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Apartment construction leading housing recovery

Builders amped up the volume in July for single-family homes and multifamily apartments, but the real strength is clearly still in the rental market.

Developers see surging demand on the rental side, as an improving economy allows more young workers to move out of their parents' basements and into apartments.

"People have been downplaying the multifamily side because that's more volatile, but that's been a big part of the construction recovery," Trulia's chief economist Jed Kolko said Tuesday on CNBC's "Squawk Box." "When we look at markets that are seeing a construction boom right now, relative to what's normal for them, it's places like New York, Boston, San Francisco, California, places where most of the new construction is multifamily."

The Space Needle stands near newly constructed apartments in downtown Seattle, July 21, 2014.
Mike Kane | Bloomberg | Getty Images
The Space Needle stands near newly constructed apartments in downtown Seattle, July 21, 2014.

These markets are on track to build at least 50 percent more new homes in 2014 than their historical average, according to Kolko's study of building permits. That's why apartment real estate investment trusts in these regions, like Avalon Bay and Equity Residential, are hitting new highs on Tuesday.

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Meanwhile, Detroit, Atlanta, Chicago and much of Florida are still building well below historical norms. They are struggling with an oversupply of vacant homes, some of them held off the market by either banks or investors—thousands still stuck in the foreclosure process.

"Bottom line, the starts figure was again mostly driven by multifamily in response to the lowest homeownership rate in almost 20 years," said Peter Boockvar, chief market analyst of the Lindsey Group. "The single-family improvement was great to see but 656,000 [annualized starts], is only slightly above the 12-month average of 628,000 and compares with the peak of 1.8 million in 2006, the 1991 recession trough of 604,000 and the 1981 recession bottom of 523,000. Good and better are very relative terms."

While builders are the most optimistic they've been since the beginning of this year, mortgage applications to purchase a home are still at six-month lows, despite falling rates. New home prices could also be a big roadblock in 2015, as cheaper, existing homes come on the market, but some builders, like DR Horton, have already said they will offer incentives to get more buyers to contract.

"They're going to open the communities and we believe that demand will be sufficient to meet the new supply, but in some instances there will be builders that are going to have to incentivize to move inventory," said real estate analyst Ivy Zelman, founder of Zelman Associates.

Along with starts and building permits, Zelman watches "pipes," that is when builders develop unfinished lots with sewers and sidewalks.

"Development activity is a leading indicator of starts, and development activity is definitely above normal now," she said. "We believe the starts will continue to result in new community growth and we will see market demand sufficient to meet that new supply."

Read MoreHome builder confidence surges despite slower sales

Bob Youngentob, president of urban builders EYA, which builds mostly town homes and condominiums in higher-density locations in the D.C. metropolitan area, is seeing big demand from empty nesters and young millennials. While he builds different products at different prices to attract each, he admits, price could still be a headwind in the coming months.

"A lot of it is attributed to the fact that in 2013 there was such a robust energy in the marketplace that every builder raised their prices, as you would expect them to do relatively aggressively, and we probably priced some people out of the market," Youngentob said.

Prices for newly built homes were up over 5 percent in June from a year ago, and new homes already come at a premium to existing homes.

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"Builders theoretically will find that there is a 'ceiling' on prices in areas where resale supplies start to increase, but my take is that the impact of that will vary greatly," said Brad Hunter, chief economist at Metrostudy. "If the new product is far superior to the resale supply, then it won't have much impact at all. I think that will be the case most of the time."

Builders are still facing some supply constraints, with a lack of skilled labor and finished lots. Single-family building permits are still below year-ago levels based on a three-month running average.

"This was a good month, but we are not out of the woods yet," said Patrick Newport, an economist with IHS Global Insights. "However, builders' optimism is picking up, as some of their pipeline pressures ease and more potential buyers enter the marketplace."

—By CNBC's Diana Olick

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  • Diana Olick serves as CNBC's real estate correspondent as well as the editor of the Realty Check section on CNBC.com.

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