Ken Heebner's Take on Real Estate

This savvy fund manager says there still are great ways to make money in this sector.

CGM Realty (symbol CGMRX (opens in new tab), another Heebner-run fund, has also produced fabulous results. Its 10% year-to-date return (through August 23) beats the Dow Jones Wilshire REIT index by 16 percentage points. Realty's five-year return of 34% per year wallops the REIT index by an average of 15 points per year.

KIPLINGER: Let's talk about real estate and CGM Realty. When we spoke with you early in the year, you indicated you were paring back your positions in real estate investment trusts.

HEEBNER: We're at about 25% in REITs today. It's near the low point. The portfolio has a concentration in industrial raw materials companies; we include mining companies in our definition of real estate. These are many of the same companies as in CGM Focus. We also define real estate as companies engaged in the financing of real estate, and recent purchases are Fannie Mae (FNM (opens in new tab)) and Freddie Mac (FRE (opens in new tab)), which I think are huge opportunities.

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How so?

When you look at what's happening in the mortgage business, the exotic mortgage activity has come to a virtual halt. And we're moving back toward traditional lending activity, where the borrower has to pay off the loan and where conservative lending standards are applied. And those standards have always been embraced by Fannie and Freddie. Basically you have to have a 25% down payment, and if you don't have a down payment of that size, you need private mortgage insurance before Fannie or Freddie will either own or securitize the loan. Their standards have not changed.

Haven't Fannie and Freddie been involved in some controversies?

Yes, both those companies have been under a cloud because the managements were manipulating earnings and taking excessive compensation. But those excesses are being corrected or well under way toward correction.

The fact of the matter is, if you look at mortgage originations in 2006, about 40% were exotic mortgages. So as we stand here today, 40% of the mortgage financing has been withdrawn from the market. And everyone knows that we need to increase the flow of mortgage money to re-stimulate housing -- no one has abandoned the support for home ownership in America.

What everyone is going to see is that we must go to Fannie and Freddie and energize them and embolden them. They'll still apply the same conservative standards. They are essentially the last men standing in the mortgage business, along with the banks and savings and loans, and they are going to have big market-share gains.

What is your view on housing stocks, which have taken huge hits?

I don't own them, and I don't know when will be the right time to buy them. The problems in the mortgage market affect the homebuilding industry. First, the most important impact will be a continued and perhaps accelerating decline in home prices broadly throughout the country. As a result of that, the companies will continue to have to take write-offs on their options and on their actual land holdings and will continue to experience losses that will reduce their book values.

So here are companies facing losses and decreasing prices for the product they are selling when they have an inventory of land based on a very different pricing environment. The tough times will continue, and I think we have a multi-year problem on our hands in the homebuilding industry. Having said that, stock prices lead fundamentals by a considerable period of time. So, if I'm bearish on homebuilding activity for the next two years, it doesn't mean that I'll be bearish on the stocks for the next two years. But I believe it's too early to buy the builders today.

Despite your concerns about housing, you don't think we're at risk of a housing-led recession?

Absolutely not. Let me make a very important point. While I said that 40% of the originations last year were for exotic mortgages, if you look at the total inventory of mortgages, it's $10.5 trillion. My estimate of exotic mortgages outstanding is $1.5 trillion. Maybe it's $2 trillion. Maybe it's $1.2 trillion. But clearly, any way you look at it, 80% of the mortgages out there are traditional. I'm leaving out the reset mortgages, where the borrower was creditworthy but he took out a mortgage with a teaser rate that resets. That's a whole other thing.

Well, the Fed could help those borrowers by cutting rates, right?

That's right. But having said that, the vast majority of mortgages are held by people who are going to pay them on time, who have jobs, who are conservatively financed and for whom this is in no way a fundamental event. They are totally unaffected by this. Clearly, the news flow gets scary and the question that's very hard to answer is to what extent people whose financial positions are comfortable and whose financing is conservative are going to cut back their spending because of the environment. And I don't know the answer to that. The important thing is that while this may be a major issue for the news media, it is not a problem for most Americans.

Manuel Schiffres
Executive Editor, Kiplinger's Personal Finance