Sept. 26 (Bloomberg) -- Apartment owners in the U.S. are benefiting as higher mortgage rates encourage people to rent rather than buy.

Shares of Equity Residential, the largest U.S. apartment landlord by market value, and AvalonBay Communities Inc., the third-biggest, have surged in the past year. They're leading a rally in real estate investment trusts that own apartments.

The stocks have climbed as rising interest rates made home ownership less attractive. The inventory of U.S. houses for sale has soared to the highest since records began in 1999 and prices have fallen for the first time in 11 years.

``What's good for homebuilders is bad for apartments and vice versa,'' said James Corl, head of real estate investment at New York-based Cohen & Steers Inc., where he has $16 billion under management. In the apartment market, ``demand is going to be swamping supply for the next few years. It's really going to be a Goldilocks environment for apartment landlords.''

An index of apartment REITs has risen 34 percent in the past year, the best performance among 10 groups in the Bloomberg REIT Index. The broader benchmark has climbed 21 percent and the Standard & Poor's 500 Index is up 9 percent.

Shares of Chicago-based Equity Residential have gained 33 percent while AvalonBay, based in Alexandria, Virginia, has risen 45 percent. Englewood, Colorado-based Archstone-Smith Trust, the second-largest apartment owner, has climbed 36 percent.

Vacancy Drop

In the top 25 U.S. markets, apartment vacancies dropped to 5.2 percent in the second quarter, the lowest in almost five years, from 6.2 percent a year earlier, Lou Taylor, an analyst with Deutsche Bank Securities Inc. in New York, said in a report last month. Rents rose 4.9 percent. Apartment construction equaled 1.3 percent of the number of existing apartments, near the three-year low set last year.

With vacancies already low and declining, and little new apartment supply coming on the market, landlords should be able to raise rents through the rest of the year and into 2007, Taylor said. As of the end of last year, rents were up just 5.6 percent from their recent low, at the end of 2002, while rents increased 37.5 percent from the 1992 trough to the 2000 peak, during the previous real estate cycle. That indicates that there's still room left for further increases, he said.

``Between the price of housing and mortgage rates, the cost of buying a house is so out of whack compared to renting, there's a huge gap that the apartment landlords can capitalize on,'' Taylor said.

`Buy' Ratings

Taylor has ``buy'' ratings on the shares of Archstone-Smith, AvalonBay, Equity Residential, Houston-based Camden Property Trust, San Francisco-based BRE Properties Inc. and Denver-based Apartment Investment & Management Co.

Housing affordability fell in July to its lowest level since 1989, according to the National Association of Realtors. The median home price rose by a record 49 percent over the past five years and mortgage rates climbed. Both increases are pushing newly formed households to become renters rather than buyers, Corl said.

The median single-family home price fell 1.7 percent in August, the realtors' association said yesterday. The decline was the first since April 1995.

If home ownership drops among the U.S.'s 100 million households by 2 percent to 3 percent, 2 million to 3 million households will be renting. The average rate on a 30-year fixed mortgage last week reached 6.4 percent, according to Freddie Mac, up from a four-decade low of 5.21 percent in 2003.

Have to Rent

``It's not that people want to rent, it's that they have to,'' Corl said. ``Rental housing is essentially an inferior good.'' Cohen & Steers has been boosting its holdings in BRE, an owner of apartment buildings in California, Arizona, Washington and Colorado, as well as AvalonBay, Camden and Equity Residential.

Prices of apartment REITs may come under pressure if the U.S. economy and housing market slow enough to hurt employment. The stocks also aren't cheap.

Apartment REITs sell for 25.5 times expected 2007 funds from operations, above the average for all REITs of 23.2 times, according to Steve Sakwa, an analyst at Merrill Lynch & Co. in New York. Funds from operations is a gauge of earnings used by REITs.

For now, the strength of the job market is boosting apartment REITs, according to Timothy Pire, managing director at Chicago-based Heitman LLC, which manages $3.5 billion. U.S. employers added 128,000 jobs last month and the unemployment rate fell to 4.7 percent from 4.8 percent in July, approaching a five- year low, according to Labor Department data.

Washington, California

``You need jobs, and that's going to be the main driver of apartment demand,'' Pire said. His firm has focused its investments on apartment REITs whose properties are mostly in supply-constrained markets such as California and Washington. Heitman owns shares of AvalonBay and Archstone-Smith.

AvalonBay's apartments are concentrated in Illinois and along the east and west coasts, including California, New York and the Washington area. Archstone-Smith's properties are in Washington, Southern California, the San Francisco Bay Area, the New York City area, Boston, Chicago, southeast Florida and Seattle.

``There's a lack of housing and a lack of affordability, and you have decent job growth, which should help support those markets,'' Pire said.

To contact the reporter on this story: Daniel Taub in Los Angeles at dtaub@bloomberg.net.

Last Updated: September 26, 2006 05:13 EDT