A Tale of Two Real Estate Funds

As investors in tech stocks and many blue chips watched their wealth evaporate with the demise of the great bull market, holders of real estate stocks were having a grand old time. And none had more fun than shareholders of two unusual no-load funds: Alpine U.S. Real Estate Equity, managed by Sam Lieber, and CGM Realty, run by Ken Heebner.

The funds\' post-bubble gains were unreal. From April 2000 through June 2005, CGM (symbol CGMRX; 800-343-5678) returned a resounding 29% annualized. Alpine (EUEYX; 888-785-5578) did even better, gaining 34% per year. Over the period, the average real estate fund earned 21% annualized while Standard & Poor's 500-stock index lost an annualized 3%.

But after marching in near lock step for years, Alpine and CGM began to part ways in the summer of 2005. In as stark a divergence as you'll ever see, CGM gained a cumulative 37% from July 2005 to September 1 of this year, while Alpine surrendered 20%. Alpine, down 15% in the first eight months of 2006, is the only real estate fund in negative territory so far this year. "This has been a crappy year, to be blunt," says Lieber.

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Neither Alpine nor CGM is a typical real estate fund. Most property funds emphasize high-yielding real estate investment trusts and are careful to diversify among the full array of property types. Lieber and Heebner aim for high growth by betting on narrow slices of the real estate universe. When they get it right -- as both did by concentrating on homebuilder stocks during the erstwhile housing boom -- they sizzle. But making sector bets within a narrow sector fund adds to the risk. Heebner cashed in a huge stake in homebuilder stocks early in 2005 and now has about two-thirds of the $1.3-billion fund's assets in REITs that own or manage apartments, hotels, offices or shopping centers.

Lieber was not so prescient. In July 2005, months after Heebner had sold the builders, Lieber had 55% of the Alpine fund in the group. Back then, Lieber says, he sensed that sales momentum and new-home prices would cool off, but he figured that the shares would escape with a "10% pullback, maybe 12%." So he stood firm.

When the downturn struck, it was harsh. Homebuilder shares fell 25% on average in late summer and fall 2005, settled down in winter, and slid again as mortgage rates rose last spring. Only in April and May -- when builders reported a surge of canceled orders, reduced profit forecasts and took charges against earnings as they cut the value of their land -- did Lieber trim builders. They now account for 35% of assets, which total $252 million, down from a peak of almost $900 million. "I'm mad at myself" for holding too long, he says.

Another dicey bet

Lieber predicts that builder stocks will recover once the housing slump hits bottom, which he thinks will occur in the first half of 2007. Meanwhile, he's placed another giant wager -- on hotel stocks, which now account for half of Alpine's assets. Lieber says hotels are changing hands at low multiples of earnings and cash flow and should gain in value. In addition, he says, hotel operators are making fat profits after raising room rates sharply over the past few years. But the prospect of a slower-growing economy with fewer people traveling makes this gambit a risky call.

In contrast, Heebner has reshaped CGM to look more like a traditional real estate fund. At last report, 70% of assets were in REITs, with big chunks in apartment, office and industrial trusts. CGM now yields 1.3%, compared with virtually zero for Alpine.

But don't mistake CGM's latest incarnation for a low-risk REIT fund. The fund held only 22 stocks as of June 30, with 31% of assets in lodging (although that's not necessarily how the fund is currently positioned; Heebner, who is known for changing his views on a dime and trading rapidly, declined to be interviewed for this article).

Moreover, Heebner has an expansive definition of real estate. Last year, he rolled some of the homebuilder-stock proceeds into coal companies -- a smart move. He then sold practically all the coal shares before the end of March. As of June 30, CGM had one-fourth of assets in industrial-metals companies, such as nickel producer Inco and copper giant Phelps Dodge. The fund's five biggest holdings were SL Green Realty, which mostly owns office buildings in New York City; La Salle Hotel Properties; Southern Copper Corp., which operates in Mexico and Peru; BHP Billiton, an Australian miner; and Jones Lang La Salle, a real estate services company. What side excursion could be next?

The lesson in all this is that real estate funds are no more interchangeable than bond funds or international funds. Advisers often suggest keeping 5% of your financial assets in real estate securities for diversification. If you agree, you might be better off with a fund that invests mainly in REITs, such as T. Rowe Price Real Estate (TRREX; 800-638-5660), a member of the Kiplinger 25. Or use exchange-traded iShares Dow Jones U.S. Real Estate Index (IYR). In either case, you\'ll get a yield of 2% or 3%, and you'll be less likely to get hit in the face -- as Alpine shareholders did and CGM investors still may -- by a nasty surprise.