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Commercial real estate is believed by many to hold the greatest risk within the mortgage REIT industry, and possibly within the financial and real estate sectors. Of course, with significant risk comes the opportunity for significant losses or gains.

Bad loans and bad tenants complicate the industry. Moreover, history indicates that commercial real estate often falls after the residential real estate market. Several investors, as a consequence, still expect commercial real estate to sustain its own separate, subsequent and consequential fall on the back of additional failing businesses and a lack of new commercial business coming in to replace them.

Commercial mortgage REITs are far more complex than residential ones, because their mortgages are more complex. The parties on both sides of the transaction are usually savvy and come to the negotiating table with lawyers, insurers and accountants. The terms are usually more complicated and the occurrence of incestuous relationships, where the borrower and lender have some close connections, is common. The issues make it difficult to conclude with any certainty when a default will trigger action, as terms are more likely to be re-negotiated between family and / or where no other tenant is likely to replace them.

Below are seven small-cap REITs that have exposure to commercial mortgages, though not necessarily exclusively or to a majority, depending on their present portfolio mix. Generally, there is an industry divide between residential mortgage REITs and commercial mortgage REITs. Many of these REITs can change their mortgage asset mix, and have in the past. The group offers yields ranging from zero to over 15%, and several with values near or well below book.
  1. Colony Financial (NYSE:CLNY)
    • Current Yield: 7.1%
    • Market Value: $600 million
    • Price to Book Value: 0.55
  1. CreXus InvestmentCorp. (NYSE:CXS)
    • Current Yield: 9.3%
    • Market Value: $823 million
    • Price to Book Value: 0.88
  1. iStar Financial Inc. (SFI)
    • Current Yield: N/A (0%)
    • Market Value: $685 million
    • Price to Book Value: 0.39
  1. NorthStar Realty Finance Corporation (NYSE:NRF)
    • Current Yield: 10%
    • Market Value: $311 million
    • Price to Book Value: 0.35
  1. Newcastle Investment Corp. (NYSE:NCT)
    • Current Yield: Just declared a 10-cent quarterly dividend (7.3% annualized)
    • Market Value: $429 million
    • Price to Book Value: 30.8
  1. Resource Capital Corp. (NYSE:RSO)
    • Current Yield: 15.7%
    • Market Value: $444 million
    • Price to Book Value: 1.03
  1. Starwood Property Trust Inc. (NYSE:STWD)
    • Current Yield: 8.6%
    • Market Value: $1.45 billion
    • Price to Book Value: 1.09

Several of these commercial mortgage REITs have significant short positions. Many investors believe an interest rate change or second real estate correction will reduce the value of the underlying properties and increase the probability of greater defaults. Moreover, higher rates should make it less profitable for future tenants to occupy commercial space, possibly keeping higher vacancies for an extended time-frame.

Further, despite the loft yields some of these REITs offer, all 7 of these equities are down so far in 2011 between approximately 5% and 20%.

(Click chart to enlarge)

Most of the above-mentioned names are below book, indicating that either much of the risk is already factored into the price or that the book value is not realistic relative to the market. Of course, market values are often capricious and volatile in times of such uncertainty. This is a risky asset class and many equity investors will end up investing in some bad mortgages. Nonetheless, higher quality mortgages with higher credit tenants and higher demand locations will probably perform well enough in the coming years, and offer inflation protected returns over time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article should not be construed as personalized investment advice as it does not take into account your specific situation or objectives.

Source: Small-Cap Commercial Mortgage REITs: Valuations Continue to Exhibit High Risk/Reward Characteristics