Many market research firms have picked the Denver metro as a good rental market over the next several years. They're wrong—it's going to be great.

It's all about the fundamentals. When you have little vacancy, limited new development, increasing demand, and affordable rents, there is nowhere to go but up.

The current state of the Denver apartment market is a true reversal of fortune. Demand was so weak during the beginning of the last decade that Denver missed the overbuilding of homes, condos, and apartments that plagued many other cities throughout the country. So when the national economy tanked in 2008, Denver didn't have very far to drop.

In fact, when the economy dropped in 2008, the local apartment market had just recovered from an eight-year decline in occupancy, according to a study by Dr. Gordon Von Stroh of the University of Denver. Since then, the Denver apartment market has absorbed back all of the occupancy it lost, finishing 2010 with the highest level of occupied stock since the fourth quarter of 2000. The absorption of apartment units in 2010 was the fourth-highest in the past 30 years, according to the study.

Driven by the record pace of absorption, Denver's rents increased 3.8 percent in 2010. Most rent growth occurred in the Class A sector, but based on history, when A properties raise their rents, Class B and C assets aren't far behind. Overall, rents in the Denver metro are expected to outpace most U.S. markets over the next three years, according to market research firms Witten Advisors, MPF Research, and Reis. And that bodes well for anyone who owns, develops, or trades apartments in the Mile High City.

Constrained Supply

All classes of apartment properties began 2011 at or above 95 percent occupancy, resulting in a renewed confidence by owners to experiment with higher rents or a reduction in concessions. This confidence is reinforced by the lack of new construction— both in current and projected development pipelines.

The current deliveries and proposed future developments are insufficient to meet the current renter demand. Only 1,000 units will be delivered in 2011, and 2,500 units are expected in 2012. Considering that more than 9,000 units were absorbed over the past 18 months, demand should greatly outpace current construction levels in the coming years. In fact, the number of available apartment units would be reduced to zero in two and a half years if the present pace of absorption continues.

As a result, there is a significant amount of interest in potential development sites in the Denver metro. The focus is on core locations, such as those in and around downtown and along the metro's recently completed light-rail corridors. Unfortunately, development interest is being slowed by the lack of construction financing, and the current levels of rents often do not justify the cost of new development. Yet, construction costs have come down significantly since the economic downturn took hold.

Three-story garden-style construction costs have dropped from $145,000 per unit to approximately $130,000 per unit in the past four years. These costs vary by location, as development fees range from as low as $5,000 per unit to more than $22,000 per unit. Four- and five-story construction costs are currently $165,000 per unit, while high-rise costs exceed $300,000 per unit.

Bouncing Back

The current fundamentals of the Denver metro, the increased interest by a diverse swath of investors in the apartment sector, as well as the lack of product available nationwide has brought a renewed interest in the acquisition of metro-area Denver apartment properties. In 2010, the market saw 18 sales of properties with more than 200 units—a 100 percent increase over 2009. What's more, the activity has resulted in a dramatic increase in new buyers in Colorado.

Last year, about 30 percent of potential buyers coming into the ARA Denver office were entirely new to the Denver market. The trends of 2010 seem to be continuing in 2011. During January, there were approximately 12 Denver-area apartment properties in some stage of the sales process, as of mid-February. However, some developing trends may result in a lack of listings during the balance of 2011.

Most of the sellers in 2009, 2010, and this year are experiencing some level of distress. The motivation to sell over the past three years has ranged from a lender taking back properties to institutional partners returning money to owners who do not have sufficient equity to refinance and have loans coming due.

But we believe that the number of distressed properties has decreased, as many owners have fixed their issues over the past year. If a property needs to be refinanced, the increase in rents and occupancies will help many owners raise their net incomes enough to obtain the level of proceeds needed for a new loan, which will pay off the existing debt.

As fundamentals in the market continue to improve, metro Denver looks like it will live up to the hype. With the lack of new construction, 36,000 young adults in the metro turning 20 each year, and only 12,000 vacant units among the 290,000 units available in the city, there will be significant rent growth for years to come.

The only bad news will be trying to find an apartment property in metro Denver that will be available to buy.

Jeffrey Hawks is principal of the Denver office of Apartment Realty Advisors. Hawks, a 36- year veteran of the real estate business, has sold more than $2.7 billion in Colorado apartment properties over the past five years.