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I was recently looking at some data regarding the REIT industry and what I found was quite interesting:

* In the last five years REITs returned more than 180% vs approximately 23% for the Nasdaq and S&P 500 (before dividends).
* Price to NAV is at a historically high level and this is occurring at a time where house prices are starting to decline.
* The dividend yield of REITs is at a historic minimum both in absolute terms and in terms of difference vs the S&P500 yield and the 10yr Treasury.

Now, someone could interpret this as worrisome, while the counterargument would be that capital appreciation is substituting the dividend yield. This would make sense for the past, given the significant appreciation in value of real estate assets.

However, what I like to look at in order to understand the value of an asset is the expected cash flow that the asset will guarantee me in the future. In the REITs industry, AFFO (adjusted funds from operations) is the best indicator, since it takes into account the real cash flow after deducting recurring capital expenditures. The apartment REITs industry is now trading at approximately 25x the 2007AFFO, for a yield equal to 4% (vs 4.5% of the 10 yr treasury bond). An extremely high multiple, especially when compared to historic averages.

In the past few years this high multiple was justified by increasing housing prices. This increase had a double positive effect: on one hand it contributed to an increase in the NAV of the REITs (apartments and new developments increased in value), on the other hand it induced more people to rent instead of buying, thus improving occupancy rates.

Now things are changing. The latest data from the National Association of Realtors suggest that this is now changing and prices are declining. The double positive effect could likely revert into a double negative effect and REITs like AvalonBay (NYSE:AVB), Essex Property (NYSE:ESS) and Equity Residential (NYSE:EQR) – all with 2007 AFFO multiples above 25 – will probably start showing some weakness.

The strategy: Investors who believe that sooner or later the valuation of apartment REITs will decline to more normal values, could take advantage of the low implied volatility of these listed options and buy long term put options on AVB or EQR.

Full disclosure: No position in any of the stocks mentioned at the time of writing.