Several months ago, I was lucky enough to sell my home relatively quickly (at full asking price, no less). Unfortunately, when the time came to hand the keys to the new owner, we still hadn’t found a replacement.

Luckily, I knew a local commercial property manager who specializes in apartments. I assumed he would have no trouble reserving a nice unit for us on short notice. No such luck. Even with a large portfolio stretching from Baton Rouge to Texas, his company didn’t have a single vacancy — nice or otherwise.

That’s how my family and I ended up in a Days Inn for a few weeks with all our belongings crammed in a storage shed. Let’s just say I’m glad those days are over. But ever the investor, I did manage to take something away from the ordeal: a newfound appreciation for the residential REIT sector.

[ad#Google Adsense]Clearly, I wasn’t the only apartment hunter to be turned away by no-vacancy signs. Millions of homeowners that got in over their head have been forced to downsize. Some have moved into less lavish homes, but many others have reached the conclusion that apartment living just makes more sense.

First, apartment rents are generally affordable and don’t require a sizeable down-payment. Renting also eliminates the hassle and expense of home maintenance — no unexpected repair bill for that leaky faucet. Nor do you have to worry about losing equity should home values keep moving south. Finally, many renters like the flexibility to quickly relocate without being anchored to a mortgage.

Whatever the reason, apartment complexes around the country seem to be filling up fast. But I don’t rely on anecdotal evidence. So I did some homework and found that my suspicions were correct — the days of giving away free gym memberships and other concessions to lure tenants were over.

So on June 16, I recommended iShares FTSE NAREIT Residential (NYSE: REZ) to my ETF Authority subscribers. The fund invests predominately in companies that own multi-family housing and self-storage units.

In the months since, the industry has continued to heat up. In fact, there are currently 84,382 more apartment occupancies now than there were three months ago. That’s a record absorption for the industry. Meanwhile, vacancies have fallen from 7.8% to 7.2%, one of the sharpest quarterly improvements on record.

But it gets better. Apartment construction activity slowed dramatically during the recession, so there hasn’t been much new capacity to soak up. That lack of availability, coupled with the increased demand, is pushing rental rates higher.

According to Axiometrics, average rent prices reversed a two-year downturn and climbed +3.2% during the first half of the year. That trend has been even more pronounced in major metro areas (some of which have seen their available inventory drop by one-third). An average apartment in New York City now goes for $2,756 per month, for example.

Major apartment owners are already moving to cash in. Equity Residential (NYSE: EQR), for example, has been feasting off distressed property sales and recently bought two luxury Manhattan residential towers for pennies on the dollar. Others are breaking ground on new developments — while single-family housing starts edged up +4% in August, construction of new apartment buildings jumped +32%.

The combination of robust demand and firmer pricing power has juiced earnings and given investors reason to cheer. My ETF Authority readers have already pocketed a nice gain on REZ, but for new money, I’d recommend Avalonbay Communities (NYSE: AVB) — arguably the industry’s premier player.

It’s no secret that real estate values are pretty much determined by three things: location, location and location. And while Avalonbay has a diverse portfolio of 164 properties (46,000 units) spread throughout 10 states, most are in densely-populated areas. Two dozen of those complexes are in the Washington D.C. area, with even more in Boston and San Francisco.

[ad#Google Adsense]Needless to say, upscale mid- and high-rise apartments in these regions (where space is at a premium) command higher prices. They also have higher barriers to entry and face less competitive threats from the “shadow inventory” of foreclosed homes.

Those competitive advantages are a big reason why Avalonbay’s shares have delivered a gain of +201% in the past decade.

Action to Take –> An unprecedented sea-change has turned tens of thousands of would-be homebuyers into renters. Home ownership rates have fallen to a decade low below 67% and could slide further as more families opt for apartments.

From a countercyclical standpoint, companies like Avalonbay benefit handsomely from weak homebuyer traffic.

In the meantime, the financial crisis has made easy credit much tougher to come by, both for home mortgages and apartment construction loans — both of which also work to the firm’s advantage.

The stock isn’t cheap, trading at 25 times forward earnings. But it does offer a tempting yield of 3.4% and could easily climb into the $120s with favorable macro trends and an ambitious development pipeline.

I consider it a strong portfolio contender, and will have my eye on third quarter results due out later this month.

— Nathan Slaughter

Source:  StreetAuthority

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