Philadelphia—In April, after being on the market for a full year, only 50 of the 128 condominiums at Venice Lofts had buyers who had signed sales agreements, and the pace of sales had slowed to a crawl.

“We were concerned that we would end up stalling out,” said Carl Dranoff, founder and owner of Dranoff Properties, a local multifamily developer.

Fortunately, the rents in Philadelphia’s consistently strong apartment market grew as condominiums sales slowed. Average effective rents increased 3.5 percent in 2006 and will grow another 4.2 percent this year to reach $996 a month, according to Reis, Inc., a New York City-based market research firm.

So with just months to go before work finished at the Lofts, Dranoff canceled sales agreements, returned deposits to the 50 buyers and began to operate the Lofts as a rental development. Nearly a third of the apartments have now been rented and lease-up is continuing at the rate of 10 to 12 renters a month, Dranoff said. Monthly rents at the $50 million project average $2 a square foot.

Philadelphia’s consistently robust rental apartment market has rescued local developments like Venice Lofts—offering strong rental income and an exit strategy for condo projects stranded by slow presales. Philadelphia’s high rents are fueled by high barriers to new apartment development, healthy job growth, and the transformation of old office or industrial districts into residential neighborhoods like the Avenue of the Arts district near Rittenhouse Square and City Hall.

Although Philadelphia is the fifthlargest city in the country and has a steadily growing population, rental developers will only finish 748 new apartments here in 2007, according to Reis. That’s less than a 0.4 percent increase to the city’s total stock of 197,330 apartments.

Over the last year in particular, the high cost of construction has choked off the pipeline of rental developments here, Dranoff said.

Philadelphia also has high barriers to development. The strongest, most established neighborhoods here, like Society Hill and the blocks around Rittenhouse Square, are largely built out, and have been for decades. Also, partly due to the “conservative, Quaker nature of Philadelphia,” the apartment supply has remained tight, said local multifamily developer Allan Domb, president of Allan Domb Real Estate.

“We’ve never had a lot of speculative building in Philadelphia,” Dranoff said.

Solid employment growth, ranging between 0.8 percent and 1.3 percent annually since 2004, and conservative construction have kept the vacancy rate in Philadelphia below 5 percent since the 1990s, according to Reis. In the second quarter of 2007, 4.2 percent of Philadelphia’s apartments were vacant, down from 4.4 percent the year before.

Now rents are high enough to encourage developers to start new rental projects. This fall, Dranoff will begin to dig the foundation of 146 new luxury apartments at 777 South Broad, a new $75 million development on the southern edge of the Avenue of the Arts district.

High rents are also prompting developers to turn ailing condominium projects into rental projects. Opus East, another local developer, switched from condominiums to rentals at its 14-story 1919 Market Street project, which is expected to deliver 257 rental apartments in 2009. The building was originally planned to be twice as tall, with 292 condominiums.

Philadelphia has a long pipeline of stalled condominium deals. In 2005, developers announced 45 projects totaling 1,500 condominiums to be finished over five years. But by September of this year, only 15 of those projects were going forward as condos, leaving the other 30 sites open for rental construction.

Developers will finish between 1,200 and 1,600 new rental apartments a year through 2011—increasing the rental stock by less than 1 percent a year, according to Reis.

That pace is slightly higher than the market’s projected appetite for new rentals. Reis expects Philadelphia to absorb an average of 600 new apartments a year through 2011, as employment grows by between half a percent and 1 percent a year through 2011, according to Moody’s

As condominium projects flip to become rental deals, Philadelphia’s new construction will get ahead of the demand for apartments, pushing vacancies above 5 percent in 2008 for the first time since 1993, according to Reis. The research firm expects vacancies to creep toward 5.4 percent by 2011.

Investment sales

The strength of the rental market here is attracting investors willing to pay increasingly high prices for apartment properties relative to net operating income, pushing capitalization rates down.

A cap rate represents the net operating income of a property as a per- centage of its sales price. The average capitalization rate in Philadelphia for the 12 months that ended in June dropped to 5.9 percent, down from 6.5 percent a year earlier, according to Real Capital Analytics, a research firm based in New York City.

That the average cap rate dropped in Philadelphia but rose nationwide over the same period, according to Real Capital Analytics, is a strong vote from investors in favor of the apartment market here.