Baron Real Estate Fund: Latest Insights and Commentary

After selling off in March due to the U.S.-Iran conflict and disruptions in the Strait of Hormuz, U.S. equities rallied to new record highs during the second quarter, with most of the gains coming in April and May. Given narrow market breadth and concentrated position sizes in recent years, the gap in performance between the market cap-weighted S&P 500 Index and the equal-weighted version has reached extremes not seen since the dotcom bubble era (based on rolling three-year results). 

Real estate shares also rebounded. The MSCI USA IMI Extended Real Estate Index rose 9.88%, while the MSCI US REIT Index gained 11.84%. Performance was broad but uneven, with REITs, homebuilders, building products companies, and travel-related businesses benefiting from improving sentiment, attractive valuations, and generally healthy demand. Retail, health care, industrial, and data center real estate remained particularly well supported, while residential and certain commercial categories showed early signs of improvement. 

M&A activity accelerated across several real estate industries, highlighting the gap between depressed public market valuations and higher private market values. At the same time, elevated interest rates and housing affordability pressures continued to constrain transaction activity, while concerns about AI-related disruption weighed on some commercial real estate services firms and alternative asset managers. 

We believe the conditions are in place for real estate to perform well over the next few years. Demand across most property sectors remains steady, while new supply has declined—often by more than 50% from peak 2002 levels—a dynamic we believe is underappreciated. 

As a result, growth may rebound more quickly than in prior cycles because the sector is not burdened by excess supply or elevated vacancies. Many public real estate shares have lagged, and valuations have reset to reflect a higher cost of capital, leaving many trading at attractive discounts to private market values. This disparity could support continued real estate M&A activity. 

CONTRIBUTORS

• The Macerich Company is a REIT that owns a high-quality portfolio of U.S. mall properties. The stock contributed to performance during the second quarter on continued strong execution by the management team in its multi-year plan to create a more efficient, faster-growing, lower-leverage retail mall portfolio. We continue to believe that Macerich should benefit from favorable real estate fundamentals for high-quality, well-located retail properties, with tenant demand exceeding available space and generating rent growth.
• Shares of global hotelier Hyatt Hotels Corporation increased in the second quarter as revenue per available room accelerated and management highlighted rising franchisee interest in its brands. As a result, the company is seeing strong growth in earnings and cash flow. Hyatt continues to have a robust balance sheet and is repurchasing shares, taking advantage of the stock’s significant valuation discount to peers despite having a similar mix of fee-based business. We believe Hyatt remains an attractive investment despite recent gains.
• AAON, Inc. is a leading manufacturer of commercial and industrial heating, ventilation, and air-conditioning (HVAC) systems. Shares rose during the quarter after the company reported exceptionally strong earnings, driven by significantly faster-than-expected growth in the BasX data-center cooling business. Up 26% sequentially and 72% over the past year, BasX has established itself as a best-in-class provider of customized cooling solutions relative to peers’ more standardized offerings. With the new Memphis facility ramping production, the company can now meet elevated demand with more than $2 billion in BasX revenue capacity. The core HVAC business also performed well, with market share gains accelerating on the back of strong heat-pump and national accounts growth. We believe AAON is well positioned to continue compounding well above peers for the foreseeable future.

DETRACTORS

• GDS Holdings Limited is a leading developer and operator of high-performance data centers, operating in key cities across China and expanding rapidly across Asia. Despite solid operating results and strong performance earlier in the year, the stock declined in the second quarter. Several factors weighed on performance, including management's commentary around the components of full-year guidance, a material step-up in expected capital expenditures over the next few years, a slight delay in the expected timing of an inflection in underlying growth. We trimmed our position and reallocated capital to ideas where we have greater visibility and lower exogenous risk, particularly given the current geopolitical environment. However, we continue to see evidence of the growing AI wave in China through significant bookings growth and believe the market underappreciates the value of GDS's stake in its spun-out international subsidiary, DayOne.
• SiteOne Landscape Supply, Inc. is the largest distributor of wholesale landscape supplies in North America. The company sells irrigation, hardscapes, agronomics, and nursery products to professional contractors through its branch network for maintenance, repair and upgrade, and new construction applications. Shares fell as investors grew concerned about the impact of the war in Iran and a possible slowdown in demand amid rising commodity prices. Even so, we believe the company remains well positioned to continue outgrowing its markets and expanding margins as it realizes benefits from ongoing initiatives and investments focused on improving underperforming branches, operational efficiency, technology, and product category management. These efforts should further differentiate SiteOne within the fragmented wholesale landscape supply distribution industry. The company also remains focused on expanding its product offering and geographic footprint through consistent M&A activity, which, combined with organic growth from market share gains, should drive EBITDA margins toward the company's long-term 13%-plus target from below 10% today, creating meaningful upside potential over time.
• Blackstone Inc. is the world’s largest alternative asset manager, with over $1.3 trillion in assets under management, and the largest real estate manager globally. Shares declined in the second quarter as mounting redemption pressures at Blackstone’s private credit vehicle (BCRED) and sector-wide liquidity concerns overwhelmed an otherwise constructive fundamental backdrop. Redemption requests reached approximately 8% of NAV in the first quarter, followed by 10% in the second quarter, requiring Blackstone to cap withdrawals at the standard 5% limit for the first time. Broader sector sentiment deteriorated further when other alternative asset managers announced withdrawal restrictions, reigniting private-market liquidity fears and dragging the entire sector lower. We retain conviction in Blackstone given its premier brand, global franchise, loyal customers, exceptional balance sheet, and excellent management team.

When reviewing performance attribution on our portfolio, please be aware that we construct the portfolio from the bottom up, one stock at a time. Each stock is included in the portfolio if it meets our rigorous investment criteria. To help manage risk, we are aware of our sector and security weights, but we do not include a holding to achieve a target sector allocation or to approximate an index. Our exposure to any given sector is purely a result of our stock selection process.

Baron Real Estate Fund (the Fund) appreciated 11.89% (Institutional Shares) in the second quarter, outperforming the more comparable MSCI USA IMI Extended Real Estate Index (the Index) by 201 basis points due to solid stock selection. The Fund was unable to distance itself from the MSCI US REIT Index because favorable stock selection in REITs and benefit of having unique exposure non-REITs was negated by the impact of holding cash (5.2% on average) in a rising market.

Stock selection was positive across most real estate categories where the Fund had investments, with the standouts being homebuilders & land developers, casinos and gaming operators, REITs, and building products/services companies, contributing 350-plus basis points of stock-specific gains. Performance in homebuilders & land developers was bolstered by Meritage Homes Corporation, Toll Brothers, Inc., Taylor Morrison Home Corporation, and KB Home, whose share prices were lifted by improved investor sentiment towards U.S. homebuilders amid stable long-term U.S. interest rates and relatively inexpensive valuations. Rising industry acquisition activity, including news of Berkshire Hathaway’s agreement to acquire Taylor Morrison for a meaningful premium, also contributed to strength in the category. We sold Taylor Morrison and increased exposure to homebuilders by establishing positions in Meritage Homes, KB Home, and PulteGroup, Inc. during the quarter. 

Regional casino operator PENN Entertainment, Inc. led the way in the casinos & gaming category. PENN benefited from property enhancements and expansions across 4 assets and their digital losses were less as they had fewer promotion and marketing costs. The company is still generating strong cash flow which is being used to improve the balance sheet and increase liquidity for further investments. PENN should still be able to grow EBITDA in the coming years with no new supply in any of their markets, giving them strong pricing power. The consumer remains strong and we see continued strength as people value experiences over things and continue to spend despite macroeconomic uncertainty. 

Global entertainment company MGM Resorts International and Las Vegas-focused casino operator Red Rock Resorts, Inc. also performed well in the category.

Strength in REITs was driven by The Macerich Company, which owns a high-quality portfolio of U.S. mall properties. Macerich stock contributed to performance during the second quarter on continued strong execution by the management team in its multi-year plan to create a more efficient, faster-growing, lower-leverage retail mall portfolio. We continue to believe that Macerich should benefit from favorable real estate fundamentals for high-quality, well-located retail properties, with tenant demand exceeding available space and generating rent growth.

A portion of the gains in building products/services were attributable to strong performance from AAON, Inc., a leading manufacturer of commercial and industrial heating, ventilation, and air-conditioning (HVAC) systems. AAON’s shares rose in response to exceptionally strong earnings, driven by significantly faster-than-expected growth in the BasX data-center cooling business. Up 26% sequentially and 72% over the past year, BasX has established itself as a best-in-class provider of customized cooling solutions relative to peers’ more standardized offerings. With the new Memphis facility ramping production, the company can now meet elevated demand with more than $2 billion in BasX revenue capacity. The core HVAC business also performed well, with market share gains accelerating on the back of strong heat-pump and national accounts growth. We believe AAON is well positioned to continue compounding well above peers for the foreseeable future. Home, security, and digital products companyFortune Brands Innovations, Inc. and indoor air quality, ventilation, thermal management, and cooling solutions provider Madison Air Solutions Corporation also performed well in the category, overshadowing poor performance from wholesale landscape supplies distributor SiteOne Landscape Supply, Inc.

The Fund also benefitted from being underexposed to Index heavyweights The Home Depot, Inc. and Lowe's Companies, Inc., as both companies faced significant headwinds from a sluggish housing market, elevated mortgage rates, and cautious consumer spending on large, discretionary renovation projects.

Partially offsetting the above was the Fund’s unique exposure to data centers via its position in GDS Holdings Limited, a leading developer and operator of high-performance data centers, operating in key cities across China and expanding rapidly across Asia. Despite solid operating results and strong performance earlier in the year, GDS stock declined in the second quarter. Several factors weighed on performance, including management's commentary around the components of full-year guidance, a material step-up in expected capital expenditures over the next few years, a slight delay in the expected timing of an inflection in underlying growth. We trimmed our position and reallocated capital to ideas where we have greater visibility and lower exogenous risk, particularly given the current geopolitical environment. However, we continue to see evidence of the growing AI wave in China through significant bookings growth and believe the market underappreciates the value of GDS's stake in its spun-out international subsidiary, DayOne. 

Real estate operating companies were another source of weakness owing largely to disappointing performance from Blackstone Inc., the world’s largest alternative asset manager, with over $1.3 trillion in assets under management, and the largest real estate manager globally. Shares declined in the second quarter as mounting redemption pressures at Blackstone’s private credit vehicle (BCRED) and sector-wide liquidity concerns overwhelmed an otherwise constructive fundamental backdrop. Redemption requests reached approximately 8% of NAV in the first quarter, followed by 10% in the second quarter, requiring Blackstone to cap withdrawals at the standard 5% limit for the first time. Broader sector sentiment deteriorated further when other alternative asset managers announced withdrawal restrictions, reigniting private-market liquidity fears and dragging the entire sector lower. We retain conviction in Blackstone given its premier brand, global franchise, loyal customers, exceptional balance sheet, and excellent management team.

Underexposure to better performing infrastructure-related companies and higher exposure to lagging real estate services businesses also hampered performance, but these impacts were largely offset by favorable allocation effects elsewhere.