Top-performing real-estate fund changes course

Kenneth Heebner, manager of the top-performing real-estate mutual fund over the past 10 years, says the economic damage from high-risk mortgage defaults is going to get worse.

"We have a trillion dollars of subprime mortgages and we're going to have huge defaults," Heebner said from his office in Boston. "If you're looking at the housing market, it's not the darkest before dawn, it's the darkest before pitch black."

Heebner, co-founder of Capital Growth Management, has been selling shares of real-estate investment trusts that buy apartments because they are no longer cheap. At year-end his CGM Realty Fund had 35 percent of its assets in REITs. He's made a "significant reduction," though he wouldn't be more specific.

The $1.5 billion Realty fund returned an average of 20 percent over the past 10 years, the most of any real-estate fund, according to data compiled by Chicago-based Morningstar.

The fund advanced 29 percent last year, almost double the gain in the Standard & Poor's 500 Index. It trailed the 36 percent rise in the Bloomberg U.S. Real Estate Index.

Heebner is known for making concentrated investments in a few industries. He owned homebuilder stocks in 2001 to 2005, record years for home sales. He bet against technology and telephone stocks in 2000, correctly timing their collapse.

He's changed course again.

"For 10 years, I've been a flat-out bull on REITs in general," said Heebner, whose 17-year-old firm oversees more than $6 billion. "I think they've reached a fair valuation."

REITs are selling at 20 times the cash they're generating per share, Heebner said. Private-equity firms eager to buy real estate have driven prices up. On Feb. 9, Blackstone Group acquired Equity Office Properties Trust for $39 billion in what was then the biggest-ever leveraged buyout.

"I don't see them as being economic buyers," Heebner said about buyout firms. "They're creating transactions that will line their pockets."

Investors are concerned rising subprime-mortgage delinquencies and defaults will hurt the U.S. economy. Heebner said the surge in bad subprime mortgages will hurt the economy as it puts a drag on the housing market, but he doesn't expect a recession.

Still, the secondary market for subprime loans could "shut down" as U.S. mortgage companies including Freddie Mac stop buying them.

"I have anecdotal information that these people are having trouble selling this paper," Heebner said.

Investors in Heebner's funds get a manager who doesn't restrict himself to a category and whose returns can fluctuate, said Morningstar analyst Federico Cepeda.

"The fund is one of the most volatile offerings in the real-estate category," he said.

The no-load Realty fund's Sharpe ratio is 1.63, compared with 1.38 for the average real-estate fund, according to Morningstar. A higher Sharpe ratio means better risk-adjusted returns.

Morningstar rates the fund five stars, its highest designation.

While Heebner's view on apartment REITs may have soured, he's more optimistic about the prospects of those investing in offices, especially SL Green Realty, New York's biggest office landlord.

"The Manhattan office market is the most powerful in the country," Heebner said.

He also favors office REITs that operate in San Francisco, Los Angeles and Boston. "There's room for rents to move up a lot," he said.