Zephyr18
Dear Baron Real Estate Income Fund Shareholder:
Following solid performance in the first quarter of 2024, Baron Real Estate Income Fund’s® (the Fund) performance reversed course in the second quarter and declined 1.92% (Institutional Shares), underperforming the MSCI US REIT Index (the REIT Index), which fell 0.22%, and the S&P 500 Index, which increased 4.28%.
In the first six months of 2024, the Fund’s performance is flat at 0.01%, modestly outperforming the REIT Index, which declined 0.84%.
Since inception on December 29, 2017 through June 30, 2024, the Fund’s cumulative return of 61.31% was more than double that of the REIT Index, which increased 25.86%.
As of June 30, 2024, the Fund has maintained high rankings from Morningstar for its performance:
- #4 ranked real estate fund for its 5-year performance period
- #4 ranked real estate fund since the Fund’s inception on December 29, 2017
Notably, the only real estate fund that is ranked higher than Baron Real Estate Income Fund for the trailing 5-year period and since the Fund’s inception on December 29, 2017, is the other real estate fund that we manage, Baron Real Estate Fund, which has three share classes.
We believe the Fund is populated with several attractively valued REITs and real estate-related companies and believe the two- to three-year prospects for the Fund are compelling.
We will address the following topics in this letter:
- Our current top-of-mind thoughts
- Portfolio composition and key investment themes
- Top contributors and detractors to performance
- Recent activity
- Concluding thoughts on the prospects for real estate and the Fund
Table I. Performance – Annualized for periods ended June 30, 2024
| Baron Real Estate Income Fund Retail Shares1,2 | Baron Real Estate Income Fund Institutional Shares1,2 | MSCI US REIT Index1 | S&P 500 Index1 | |
|---|---|---|---|---|
| Three Months3 | (1.93)% | (1.92)% | (0.22)% | 4.28% |
| Six Months3 | (0.05)% | 0.01% | (0.84)% | 15.29% |
| One Year | 6.59% | 6.77% | 6.25% | 24.56% |
| Three Years | (2.60)% | (2.36)% | (0.97)% | 10.01% |
| Five Years | 8.27% | 8.49% | 2.68% | 15.05% |
| Since Inception (December 29, 2017) | 7.40% | 7.63% | 3.60% | 13.55% |
| Since Inception (December 29, 2017) (Cumulative)3 | 59.10% | 61.31% | 25.86% | 128.42% |
|
Performance listed in the above table is net of annual operating expenses. The gross annual expense ratio for the Retail Shares and Institutional Shares as of December 31, 2023 was 1.32% and 0.96%, respectively, but the net annual expense ratio was 1.05% and 0.80% (net of the Adviser’s fee waivers), respectively. The performance data quoted represents past performance. Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate; an investor’s shares, when redeemed, may be worth more or less than their original cost The Adviser waives and/or reimburses certain Fund expenses pursuant to a contract expiring on August 29, 2034, unless renewed for another 11-year term and the Fund’s transfer agency expenses may be reduced by expense offsets from an unaffiliated transfer agent, without which performance would have been lower. Current performance may be lower or higher than the performance data quoted. For performance information current to the most recent month end, visit BaronCapitalGroup.com or call 1-800-99-BARON. (1)The MSCI US REIT Index Net (USD) is designed to measure the performance of all equity REITs in the U.S. equity market, except for specialty equity REITs that do not generate a majority of their revenue and income from real estate rental and leasing operations. The S&P 500 Index measures the performance of 500 widely held large-cap U.S. companies. MSCI is the source and owner of the trademarks, service marks and copyrights related to the MSCI Indexes. The MSCI US REIT Index and the Fund include reinvestment of dividends, net of foreign withholding taxes, while the S&P 500 Index includes reinvestment of dividends before taxes. Reinvestment of dividends positively impacts performance results. The indexes are unmanaged. Index performance is not Fund performance. Investors cannot invest directly in an index. (2)The performance data in the table does not reflect the deduction of taxes that a shareholder would pay on Fund distributions or redemption of Fund shares. (3)Not annualized. As of 6/30/2024, the Morningstar Real Estate Category consisted of 237, 225, 206, and 211 share classes for the 1-, 3-, 5-year, and since inception (12/29/2017) periods. Morningstar ranked Baron Real Estate Income Fund Institutional Share Class in the 28th, 67th, 2nd, and 2nd percentiles for the 1-, 3-, 5-year, and since inception periods, respectively. On an absolute basis, Morningstar ranked Baron Real Estate Income Fund Institutional Share Class as the 63rd, 155th, 4th, and 4th best performing share class in its Category, for the 1-, 3-, 5-year, and since inception periods, respectively. Morningstar calculates the Morningstar Real Estate Category Average performance and rankings using its Fractional Weighting methodology. Morningstar rankings are based on total returns and do not include sales charges. Total returns do account for management, administrative, and 12b-1 fees and other costs automatically deducted from fund assets. Since inception rankings include all share classes of funds in the Morningstar Real Estate Category. Performance for all share classes date back to the inception date of the oldest share class of each fund based on Morningstar’s performance calculation methodology. © 2024 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its affiliates or content providers; (2) may not be copied, adapted or distributed; (3) is not warranted to be accurate, complete or timely; and (4) does not constitute advice of any kind, whether investment, tax, legal or otherwise. User is solely responsible for ensuring that any use of this information complies with all laws, regulations and restrictions applicable to it. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. MORNINGSTAR IS NOT RESPONSIBLE FOR ANY DELETION, DAMAGE, LOSS OR FAILURE TO STORE ANY PRODUCT OUTPUT, COMPANY CONTENT OR OTHER CONTENT. |
Our Current Top-of-Mind Thoughts
At the half-way point of 2024, we have several top-of-mind thoughts:
We believe it is an attractive time to increase exposure to public real estate
- Several public REITs and non-REIT real estate-related companies have underperformed the S&P 500 Index since 2019, in part due to the lingering impacts from COVID-19, the aggressive Federal Reserve (the Fed) interest rate tightening cycle, and more recently, the overhang of the commercial real estate crisis narrative which we continue to believe is unlikely to materialize.
- Much of public real estate has been repriced for a higher cost of capital, and valuations are now attractive (see below).
- We believe Fed interest rate cuts are forthcoming, which historically have been positive for public real estate (see below).
- Our research conclusions for most real estate companies are encouraging:
- Business conditions, though moderating, are still growing and do not foretell a significant decline in growth.
- We see attractive demand versus supply prospects. Vacancies are low, rents and home prices continue to increase albeit at a slower rate, and competitive new construction is modest for most commercial and residential sectors and geographic markets over the next several years.
- Most balance sheets are in strong shape.
- The banking system is well capitalized, with ample liquidity.
- We believe future loan defaults will be mostly isolated to class “B” and “C” office buildings.
The valuations of several public real estate-related companies are compelling
- REITs versus the S&P 500 Index: According to research from Citigroup Inc., since 2007, REIT price to earnings multiples (P/E or FFO) have traded, on average, at a modest 0.7 times premium to the S&P 500 Index P/E multiple. Currently, however, REIT P/E multiples of 16.4 times are at a 4.6 times discount to the S&P 500 Index multiple of 21.0 times. The last time REIT valuations were cheaper versus the S&P P/E multiple was during the Global Financial Crisis in 2009.
- Public real estate valuations versus private real estate valuations: We find it notable that in the last few months private equity firms such as Blackstone Inc. (BX) have chosen to deploy billions of dollars of real estate capital in the public market rather than the private market due to the relative valuation appeal in public real estate. In April, Blackstone announced the $10 billion acquisition of publicly traded Apartment Income REIT Corp., a multi-family REIT. Blackstone also announced the $3.5 billion acquisition of Tricon Residential Inc., a publicly traded company that provides quality rental homes and apartments, earlier this year. We anticipate additional public market privatizations in the months ahead because there may be additional opportunities for private funds to purchase quality public real estate at valuation discounts to private market values.
- We believe several REIT and non-REIT real estate companies are cheap. Among REITs, we are identifying attractively valued REITs across all REIT categories, and we believe several non-REIT real estate categories are also attractively valued.
Fed interest rate cuts should be positive for real estate stocks and our Fund
- The global pivot in monetary policy – from restrictive to accommodative – has historically been bullish for real estate and the Fund. Lower interest rates and tighter credit spreads should support real estate valuations, reduce the weight of debt refinancings, and reignite the transaction market.
- Since the launch of the Fund on December 29, 2017, the Fed has lowered interest rates twice – in 2019 and 2020.
- 2019: The Fed cut interest rates 75 basis points (25 basis points on three different dates). In 2019, the Fund increased 36.5%, significantly outperforming the REIT Index, which increased 24.3%.
- 2020: The Fed cut interest rates 150 basis points in March 2020 in response to COVID-19. In 2020, the Fund increased 22.3%, significantly outperforming the REIT Index, which decreased 8.7%.
The 5-year period from 2019-2023 is an excellent case study that highlights the long-term appeal of the Fund
- From 2019 to 2023, real estate was faced with a highly unusual and, at times, challenging investing environment that included:
- COVID-19 and its positive and negative implications for various real estate categories
- A decline in the U.S. 10-year treasury rate to the lowest in history (0.52% on March 2020)
- A sharp reversal in interest rates as the Fed increased interest rates 525 basis points
- Multi-decade high inflation fueled by trillions of dollars of fiscal and monetary stimulus to combat COVID-19
- Emerging headwinds for some segments of real estate – notably lower quality office buildings
- Several other unusual developments, including bank failures, supply chain challenges, and the Russia-Ukraine war
- We believe the developments that occurred in the 5-year period from 2019 to 2023 highlight the long-term benefits of the Fund’s broader, more flexible, and more comprehensive approach to investing in REITs and non-REIT real estate-related companies.
- In certain years, the Fund may underperform – perhaps due to underperformance of non-REIT investments (2021, for example).
- Over the long term, however, we believe the Fund’s more expansive approach to real estate research and portfolio construction relative to more typical REIT dominated funds (we may invest up to approximately 25% of the Fund’s net assets in non-REIT real estate-related companies), and the merits of our actively managed strategy to navigate and capitalize on the ever-changing real estate investment landscape should result in long-term returns at or near the top of the real estate peer group.
- For the 5-year period ending December 31, 2023, the Fund:
- Significantly outperformed its benchmark index in 2019 and 2020
- Underperformed in 2021 largely due to the Fund’s non-REIT real estate investments which lagged following strong performance in 2019 and 2020 – and REITs had one of their best years on record in 2021
- Modestly underperformed in 2022 when growth-related real estate companies underperformed
- Outperformed in 2023
- Notably, for the 5-year period from 2019 to 2023:
- The Fund’s annualized 5-year performance of 12.64% more than doubled the REIT Index’s performance of only 6.15%
- According to Morningstar, the Fund was the #5 ranked real estate fund over this 5-year period
| Period | Baron Real Estate Income Fund Institutional Shares | MSCI US REIT Index | S&P 500 Index |
| Calendar Year 2019 | 36.54% | 24.33% | 31.49% |
| Calendar Year 2020 | 22.30% | -8.70% | 18.40% |
| Calendar Year 2021 | 29.58% | 41.71% | 28.71% |
| Calendar Year 2022 | (27.47)% | (25.37)% | (18.11)% |
| Calendar Year 2023 | 15.51% | 12.27% | 26.29% |
| 5-Years Ended 12/31/2023 (Annualized) | 12.64% | 6.15% | 15.69% |
- Looking forward, we believe the merits of our more diversified and flexible approach to investing in real estate may shine even brighter in part due to the rapidly changing real estate landscape which we believe will require a more expansive, discerning, and actively managed approach to investing in real estate.
Portfolio Composition and Key Investment Themes
As of June 30, 2024, we invested the Fund’s net assets as follows: REITs (82.6%), non-REIT real estate companies (14.7%), and cash (2.7%). We currently have investments in 11 REIT categories. Our exposure to REIT and non-REIT real estate categories is based on our research and assessment of opportunities in each category on a bottom-up basis (See Table III below).
| Percent of Net Assets | |
| REITs | 82.6% |
| Multi-Family REITs | 20.5 |
| Health Care REITs | 13.7 |
| Data Center REITs | 11.9 |
| Single-Family Rental REITs | 9.8 |
| Wireless Tower REITs | 8.7 |
| Industrial REITs | 6.1 |
| Mall REITs | 4.2 |
| Hotel REITs | 4.0 |
| Manufactured Housing REITs | 1.8 |
| Shopping Center REITs | 1.0 |
| Self-Storage REITs | 0.7 |
| Non-REIT Real Estate Companies | 14.7% |
| Cash and Cash Equivalents | 2.7% |
| Total | 100.0%* |
* Individual weights may not sum to the displayed total due to rounding.
REITs
Business fundamentals and prospects for many REITs remain solid although, in most cases, growth is slowing due to debt refinancing headwinds, a moderation in organic growth (occupancy, rent and/or expense pressures), reduced investment activity (acquisitions and development), and, in a few select instances, the impacts from transitory oversupplied conditions. Most REITs enjoy occupancy levels of more than 90% with modest new competitive supply forecasted in the next few years due to elevated construction costs and contracting credit availability for new construction. Balance sheets are in good shape. Several REITs have inflation-protection characteristics. Many REITs have contracted cash flows that provide a high degree of visibility to near-term earnings growth and dividends. Dividend yields are generally well covered by cash flows and are growing.
REIT valuations are attractive on an absolute basis relative to history and relative to private market valuations, but not relative to fixed income alternatives. If economic growth contracts and evolves into no worse than a mild recession and the path of interest rates peaks at levels not much higher than current rates, we believe the shares of certain REITs may begin to perform relatively well. Should long-term interest rates begin to decline and credit spreads compress, REIT return prospects may also benefit from an improvement in valuations as valuation multiples expand (e.g., capitalization rates compress).
Notable changes to the Fund’s REIT exposures since the end of the first quarter include:
- We increased the Fund’s allocation to REITs from 75.3% to 82.6% as REIT performance lagged in 2023 and in the first quarter of 2024.
- Notable increases to the Fund’s REIT allocations include multi-family, health care, and wireless tower REITs.
- Notable decreases to the Fund’s REIT allocations include industrial and mall REITs.
We continue to prioritize secular growth REITs and short-lease duration REITs with pricing power:
Secular growth REITs: Our long-term focus remains on real estate companies that benefit from secular tailwinds where cash-flow growth tends to be durable and less sensitive to a slowdown in the economy. Examples include our investments in data center, wireless tower, and industrial REITs. As of June 30, 2024, secular growth REITs represented 26.7% of the Fund’s net assets.
Short-lease duration REITs with pricing power: We have continued to emphasize REITs that are able to raise rents on a regular basis to combat inflation’s impact on their businesses. Examples include our investments in multi-family, single-family rental, manufactured housing REITs, and self-storage REITs. As of June 30, 2024, short-lease duration real estate companies represented 36.8% of the Fund’s net assets.
Secular growth REITs (26.8% of the Fund’s net assets)
Data Center REITs (11.9%): We believe the multi-year prospects for real estate data centers are compelling. Data center landlords such as Equinix, Inc. (EQIX) and Digital Realty Trust, Inc. (DLR) are benefiting from record low vacancy, demand outpacing supply, and rising rental rates. Regarding the demand outlook, several secular demand vectors are contributing to robust demand for data center space globally. They include outsourcing of information technology, increased cloud computing adoption, ongoing growth in mobile data and internet traffic, and artificial intelligence as a new wave of data center demand.
Wireless Tower REITs (8.7%): We are optimistic about the long-term growth prospects for wireless tower REIT American Tower Corporation (AMT), given strong secular growth expectations for mobile data usage, 5G spectrum deployment and network investment, edge computing (possible requirement of mini data centers next to a tower presents an additional revenue opportunity), and connected homes and cars, which will require increased wireless bandwidth and increased spending by the mobile carriers. In the most recent quarter, we acquired additional shares of American Tower because we believe growth is likely to accelerate in 2025 and the shares are attractively valued.
Industrial REITs (6.1%): In the second quarter, we lowered the Fund’s exposure to industrial REITs due to expectations that demand will continue to normalize to pre-pandemic levels (elongated corporate decision-making), elevated supply deliveries in the first half of 2024, and expectations of moderating rent growth in certain geographic markets.
We remain optimistic about the long-term prospects for industrial REITs. With industrial vacancies at approximately 5%; moderating new supply in the second half of 2024; rents on in-place leases significantly below market rents; and multi-faceted secular demand drivers including the ongoing growth in e-commerce, companies seeking to improve inventory supply chain resiliency by carrying more inventory (shift from just in time to just in case inventory), and on-shoring, we believe our investments in industrial warehouse REITs Prologis, Inc. (PLD), Rexford Industrial Realty, Inc. (REXR), and First Industrial Realty Trust, Inc. (FR) have compelling multi-year cash-flow growth runways.
Short-lease duration REITs (36.8% of the Fund’s net assets)
Multi-Family REITs (20.5%): In the second quarter, we significantly increased the Fund’s allocation to multi-family REITs from 8.8% at March 31, 2024 to 20.5% at June 30, 2024. Rental apartments are benefiting from the current homeownership affordability challenges. Multi-family REITs provide partial inflation protection to offset rising costs due to leases that can be reset at higher rents, in some cases, annually. We believe the supply outlook is likely to be attractive over the next few years. Balance sheets are well capitalized with low leverage thereby positioning certain multi-family REITs to take advantage of M&A opportunities should they arise. In summary, we are long-term bullish on multi-family REITs. For additional thoughts on multi-family REITs Equity Residential (EQR) and AvalonBay Communities, Inc. (AVB), please see the “Top net purchases” section later in this letter.
Single-Family Rental REITs (9.8%): Demand conditions for single-family rental home REITs, Invitation Homes, Inc. (INVH) and American Homes 4 Rent (AMH), are attractive due to the sharp decline in home purchase affordability; the propensity to rent in order to avoid mortgage down payments, avoid higher monthly mortgage costs, and maintain flexibility; and the stronger demand for home rentals in the suburbs rather than apartment rentals in cities. Rising construction costs are limiting the supply of single-family rental homes in the U.S. housing market. This limited inventory combined with strong demand is leading to robust rent growth.
Both Invitation Homes and American Homes 4 Rent have an opportunity to partially offset the impact of inflation given that their in-place annual leases are significantly below market rents. Valuations are compelling at mid-5% capitalization rates, and we believe the shares are currently valued at a discount to our assessment of net asset value.
We remain mindful that expense headwinds and slower top-line growth could weigh on growth in 2024. We continue to closely monitor business developments and will adjust our exposures accordingly.
Hotel REITs (4.0%): We remain long-term bullish about the prospects for hotel REITs and other travel-related real estate companies. Several factors are likely to contribute to multi-year tailwinds, including a favorable shift in consumer preferences, a growing middle class, and other encouraging demographic trends. Even though travel-related business conditions may moderate in the year ahead, which would negatively impact leisure spending and business travel, we maintain an allocation to select travel-related real estate because we believe the long-term investment case for travel is compelling and valuations are compelling.
Manufactured Housing REITs (1.8%): In the most recent quarter, we visited the management team of Sun Communities, Inc. (SUI) at the company’s corporate headquarters in Michigan and toured one of their properties. We have maintained our position in Sun Communities because demand for the company’s core business (manufactured housing, RVs, and marinas) remains strong, we believe the shares are attractively valued, and we have a favorable view of CEO Gary Shiffman, whose interests are aligned given his significant investment in the company.
Manufactured housing REITs such as Sun Communities represent a niche real estate category that we expect to benefit from favorable long-term demand/ supply dynamics. They are beneficiaries of strong demand from budget-conscious home buyers such as retirees and millennials, and negligible new inventory due to high development barriers. Manufactured housing REITs Sun Communities and Equity Lifestyle Properties have solid long-term cash-flow growth prospects and lower capital expenditure requirements than a number of other REIT categories.
Self-Storage REITs (0.7%): The Fund has modest exposure to self-storage REITs and will discuss our latest thoughts in our third quarter letter.
Other REIT and non-REIT real estate investments (33.8% of the Fund’s net assets)
Health Care REITs (13.7%): In the second quarter, we significantly increased the Fund’s allocation to health care REITs from 7.5% at March 31, 2024 to 13.7% at June 30, 2024. We are optimistic about our health care REIT investments in Welltower Inc. (WELL), Ventas, Inc. (VTR), and Healthpeak Properties, Inc. (DOC).
Our bullish outlook for Welltower and Ventas is largely due to our favorable view of the multi-year prospects for senior housing. We believe senior housing real estate is likely to benefit from favorable cyclical and secular growth opportunities in the next few years. Fundamentals are improving (rent increases and occupancy gains) against a backdrop of muted supply growth due to increasing financing and construction costs and supply chain challenges. The long-term demand outlook is favorable, driven in part by an aging population (baby boomers and the growth of the 80-plus population), which is expected to accelerate in the years ahead. Expense pressures (labor shortages/other costs) are abating, and we believe highly accretive acquisition opportunities may surface, particularly for Welltower given its cost of capital advantage.
In the most recent quarter, we initiated a position in Healthpeak Properties. Please see the “Top net purchases” section of this letter for our more complete thoughts on the company.
Mall REITs (4.2%): We remain optimistic about the prospects for the Fund’s investments in mall REITs Simon Property Group, Inc. (SPG) and The Macerich Company (MAC). We believe both companies are attractively valued and their real estate portfolios are benefiting from strong tenant demand for space, positive rent growth, and limited store closures and bankruptcies.
In the most recent quarter, we met with Jackson Hsieh, the newly appointed CEO of Macerich. We came away impressed and believe he will implement a strategy to improve the quality of Macerich’s real estate portfolio and enhance the company’s valuation by selling non-core real estate properties and repaying debt.
Shopping Center REITs (1.0%): We recently established a modest position in Federal Realty Investment Trust (FRT), a recognized leader in the ownership, operation, and redevelopment of high-quality, shopping center-focused retail properties located primarily in major coastal markets from Washington, D.C. to Boston as well as San Francisco and Los Angeles.
Non-REIT Real Estate Companies (14.7%): We emphasize REITs but have the flexibility to invest in non-REIT real estate companies. We tend to limit these to no more than approximately 25% of the Fund’s net assets. At times, some of our non-REIT real estate holdings may present superior growth, dividend, valuation, and share price appreciation potential than some REITs.
Following strong share price performance for several of the Fund’s non-REIT real estate holdings in 2023 and in the first quarter of 2024 and our expectation that growth may slow for some of the companies, we lowered exposure to non-REIT real estate investments from 22.1% at March 30, 2024 to 14.7% at June 30, 2024. Current non-REIT holdings include GDS Holdings Limited, Toll Brothers, Inc., Wynn Resorts, Limited, Lennar Corporation, Hilton Worldwide Holdings Inc., Brookfield Asset Management Ltd., Blackstone Inc., Lowe’s Companies, Inc., Brookfield Renewable Corporation, Brookfield Corporation, and Tri Pointe Homes, Inc.
Top Contributors to Performance
| Quarter End Market Cap (billions) | Percent Impact | |
|---|---|---|
| Welltower Inc. | $62.3 | 1.06% |
| Equity Residential | 26.3 | 0.94 |
| AvalonBay Communities, Inc. | 29.4 | 0.92 |
| GDS Holdings Limited | 1.8 | 0.59 |
| Digital Realty Trust, Inc. | 50.3 | 0.37 |
The shares of Welltower Inc. continued to perform well in the second quarter. Share price appreciation was driven by continued strong cash flow growth in its senior housing portfolio driven by strong occupancy and rent growth, strong execution on its highly accretive proprietarily sourced capital deployment opportunities, and an improved full-year growth outlook.
Welltower is a REIT that is an operator of senior housing, life science, and medical office real estate properties. We recently met with the entire Welltower senior management team and remain encouraged that the shares can continue to be a strong multi-year contributor for the Fund. We are optimistic about the prospects for both cyclical growth (a recovery from depressed occupancy levels following COVID-19) and secular growth (the senior portion of the population is the fastest growing portion of the population and people are living longer) in senior housing demand against a backdrop of muted supply that will lead to several years of compelling organic growth. Welltower is a “best-in-class” operator with a high-quality curated portfolio that is led by astute capital allocators, thereby allowing it to capture outsized organic and inorganic growth opportunities.
In the second quarter, the shares of Equity Residential and AvalonBay Communities, Inc., two large U.S. multi-family REITs, appreciated due to continued strong operating updates, improved full-year growth outlooks, and faster-than expected improvements in each company’s West Coast markets. Both management teams have assembled excellent portfolios of Class A apartment buildings located in high barrier-to-entry coastal markets with favorable long-term demographic trends and muted overall supply growth. Please see our section on “Top net purchases” for further thoughts on both companies.
Top Detractors from Performance
| Quarter End Market Cap (billions) | Percent Impact | |
|---|---|---|
| Prologis, Inc. | $104.0 | -1.69% |
| Equinix, Inc. | 71.8 | -0.75 |
| Wynn Resorts, Limited | 10.0 | -0.46 |
| Toll Brothers, Inc. | 11.8 | -0.39 |
| Park Hotels & Resorts Inc. | 3.2 | -0.36 |
The shares of Prologis, Inc. underperformed during the second quarter. Prologis is a REIT that is the global leader in logistics real estate with a focus on high-barrier, high-growth markets. The share price began to correct in April when the company reported strong first quarter financial results but slightly lowered its full-year outlook. Rent growth has been moderating in the industrial logistics real estate sector as tenants slow their decision-making amidst an environment of heightened macroeconomic uncertainty, while a wave of recently delivered new development projects provide tenants with more real estate options. We view these near-term headwinds as transitory and remain quite optimistic about Prologis’s multi-year growth prospects.
We expect industry fundamentals will firm up in the coming quarters in light of still healthy levels of demand combined with a dearth of expected new development deliveries. Long-term demand is poised to benefit from several ongoing secular tailwinds, including the growth of e-commerce, the build out of “last mile” supply chains, and the desire for more “just-in-case” inventory of goods. Management, who we think is top notch, expects to grow cash flow at close to 10% per year over the next several years as the company resets the portfolio’s low in-place rents up to market levels and investments in development, data centers and energy begin to bear fruit.
In the second quarter, the shares of Equinix, Inc., a leading global data center REIT, lagged following a hedge fund report in late March questioning the company’s accounting practices. Equinix’s Board subsequently launched an independent investigation. Over the course of nearly two months, a highly respected U.S. forensic accounting firm completed an in-depth outside review and concluded that there were no issues with either the GAAP or non-GAAP financial metrics that the company presented to investors. Equinix filed its quarterly financials and reported results that were above expectations.
We recently met with long-time CFO Keith Taylor, who we have known for 20 years, in our offices and continue to be optimistic about the long-term growth prospects for the company due to its interconnection focus among a highly curated customer ecosystem, irreplaceable global footprint, strong demand and pricing power, favorable supply backdrop, and evolving incremental demand vectors such as AI. Equinix continues to be a core position in the Fund – the company has multiple levers to drive outsized bottom-line growth with operating leverage. Equinix should compound its earnings per share at approximately 10% over the next few years and we believe the prospects for outsized shareholder returns remain compelling from here given the superior secular growth prospects combined with a discounted valuation.
Following strong share price performance in the first quarter, the shares of Wynn Resorts, Limited, an owner and operator of hotels and casino resorts, declined in the second quarter despite strong quarterly results.
We remain optimistic about the multi-year prospects for Wynn. We believe the ongoing re-emergence of business activity in Macau will drive additional shareholder value. If cash flow returns to the level achieved in 2019 prior to COVID-19, we believe Wynn’s shares will increase 30% to 50% from where they have recently traded.
We believe additional drivers for future value creation beyond a re-emergence in Macau business activity include: (i) our expectation for long-term growth opportunities in the company’s U.S.-centric markets of Las Vegas and Boston, including an expansion of Wynn’s Encore Boston Harbor resort; (ii) Wynn’s plans to develop an integrated resort in the United Arab Emirates with 1,500 hotel rooms and a casino that is similar in size to that of Encore Boston Harbor; (iii) opportunities to improve cash-flow margins by rightsizing labor and achieving lower staff costs in Macau; (iv) the possibility that Wynn is granted a New York casino license; and (v) an expansion in the company’s valuation multiple to levels achieved prior to the pandemic.
Recent Activity
| Quarter End Market Cap (billions) | Net Amount Purchased (millions) | |
|---|---|---|
| Equity Residential | $26.3 | $5.8 |
| AvalonBay Communities, Inc. | 29.4 | 4.6 |
| Healthpeak Properties, Inc. | 13.8 | 4.0 |
| American Tower Corporation | 90.8 | 3.9 |
| Independence Realty Trust, Inc. | 4.2 | 3.5 |
In the second quarter, we increased the Fund’s REIT exposure to best-in-class multi-family owners/operators Equity Residential and AvalonBay Communities, Inc. Our meetings with each management team supported our view that both companies are led by astute executives who are highly focused on driving value creation for shareholders.
Equity Residential and AvalonBay each own approximately 80,000 apartment homes primarily in coastal markets. We believe these portfolios offer superior long-term growth prospects due to:
- Favorable long-term demographic trends driven by strong population and job growth in their key geographic markets
- An undersupply of housing in the U.S. with outsized cost of ownership versus renting in their respective markets
- A high-earning, well-employed resident profile with attractive rent-to-income ratios allowing for future pricing power
- Low levered balance sheets which may present attractive opportunities for accretive external growth
In our opinion, the shares of Equity Residential and AvalonBay have been highly discounted relative to private market values and the underlying replacement cost of their portfolios. Our view was further cemented when Blackstone, one of the largest real-estate owners in the world, privatized Apartment Income REIT Corp., a multi-family REIT that owns and operates 27,000 apartments, in April 2024 for $10 billion or a 25% premium to its public market price. Blackstone’s purchase price was at a premium to where the higher quality portfolios of Equity Residential and AvalonBay were trading in the public markets.
Despite strong performance in the second quarter, we continue to believe that Equity Residential’s and AvalonBay’s shares are attractively valued relative to private market values and each company owns and operates excellent and relevant real estate that should perform well over the long term.
In the most recent quarter, we initiated a position in Healthpeak Properties, Inc. following our meeting with CEO Scott Brinker and CFO Peter Scott. Healthpeak is one of the largest health care REITs and owns a diversified portfolio of lab, outpatient medical, and continuing care retirement community (CCRC) properties.
We are excited about the long-term prospects for health care real estate, driven by an aging senior population and accelerating scientific discovery and drug approvals. We believe the multi-year growth prospects for Healthpeak are especially attractive for four reasons:
- The leasing demand environment for Healthpeak’s lab portfolio (approximately 45% of the total portfolio) continues to improve. Demand improvement follows a period of softer industry fundamentals and declining rent growth. The capital markets environment for biotechnology in particular has since improved dramatically, and management is optimistic that lab market rent growth may soon reaccelerate across the portfolio.
- Healthpeak’s outpatient medical and CCRC portfolios continue to perform well (approximately 44% and 10%, respectively, of the total portfolio). The outpatient medical portfolio has performed resiliently even as several competitor properties have underperformed owing to their inferior locations and tenant credit profiles. The CCRC portfolio continues to grow at a rapid clip.
- Several development and redevelopment projects offer significant growth potential over the next several years. The company has several development and redevelopment projects in California that are actively leasing and are expected to drive outsized growth over the next several years. Based on our recent discussions with management, we believe tenant demand for each project remains strong.
- The company’s recently completed merger with Physicians Realty Trust is highly synergistic. In March 2024, Healthpeak closed on its previously announced all-stock acquisition of Physicians Realty Trust for $4.6 billion. The combination formed a leading platform of outpatient medical real estate and is expected to realize meaningful synergies in 2024 and 2025, resulting in compelling long-term upside.
We believe the company can grow cash flow at a mid-high single-digit rate in the next few years. We view the current valuation as depressed relative to historical levels, publicly traded peers and the private market, and we expect the valuation multiple to expand in time. In the meantime, we earn a 6.2% dividend yield that is well covered, while management continues to look for opportunities to sell non-core properties at high multiples and recycle proceeds into share repurchases at low multiples.
| Quarter End Market Cap or Market Cap When Sold (billions) | Net Amount Sold (millions) | |
|---|---|---|
| Prologis, Inc. | $104.0 | $6.5 |
| Toll Brothers, Inc. | 11.8 | 3.3 |
| Wynn Resorts, Limited | 10.0 | 3.1 |
| DiamondRock Hospitality Company | 1.8 | 2.3 |
| EastGroup Properties, Inc. | 7.6 | 1.9 |
In the most recent quarter, we trimmed the Fund’s position in Prologis, Inc., the global leader in logistics real estate with a focus on high-barrier, high- growth markets, due to greater-than-expected near-term industry and business headwinds and less clarity around the timing of a positive inflection in the business. We believe these headwinds are transitory and should abate over the next several quarters, and that the multi-year secular growth prospects remain bright. Prologis continues to be a core position in the Fund, and we remain optimistic about the long-term growth prospects for the company due to its competitively advantaged global footprint and capabilities, property portfolio with highly visible embedded rent growth potential, and meaningful long-term potential upside from ongoing investments in development, energy storage, and ancillary services. We believe Prologis can continue to compound earnings at approximately 10% over the next few years.
In the second quarter, we trimmed our position in Toll Brothers, Inc. following exceptionally strong share price appreciation over the last year. Toll Brothers remains a position in the Fund, and we remain enthusiastic about the company’s prospects over the next few years. We believe that Toll Brothers has the ability to grow its community count of homes by approximately 10% per year as the company continues to gain market share against its smaller competitors who lack scale advantages, brand awareness, and access to attractively priced financing. For additional reasons we remain optimistic on our investment in Toll Brothers, please see the “Top contributors” section of our first quarter 2024 shareholder letter.
Following strong share price performance in the first quarter, we trimmed the Fund’s large position in Wynn Resorts, Limited, an owner and operator of hotels and casino resorts. We have maintained a position in the company and remain optimistic about the multi-year prospects for Wynn.
Concluding Thoughts on the Prospects for Real Estate and the Fund
We believe many of the real estate-related challenges of the last few years are subsiding and brighter prospects for real estate are on the horizon. We are optimistic about the prospects for the Fund with a two- to three-year view.
In our opinion, several of the headwinds since 2020 are reversing course and may become tailwinds for real estate. Examples include the lingering headwinds from COVID-19, the most aggressive Fed interest rate tightening campaign in decades, a spike in mortgage rates from 3% to 8%, fears of a commercial real estate crisis, a tightening of credit availability, multi-decade high inflation, and supply chain challenges.
We continue to believe the narrative about a commercial real estate crisis is hyperbole and unlikely to materialize. Public real estate generally enjoys favorable demand versus supply prospects, maintains conservatively capitalized balance sheets, and has access to credit.
We believe we have assembled a portfolio of best-in-class competitively advantaged REITs and non-REIT real estate companies with compelling long-term growth and share price appreciation potential. We have structured the Fund to capitalize on high-conviction investment themes.
We believe valuations and return prospects are attractive.
We continue to believe our approach to investing in REITs and non-REIT real estate companies will shine even brighter in the years ahead, in part due to the rapidly changing real estate landscape which, in our opinion, requires more discerning analysis.
For these reasons, we remain positive on the outlook for the Fund.
One final thought on return prospects. History suggests that if investors wait for the “all-clear signal” (e.g., a Fed interest rate cut), they may miss a good portion of the total return prospects for real estate. Markets tend to be anticipatory.
For example, following Fed Chairman Powell’s commentary in the fourth quarter of 2023 which implied that the Fed may no longer increase interest rates due to several months of improving inflationary data and may begin to cut interest rates in 2024, real estate stocks rebounded sharply in the last two months of 2023 – way in advance of a Fed interest rate cut. After bottoming on October 27, 2023, the Fund and the REIT Index both increased, in just over two months, by 22% and 24%, respectively, by the end of 2023.
| Quarter End Market Cap (billions) | Quarter End Investment Value (millions) | Percent of Net Assets | |
| Equity Residential | $26.3 | $14.3 | 9.8% |
| Welltower Inc. | 62.3 | 12.8 | 8.8 |
| American Tower Corporation | 90.8 | 12.7 | 8.7 |
| AvalonBay Communities, Inc. | 29.4 | 11.8 | 8.1 |
| Equinix, Inc. | 71.8 | 8.9 | 6.1 |
| Digital Realty Trust, Inc. | 50.3 | 8.5 | 5.9 |
| Invitation Homes, Inc. | 22.0 | 7.2 | 4.9 |
| American Homes 4 Rent | 13.6 | 7.1 | 4.8 |
| Prologis, Inc. | 104.0 | 5.8 | 4.0 |
| Healthpeak Properties, Inc. | 13.8 | 4.2 | 2.9 |
I would like to thank our core real estate team – assistant portfolio manager David Kirshenbaum, George Taras, David Baron, and David Berk – for their outstanding work, dedication, and partnership.
I, and our team, remain fully committed to doing our best to deliver outstanding long-term results, and I proudly continue as a major shareholder, alongside you.
Sincerely,
Jeffrey Kolitch, Portfolio Manager
|
Investors should consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus and summary prospectus contain this and other information about the Funds. You may obtain them from the Funds’ distributor, Baron Capital, Inc., by calling 1-800-99-BARON or visiting BaronCapitalGroup.com. Please read them carefully before investing. Risks: In addition to general market conditions, the value of the Fund will be affected by the strength of the real estate markets as well as by interest rate fluctuations, credit risk, environmental issues and economic conditions. The Fund invests in debt securities which are affected by changes in prevailing interest rates and the perceived credit quality of the issuer. The Fund invests in companies of all sizes, including small and medium sized companies whose securities may be thinly traded and more difficult to sell during market downturns. The Fund may not achieve its objectives. Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk. Discussions of the companies herein are not intended as advice to any person regarding the advisability of investing in any particular security. The views expressed in this report reflect those of the respective portfolio managers only through the end of the period stated in this report. The portfolio manager’s views are not intended as recommendations or investment advice to any person reading this report and are subject to change at any time based on market and other conditions and Baron has no obligation to update them. This report does not constitute an offer to sell or a solicitation of any offer to buy securities of Baron Real Estate Income Fund by anyone in any jurisdiction where it would be unlawful under the laws of that jurisdiction to make such an offer or solicitation. The portfolio manager defines “Best-in-class” as well-managed, competitively advantaged, faster growing companies with higher margins and returns on invested capital and lower leverage that are leaders in their respective markets. Note that this statement represents the manager’s opinion and is not based on a third-party ranking. Price/Earnings Ratio or P/E (next 12-months): is a valuation ratio of a company’s current share price compared to its mean forecasted 4 quarter sum earnings per share over the next twelve months. If a company’s EPS estimate is negative, it is excluded from the portfolio-level calculation. BAMCO, Inc. is an investment adviser registered with the U.S. Securities and Exchange Commission (SEC). Baron Capital, Inc. is a broker-dealer registered with the SEC and member of the Financial Industry Regulatory Authority, Inc. (FINRA). |
