Interview with Ken Heebner from WSJ!

MUTUAL FUNDS QUARTERLY REVIEW

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Surviving a Real-Estate Slowdown
A 'Loud Pop' Is Coming,
But Mr. Heebner Sees Harm
Limited to Inflated Regions
By GREGORY ZUCKERMAN
July 5, 2006; Page R1
The real-estate market shows signs of slowing. Is there deeper weakness ahead? Fewer questions are more important to mutual-fund investors. Many own funds with real-estate-related shares -- not to mention homes and vacation properties. And many economists believe a slowdown of the housing market could hurt the overall economy.

To get a lay of the land, we tracked down Kenneth Heebner, who since 1994 has managed the $1.2 billion CGM Realty Fund. It has the best 10-year record of all real-estate-focused mutual funds, according to fund tracker Lipper Inc., up an average of nearly 22% a year during the past decade, well more than double the broader market. The fund also has one of the best one-year records, up 32% through June 30.

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Mr. Heebner, 65 years old, is better positioned than many real-estate fund managers to speak about prospects for the housing sector. His fund has viewed its mission more broadly than most rivals, so he isn't shy about ditching real-estate stocks. Among big holdings for CGM Realty during the past year: coal-company stocks, a hot category that qualifies in Mr. Heebner's view because coal companies own a lot of land. He also runs three other mutual funds, including CGM Focus Fund, so he spends a lot of time looking beyond houses and hotels to other parts of the economy. These three funds have among the best five-year records in their categories.

Here is our conversation:

WSJ: How is the housing market?

Mr. Heebner: A significant decline in prices is coming. A huge buildup of inventories is taking place, and then we're going to see a major [retrenchment] in hot markets in California, Arizona, Florida and up the East Coast. These markets could fall 50% from their peaks.

WALL STREET JOURNAL VIDEO


Journal reporter Gregory Zuckerman discusses how concerns about a housing slowdown have investors shifting their money to hotel and apartment REITs.
TAKING QUESTIONS


PODCAST: Mr. Zuckerman interviews Ken Heebner of CGM Realty Fund to discuss investing in the real-estate market. Listen now or subscribe, plus see all the Journal's podcasts.
WSJ: What has you so concerned?

Mr. Heebner: I'm worried that more people will default on their mortgages. Risky mortgages such as interest-only and pay-option adjustable-rate mortgages require no principal amortization and in some cases payment of only a fraction of the interest due, have been widely used in the last two years. Some people got 100% financing for their homes. It made the tech bubble look like a picnic. When housing is going up rapidly and you can buy far more than your income can support, some people are eager to make big profits by extending themselves financially.

As housing prices fall more people will be under water, and these people are just going to walk away from their homes. They are going to say, 'I'm outta here.' You're going to see increasing foreclosures over the next several years. As [home] prices come down, it will create a difficult environment for home builders.

WSJ: What data have you most worried?

Mr. Heebner: We're seeing a huge increase in inventories of unsold homes. The role of incentives in selling a home is increasing so the weakness doesn't show up immediately in list prices. Large price declines will follow in inflated markets.

WSJ: More than 25% of homeowners don't have a home mortgage because they own their property outright. Won't this keep problems in check?

Mr. Heebner: Most people won't have problems and much of the country will be fine. I don't think anything will go wrong in places like Texas, Iowa City or Minneapolis. ... But prices are being set by a minority of participants in the market, [those who have borrowed the most and used the most aggressive types of mortgages]. There will be a loud pop in inflated markets. It's where prices were artificially inflated by people buying houses with risky mortgages that we'll see problems. ... The person who feels the pinch is the person who used an aggressive mortgage and is struggling to meet the mortgage payments.

WSJ: Given the big size of some of the markets that you see as inflated, won't the regional 'pops' reverberate throughout the economy?


Mr. Heebner: The pops will reduce the growth rate of the economy, but they won't precipitate a downturn. The economy only turns down when the Federal Reserve takes aggressive action to cause a downturn. I think the current pattern of higher interest rates reflects a decision to normalize rates after taking them to abnormally low levels to stave off potential deflation. When the extent of the housing slowdown becomes apparent, I think the Fed will pause, rather than take rates to a level that threatens an economic downturn. The only real threat to the economy is an overly aggressive Fed, and not a downturn in the housing market, which won't by itself push the economy down. In fact, it provides an insurance policy against the Fed becoming overly aggressive.

WSJ: Do you agree with economists who have described the individual consumer as a linchpin of the economy during the past few years, using refinancings to fuel the expansion?

Mr. Heebner: Borrowing against home equity has been overrated as a source of economic stimulus. While it has been a factor in the economic expansion, I don't think it's been the most important factor.

WSJ: How are you allocating investments in your real-estate fund?

Mr. Heebner: We define real estate broadly; it includes mining companies, because of the land they use. Today we have about 25% of the fund in mining stocks. The stocks are attractive, but I also see significant opportunity in real-estate investment trusts, which comprise 69% of the portfolio. We also have 6% in commercial real-estate brokers.

WSJ: What areas of real estate are you most excited about?

Mr. Heebner: We're investing in office and apartment REITs, like Archstone-Smith Trust, Essex Property Trust Inc., SL Green Realty Corp. and AvalonBay Communities Inc. Apartment rents are going higher [as rising interest rates makes homes less affordable for many consumers, and a strong economy encourages rent increases].

In many parts of the country, like Texas, when demand goes up, companies can do more building of rental apartments. But the greatest supply constraints are in parts of the Northeast and California. And that's where the apartment REITs we own are focused.

In the office sector we like Vornado Realty Trust as well as SL Green, which have great management and are in Manhattan, one of the most supply-constrained areas in the country.

WSJ: Many apartment-REIT stocks already have climbed. Aren't rent increases baked into the stock price?

Mr. Heebner: Yes, people assume rents are going up, but the question is the magnitude of the increases. Consensus appears to assume 5% increases in the next year but I think the increases will be a lot more than that. Demand will grow, but supply of apartments won't because construction costs are increasing significantly and supply constraints will limit new developments in California and parts of the Northeast.

WSJ: What's your take on home-builder stocks?

Mr. Heebner: At the end of 2001 we bought home builders. These stocks were trading at six times earnings, and people were worried that the stocks would be hurt by an economic downturn. I became positive when I saw the growth potential created by rising demand and market share gain by the public builders. But if 20% of purchases are for investment purposes and so many borrowers are subprime, that says to me trouble is coming. We started cutting back on home-builder shares at the end of the fourth quarter of 2004 and eliminated them during the first six months of 2005.

WSJ: Why are you buying hotel REITs?

Mr. Heebner: After the 9/11 attacks, hotel construction fell, and it has only slightly recovered. But demand is growing, as the global economy strengthens and leisure travel is strong, as is business travel. You'll see more tourism with the dollar weaker. During the next several years, there will be an inadequate supply of hotels and that makes for a healthy environment for REITs. We like Host Hotels & Resorts, LaSalle Hotel Properties and FelCor Lodging Trust.

WSJ: What sectors are you favoring in your other funds?

Mr. Heebner: Energy and steel. I believe that the global supply and demand imbalance for crude oil remains in place. Robust global demand for steel is outrunning the ability of steel producers to meet demand.

WSJ: Your 10-year record includes a tough period. In 1998, the real-estate fund lost 21%, worse than the REIT index and much worse that the big gains of the broader market that year. What did that period teach you?

Mr. Heebner: In 1998 I had an aggressive position in hotel REITs. ... I anticipated that more companies would use a REIT structure to shield their earnings from taxes. But Congress changed the law, and I didn't see it coming. The market was smarter than I was. The lesson is that, if I see legislative activity that could be negative, I should pay more attention.

WSJ: How much should ordinary individual investors have in real-estate stocks and funds, given they probably own their homes?

Mr. Heebner: Commercial real estate has a totally different outlook than residential housing, [so commercial REITs] represent diversification. ... I own all the funds I manage and I own the condo I live in.

Write to Gregory Zuckerman at gregory.zuckerman@wsj.com