Two storms are converging on the U.S. apartment industry amid the deepening credit crisis. While developers are forced to scrap projects because financing has dried up, many owners fear that the weak economic climate, with frailty among some of the nation's top financial institutions, steep plunges in the stock market and job losses totaling 760,000 to date in 2008, portend darker days for the industry. But amid these conditions, real estate experts call the apartment market the brightest light on a bleak landscape.

Analysts are bullish on the apartment sector because its fundamentals have outperformed the other major property types. In the second quarter, the national vacancy rate for apartments stood at 6%, while the office vacancy rate was 13%, according to New York real estate research firm Reis. Multifamily effective rents rose 1.1% in the second quarter, while office effective rents grew by only .07%.

But the economic crisis has not spared the apartment industry, and vacancy rates are rising, says Gleb Nechayev, senior economist at Boston-based CBRE Torto Wheaton Research. He predicts that the vacancy rate will increase over the next two years by 50 to 100 basis points.

“One thing is clear, it will show further weakening,” Nechayev says. “We do expect it to weaken for at least another year, or year and a half.”

While total returns for the 14 multifamily REITs fell nearly 21% year-to-date through Oct. 23, according to the National Association of Real Estate Investment Trusts (NAREIT), other sectors fared far worse over the same period.

In the office sector, REIT returns fell 39%, while retail dropped nearly 48%, and industrial, a startling 67%. The problems can be traced to the lack of credit, says Ronald Kuykendall, vice president of NAREIT.

Where were safeguards?

As spring turned to summer, the apartment industry was on track for a solid year. Credit markets had begun to rebound from a deep lending freeze, when the unthinkable happened. The federal government seized control of Fannie Mae and Freddie Mac on Sept. 7.

Then Lehman Brothers filed for Chapter 11 federal bankruptcy protection on Sept. 15, and the Dow Jones Industrial Average dove a record 777 points before Congress approved a $700 billion bailout of damaged mortgage assets held by financial institutions. The alarming sequence of events triggered a renewed credit freeze.

Chicago apartment developer Dan McCaffery is angry and frustrated over the domino effect from the subprime mortgage crisis. “I can't say anything other than that I'm shocked. It's just a damn shame that so many people have been so negatively affected by something so few people had control over. It's too bad that those who had control in government or higher places of finance weren't more on the ball.”

Tremors from Washington and Wall Street have rocked his own offices, says McCaffery, president of McCaffery Interests. “There's a direct correlation. We, and every business, depend on the free flow of capital. Today, credit is evaporating quickly.” Loans have become scarce.

He had the foresight months ago to arrange construction financing at 70% loan-to-value for the $80 million, 26-story Flair Tower in the River North area. McCaffery recently broke ground on the development, which will include 152 luxury apartments that will rent for about $2,500 per month when the tower is completed in 2010.

McCaffery says that if he were to seek a loan today to build the high-end development, he doubts he would get it.

Protecting the golden egg

The consensus among industry experts and many owners is that the takeover of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Corp. (Freddie Mac) was necessary to safeguard the enterprises' traditional role of supporting multifamily lending.