From the June 2006 issue of Investment Advisor • Subscribe!

Location, location, location

Ken Heebner's broader definition of real estate can mean opportunity for investors

As advisors strive to diversify clients' portfolios by allocating investments across a broad range of asset types, one challenge may be finding assets that should benefit from an economic scenario that includes rising inflation and interest rates. Some advisors place part of the portfolio in real estate investment trusts, but how many REITs must one have in order to be diversified in that asset? Would those assets perform well in a low inflation and interest-rate environment?

"Our definition is broader than just real estate investment trusts, and there are times when we have invested in other types of real estate to capture opportunities for the investor," says Boston-based G. Kenneth Heebner, co-founder and portfolio manager of the $1.3 billion CGM Realty Fund (CGMRX), a real estate mutual fund. His strategy seems to be working: of all of the funds in Standard & Poor's Equity U.S. Real Estate sector, the CGM Realty Fund ranks number one, in total returns, for the one-, three-, five- and 10-year time periods ending April 28.

S&P gives CGM Realty Fund five stars overall, as well as across the board in the one-, three-, five- and 10-year periods. The fund has earned a five-year average annual return of 33.54% versus 20.42% for its real estate sector peer group, and a three-year average annual return of 46.75% versus 27.86 for its peer group. We spoke to Heebner in early May.

How much money do you manage in all the funds?

In the CGM Funds, it is $4.7 billion.

This fund looks different from other realty funds. Why?

The way we define real estate is broader than just real estate investment trusts; we brought this fund out in May of '94, and they have been the predominant investment in the fund over that 11-year period. However, there are times when we have invested in other types of real estate to capture opportunities for the investor. For instance, in the period between 1994 and 2001, the fund only owned REITs, but starting in '01 and particularly in '02, '03, and '04, the fund was largely invested in homebuilders because we felt that, even though REITs were good investments during the period, there was even more opportunity in homebuilders because of the advantages the national homebuilders had competitively and the strength of the homebuilding market overall--despite the fact that there was a recession in '01. We sold the homebuilders in early '05, and the real estate investment trusts have become again the predominant investment in the fund. We did something new in '05: in our definition of real estate we include mining companies because of their landholdings and their leaseholds. In effect, when you're talking about a homebuilder or a real estate investment trust, you're looking at what's on top of the land; with a mining company it's what's under the land. So in '05 we invested in mining companies--the principal ones were coal and copper.

Is it that the underlying commodities themselves were doing well, and giving you a little boost there, too?

The key ingredient in affecting the earnings and the stock price of the mining company is the commodity it produces. We continue to like real estate investment trusts today because the cash-flow-per-share in a number of the REIT sectors is going to be very strong, but we recognize that over the last five years, real estate investment trusts have been stellar performers, and the valuations relative to cash flow are on the high end of historical ranges. In the case of hotels, and office REITs in certain areas, and apartment REITs in certain areas, we still think the earnings and the growth in cash flow is going to be strong enough to make the stocks attractive. But in certain other cases, we think there's more opportunity in mining companies. But we're opportunistic--it's, "Where do we make the most money for the shareholder in real estate?"

Now, in terms of the overall environment--I think that this is very important in looking at real estate--over the last 20 years inflation has been declining in this country and around the world. I think we are in a period where there's a sea change in the long-term outlook, and the long-term outlook is for higher inflation, and this is not a bad thing for real estate. Real estate is a principal beneficiary of higher inflation. Inflation is a challenge for investors, because a higher cost of living means they need more money to maintain the same standard of living, and in most cases, investments still provide an offset--they don't grow as fast as the higher cost-of-living growth invades the buying power of the resources of the investor. But real estate is an exception to that, so I think that many types of real estate would be very good places for people to invest in an environment with rising inflation. Real estate investment trusts are in that category, and so, too, are mining companies that benefit from higher commodity prices.

Can you talk about your investment process for the fund?

We look for companies where the earnings or cash flow will exceed investor expectations and create strong relative performance. I also should mention one more area that has not, as a percentage of assets, been a big area for the fund, but which in 2005 we had very strong performance from, and that is commercial real estate brokerage firms. We have owned CB Richard Ellis Group, (CBG), and Jones Lang LaSalle, (JLL); both are consolidators in a fragmented industry. Both companies are acquiring smaller firms on an accretive basis. Both companies are benefiting from rising rents and rising property values, but also a trend for institutional investors to invest in commercial real estate. These companies are, for fees, assisting these [institutions] with their [investment] programs, and they have [plans] where they get a portion of the profits they earn for their pension fund customers. It's a little bit like a hedge fund, although it's not as lucrative as hedge funds are; they're running mini hedge funds for pension funds that want to invest in real estate.

Both companies are leaders in developing the foreign business, and the development of real estate investment trusts and commercial property investing is a lot less developed in foreign countries than it is in the United States. These companies are pioneering the effort in building significant market share in foreign countries, so they are also the beneficiaries of a weaker dollar, which is another piece of the investment landscape, because their earnings in these foreign countries are going to be worth more.

Is there any more that you can say about it?

Hotels were the biggest part of the portfolio on March 31. Hotel REITS were 34% of the portfolio. Look at the factors in the hotel industry: There is limited construction of new hotels; supply is estimated to grow at about 1.5% in the next two years, which is a low expansion rate by historical standards; the need is very strong because you have a strong economy, [with] high and growing corporate profits--so the combination of strong demand growth and limited supply growth is causing strong growth in occupancy and [room] rates, and that is causing high growth in cash-flow-per-share for hotel REITs. The consequence of that--and for valuation--is that these hotel REITs are less expensive than the other property types--so you've got higher growth at a lower valuation, and that is usually a strong driver of relative performance.

When you look at the office and apartment sectors, their regional differences are very important. Certain markets--we're talking offices now--California, Southern California, and Manhattan are seeing sharp upturns in occupancy and rental rates, and so the office REITs that are in those markets have a very strong outlook and we've invested in them. We have not been investing in office REITs that are in Dallas, Houston, or a number of markets around the country where there's still a glut of office space, and cash flows [would] probably not be increasing. In apartments, you've got a lot of regional differences here; once again all of California, Washington State, Washington, DC, Manhattan--these are markets where rents are rising in apartments, but there are many parts of the country where rents are not rising. So our apartment REIT investments are concentrated in those regions [where the rents are rising].

Could you talk about some of the largest holdings?

On March 31, the portfolio was 85% real estate investment trusts and 15% commercial real estate brokers. So in terms of holdings, the largest in the fund was CB Richard Ellis, the leading global commercial real estate brokerage company, which is benefiting from higher rents, increased investment activity, growing property values where they share in the profits of the [institutional investors] that they invest the money for, and particularly from the global consolidation and the growth of the foreign real estate markets, [so in] many, many ways this company is benefiting.

In terms of our hotel rooms, the largest [hotel REIT] investment [as of March 31] was LaSalle Hotel Properties, (LHO). This company is an opportunistic investor in, and up-grader of, hotels. It invests in those regions where it thinks the outlook for the hotel business is best, and in those regions they select hotels where they think there is an upgrade potential. For instance, today, its concentrations are in Washington, D.C.; it has bought Holiday Inns in that market and upgraded them to boutique hotels. The advantage is, they buy it on the basis of the income it earns as a Holiday Inn, and [LaSalle] enhances the return by upgrading the facility and realizing very significant increases in the room rates. [The firm] also plays turns in regional markets. Management believes that the Boston market is going to turn sharply to the upside, so they've made a number of investments in Boston. We've owned this company since 1998 and it has a superb record in this process of regional selection and upgrading.

The largest REIT investment is SL Green Realty, (SLG). SL Green is, I think, one of the best-managed real estate investment trusts in the country today. It only operates in Manhattan; it buys class B buildings and upgrades them. [The firm] uses its local knowledge to source deals before the deals become public auctions, so it can buy them less expensively. SL Green has a superb record of buying properties and upgrading them, and enhancing the return beyond that which the Manhattan market enjoys. It's focused in the area around mid-town, particularly the Grand Central area.

Is there anything that you've invested in for this fund that just didn't work out the way that you wanted?

Yes, we've had stocks that we've sold because they weren't doing as well as we thought. One of the things that happens with real estate investment trusts [is that] because they sell on a yield basis, when you find you want to move on to a different one that's performing better, the losses tend to be a lot less than in traditional stocks, because of the yield support.

Where would this fund fit in an individual's portfolio?

[With] an individual who shares my view that inflation is going to be increasing over the next several years, because I think that real estate and mining companies benefit from higher inflation whereas most investments don't.

Do you hold this fund in your personal portfolio?

I own all the funds I manage.

Staff Editor Kate McBride can be reached at kmcbride@investmentadvisor.com.

For a longer and more detailed version of this interview, as well as, "In The Running," a list of the other funds we considered for this month's profile and that you may find of interest, go to "Web Extras" at www.investmentadvisor.com.

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