Demand for apartments could be the solution for condo oversupply in many U.S. downtowns.

Busted condo projects have stalled downtown revitalization efforts throughout the country. But help is on the way as these developments get restructured and are converted to rentals.

Take the case of San Jose, Calif., which has been trying to develop a vibrant downtown since the mid-1980s. Over the years, roughly 4,500 rentals and condominiums have been built downtown. The San Jose Sharks, a National Hockey League team, began playing there in 1993. Restaurants have opened, and a theater has been refurbished for opera.

But the downturn waylaid one of the critical pieces of the revitalization effort. A luxury 23-story condominium tower, which officials had hoped would help bring a critical mass of residents downtown, was originally slated to be finished by 2009, according to Harry Mavrogenes, executive director of the San Jose Redevelopment Agency.

Construction costs ran over budget, however, and developers couldn’t sell units in the $750,000 price range as hoped. Now, the curvy Three Sixty Residences is still empty after completion in early 2010, Mavrogenes says.

The gridlock is now set to ease as a Beverly Hills, Calif., real-estate company has cut a deal to buy the property’s $119 million construction loan at a discount from U.S. Bank. If the deal is successful, real-estate investment firm Kennedy Wilson plans to foreclose on the property and convert it into a rental, Mavrogenes says.

That would likely be good for San Jose. Although buyers are arguably more desirable residents than renters, getting more bodies downtown is paramount to keep the revitalization energized.

“Empty buildings stop revitalization cold,” says John McIlwain, a senior fellow for housing at the Urban Land Institute. “You want to get it occupied so you can get the people in there who can support the stores.”

Similar stories are playing out in downtowns throughout the country that are suffering from a glut of empty condos. These projects failed because developers couldn’t sell at the prices they needed to pay off their construction loans.

But opportunistic investors who buy that debt at a discount or take over the projects in another way typically can make a profit renting out units at market rates. 

Victor Calanog of Reis Inc., a real-estate research firm, says busted condos have hit Phoenix, Miami and other overbuilt housing markets the hardest. He estimates that about 6,300 failed condo units were converted to apartments from 2008 to the third quarter of 2010 nationally and that an additional 10,000 former condos are expected to be added in the next two years.

The conversion strategy is working partly because the rental market is faring better than most other commercial property types. Average vacancies in the major apartment markets nationwide fell to 7.1% in the third quarter of 2010, from 7.9% in the same period in 2009, and average monthly asking rents increased 0.5% from the second quarter to $1,037, Reis says. At the same time, U.S. office, retail and warehouse vacancies and rents are still deteriorating or stabilizing.

Part of the reason for this strong performance is that new development of rental apartments has been limited in recent years.

New supply is coming on the market from busted condos and single-family homes now for rent. But in many cities, this source of supply hasn’t been enough to halt rising rents, given the size of the market. There are an estimated 10 million apartment units in major U.S. cities, Reis says.

“In many markets, the recovery is just powering through the repurposed condos,” Calanog says.

Kennedy Wilson is betting that San Jose will be one of those markets. The San Jose rental market does look particularly promising: At 3.9%, its third-quarter vacancy rate is the third-lowest of the nation’s major metro areas. It also reported the 10th-strongest asking-rent growth, rising 1.1% from the previous quarter to average $1,515.50 a month, Reis says.

By contrast, the median sale price for resold condos in San Jose’s Santa Clara County fell 4.5% to $320,000 in October from about $335,000 in October 2009, and sales volume fell about 25.9% in the same period, according to MDA Dataquick.

Three Sixty Residences was built by Mesa Development LLC of Chicago. The project is one of the most luxurious apartment buildings downtown, with a pool, kitchens featuring Italian cabinetry and views of the Santa Cruz Mountains. Analysts predict two-bedroom units could fetch between $2,600 and $3,200 a month as rentals.

It is also one of four downtown condo towers that were conceived near the peak of the housing boom and that bring more than 800 units to the market. But those projects are faring somewhat better. A spokesman for the 88, one of the other new downtown towers, says more than 55% of its units have sold.

By Maura Webber Sadovi of The Wall Street Journal