Determining how alveoli are formed and maintained is critical to understanding lung organogenesis and regeneration after injury. To study the cellular dynamics of this critical stage of lung development, we have used scanned oblique-plane illumination microscopy of living lung slices to observe alveologenesis in real time at high resolution over several days. Contrary to the prevailing notion that alveologenesis occurs by airspace subdivision via ingrowing septa, we found that alveoli form by ballooning epithelial outgrowth supported by contracting mesenchymal ring structures. Systematic analysis has produced a computational model of finely timed cellular structural changes that drive normal alveologenesis. With this model, we can now quantify how perturbing known regulatory intercellular signaling pathways and cell migration processes affects alveologenesis. In the future, this paradigm and platform can be leveraged for mechanistic studies and screening for therapies to promote lung regeneration.