To some, the term “distressed real estate” might conjure up visions of their teenagers’ bedrooms. For David Jarvis and Malcolm MacLean, co-founders of Mercury Special Situations Fund, properties selling at large discounts to asset value inspire a different outlook.

Mercury is a long/short fund specializing in small capitalization real estate securities. The objective is to find companies whose assets are selling for 30%-60% of realizable value, and to then engineer a more realistic appraisal. This sounds simple, but of course it’s not.

In reality, the opportunity exists for several reasons. First, both Mr. Jarvis and Mr. MacLean have a background in real estate investment banking at Kidder Peabody, and then Paine Webber, where the former was co-head of the Real Estate Group. They have both been involved in innumerable transactions in the industry, and are familiar with a broad range of properties.

Second, they venture where few dare. The companies currently owned in the portfolio are not followed by a single Wall Street analyst. They are flying, in effect, below the radar. Typically, they are buying companies with market caps of $150 million to $175 million.

They also buy complicated instruments, often distributed in the midst of a reorganization or recapitalization. Happily, few competing investors have the resources or patience to analyze such unusual securities.

For example, early this year they purchased a “pay in kind” preferred stock of a lodging company called Lodgian (AMEX-LGN) that was coming out of bankruptcy. This is a security in which a company may make dividend payments in stock if unable to meet cash requirements.

The security was priced at a discount to estimated liquidation value, so the Mercury managers deemed it low risk, especially when combined with a company turning itself around. Several months later, when the smoke cleared, they were able to sell the security for a quick profit of approximately 33%.

Finally, the team is able and willing to do extensive appraisal work on real estate properties. They are interested in a wide range of companies, including REITs, property operating companies and developers. These companies may be invested in office, multifamily, industrial, healthcare, or other kinds of properties.

Mercury looks for stocks selling at historical multiples of cash flow – as opposed to those prevalent in today’s frothy marketplace. Currently, in Mr. Jarvis’s view, the large real estate stocks tend to be overvalued. And that, too, presents an opportunity.

Mercury also sells short real estate securities. Of particular interest are companies paying out excessive dividends. Other red flags include companies which have recently changed auditors or rating agencies. Also, they look for companies with too much floating rate debt; this position in the past few years has bolstered income, but could pose a problem as interest rates reverse course.

Though the fund has a long bias, and usually owns 15 to 20 securities, Mercury typically also has a handful of short positions. One of the easiest ways to hedge a long bet in the sector is by shorting real estate exchange traded funds, or ETFs.

According to the Mercury team, these instruments are liquid and often are loaded to the gills with high-priced securities.

The liquidity issue is a real one for any manager dealing in small cap stocks. The Mercury managers watch their positions closely to ensure a comfortable exit strategy. Most positions can be liquidated in five to seven days; usually it takes longer than that to buy a position. Turnover is relatively low; they may hold stocks for one to three years.

Liquidity is not the only issue when dealing with small-cap stocks. The other is capacity. Though they point out that the combined market cap of their twenty long positions is over $2 billion, the Mercury managers concede that theirs is a narrow space.

Today they have $80 million under management, including two separately managed accounts with prestigious names. They expect to close the fund when it reaches $300 million. Given recent results, that may not take long.

So far this year, Mercury is up nearly 31% net of fees. Not bad in a year when most hedge funds are flat or down. In April and May, when most interest-rate sensitive funds got hammered by the uptick in rates, Mercury was off 2% and 2.1% respectively. In June the fund got back on track with an 11% bounce.

For all of 2003 the managers posted a gain of 43%; from inception in August 2002 the fund and its predecessor limited partnership are ahead 119%. This could be a tough act to follow, especially given current investor enthusiasm for real estate and consequent high valuations in the sector.

However, management claims to be finding as many good opportunities as in any recent period. They intend, furthermore, to rely on their ability to “harvest” valuation discrepancies. This is a nice way of saying that Mercury will, if necessary, force managements to realize asset values through privatization, asset sales, or liquidations.

Since the fund is concentrated in small companies, and is often one of the largest shareholders, Mercury can from time to time force managements’ hands. Recently, the management was in a contretemps with a company called Capital Properties (ticker symbol CPI on the AMEX).

Capital attempted to violate a shareholder agreement (according to Mercury) by trying to postpone the date by which it could elect REIT status. Mercury, a “significant” shareholder anticipating a stock price boost from the election, wrote an outraged letter to the American Stock Exchange protesting the delay; subsequently the AMEX turned down the request. Score one for Mercury.

Because Mercury is normally buying real assets at a hefty discount, the managers see limited downside to their holdings, and modest volatility. Since inception the fund has recorded a standard deviation of 14.5%, below the 15.2% of the S &P 500.

Also appealing is that the fund has proven to have little correlation to most conventional benchmarks, including real estate indicators such as the NAREIT index. The group’s goal is to earn net returns of 18%-22%; though this is way below the actual gains of the past two years, it is still an ambitious target.

Helping fill the sails has been interest and dividend income of 5%-6% annually. Though the portfolio is not managed to generate income, the nature of the underlying securities has produced this “icing on the cake.”

Investors are being charged plenty for the excellent results. The management fee is 2.5% with breakpoints for different asset totals. The incentive fee is 25% beyond a 10% hurdle. These fees are high compared to industry norms; we’re betting no one will object if Mercury’s managers continue to deliver. Talk about high-rent district.

Ms. Peek, CFA, is a former managing director of Wertheim Schroder, now part of Citigroup.