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The Safe Real Estate Investment That Nobody’s Talking About

We’re more than four years into the housing downturn and it’s still fashionable to be bearish on real estate. And why not? The latest reading S&P/Case-Shiller Home Price Index revealed that home prices fell for the sixth consecutive month.

Eventually, though, the real estate market is destined to rebound. And history proves that investing in such turnarounds can lead to significant profits. For example, emerging from the last housing downturn in the early 1990’s, homebuilding stocks like Lennar Corp. (NYSE: LEN) and PulteGroup (NYSE: PHM) more than quadrupled in value.

Here’s the rub: Wall Street is telling you to do one of two things in order to profit from an imminent real estate rebound: Either buy homebuilding stocks or a (residential-based) Real Estate Investment Trust (REIT).

I’m sorry… but if this housing downturn lasts much longer – or worsens – homebuilding stocks, which are notoriously volatile, are going to get battered and bruised. And the dividends that residential REITs offer could dry up.

I assure you there’s a much safer option… even though nobody on Wall Street is talking about it. It’s called a pairs trade. And it’s the only way to profit no matter what direction real estate heads next.

Let me explain how it works…

Pairs Trading 101

Pioneered in the 1980’s by Morgan Stanley (NYSE: MS), a pairs trade involves taking a long position in one stock and a short position in another. At the same time.

The way this two-stock strategy sets you up to profit – in all market conditions – is simple.

Scenario 1: The two stocks you own both go up. But the stock you’re long on goes up more and faster than the stock you’re short.

Scenario 2: The two stocks you own both go down. But the stock you’re short drops faster and farther than the stock you’re long.

Scenario 3: The stock you’re long goes up and the stock you’re short goes down. The end result? Maximum profits.

As you can see, one half of the pairs trade could be unprofitable. But the goal is for the profits on the other half to exceed the losses, thereby resulting in a gain for the overall position.

A 1998 study from the Yale School of Management proves that it works, too. Using data going back to 1967, the researchers found that over a six-month period, each pairs trade averages a return of 12%.

The good news is that in certain cases, we can employ a pairs trading strategy without ever selling a stock short. Real estate happens to be one such example.

Buy or Rent? How About Both?

It’s important to realize that the downturn in the housing market has created a boon days for apartment owners.

A sluggish economy, tighter lending standards and job uncertainty combined to put 1.1 million more Americans into the rental pool last year. And apartment rental vacancies dropped to 6.5% from 8.2%.

But of course, apartment supply hasn’t increased as quickly as the number of renters. So basic economics are kicking in – increased demand and limited supply is leading to higher prices.

If you need proof, just review the most recent earnings reports of any apartment REIT. All are benefiting from increased rental rates.

What’s more, these conditions aren’t expected to end anytime soon, either. In fact, MPF Research expects apartment rental rates to jump by a solid 5.1% this year.

But even if the residential market starts to recover, apartment owners should keep profiting for three key reasons:

  1. Increased demand for apartments won’t suddenly dry up. The transition from buying to renting was gradual. The transition back promises to similarly slow moving.
  2. Leases tend to create significant “switching costs.” Renters can’t suddenly become homebuyers.
  3. As residential prices rebound, so too does the actual value of apartment buildings. In other words, apartment owners will share in any price appreciation, too.

Add it all up and the first move we need to make is to buy some apartments, stat!

Plenty of options exist, too…

A Residential Bargain Even Benjamin Graham Would Love

I’d stick with the nation’s largest apartment owners like Equity Residential (NYSE: EQR), AvalonBay Communities (NYSE: AVB), Camden Property Trust (NYSE: CPT) or UDR, Inc. (NYSE: UDR).

All sport modest yields of about 3%, too. In a sideways market, a little income never hurts.

Being an apartment owner during a housing downturn is a smart move. But we also need to realize this: residential housing won’t stay in the tank forever. That’s why the second half of our pairs trade should be an investment in a residential real estate company.

Which one?

This Company is Grabbing Discounts… And You Can, Too

It stands to reason that the hardest hit markets should also be the first to rebound. I’m talking about Arizona, California, Florida and Nevada. And that makes Avatar Holdings (Nasdaq: AVTR) a strong choice.

The company develops active adult and primary residential communities, with over 16,000 acres in Florida and Arizona. And it’s fundamentally fit to survive this downturn.

Since 2005, management has slashed staffing numbers by 60%. The company has retooled its business model, too, focusing on smaller houses with fewer amenities at lower price points (i.e. the sweet spot of the future market).

Most importantly, rather than acting like turtles, curling up in their shells until the crisis passes, Avatar’s management has actively scavenged the land for historic discounts.

And they’re finding them… at up to 91% discount.

Over the past year, Avatar acquired about 1,100 residential lots in Arizona and about 400 residential lots in Central Florida. Plus, management just raised $100 million via a convertible bond offering, which I fully expect it to use to fund more acquisitions.

I’m also encouraged by the fact that insiders own a sizeable 22% stake. They’re clearly invested for the long haul.

Avatar currently trades for about $22. But it’s conservatively worth about $28 per share, based on deep-value investor Benjamin Graham’s famous net Current Asset Value (NCAV) formula.

That represents an attractive 27% upside. If the residential market stays in the tank for a while, Avatar should at least trade up to its liquidation value. And if a true rebound kicks in? Shares of Avatar should really take off.

Ultimately, an investment in Avatar and a high-quality apartment owner at the same time should position you to profit no matter what direction the real estate market heads next. So get to it.

Good investing,

Louis Basenese