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Sule Aygoren Carranza is managing editor of Real Estate Forum and editor of Multi Housing forum, from which this article is excerpted.

Denver—Apartments are again the number one sector to invest in for return potential, according to PricewaterhouseCoopers LLP and the Urban Land Institute. In their Emerging Trends in Real Estate 2007 report, unveiled at ULI’s fall meeting here last month, the firms note that expensive housing prices and rising mortgage interest rates are pushing more people into the rental market, which is also experiencing heightened demand from young adults. Moreover, job growth is making it less likely that people will share units or live with parents.

All of these bullish trends are allowing owners of multifamily product to increase rents along with occupancies. Further, homeowners with adjustable-rate mortgages may default on their payments and return to the rental pool. For buyers, cap rates will begin to rise slightly, since condo converters will no longer push prices up and eventually compress cap rates to unsustainable levels.

However, reversions from failed condominium projects will create short-term difficulties for recent buyers that had banked on a continuation of significant rent hikes to escape negative leverage. Reversions and the blowup of condominium projects could soften rent increases, especially for upscale apartments. “Condo stock leans to more high-quality construction and higher-finish amenities and would compete more directly with existing A-quality rentals,” the report states. Also, immigration politics are some cause for concern. A crackdown on new arrivals to the country could cool gateway markets, although Congress is making little headway in its efforts to ease the influx of immigrants.

The smart money, according to the study, buys moderate-income, class B properties on the coasts, particularly San Francisco, New York City, Los Angeles and Boston. Not only are these areas some of the most expensive markets for single-family housing, but the cities also experienced a relatively low amount of condominium conversions. While Seattle is also strong, the firms warn that investors should be careful in Washington, DC and Chicago.

Occupants of class B product are often renters by necessity, a segment that grows in concert with Generation Y adults and higher interest rates. Growth in net operating income could help offset cap rates, which will remain relatively low. Traditional job growth markets such as Atlanta, Houston, Dallas and Denver offer less potential, the study states.

For sellers, generous gains can be found despite rising cap rates and core holders will benefit from solid revenue growth. Yet, because opportunity funds are on the hunt for broken condominium properties, it may be difficult for typical investors to find bargains.

As a result, New York City-based PwC and Washington, DC-based ULI suggest that investors avoid buying communities that may compete against failed condominium developments and conversions, such as those in Florida, Las Vegas, San Diego and Phoenix. Returns for value-add plays are also getting squeezed in many “priced to perfection” markets. “Those investors counting on converting rental units to condominiums realize that recipe is cooked,” the report says. “Early birds scored with conversions, but late entrants have been nailed by bad timing–those strategies just haven’t panned out.”

Value-added investors, however, still have “plan B,” which entails buying B-minus to C-quality units in good locations, making renovations and selling the stabilized community once rent increases have been realized. The problem, PwC and ULI reports, is that everyone is in this game and profits aren’t what they used to be.

In terms of development, reversions of condo product could put the breaks on new projects in some areas, and construction nationwide is under control. In markets that are very heated, building new may prove to be less expensive than buying, even with higher construction costs. “Development offers initial rates of return 100 basis points over existing cap rates,” according to the study, and rising land costs and long entitlement processes are tempering enthusiasm. Going forward, cap rates will edge higher a little, but increased investor demand for apartments will keep the correction relatively modest.

“The race is on! For 2007, NOI growth takes the lead, but development and oversupply from broken condos could slow revenue gains before year-end,” the Emerging Trends report states. Over the long term, steady demand help most markets remain in equilibrium, generating good returns until single-family housing becomes a more affordable option. And as occupancy and rental rates improve, “apartments seem poised for a good long run.”

Investors and lenders are also becoming more comfortable with mixed-use development in infill and suburban areas. As high-end grocers, national retailers and service-type stores take up residence in these complexes, which often have pedestrian-friendly designs and are located near major transit stops, renters will gravitate toward the greater convenience offered by mixed-use communities. Finding sites may be an issue and developers must be smart in their planning. “Plopping a high-rise apartment building with a Whole Foods Market next to a mall doesn’t necessarily create a desirable mixed-use neighborhood,” PwC and ULI contend.

In terms of niche multifamily segments, the report found that active-adult communities for residents age 55 or older make more sense than traditional seniors housing today. The Baby Boomer cohort is still 10 to 15 years away from entering into full-fledged retirement and advancements in medicine and healthier lifestyles indicate that this group of seniors will likely delay its entry into assisted living and nursing facilities.

Meanwhile, investors have plenty of opportunities in the student housing sector. “Universities don’t mind outsourcing their housing headaches now that the Echo Boom generation arrives on college campuses in full force,” according to PwC and ULI. “Demand outstrips supply in many places and some pampered preppies are willing to pay more thanks to parental largesse. But all those keg parties and Animal House antics can be a downside.”

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