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.