ALTHOUGH ECONOMIC conditions are improving in Connecticut's Fairfield and New Haven counties, the turnaround has yielded only modest changes in apartment fundamentals so far this year.

The Fairfield and New Haven metro areas posted job growth during the first quarter, which hasn't occurred since the fourth quarter of 2007. As such, vacancy rates in each metro remained steady and rents increased modestly in the first half of 2010. But the recently stabilized vacancy rates can also be attributed to a lack of major apartment deliveries over the past year. Just 120 market-rate units have come online in the counties since the second quarter of 2009, down from more than 425 units in the preceding 12 months.

Permitting activity has also continued to decline. The number of multifamily permits pulled has fallen 37 percent to 790 units since the second quarter of 2009. In the previous 12-month span, multifamily permitting activity decreased 11 percent.

Yet, despite limited construction lending, 1,875 units have been planned in New Haven County, while 1,500 units have been proposed for Fairfield County. And the volume of new units hitting the market will almost double this year. As construction activity picks up, a total of 810 units are expected to come online this year, and another 836 units are forecast to be delivered in 2012, according to market research firm Reis.

These deliveries will be concentrated in the Greater New Haven and the Fairfield West submarkets, which should increase competition for renters and weigh on property performance in the area. Operational challenges will, in turn, drag on revenue gains and loan underwriting, creating opportunities to acquire assets at a discount through the near term.

Erratic Fundamentals

Economic contraction and subsequent shifts in renter demand have underpinned erratic vacancy trends.

The vacancy rate increased 20 basis points (bps) to 4.6 percent during the fourth quarter of 2009 and the first quarter of 2010, following a 90 bps decline in the prior two quarters. In 2010, supply growth will drive up vacancy another 20 bps to end the year at 4.8 percent.

Effective rents have fallen 3.5 percent in the past year, after regressing 1.6 percent in the previous 12-month period. But the good news is that decline has been halted: Effective rents are expected to gain 50 bps this year.

In both counties, weak demand has pushed down average revenues 2.8 percent in the last 12 months, after revenues decreased by 2.3 percent in the preceding year.

While the apartment market recovery will gain momentum in the second half of the year, consecutive quarters of job creation will be required to spur household formation and buoy demand.

Market Momentum

Although investment activity remains at depressed levels in Fairfield and New Haven counties, local buyers continue to make acquisitions, capitalizing on decreased competition due to a smaller pool of investors.

The median price has increased in both counties over the past year, though the gains are likely due to the tight lending environment. The constrained debt markets have caused buyers to focus on smaller properties, which generally trade at higher per-unit prices. The average deal size of Fairfield County transactions during the past year was nine units, compared with 38 units in the preceding 12 months. Meanwhile, the median price surged 36 percent.

Similarly, in New Haven County, the average sold property size has plummeted 73 percent year-over-year to 40 units. The median price, meanwhile, has climbed due to smaller property sizes, more upper-tier asset sales, and milder rent declines.

Tight capital markets and declining revenues continue to slow investment activity. Since the first quarter of 2009, deal flow has retreated 45 percent, following a 37 percent decrease during the previous year. The increased number of small assets trading has caused the median price to rise.

In the past year, cap rates have increased an average of 60 bps reaching the low-7 percent to low-8 percent range. Initial yields for top-quality assets start at approximately 6 percent. Eyeing the Future Although the first half of 2010 was challenging for the region's investment real estate market, multifamily remains the preferred product type for institutional and private investors. To that end, 2010 should close on a positive note, and 2011 will see strengthening fundamentals, with some area submarkets expecting doubledigit rent growth and normalized levels of transaction velocity.

Through April 30 of this year, only 315 units have traded statewide for nearly $16 million. Pending regional transactions that are anticipated to close over the next two quarters total more than $200 million, so we do anticipate a reasonably strong year for multifamily sales. Still, the pace will be well off of 2008 when nearly $800 million closed, not to mention 2007, when nearly $1 billion traded hands.

But the high barrier-to-entry, supply constrained New Haven and Fairfield markets are performing better than most other U.S. markets, and investor demand from both private and institutional investors well outweighs the current and anticipated supply.

Steve Witten is first vice president of investments and senior director of the National Multi Housing Group in the New Haven, Conn., office of Marcus & Millichap Real Estate Investment Services.