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The Real Estate Data firm Reis announced this morning that the apartment vacancy rate fell to 5.6% in the third quarter, down from 6.0% in the second quarter and 7.1% a year ago. The rate peaked in the fourth quarter of 2009 at 8.0%.

This is a hopeful sign about the recovery of the housing market. First, some of the excess inventory in the rental market is being cleared up, and then later, the excess inventory in the for sale market will start to be absorbed.

It is not clear, though, from the data if this is a reflection of higher household formation, or simply people who used to be homeowners who have been foreclosed upon or otherwise lost their houses. If it is a rise in the rate of household formation, which has been very depressed over the last few years, that is extremely good news. The vacancy rate is now back to pre-crisis levels as shown in the graph below (from this source).

However, not all of the improvement is coming from higher demand. Over the last two years, apartment construction has plunged along with just about every other part of construction. As a result, only 8,200 new units came online in the third quarter, which is a record low (OK, the data only goes back to 1999). A total of 36,000 net units were filled in the quarter but that is down from 42,000 units filled on balance in the second quarter.

More recently, multi-family housing starts have picked up, but most of those units will not come on line and be available to rent until the middle of 2012. In the meantime, though, it is a bright spot for the long-beleaguered construction industry, and one place where construction workers are able to find jobs. Since the start of the Great Recession/Lesser Depression, the construction industry has been responsible for 31% of all the jobs lost in the country.

As is normal when supply is low and demand is growing, prices rose. The average rent in the 82 markets covered by Reis (most of the major metropolitan areas) rose to $1,004 per month (after the effect of any discounts or incentives), up 2.4% from a year ago. While that is not exactly Zimbabwesque, it is a bit on the hot side.

If the rise in regular rents (i.e. what a tenant pays to a landlord) starts to bleed over into owner’s equivalent rents (or OER. what the government figures you pay yourself to live in the house you own) it could have negative implications for the CPI. Together regular rent and OER make up 31% of the CPI, more than food and energy combined.  Since rent is neither food nor energy, it makes up a much bigger part of the core CPI, almost 40%.

The obvious beneficiaries of the decline in vacancies and the rise in rents are the Apartment REITs like Equity Residential ([url=]EQR[/url]), Mid American Apartments ([url=]MAA[/url]), Avalon Bay ([url=]AVB[/url]) and Apartment Investors ([url=]AIV[/url]).

The yields on these stocks are not as attractive as they have been in the past relative to the rest of the market, given the huge rise in dividend yields for the rest of the market. They are, however, very attractive relative to long-term interest rates. With falling vacancies and rising rents, their earnings are set to rise. As REITs they are required to pay out almost all their earnings, so a year from now, your effective yield on cost could be much greater than the trailing dividend yield of generally between 2.2% to 4.2% that firms in this group are currently being quoted at.

In the short term, most of the firms in the group hold Zacks #3 Ranks of 3, or Hold. The one exception, MAA holds a Zacks #2 Rank, or Buy. It also has the highest yield in the group, and as such should probably be the first one you investigate.