The Chicago apartment market is poised for a very good year, thanks to a combination of job growth, maxed-out mortgages, and low construction costs. Local employers are expected to add jobs at a relatively strong rate for the fourth consecutive year—an estimated 40,000 during the year—which in turn will keep demand on the rise. Chicago's large professional and business services sector will lead job growth, accounting for one-quarter of the new positions.

After driving economic expansion for several years, the housing market has become a drag on growth and will likely continue to slow well into 2007, which should bode well for the apartment market. For-sale inventories increased dramatically last year but have begun to level off in Chicago, as many sellers are recognizing that their pricing expectations may be unrealistic at this point in the cycle.

The housing market slowdown likely will affect several industries. The construction sector began to shed jobs in the second half of last year as home building activity dropped off. Many first-time buyers relied on adjustable-rate mortgages, or ARMs, to qualify for home purchases in recent years. But as the ARMs that were originated in the past few years reset at higher rates, many recent buyers are finding it increasingly difficult to afford monthly mortgage payments. As a result, many homeowners will return to the renter pool over the next few years. A combination of fewer renters fleeing to homeownership, an influx of new renters entering the market, and low construction rates for rental housing has resulted in increased occupancy rates throughout Chicagoland.

BIG RENT INCREASES: Condo conversions have reduced the apartment supply and amped up demand in Chicago. UP AND DOWN Projected completions in the metro Chicago market are down compared to 2006, and current construction rates will not replenish apartment stock lost to condo conversions for some time. Developers will deliver 1,500 apartments this year, significantly fewer than the 2,200 units delivered in 2006. This year's deliveries will increase total apartment inventory by less than 0.5 percent, which will keep supply and demand in balance.

More than 13,000 apartments were converted since the beginning of 2004, and the resulting 2.9 percent reduction in inventory has led to significant improvements in vacancy. As a result, owners will be able to raise rents at the most aggressive rate in five years. After experiencing a period of relatively flat rent growth in those past five years, net effective rents increased between 6 percent and 8 percent because of the reduction—and almost elimination, in most markets—of rent concessions. Landlords in the southern part of Du Page County are among the few still offering concessions.

Strong demand for both urban and suburban properties will push Chicago's asking rents up this year. In-city rents are forecast to jump 4.7 percent to $1,163 per month. The north side submarkets should outperform the rest of the city's submarkets as competitive stock has been drastically depleted. Overall, suburban rents are expected to gain 4.1 percent to $986 per month.

On the heels of an 80-basis-point improvement last year, overall vacancy in Chicago will decline 50 basis points to 5.2 percent in 2007. The greatest improvements are expected in the suburban Downers Grove and Woodridge submarkets, both of which have above-average vacancy. In-city vacancy is expected to decrease by 20 basis points to 4.9 percent.

RETURN ON INVESTMENT Chicago's dynamic apartment market presents distinct investment opportunities across property classes. For example, luxury apartments could be strong money-makers in the months ahead due to recent inventory reductions. Even with fewer conversion buyers in the market to bid up values, owners of urban luxury properties will expect top prices to compensate for the projected revenue growth they are relinquishing.

The best Class A product will sell at sub-6 percent cap rates, or even in the high 5 percent range. Meanwhile, suburban Class B and C assets—particularly those in quality neighborhoods—will continue to attract investors due to their stable tenancies and consistent rent growth. The long-term prospects for the Class B and C sectors should hold steady, as high rents in the upper-tier segment of the market and the high cost of for-sale housing continue to expand the renter pool.

CLOSE TO HOME In 2006, the most active buyers were private equity partnerships, a trend that is expected to continue this year. Chicago is not a big import capital market, with the exception of transactions priced at more than $20 million. Instead, it tends to be more of a capital export market. For smaller deals, it is very common for a Chicago investor to enter a market like Indianapolis and acquire a $4 million deal. On the other hand, it's rare for an Indianapolis investor—or a California buyer, for that matter—to go to Chicago and do a $4 million deal.