A couple months ago, I wrote an article on the different sectors of commercial real estate called, Commercial Real Estate Market on the Road to Recovery? Part II. It's easy to look at the residential market and know which direction it's going, but not quite as easy with the commercial market because of the different sectors and what things affect them.

In this article, we're just going to focus on the multi-family sector and its recovery. The last two years have not been uplifting ones for owners of apartments. Vacancies have been high, peaking at 8% in the fourth quarter of 2009, and remaining unchanged in the first quarter of 2010. Rents showed a gain (0.1%) in the first quarter of 2010; although very small, this is the first gain since the third quarter of 2008.

The exciting news comes when we see things like over 20,000 apartment units being absorbed in the first quarter of 2010; this is the strongest first-quarter in over 10 years.

According to Victor Calanog, Director of Research at Reis, Inc., "The multi-family market appears to be on the cusp of recovery. If so, pricing and transaction activity will raise the window of opportunity for landing good deals..." Mr. Calanog also states that the next two quarters are critical to see if we can sustain positive rent growth.

Some industry watchers were surprised by the latest results. One of the concerns is the shadow inventory of condos and homes. I will admit my first thoughts about the multi-family sector when the subprime mess hit was, "This will be great for the rental market, people always need a place to live." Well, surprisingly enough, there isn't a direct correlation between people losing their homes and needing to rent an apartment. In fact, we've see the opposite. We had properties foreclosed on left and right, and vacancies of units in multi-family buildings increase. Why? Because households have been contracting.

So, how will the shadow inventory of foreclosed properties affect the rental market? We'll break it down into two parts: One, how do single-family homes impact the market and two, how do condos and townhomes impact it?

Victor Calanog has examined this issue, "Whenever we've tried to establish a casual relationship between single-family vacancies and multi-family vacancies in a formal econometric setting, controlling for possible omitted variables, we've found any relationship to be weak at best and difficult to establish for most." The biggest reason behind this is that an apartment isn't a perfect substitute for a single-family home. If a family loses their home to foreclosure, they are more likely to rent another home, rather than an apartment. So there is no direct impact on the multi-family market.

Where as if someone loses their condo or townhouse to foreclosure, it's more likely they will go back to renting a typical apartment unit. We also see that builders will convert condo/townhouse projects to rental multi-family units. During the boom of 2003-2007, we saw conversion in the other direction, from apartments to condos. In fact, one of the first units I ever purchased was a unit in a building that had been a condo development; in the downturn, it was converted to apartments and then, 9 years later in the next boom, they were converted back to condos. In areas like south Florida and Las Vegas, we're already seeing this impact the apartment market and it will for a while.

Over 70% of investors polled in the multi-family sector feel now is the time to invest. "The survey results really point to the fact that investors believe in the economic recovery, and that's the first domino that we need to ignite a recovery in commercial real estate," says Hessam Nadji, Senior Vice President and Managing Director of Marcus & Millichap.

So, what are my feeling about this market? We still have weak real estate fundamentals, i.e., a lack of quality jobs, unemployment still too high, and there is a lack of spending and confidence among consumers, which makes me leery. However, there is a limited supply coming online and there is an influx of Echo boomers entering into the rental market. So I'll put up my "proceed with caution" sign and move forward.