Owners of apartment properties surely must feel loved: Buyers just can't get enough of their buildings these days, despite rising prices and falling cap rates.

The most widely discussed reason (among many) for this strong demand? The boom in conversions of apartment buildings to condominiums. In an environment of historically low mortgage rates, the "miniaturization" of down payment requirements, and aggressive promotion of homeownership, converters have been in a position to pay premium prices for apartments (or other commercial properties, for that matter) and still earn attractive returns.

David Clark

It appears this boom has already begun to fade, although it's too soon to say whether this is the start of a full-fledged condo bust or just an inevitable cooling after a period of unsustainably strong growth. But as demand for apartment properties by condo converters wanes, multifamily owners are wondering what the impact will be on the industry and their own properties. To put it bluntly: Are we seeing the beginning of the end in the condo-induced pricing bubble in the apartment market? Or is the demand for rental apartment properties strong enough to withstand the departure of converter buyers and maintain a sellers' market?

Before hazarding an answer to that question, it's worth seeing if we can isolate the impact of condo demand on apartment prices during the past five years. From my vantage point, even without condo converters, demand for apartments would have been quite strong last year. In fact, even without condo converters, apartment property appreciation in 2005 would have been the highest in more than 20 years.

Apartment Pricing

When it comes to apartment price appreciation, the most widely used yardstick comes from the National Council of Real Estate Investment Fiduciaries, or NCREIF, which provides quarterly performance benchmarks for all the commercial real estate "food groups."

With the exception of the historically weak period of 1990 to 1993, price appreciation generally ranged from zero percent to five percent. But that changed in late 2004, as prices began to rise rapidly, reaching a rate of 15 percent by the end of 2005, far greater than at any other time in the last two decades. Other data sources, not to mention innumerable anecdotes from multifamily industry leaders, confirm the extraordinary run-up in prices.

What explains such strong appreciation? It certainly isn't supply. Even a cursory glance at any chart of multifamily construction makes clear that the last decade has seen the most stable, least volatile construction of apartments and condos on record. As an aside, it's worth noting that just a few short years ago, more than a few observers were criticizing developers for not stopping the flow of new construction even as net apartment absorptions turned negative. Had they done so, the multifamily property market of the last several years would have been even more of a sellers' market that it has been. Looking back, it's apparent that new construction has barely kept pace with the expected long-term need for apartments.

The investment market definitely has been affected by this surge in demand, which has come from four sources. First, apartments have undergone a cyclical recovery and expansion. A historically weak labor market recovery kept the demand for apartment residences low in 2002 and 2003, even while the economy was improving. Sustained growth in employment in 2004 and 2005 returned absorptions to positive territory, boosting operating income and making apartments more attractive to would-be investors.

Second, demographic trends are increasingly favorable for apartments. "Echo boomers" have started to move into their twenties, the time of life when people have the highest propensity to rent of any age group. Immigrants, who also are highly likely to rent housing, also continue come to the United States in high numbers.

Third, capital continues to seek investment in real estate in general, and apartments in particular. Both public and private markets have benefited from the increased portfolio allocations dedicated to real estate. Some of this capital flow simply represents the dissemination of research showing that adding real estate to a portfolio can simultaneously increase returns and reduce risk. But a renewed focus on dividends and the fact that real estate has significantly outperformed the post-bubble equity markets also spurred interest in real estate investment.

Fourth, the increased popularity of condos–far greater than anyone imagined five years ago–has led to a wave in conversions of apartments to condos.

Price Effects

The conversion of rental apartments into for-sale condos has a two-fold effect on apartment deals, raising prices both directly and indirectly.

While cap rates for apartment sales certainly have dropped, that's not a figure to which condo converters pay attention when they make their offers. Instead, they estimate how much the converted units will sell for and base their bids on that. In recent years, the strong demand for condos has allowed converters to outbid other potential buyers, thus raising prices for apartment properties directly. There is also an indirect effect: As rental housing gets converted into condos, the supply of rentals falls, leading to stronger rent growth. This, in turn, makes rental properties more valuable and should lead to higher prices for properties.

But how much of the recent price appreciation in apartments stems solely from the condo converter demand? One wonders how much would apartment properties have appreciated in the past few years if there had been no increase in condo demand.

One way to determine this is to look at appreciation and condo conversions across metro areas. Since both vary considerably by area, we can get a better grasp on how much condos contribute to the total price effect.

When one compares the 2005 apartment appreciation rate within a U.S. metro area with the amount of condo conversion transactions as a share of the total apartment stock, there does appear to be some correlation between the two variables. If you plotted all this data on a scatter graph, you could fit an upward-sloping straight line to represent the predicted effect of increased condo conversions on apartment appreciation.

It's not a perfect correlation, but the "outliers" on such a graph have reasonable explanations. For example, the San Francisco metro area had the lowest share of its stock sold to condo converters (a mere 0.2 percent), yet had one of the highest appreciation rates (19.1 percent). The low conversion share may be largely the result of the difficult regulatory environment for condo conversions there. The rapid price rise is partly "catch-up" from 2001-03, which saw San Francisco's apartment pricing lag significantly behind other markets. Once demand picked up, so did Bay Area property prices, which were boosted by the difficult of building new apartments there.

Mark Obrinsky

Here's my conclusion: In the absence of demand from condo conversions, apartment appreciation in 2005 would have averaged 9 percent–the highest in more than two decades. Since appreciation in these markets actually averaged 14 percent (slightly less than the national average), condo demand accounted for about 500 basis points of performance, or just more than one-third of the total.

Thus, while condo converters have had a considerable effect on apartment prices, the demand for apartment properties is much broader and deeper than that. As long as economic trends remain favorable, demand for apartments should remain strong, with values able to withstand even a big drop in acquisitions by condo converters.

–Mark Obrinsky is chief economist for the National Multi Housing Council in Washington, D.C.