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Searching for undervalued stocks in today's bull market seems quixotic. But one stock group is catching the eye of some value players: battered-down mortgage real estate investment trusts.

Rather than buying buildings, these REITs buy securities backed by pools of residential and commercial mortgage loans. An oversupply of mortgage REIT initial public offerings, and the failure of some of them to produce their projected returns, has combined with unease over the direction of interest rates to send the Bloomberg REIT Mortgage Index down more than 26% from a year ago. ''With a whole industry down and out like this, you know darn well that out of the 20 or so companies out there, some know what they're doing,'' says John E. Maack Jr. of Crabbe Huson Real Estate Investment Fund.

If you're tempted to join Maack in his hunt for value, tread carefully. Yields of 9% to 12% on some of these REITs are seductive. That's one reason why individuals have snapped up many recent mortgage REIT IPOs. But institutional players, noting how the hard-to-value stocks tend to decline after their IPOs, are holding back. Even Maack has yet to find a stock he wants to buy. ''It's easy to figure out possible rewards,'' he says, ''but harder to assess risks.''

POOL PROBLEMS. Mortgage REITs are far from a generic bunch. Some target adjustable-rate or fixed-rate residential mortgages. But a new focus is emerging. Like residential loans, many commercial mortgages are now being packaged in pools and sliced by Wall Street into interest-rate-bearing commercial mortgage-backed securities (CMBS). REITs that buy CMBS deals face different risks than do residential players. Because of the nature of these securities, and the way the REITs finance and leverage them, it's very hard to assess credit and interest-rate risks.

Commercial mortgage REITs may own a mix of mortgage loans, including non-investment-grade portions of CMBS deals. Many loans have prepayment penalties that give investors some protection against getting principal back too soon if rates keep falling. But rising rates could mean falling income for some REITs, since they finance purchases of longer-term, high-yield securities with short-term borrowings at lower rates.

Mortgage REITs are volatile. In 1996, the group returned 50.9%, compared with 35.7% for all REITs tracked by the National Association of Real Estate Investment Trusts. But in 1997, they were up 3.8%, compared with 18.9% for all REITs. Year-to-date, the all-REIT index is down about 5%; mortgage REITs, which have fallen much farther than the all-REIT index in the past 12 months, are down 1.75%.

Mortgage REITs also have a checkered past. In the 1970s, highly leveraged mortgage REITs made a load of construction and development loans at the top of the real estate cycle. When real estate cratered, the loans--and the REITs--blew up. Today's mortgage REITs are investing more in the loans of existing buildings. But some of the REITs, such as Ocwen Asset Investment Corp., plan to invest in construction loans.

Most new mortgage REITs are externally administered, with the adviser motivated primarily by fees. Management fees often are based on the size of average invested assets, so managers are rewarded for piling up assets. Mike Kirby, an analyst with Green Street Advisors in Newport Beach, Calif., prefers the structure of Capital Trust, a self-managed, non-REIT mortgage investment firm whose top executives own about a third of the stock. ''When they place a bet, they're putting their own chips on the table,'' he says.

FEE REWARDS. Another structure that ties performance to profitability is one whose management fees are based on the average size of stockholder's equity. That's the case at Clarion Commercial Holdings, which went public May 28. But it and many other REITs also have incentive fees to reward managers for good performance. REITs argue that this helps combat any urge to pile on assets. But Clarion's prospectus notes that such performance fees ''may create an incentive'' for managers to recommend riskier, speculative high-yield investments.''

If you're still ready to take the plunge, EVEREN Securities Inc. analyst Thomas J. Maier maintains that there are ''real bargains'' today. He has reason to be bullish--his firm has been an underwriter of many mortgage REITs. He likes residential REIT Impac Mortgage Holdings (IMH). ''In addition to having a portfolio and the ability to manage it, they have a mortgage origination arm so they can benefit from prepayments,'' while REITs who lack such arms suffer from prepayments, he says. Among commercial players, he likes its sister company, Impac Commercial Holdings, as well as Ocwen Asset Investment--the latter a choice not universally shared. ''They raised money, but they've been a little slow putting it to work,'' says Greg Eisen, who owned Ocwen in the SAFECO Small Company Stock Fund, but sold it in May. He says ''competition is tough for what they want to buy''--the risky, high-yielding parts of real estate loans.

If you're tempted by a mortgage REIT, read the risk factors in its prospectus. If you understand the risks and still want to invest, you may garner some tidy yields. But don't be shocked if your purchase gives you a few sleepless nights.

By Suzanne Woolley


TABLE: Risks in Mortgage REITs


Updated June 11, 1998 by bwwebmaster
Copyright 1998, Bloomberg L.P.
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