Baron Real Estate Fund: Latest Insights and Commentary

CONTRIBUTORS

• Airbnb, Inc. operates a global marketplace connecting travelers with unique accommodations and experiences across more than 220 countries and regions. Shares rose on better-than-expected second-quarter results and management’s outlook for continued growth acceleration. Topline growth reached the high teens, while cash flow increased more than 20%. We believe Airbnb is in the early stages of a durable, multi-year growth reacceleration, supported by meaningful untapped opportunities including the rollout of dynamic pricing, expansion into boutique hotels, and a forthcoming loyalty program. We remain optimistic about Airbnb’s long-term prospects given its leading share in alternative accommodations and significant scale, which drive strong brand awareness and repeat bookings; 90% direct traffic, enabling lower customer acquisition costs; a strong value proposition for both guests and hosts, resulting in differentiated listings and exclusive inventory; and a unique two-sided marketplace in which user reviews foster trust between guests and hosts.
• Mohawk Industries, Inc. is the world’s largest manufacturer of flooring products, including carpet, tile, laminate, wood, and luxury vinyl. The company serves residential and commercial customers across the U.S., Europe, Latin America, and Asia-Pacific. Shares rose during the quarter amid optimism surrounding the company’s leadership transition. Investors have responded favorably to new Chief Executive Officer Paul De Cock, with expectations that he will bring a sharper growth strategy, more disciplined capital allocation, and improved communication with investors that could help build confidence. Second-quarter results also exceeded expectations, driven by better-than-anticipated volumes, strong product placements and retailer stocking, and outperformance in the commercial channel, all of which suggest the business is gaining momentum. We continue to own Mohawk and believe effective execution of the new leadership team’s strategy could help close the valuation gap with industry peers and drive strong share price performance.
• Procore Technologies, Inc., a leading provider of cloud-based construction management software, contributed to performance. Results underscored a marked inflection in profitability: non-GAAP operating margin expanded roughly 800 basis points year-over-year, trailing 12-month free cash flow margin improved more than 1,300 basis points, and the company generated its first GAAP operating profit. Management raised full-year revenue, margin, and free cash flow guidance and introduced a 2027 operating margin target well above consensus expectations. Importantly, profitability gains came alongside accelerating growth, with revenue increasing 16% and current remaining performance obligations rising 22% year-over-year. Procore also closed its acquisition of DroneDeploy, adding reality capture and robotics capabilities to the platform. We retain long-term conviction given management’s operating discipline and Procore’s growing base of proprietary jobsite data, which we believe support durable earnings power.

DETRACTORS

• Meritage Homes Corporation is a U.S. homebuilder best known for building energy-efficient, entry-level, and first move-up homes. Shares declined during the third quarter due to a broader slowdown in the U.S. homebuilding industry, as materially higher mortgage rates exacerbated affordability pressures and prompted homebuyers to delay purchase decisions. We believe these industry challenges are already reflected in the company’s depressed valuation and remain optimistic about the potential for share price appreciation.
• PENN Entertainment, Inc., a regional U.S. casino gaming company, detracted from performance as investors grew concerned about consumer spending at its properties in the face of higher interest rates, inflation, and oil prices. Even so, the company continues to generate strong earnings, with growth expected to accelerate next year as recently opened property expansions contribute to results. Strong cash flow is also enabling PENN to reduce debt and repurchase shares, which should create additional value for shareholders over the coming years. Despite these improving fundamentals, the stock continues to trade at a historically low valuation multiple. We believe the multiple has room to expand as earnings growth reaccelerates and the balance sheet strengthens, supporting attractive long-term return potential.
• Toll Brothers, Inc. is a leading high-end, luxury homebuilder that caters to move-up, empty-nester, active-adult, age-qualified, and second-home buyers in the U.S. The stock detracted from performance during the third quarter due to a broader slowdown in the U.S. homebuilding industry, as materially higher mortgage rates exacerbated affordability pressures and prompted homebuyers to delay purchase decisions. We believe these industry challenges are already reflected in the company’s depressed valuation and remain optimistic about the potential for share price appreciation.

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.

It was a difficult quarter for real estate-related equities, particularly housing-linked and consumer-oriented businesses. The 10-year U.S. Treasury yield surpassed 5%, its highest level since 2002, and mortgage rates rose. Elevated inflation and energy prices also weighed on consumer spending, especially among lower- to middle-income households. Investor enthusiasm for the AI infrastructure and energy secular growth theme cooled meaningfully as well, pressuring companies tied to the data center build-out.

Against this backdrop, Baron Real Estate Fund (the Fund) fell 13.05% (Institutional Shares), trailing the more comparable MSCI USA IMI Extended Real Estate Index (the Index), which declined 10.53%, by 252 basis points. The shortfall was driven by disappointing stock selection in a handful of categories, which outweighed the benefit of holding cash in a declining market. The Fund also underperformed the MSCI US REIT Index, which fell 6.33%, as its non-REIT real estate exposure, primarily in real estate services and operating companies, hampered relative performance.

Homebuilders & land developers were the largest drag on performance, owing to adverse stock selection and, to a lesser extent, higher exposure to this lagging category, which declined 14.1% in the Index. Homebuilders Meritage Homes Corporation, Toll Brothers, Inc., and KB Home were the principal detractors, hurt by a broader industry slowdown as materially higher mortgage rates exacerbated affordability pressures and prompted homebuyers to delay purchase decisions. We believe these challenges are already reflected in their depressed valuations, and we remain excited about the share price appreciation potential of our investments. 

Building products/services was another area of weakness, as poor stock selection more than offset the benefit of lower exposure to this underperforming category. Indoor air quality, ventilation, and thermal management solutions provider Madison Air Solutions Corporation and commercial HVAC manufacturer AAON, Inc. were the largest detractors. Mixed quarterly results, coupled with their ties to data center cooling, left both vulnerable to the broader pullback in AI infrastructure-related stocks. Madison Air’s shares declined after the company reported a mixed second quarter, in which price/cost dynamics from persistent inflation weighed on margins, and then announced a transformative multi-billion-dollar acquisition that is margin dilutive. Given the complementary nature of the target’s offerings and the Madison Air team’s strong track record integrating M&A, we expect a stronger company to emerge over the medium to long term, though we recognize some overhang will remain near term. AAON’s stock declined after the company reduced its gross margin guidance, overshadowing record second quarter revenue that more than doubled year over year. Management pulled forward a substantial amount of BasX demand across a yet to be fully ramped footprint, largely the new Memphis plant. This issue, alongside inflation-driven cost pressure, led to a gross margin miss. We expect sequential margin improvement in the back half of the year.

The Fund’s real estate operating companies also contributed to stock-specific losses, led by Brookfield Corporation, a leading owner and operator of real assets that invests globally in real estate, infrastructure, renewable power, private equity, and credit assets and has $1.3 trillion in assets under management. The company’s shares declined on investor concerns that weighed on alternative asset managers broadly, including higher interest rates that could impede monetizations and real estate values for investments held on balance sheet, as well as continued worries about private credit exposure. These losses were mostly offset by the Fund’s higher exposure to this better-performing category.

Apart from weak stock selection, the Fund was penalized for being overweight lagging casinos & gaming operators, having no exposure to the top-performing senior housing operators & health care facilities category, and being underweight REITs, which held up better than the broader real estate universe. However, these headwinds were more than offset by the Fund’s cash position and limited exposure to infrastructure-related companies, which were down 21.0% in the Index as investors reassessed the AI infrastructure trade amid concerns about overcapacity, elevated valuations, and the sustainability of AI-related capital spending.