When the housing stocks started tanking, another group of real estate shares took off. I’m talking about the apartment Real Estate Investment Trusts (REITs).

The PHLX Housing Sector Index (HGX) is down around 29% from its peak in July 2005. Meanwhile, Archstone-Smith Trust (ASN), the second-largest U.S. apartment company in terms of market value, is up 34%.

Another apartment REIT, AvalonBay Communities (AVB), has climbed 42%. Throw in reinvested dividends and you’re talking about a total return of nearly 46%.

Why are investors rushing into these stocks? Here’s their investment thesis: Housing is unaffordable, and both sales and prices are falling. But since Americans have to live somewhere, they’ll end up renting. That will push demand up, supply down, and rental rates through the roof.

This was all true for a while, and if you made money in these stocks ... great! But now it looks like the times are changing. And that means these supposed “housing bust havens” aren’t all they’re cracked up to be ...

Three Strikes Against
The Rental REITs

First, the great condo conversion is reversing directions. See, one major force that tightened the rental market was strong condo sales.

At the tail end of the boom, investors were snapping up apartment complexes all over the country, fixing them up, then trying to re-sell them as condos.

Last year, roughly 200,000 apartments were bought for conversion last year, according to the Wall Street Journal. That was more than twice the level in 2004.

Now, many of these conversions are proving disastrous. The housing slump soured investors on what were essentially glorified apartments and sales withered on the vine.

That’s left many conversion investors scrambling. They’re rapidly switching their properties back to rentals, putting supply back onto the market. It happened to a complex in my own neighborhood, and the same scene is being played out all over the country.

Here’s another thing: The bulls argue that rising construction costs have made it less economically feasible to build new rental complexes. As a result, less apartment complexes have been built. 

But I’m starting to see new condo buildings advertise units as rentals or purchases. So while we may not have seen many new apartment complexes built in recent years, we have seen plenty of condo buildings get constructed. Those may convert (at least partially) to rentals. That’s yet another heap of supply to deal with.

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