both from the operational and the demand standpoint. Of increasing importance though, with today's record high level of condo construction and conversion and investment home-buying, is the possibility of a "shadow" rental market developing within the professionally managed multifamily housing industry.

Historically, about one-fourth of condominiums are occupied by renters. Depending on how extensive that market becomes during the next five years, it could affect both real estate and investment fundamentals of professionally managed apartments. Some markets might be particularly vulnerable to this trend because of their current housing inventory compositions and the pace of new supply.

5 Scenarios

It is hard to tell for sure what share of today's existing and new condominium supply could end up back in the rental pool, either as reverse conversions of whole properties (in case the sales go bust) or "shadow" sublets. "Only the Shadow knows! "--as the classic radio mystery drama once broadcast. However, many plausible scenarios can be built as a result of "shadow" market behavior to test how the actual rental markets might react.

Scenario I. Share of condo in new multifamily housing supply remains at its historical level of 25 percent.

Scenario 2. 20 percent of newly completed condos are rented (150,000 x 20 percent = 30,000 units).

Scenario 3. 5 percent of recently sold condos are rented (0.9 million x 5 percent = 45,000 units).

Scenario 4. 25 percent of existing condo stock is rented. The annual change in this renter-occupied condo stock can be viewed as additional competition to the professionally managed rentals (1.39 million-1.32 million = 70,000 units).

Scenario 5. Condo sales stall and the distribution of renter demand across the universe of apartment communities with five or more units in a structure resembles its composition in 2000.

Even at the national level, some of the plausible scenarios described can result in a reversal of fortune for the professionally managed apartment industry. While it is unlikely that the more extreme of those scenarios will materialize at the national level, owners and management firms should be prepared to deal with potential fallout from the current condo boom in certain locations and adjust expectations about their future performances accordingly. Pricing of apartment communities remains rather aggressive in many markets but especially where new condo deliveries (new and conversions) continue on an unprecedented scale.

In Florida alone there were 70,000 multifamily housing permits issued last year (tip from 60,000 in 2004, and 50,000 in 2003). At the same time, the number of units sold for condo conversions was more than 75,000--exceeding the volume of new multifamily housing construction activity in the state. Of course, there is variation in these trends even within Florida: Current condo prices are well above development costs in places like Miami, for example, and such gaps usually don't last long. Rising insurance costs and other fees also make condo ownership less attractive than it once was, at least at the current price levels. As far as non-resident and foreign demand is concerned, it is mainly "investment driven" and, therefore, is less transparent, adding risk to pricing, not reducing it.

Falling housing affordability and the reduction of the competitive rental inventory resulting from condo conversions make an attractive argument in favor of rent spikes three to five times above inflation. Rent spikes are possible at the submarket and community level and in the very near term, but are unlikely across an entire market and over a longer time frame. In fact, if even some small (by historical standards) share of new and existing condos is back as some form of rental two to three years from now, a rather cautionary outlook will emerge for such areas.

Coincidentally, apartment communities in the hottest housing markets have low capitalization rates, implying shrinking risk premiums or high hopes for future appreciation. Rising long-term interest rates may quickly change these perceptions, creating many good opportunities for shrewd apartment investors. One strategy simply might be to keep expectations in check.

The professionally managed rental market has earned its reputation as a stable and worthy asset for real estate investors. Apartment pricing is now in somewhat uncharted water, however, and a better understanding of the downside risks, such as the "shadow" rental market, might now be warranted.

Gleb Nechayev is Vice President, Senior Economist with Torto Wheaton Research, Boston. He can be reached at [e-mail] or 617/912-5245.