Baron Real Estate Fund | Q3 2024

Baron Real Estate Fund® (the Fund) generated strong performance in the third quarter of 2024, gaining 17.89% (Institutional Shares). The Fund outperformed both the MSCI US REIT Index (the REIT Index), which increased 15.79%, and the MSCI USA IMI Extended Real Estate Index (the MSCI Real Estate Index), which rose 15.61%.

Since inception on December 31, 2009 through September 30, 2024, the Fund’s cumulative return of 605% was more than double that of the REIT Index, which increased 240%, and significantly higher than the MSCI Real Estate Index, which increased 414%.

The Fund has maintained its industry leading performance as of September 30, 2024. According to Morningstar, the Fund has achieved the following:

• #1 real estate fund ranking for both its 10-year and 5-year performance periods
• #1 real estate fund ranking since the Fund’s inception on December 31, 2009
• 5-Star Overall Morningstar Rating™

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

The key message from our second quarter shareholder letter was that we believed it was an attractive time to increase exposure to public real estate given our view of favorable valuations, expectations of Federal Reserve interest rate cuts, and generally solid, albeit slowing, business prospects. In the most recent quarter, the Fund increased 17.89%.

As we peer into the fourth quarter of 2024 and the full year 2025, we continue to believe now is an attractive time to invest in real estate.

BOTTOM LINE: WE REMAIN BULLISH.

Additional top-of-mind thoughts are as follows:

The dark clouds over real estate are lifting

For the last five years, real estate fears have been rampant. Concerns about COVID’s negative impact on certain segments of real estate, sharply higher interest rates, bank failures, commercial real estate crisis fears, and recession concerns have cast a dark cloud over real estate.

We have been vocal for some time that real estate-related fears are exaggerated and hyperbole.

Now there is emerging evidence that the dark clouds over real estate are lifting, and brighter days are on the horizon.

• Business conditions, though moderating, are still growing and do not foretell a significant decline in growth.
• We continue to 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 (see below).
• Most balance sheets are in strong shape and real estate companies are refinancing at lower rates than last year.
• The banking system is well capitalized, with ample liquidity.
• Federal Reserve interest rate cuts bode well for real estate (see below).
• Several public real estate companies have underperformed the S&P 500 Index since 2019, and we believe there is a “catch-up” opportunity.
• Much of public real estate has been repriced for a higher cost of capital, and valuations are now attractive (see below).

Interest rate cuts bode well for real estate

Federal Reserve Chairman Jay Powell on September 18, 2024, said the following:

“We think that it’s time to begin the process of recalibrating it (the federal funds rate) to a level that’s more neutral, rather than restrictive.”

Jay Powell used the word “recalibrate” nine times following the Federal Reserve’s decision to cut interest rates 50 basis points to signal, in our opinion, that more interest rate cuts are expected later in 2024, 2025, and perhaps after that. We believe a recalibration of interest rates to much lower levels will be bullish for real estate and the Fund.

Lower borrowing costs and tighter credit spreads tend to:

• Support real estate valuations
• Reduce the weight of debt refinancings
• Reignite the real estate transaction market
• Instill more optimism in tenants about the prospects for their businesses
• Increase the attractiveness of REIT dividend yields compared with other debt and cash-equivalent securities

The Fund excelled during the two most recent interest rate cut periods. The Federal Reserve cut interest rates in both 2019 and 2020. The Fund gained more than 44% in both 2019 and 2020, far outdistancing the REIT Index in both years. We are optimistic the Fund will perform well, once again, during the recently initiated rate cut cycle.

The real estate recovery is likely to be faster than expected

In prior real estate cycles, a poorly timed combination of excessive use of debt and overbuilding of homes and commercial real estate (collectively the “curses of real estate”), led to real estate downturns that, in some cases, were severe.

• The 1980s saw a boom in commercial construction which led to a correction in the late 1980s and early 1990s.
• The rapid supply of newly built homes and the excessive use of subprime mortgages and lax lending standards led to the global financial crisis of 2007 and 2008.

Today, we believe the real estate market is much healthier than in prior real estate cycles and this important point is not widely appreciated.

• Healthy balance sheets: Most real estate balance sheets are in far better shape than in prior real estate cycles. Leverage levels, the use of fixed versus floating rate debt, and the staggering of debt maturities are far superior then in the past. For example, REIT leverage levels (net debt divided by cash flow) are approximately 5.5 times today versus more than 8.5 times during the global financial crisis of 2007 and 2008.
• Limited new construction: Over the last few years, the steep increase in land prices, labor costs, and material prices has curtailed commercial real estate development because, in most cases, new development has not been economical. Residential real estate also has a supply shortage. The U.S. is building a similar number of homes and apartments today as it did 60 years ago – approximately 1.5 million homes – despite the fact that the U.S. population is approximately 340 million people versus 180 million 60 years ago!
• High occupancy levels: Several real estate categories have occupancy levels above 90% including apartments, industrial warehouses, single- family rental homes, manufactured housing, and others.

Relative to prior real estate cycles, which were burdened with excessive debt and an overbuilding of real estate, today’s healthier balance sheets, limited supply of residential and commercial real estate, and high occupancy levels should lead to better-than-expected rent growth, home price appreciation, and cash flow generation in the years ahead.

There are compelling valuations in public real estate

Several real estate segments and individual companies remain attractively valued despite recent share price appreciation. A few examples include:

• REITs: Green Street Advisors, a highly regarded real estate and REIT research company, noted in a report published on September 25, 2024, that the historic underperformance of REITs versus the S&P 500 Index is near the highest levels in the last 20 years. Green Street also believes that REIT valuations are cheap versus the S&P 500 and several years of strong REIT returns (or S&P 500 underperformance) would be required to close the valuation gap. We agree with Green Street’s observations. We believe several REIT categories are attractively valued including hotel, office, retail, and other individual REITs.
• Homebuilders: Despite strong performance over last few years, homebuilding companies are still valued at less than half the price to earnings (P/E) multiple of the S&P 500 Index (P/E of 10 times versus nearly 22 times). We believe there is a compelling case for a favorable paradigm shift higher in homebuilder P/E multiples. The strategic pivot by several homebuilders to a more land-light business model, the utilization of lower leverage, improved capital allocation, and the prioritization of scale advantages could lead to higher valuations for homebuilders over time. Further, despite several black swan events – COVID-19, a sharp increase in mortgage rates from 3% to 7%, and supply-chain disruptions – public homebuilders have managed their businesses exceptionally well and demonstrated that the demand to buy homes is resilient.
• Casino gaming companies: Several casino gaming companies are valued at or near trough valuation levels and offer compelling return prospects over the next few years including MGM Resorts International, Caesars Entertainment, Inc., Las Vegas Sands Corporation, and others.
• Additional examples of attractively valued non-REIT real estate categories: We believe certain residential-related building product/ services companies, commercial real estate services companies, and other non-REIT real estate companies offer compelling share price appreciation potential the next few years.
• A few examples of attractively valued real estate companies:
  • Brookfield Corporation: The recent share price of this best-in-class real asset-related alternative asset manager is only $53 and compares favorably to management’s estimate of its current net asset value of $84 and its expectation of $176 in five years. 
  • GDS Holdings Limited: At its recent price of $20, the company’s China data center business is valued at less than 10 times cash flow versus global data center peers that are valued at more than 20 times cash flow. We believe the shares may appreciate by more than 100% in the next three to four years.
  • CoStar Group, Inc.: At its recent price of $75, we believe that shares of CoStar, the global leader in digitizing real estate, are trading at a 20% to 30% discount to the current value of the company’s non-residential businesses, which we believe will be worth almost $200 over the next four to five years. We believe that CoStar’s aggressive expansion into the residential marketplace represents significant upside optionality if it proves successful.

We believe the Baron Real Estate Fund is a compelling mutual fund option

We continue to believe the benefits of the Fund’s flexible approach, which allows us to invest in a broad array of real estate companies including REITs and non-REIT real estate-related 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.
 

We currently have investments in REITs, plus seven additional non-REIT real estate-related categories. Our percentage allocations to these categories vary, and they are based on our research and assessment of opportunities in each category on a bottom-up basis (See Table II below).

* Individual weights may not sum to the displayed total due to rounding.

Investment Themes

We continue to prioritize seven long-term high-conviction investment themes or real estate categories:

1. REITs

2. Residential-related real estate

3. Travel-related real estate

4. Real asset-focused alternative asset managers

5. Commercial real estate services companies

6. Property technology companies

7. Data center operators

REITs

Business fundamentals are generally solid. Limited new competitive supply is forecast in the next few years. Most balance sheets are in good shape. Several REITs benefit from some combination of all or some of the following favorable characteristics including inflation-protection, contracted cash flows, and an ability to increase dividends. We are identifying several REITs that are cheap relative to history and private market valuations. REIT share price performance has historically benefited from an accommodative pivot in central bank monetary policy.

As of September 30, 2024, we had investments in nine REIT categories representing 27.9% of the Fund’s net assets. Please see Table III below.

* Individual weights may not sum to the displayed total due to rounding.

Residential-related real estate

A multi-decade structural underinvestment in the construction of residential real estate relative to the demographic needs of our country bodes well for long-term housing construction activity, sales, rentals, pricing, and repair and remodel activity. Cyclical tailwinds (pent-up demand, low inventory levels, and a still healthy consumer) and secular tailwinds (flexible work arrangements that favor suburban living, a desire to own newly built homes rather than existing homes which, on average, are more than 40 years old, and the lock-in effect for existing homeowners to remain in their homes due to the move higher in mortgage rates) should aid the new home market for several years. The strategic pivot by several homebuilders to a more land- light business model, the utilization of lower leverage, improved capital allocation, and the prioritization of scale advantages may lead to higher valuations for homebuilders over time.

As of September 30, 2024, residential-related real estate companies represented 33.1% of the Fund’s net assets. Please see Table IV below.

¹ Total would be 34.3% if included residential-related housing REIT Invitation Homes, Inc. 
* Individual weights may not sum to the displayed total due to rounding.

Travel-related real estate

* Individual weights may not sum to the displayed total due to rounding.

Real estate-focused alternative asset managers

Leading real estate-focused asset managers Blackstone Inc. and Brookfield Corporation have an opportunity to increase market share due to impressive investment track records and global scale advantages. They are also positioned to benefit from a secular growth opportunity for alternative assets due to long track records of generating attractive relative and absolute returns with less volatility than several other investment options.

Commercial real estate services companies

Leading commercial real estate services companies CBRE Group, Inc. and Jones Lang LaSalle Incorporated should benefit from structural and secular tailwinds: the outsourcing of commercial real estate, the institutionalization of commercial real estate, and opportunities to increase market share in a highly fragmented market.

Data center operators

In the most recent quarter, we acquired additional shares in data center operator, GDS Holdings Limited. We believe the shares are attractively valued and offer compelling long-term growth prospects. Please see “Top contributors to performance for the quarter ended September 30, 2024” for more on GDS.

Property technology companies

The collision of real estate and technology has led to a new category within real estate–real estate technology, also referred to as proptech. The emergence of proptech and the digitization of real estate is an exciting and promising new development for real estate. We believe we are in the early innings of a technology-driven investment cycle centered on data and digitization that allows real estate-related businesses to drive incremental revenue streams and lower costs.

CoStar Group, Inc., the leading provider of information, analytics, and marketing services to the real estate industry, is well positioned to capitalize on this burgeoning secular growth trend.

As of September 30, 2024, other real estate-related companies (which includes the four investment themes mentioned directly above) represented 24.0% of the Fund’s net assets. Please see Table VI below.

* Individual weights may not sum to the displayed total due to rounding.

The shares of homebuilders Toll Brothers, Inc., D.R. Horton, Inc., and Lennar Corporation increased sharply in the third quarter due to strong quarterly results, optimistic management commentary about future business prospects, and expectations that the Federal Reserve would lower interest rates which would ultimately improve home affordability and increase home buyer demand.

We believe the prospects for the Fund’s homebuilder companies remain promising due to:

• The multi-decade structural underinvestment in the construction of residential real estate relative to the demographic needs of our country which bodes well for new home sales.
• Cyclical tailwinds (pent-up demand, low inventory levels, and a still healthy consumer).
• Secular tailwinds (flexible work arrangements that favor suburban living, a desire to own newly built homes rather than existing homes which, on average, are more than 40 years old, and the lock-in effect for existing homeowners to remain in their homes due to the move higher in mortgage rates).
• The strategic pivot by several homebuilders to a more land-light business model, the utilization of lower leverage, improved capital allocation, and the prioritization of scale advantages may lead to higher valuations for homebuilders over time.

Shares of GDS Holdings Limited appreciated significantly during the quarter. We were encouraged by several fundamental updates and recently met with CEO/founder William Huang and CFO Daniel Newman in our offices.

We remain optimistic about the company’s growth prospects over the next several years, which can be bucketed into: i) its Asia ex-China data center business (GDS International or GDSI); and ii) its mainland China data center business (GDS Holdings or GDSH).

Bottom line: We see a path for the business to be worth $46 to $56 a share in two to three years versus approximately $20 at the recent market price.

• GDS International (Asia ex-China): We see cash flow for GDSI growing from less than $50 million today to over $500 million over the next three years! We value GDS’ ownership stake at $16 per share after accounting for the growth capital it has secured from renowned U.S. and global investors. Blackstone’s recent $16 billion acquisition of Southeast Asia based data center operator AirTrunk at 25 times cash flow is still at a substantial premium to where GDS is raising growth capital today, which provides an important valuation marker for a potential IPO of this business over the next 12 to 15 months.
   
• GDS Holdings (China): We believe the China data center business is at the doorstep of a growth inflection and see cash flow growing from about $700 million today to $1 billion over the next three years. We value the China business at $30 to $40 a share on what we believe is a conservative cash flow multiple and remain encouraged that there will be several catalysts to further
  surface value (e.g., a transaction to place certain stabilized assets into a listed REIT vehicle).

The shares of MGM Resorts International, a global casino and entertainment company that has properties in Las Vegas, high-end U.S. regional destinations, and Macau, declined in the most recent quarter due to concerns that near-term growth in its business will disappoint. At its recent price of only $39 per share, we believe these concerns are largely reflected in MGM’s share price. Our $57 per share estimate of the company’s sum-of-the-parts value represents 46% upside from its current price.

The shares of Wynn Resorts, Limited, an owner and operator of hotels an casino resorts, detracted from performance in part due to the disappointing recovery in business in Macau. The shares rebounded late in the third quarter in response to monetary and fiscal stimulus from the Chinese government. We chose to exit the Fund’s investment in Wynn and reallocated the capital to other investments that we believe offer superior performance prospects over the next few years.

In the third quarter, the shares of Martin Marietta Materials, Inc., a leading producer of aggregates (77% of gross profit) and specialty products, lagged in part due to wet weather which delayed work and likely negatively impacted mid-year aggregate price increases. Further, growing delays of non-residential activity may continue to limit volume growth. Though we remain optimistic about the multi-year growth prospects for the company, we trimmed a portion of the Fund’s holdings in Martin Marietta and may look for an opportunity to acquire additional shares at a later date.

In the most recent quarter, we acquired shares in Caesars Entertainment, Inc., the largest casino-entertainment company in the U.S. and one of the world’s most diversified casino-entertainment providers. We are big fans of CEO Tom Reeg and remain optimistic about the long-term prospects for the company.

The company operates primarily under the Caesars, Harrah’s, Horseshoe, and Eldorado brand names. The company generates approximately 50% of its cash flow from Las Vegas and 50% of its cash flow from regional destination markets. The company owns approximately half of its real estate and leases the other half from gaming REIT companies – Gaming and Leisure Properties, Inc. and VICI Properties Inc.

We believe currently soft business conditions are reflected in the company’s valuation. At its recent price of only $42 per share, the shares are highly discounted at only 8 times enterprise value to cash flow, a mid-teens free cash flow yield, and our assessment of fair value of more than $70 per share or more than 65% above its current price.

Further, we remain optimistic about the long-term prospects for Caesars for the following reasons:

• We are optimistic about the long-term prospects for Las Vegas and Las Vegas represents approximately 50% of Caesars’ cash flow. We believe that Las Vegas has structurally changed and has a year-round business and event calendar that has effectively eliminated off-peak months or lulls in business activity.
• Management remains focused on improving its balance sheet and believes there is a path to lowering its current lease-adjusted net debt to cash flow from approximately 5.5 times to less than 4 times through cash flow generated from asset sales and the company’s business operations.
• The company has an online sports betting and casino business that management believes will turn profitable and generate more than $500 million of cash flow by 2025.
• Additional positive catalysts could propel the shares higher including capital expenditures and cash interest expense, both of which have peaked, will decline in 2025, and will lead to additional cash flow generation. Further, Caesar’s plans to sell non-core real estate assets and acquire shares in its highly discounted stock.

During the third quarter we initiated a position in Vornado Realty Trust, a REIT that owns a portfolio of premier office and street retail properties concentrated in New York City. The company also owns a small portfolio of apartment units in NYC and two iconic commercial properties in Chicago (the Mart) and San Francisco (555 California Street).

While we have remained generally cautious on office real estate for several years in light of both cyclical and secular headwinds that we expected would persist, we also have acknowledged that certain well-located, modern office properties were poised to gain market share and outperform as market conditions improved. We would categorize Vornado’s portfolio as falling into the latter bucket.

We are optimistic about our investment in Vornado for several reasons:

1. We have begun to see several encouraging signs that lead us to believe that office fundamentals are bottoming and beginning to improve in several markets, most notably New York City. These signs include stable or rising utilization of office space, strong and broad leasing activity and tenant interest, more confident corporate decision making, and stabilizing market rents and concessions. We think Vornado CEO Steve Roth framed it well with his comments during the company’s second quarter earnings call in August:

“After a difficult four or so years, market dynamics are now reversing and growing constructive. There is no new supply on the horizon, tenants are growing and expanding and searching for space. And New York continues to be the single best market in the nation.”

2. Prospects appear bright for Vornado’s recently completed PENN 2 redevelopment project (total cost $850 million), as management recently noted a significant pick up in tenant tour activity and proposals in recent months at rents consistent with their underwriting. The lease-up of this property is expected to contribute meaningfully to cash flow growth over the next several years and improve tenant interest in the Penn District more broadly, where Vornado has a leadership position.
3. Management has also noted a pickup in buyer interest for its best-in-class street retail properties in New York City (17% of total cash flow) and recently sold one property at a premium valuation. Management believes valuations for many of their retail properties are back to or in excess of 2019 levels and that additional property sales may occur.
4. Vornado is well positioned to capitalize on any distressed real estate opportunities that may arise given its strong balance sheet and liquidity position.
5. Though Vornado’s stock has appreciated significantly since we first began acquiring shares, we still think Vornado’s valuation remains untethered from the private market value of its real estate portfolio. We also observe that Vornado’s stock trades at a meaningful and unwarranted discount relative to certain publicly traded REIT peers.

In the most recent quarter, we acquired additional shares of Equinix, Inc., the premier global operator of network-dense, carrier-neutral data centers.

We 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. 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.

Stepping back, we believe the multi-year prospects for real estate data centers are highly compelling – perhaps as strong as they have ever been.

Data center landlords such as Equinix and Digital Realty Trust, Inc. are benefiting from record low vacancy, demand outpacing supply, more constrained power availability, and rising rental rates. Several secular demand vectors, which are currently broadening, are contributing to robust fundamentals for data center space globally. They include the outsourcing of information technology infrastructure, increased cloud computing adoption, the ongoing growth in mobile data and internet traffic, and AI as a new wave of data center demand. Put simply, each year data continues to grow exponentially, and all of this data needs to be processed, transmitted, and stored – supporting increased demand for data center space. In addition, while it is still early innings, we believe AI could not only provide a source of incremental demand but also further accelerate existing secular trends by driving increased prioritization and additional investment in digital transformation among enterprises.

We reduced our position in American Tower Corporation during the quarter after outsized absolute and relative performance and the company’s execution on several key milestones, which investors began to recognize and led to what we perceive to be a fair valuation level. We recycled capital into several other new ideas with what we believe are more compelling risk/reward opportunities. Nonetheless, our fundamental conviction regarding the secular growth of mobile data, evolving network needs, and the idiosyncratic growth prospects for American Tower remain unchanged and may look to acquire additional shares in the future.

As noted earlier, we chose to exit the Fund’s investment in Wynn Resorts, Limited, an owner and operator of hotels and casino resorts, and reallocate the capital to other real estate-related investments that we believe offer superior performance prospects the next few years.

Shares of Equity Residential performed well during the quarter. We reduced our position due to less attractive return prospects for the shares over the medium term as our investment underwriting was pulled forward combined with a fair current valuation level. As we have previously written, we remain optimistic about the prospects for rental housing over the next several years due to favorable supply/demand dynamics and attractive renter income demographics. We continue to hold the management team at Equity Residential in high regard and are optimistic about the fundamental growth prospects for its curated rental housing portfolio in high barrier to entry coastal markets over the next several years. 

As noted earlier, 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 remain optimistic about the prospects for the Fund with a two- to three-year view.

We believe we have assembled a portfolio of best-in-class competitively advantaged 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 continue to believe the benefits of our flexible approach, which allows us to invest in a broad array of real estate companies including REITs and non-REIT real estate-related 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.

I would like to congratulate David Kirshenbaum who was recently appointed assistant portfolio manager of our Baron Real Estate Fund. David was previously named the assistant portfolio manager of Baron Real Estate Income Fund in 2018. David has made a significant and consistent contribution to the success of our real estate franchise and his appointment is a well-deserved promotion.

I would also like to thank the other core members of our real estate team – George Taras, David Baron, and David Berk – for their ongoing 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,