There’s no doubt about it: The apartment market remains robust.

Vacancies have fallen below 5 percent for the first time since 2001, while rents continue to increase and have already surpassed the previous peak level. Yet, amid this standout success, we are now seeing some of the demand dynamics shift.

The reason the apartment market could sustain such a robust recovery—especially in the face of such a disappointing economic backdrop—was the decoupling of demand from broader economic trends. Most of the incredible absorption that has driven vacancies so low, so fast, has been powered by the shift from homeownership to renting. 

Despite the homeownership rate plunging to 65.4 percent (the lowest level since 1996), we may be closing in on the range where the massive own-to-rent shift will peter out. While we estimate that homeownership will eventually settle in the 65 to 65.5 percent range, we often see an overshoot during adjustments before an equilibrium is reached. Nevertheless, at 65.4 percent, we are likely near the end of this demand driver for apartments.

The last two quarters have signaled the beginning of the next stage of apartment demand: the long-delayed pop in household formations. 

Household Formation, and Gen Y
After an extremely weak 2010, household formations started to take off in 2011 and continued this momentum into the first quarter of 2012. In March, the number of U.S. households was up a whopping 1.8 million from the year before, well above the trend rate of 1.1 million.

However, here is where the latest stall in this troubled economic recovery comes into play for the apartment market. Right now, our outlook anticipates that apartment absorption will be sustained, albeit at more moderate levels, by the pop in household formations. But if the sluggish economy interrupts this spike in household formations, future apartment demand could be weaker than we currently anticipate. 

A corollary to the household formation explosion is the demand that will be generated as the massive population of young adults—many of whom are currently unemployed or seeking shelter from the economic storm in school—get jobs and move into apartments. We have seen some significant declines in young adult unemployment in recent months, but the newly weak labor market could also disrupt this improvement. 

Our outlook for demand is that it will remain positive and healthy but less robust than it has been as a result of these shifting dynamics.

Growing Pipelines
Meanwhile, the increase in multifamily development continues.

Through the first half of this year, multifamily starts averaged a 212,000-unit annual rate, up from last year’s 165,000 and 2010’s total of just more than 100,000, a 50-year low. While this is still well below the historical rate of around 350,000 units per year, we expect starts to continue to increase. But we also recognize that there is a lag between starts and completions, meaning the market will still be undersupplied for a time. 

On a macro level, this new supply and our expectation that the upswing in development will continue—coupled with the anticipated moderation of demand—means that the recovery in vacancies will begin to lose steam in 2013, and be followed by eventual increases. This process will vary from market to market in terms of timing and strength. Markets that will see this shift sooner are typically already-tight markets where the development process is subsequently further along. 

New York City, the nation’s tightest market, saw the largest increase in stock over the past year, with a 1.6 percent addition to its apartment inventory. Despite this, vacancies have continued to decrease amid strong demand.

Beyond New York, the markets facing the most new supply over the next two years include Washington, D.C. and its suburbs; Austin; San Antonio; and Salt Lake City. Of these, San Antonio has the highest current vacancy rate, at 6.7 percent.

Even as vacancies begin to rise in the 2014-15 period, they will still be very low and continue to support healthy rent increases. But the shift in occupancy will temper market NOI gains.

Peter Muoio, PhD., is senior principal of New York-based research and consulting firm Maximus Advisors. Prior to founding Maximus Advisors, he was managing director and global head of Deutsche Bank’s Real Estate Research.