Mr. Market's Subprime Vision

In my last article, I talked about being an "anti-sheep" by ignoring the crowd of investors fixated on the subprime mess. I'm increasingly perplexed by the number of smart people who seem content to let Mr. Market lead the way, despite his failing eyesight. After all, he no longer seems able to distinguish between an office building and a residential two-bedroom rancher.

When you read about the subprime horrors that continue to unfold in front of our very eyes, real estate investment trusts (REITs) seem to be at the center of it all -- even though not all REITs should be. You don't have to look too hard to see that numerous REITs have little to no residential exposure, and by extension, little to no subprime exposure.

The real estate market in focus
A little REIT clarification is a good place to start in your quest to find values. REITs typically come in two flavors.

Equity REITs tend to own real property -- things you can touch, such as office buildings, hotels, and residential complexes. Major equity REITs include Boston Properties (NYSE: BXP  ) and Archstone-Smith (NYSE: ASN  ) .

Mortgage REITs (MREITS), on the other hand, make investments in financial instruments. Commercial MREITS originate and buy loans on properties such as hotels, retail properties, office buildings, nursing homes, and warehouses. Commercial mortgage-backed securities (CMBS) represent securitized interests in these various commercial loans; these vehicles have exploded in popularity in the last few years.

Now let's identify the real subprime culprit. Residential mortgage-backed securities (RMBS), as their name implies, are backed by residential debt: home loans and, more troublingly, subprime home loans. These asset-backed securities were assembled by investment banks such as Citigroup (NYSE: C  ) , based on home loans issued by companies such as Countrywide (NYSE: CFC  ) , and ultimately backed by ordinary homeowners' ability to repay their loans.

As the housing market has cooled, and those homeowners have begun to sweat the payments on their suddenly unsellable homes, investors have rightly panicked. The notorious Bear Stearns (NYSE: BSC  ) hedge funds that now lie in a smoldering heap were primarily underpinned by these residential investment products.

But Mr. Market, in his highly depressed and myopic state, has cast aside numerous companies in the equity REIT and commercial-mortgage backed securities space, even though, as we have seen, they don't really have subprime exposure. Understanding that the CMBS and RMBS markets are performing very differently is the key to seizing the present market opportunity.

Naming names
Before I call a press conference to defend those firms wrongly accused by Mr. Market, I think one of Warren Buffett's more famous quotes bears repeating: "We try to price, rather than time, purchases. In our view, it is folly to forego buying shares in an outstanding business whose long-term future is predictable, because of short-term worries about an economy or a stock market that we know to be unpredictable."

Right now, the market is fixated on its fears about the subprime housing meltdown, rather than on price and fundamentals. Accordingly, investors are ignoring conference calls, presentations, and 10-Ks from REITs that report pristine loan portfolios and scant, if any, exposure to the subprime mess. I believe that for a number of these commercial REITs, the price is right or close to right, despite (or sometimes because of) the market's fixation on subprime woes.

Take Northstar Realty Finance Corp. (NYSE: NRF  ) as one example. The company is a sort of hybrid-commercial equity outfit, holding commercial loans, physical commercial properties, and some synthetic debt products. Earlier this year, Northstar raised its dividend slightly, and the company has reported solid profits and high, stable returns on equity. As if that wasn't enough, Northstar has reported no portfolio losses or delinquencies, its spotless credit has enjoyed a steady stream of ratings increases, and insiders are regular buyers. The company also recently launched two private real estate funds, for which it acts as the general partner, creating another potential source of significant value.

Nonetheless, Mr. Market myopically shaved almost 3% off Northstar when the now-infamous Bear Stearns hedge funds, backed by residential mortgages, reported an almost complete loss of capital. In total, NRF has dropped 26% since the subprime worries began in earnest more than three months ago.

If you take the time to listen to presentations and earnings calls that happened just last month, names such as Northstar, Newcastle Investment (NYSE: NCT  ) , and RAIT Financial Trust (NYSE: RAS  ) seem to present potential buying opportunities with limited subprime exposure.

However, these opportunities probably won't stick around forever. Mr. Market will likely schedule laser eye surgery or don a pair of bottle-cap glasses soon. And when that correction comes, many of these values will likely vanish.

For related Foolishness:

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Fool contributor Rimmy Malhotra is a New York City-based money manager. He welcomes your feedback. He holds no personal or professional interest in any of the stocks listed above. The Fool has a disclosure policy you can trust.


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