By Lynn Novelli

Multifamily
# of REITs	16
Industry Market Cap (in thousands)	$57,006,387
% of Industry	17.0%
Yield	4.02%
YTD Total Return	-11.08%
One-Year Return	39.95%
Three-Year Return	34.72%
Five-Year Return	-6.13%
Average Daily Trading Volume (Shares)	744,227
Source: NAREIT data as of Aug. 31, 2007

Multifamily REITs began the year energized by last year's 40 percent total return. That degree of enthusiasm was short-lived, however, rapidly replaced by a cooling economy and a slowdown in the pace of apartment-to-condominium conversions.

"Conditions in 2006 were ideal for multifamily owners, with negative supply and high demand," says BMO Capital Markets analyst Richard Anderson. "However, by the end of 2006, we were expecting a deceleration in the sector's growth potential in 2007."

Although that expectation has come to pass, Anderson and other analysts nonetheless still are anticipating a sound, if not stellar, performance for multifamily REITs in 2007 and into 2008.

"It will be hard to follow 2006—a year when everything was right for multifamily. However, fundamentals should remain solid for 2007," says Moody's Investor Services' Vice President and Senior Analyst Christopher Wimmer.

Healthy Occupancy Rates

Occupancy rates have slipped slightly from 2006, but are still at 95 percent, which Craig Leupold, principal of Green Street Advisors, says is a quite healthy level. "We expect that level to hold for the balance of the year," he says.

Throughout 2006, high home prices forced would-be buyers to remain apartment dwellers and kept occupancy rates above 95 percent. Rising mortgage interest rates and current conditions in the debt markets will continue to dissuade many renters from pursuing home ownership into 2008, Leupold predicts. Declining home prices should apply an opposite pressure on the multifamily market.

"However, the ratio of the cost of home ownership versus renting is well in excess of historic norms, and without the expectation of near-term home price appreciation, people aren't going to buy," Leupold says.

Slight Supply Growth

After several years of flat or negative supply growth, analysts expect a slight uptick in multifamily supply this year, a combination of fewer condo conversions and new construction.

The condo craze that saw thousands of apartments converted into condos for sale appears to have ended. This trend was significantly reducing the supply of rental properties. "There's not only a slowdown in conversions of for-sale units, some conversions are even coming back as apartments," Leupold says.

David Rodgers, a research analyst with RBC Capital Markets, agrees. "We believe that condo conversions are done in most markets," he says. "Margins now are thinner on them than on new construction, and the volatility in the debt market does not allow for expansion."

As a result, condo developers who had been snapping up prime property in recent years have backed off, making land more accessible to apartment developers.

A case in point is Avalon Bay Communities' (NYSE: AVB) recent purchase of four parcels of land in California from a condominium developer. The multifamily REIT plans to develop the property as apartments, and construction is already under way in Anaheim, Calif. and San Diego.

Overall, the upward trend in interest rates, tightening of lending standards and rising construction costs that reduce development yields should moderate new construction.

"New supply should not significantly impact fundamentals until late 2008," Leupold says. "But it's definitely something to watch."

Consistent Rental Growth

While occupancy remains strong, rental growth as reflected in net operating income (NOI) and revenue is expected to slow when compared with 2006, Green Street reports.

"Over the next couple of years, rental growth should be enough to support NOI growth of 4 percent to 6 percent," Rodgers says. "However, with considerable new supply slated to become available in 2009, it raises the question of whether there will be sufficient demand to maintain that growth in NOI."

Green Street predicts NOI growth of 6 percent to 6.5 percent for 2007, "driven by revenue growth and expense growth in the 4 percent to 5 percent range," Leupold says. "Our forecast for revenue growth in 2007 is 5.6 percent and 4.5 percent in 2008."

M&A Questions

The Tishman Speyer and Lehman Brothers acquisition of Archstone Smith undoubtedly will be the deal of the year. "However, there's a lot of merger chatter and a lot of candidates," Anderson says. REITs in the most favorable position for being acquired are those with redevelopment potential for high quality assets in strong markets, such as UDR, Inc. (NYSE: UDR) and Home Properties (NYSE: HME), he adds.

UDR trades at a steep discount and has a highly qualified management team with significant opportunity to redevelop its assets," he says. "Likewise, Home Properties has the opportunity to redevelop high quality assets in strong markets to grow rents." He adds that stocks trading at significant discount to net asset value (NAV) typically are targets for public-to-public mergers.

However, Wimmer disagrees with Anderson in anticipating additional M&A activity in the sector later in 2007 or early 2008. "Capital markets are taking a breather due to concerns about rates and availability of debt," Wimmer says. "Private equity investors are facing the same issues and uncertainty." Acquisitions in other industries are either being cancelled or leaving investors unable to sell the bonds, he adds.

"It's definitely a changing world," BMO's Anderson says. "Our suggestion to investors is to sit tight in 2007 and wait for 2008."