Defining Real Estate Broadly

This interview with Kenneth Heebner, manager of the $1.2 billion CGM Realty Fund, appeared in yesterday's Wall Street Journal. It is notable for several reasons, the most interesting of which was surely lost on the vast majority of those who read the article.

Of course what's interesting and what's not all depends on your perspective and for most people these days who are fretting over the value of their home or the cost of their debt service, what probably struck a nerve was the dire prediction regarding real estate prices.

What caught our attention here we'll get to in a few minutes, but first, another real estate pro tells it like he sees it and not because he gets paid to see it a particular way.

After catching a few minutes of a CNBC program on real estate over the long weekend, where none other than National Association of Realtors Chief Economist David Lereah and the President of Century 21 were acting as though everything were hunky-dory, it was refreshing to see someone who manages a billion dollar real estate fund talking about "a significant decline in prices" in residential real estate in the hottest markets where home values "could fall 50% from their peaks".

After going through a litany of what ails real estate today - from risky mortgages and too little money down to rising inventory amid rising interest rates - it all seems so obvious when coming out of the mouth of someone well connected within the real industry, who can also speak freely.

"A significant decline in prices" and "could fall 50% from their peak".

There was this question by interviewer Gregory Zuckerman, who appears to have had some coaching from someone like David Lereah and was trying to elicit soothing words like "soft landing" from his subject, but got the exact opposite instead.

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.

What a stupid question from someone who works at the Wall Street Journal - prices are set at the margin. Shouldn't that be something that they go over with you early on, like when you're choosing a health care provider during orientation?

Now that a soft landing is ruled out, how bad might things get for the rest of the economy? Once again, Mr. Zuckerman zigs and Mr. Heebner zags.

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.

Some interesting points here - the Fed causes economic slowdowns, they will pause when a housing slowdown becomes apparent, and a slowing housing market is an insurance policy against overtightening.

Too bad about the monetary policy lag of six months or more, waiting for higher interest rates to work their way through the system - that's why the Fed always overtightens - the "running into a ditch" problem that Federal Reserve Board member have spoken of in recent months.

As for insurance against overtightening, maybe that's why they brought Henry Paulson in from Goldman Sachs to run the Treasury Department - maybe they're going to create some sort of "overtightening derivative" for the Fed where they can hedge their position on interest rate hikes like owners of mortgage backed securities lay off their credit default and interest rate risk.

That would likely work better as insurance than a housing market that is taking its sweet time in working back toward price levels that are not so outrageous. In many parts of the country, real estate prices have been so high for so long, that people have begun to think that this is normal.

But enough monetary policy small talk, what are you buying?

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.

Yes, if you're going to manage a real estate fund in the middle of this decade, be sure to own lots of mining companies - roughly $300 million of mining companies for this real estate fund. Although it would be hard to figure it out from reading the prospectus for CGM Realty (CGMRX), mining companies do own real estate so therefore they qualify.

Coal mining is mentioned elsewhere in the article, but who knows what other types of mining companies they've got in there - maybe some aluminum, copper, zinc, maybe even gold. And owning the commodity itself would probably qualify for this fund, since coal and metals are real estate.

Owning mining companies in a real estate fund can sure help the performance of your fund, as is the case for CGM Realty, which is up 32% in the last year.

As for more traditional forms of "real estate" investment, rising rents have been spotted across the land and therein lies a great opportunity.

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.

In what might be one of the more ironic of all possible outcomes for the real estate craziness of the current decade, the possibility of an apartment rental boom may be dead ahead.

With some of the millions of renters who were cajoled into becoming homeowners in recent years now doing an about-face back to apartment living, at the same time that the last of the condo conversions are being sold to first time buyers who still think real estate is a safe bet - all this has led to an oversupply of renters and a shortage of apartments, and naturally, rising rents.

Of course, just like homeownership in recent years, the apartment rental imbalance can not be resolved quickly, so in the interim, y0u guessed it, prices rise.

The apartment dweller, turned homeowner, turned renter again is sure to be delighted with the prospect of rising rental costs in the years ahead following the rising adjustable rate mortgage costs that prompted his return to the housing choice he happily accepted five years ago.