Baron Real Estate Income Fund: Latest Insights and Commentary

Real Estate underperformed the broader market in the fourth quarter as REITs and other rate-sensitive real estate-related categories such as homebuilders & land developers and building products/services came under pressure due to an increase in long-term interest rates. Concerns that restrictions on immigration, the possibility of raising or imposing new tariffs, still high federal deficits, and an acceleration in economic growth may result in an uptick in inflation and even higher interest rates further pressured real estate stocks.

Against this backdrop, Baron Real Estate Income Fund increased. Investments within the non-REIT real estate companies, data center REITs, and mall REITs categories contributed the most. Holdings within the industrial REITs, health care REITs, and multi-family REITs categories detracted the most. Top contributor GDS Holdings Limited led gains within non-REIT real estate companies. Equinix, Inc. and Digital Realty Trust, Inc., respectively the second and third largest contributors, drove appreciation within data center REITs. The Macerich Company drove gains within mall REITS, after the stock of this owner of an exceptionally high-quality portfolio of malls and shopping centers increased on impressive progress on a multi-year business turnaround under its new management team. All five industrial REITs pulled back in a challenging quarter for the category. Top detractor Ventas, Inc. led depreciation within health care REITs. Multi-family REITs detracted as all three holdings within the category declined.

Though daily market volatility is likely to be high as the sequencing of the incoming administration’s policies are announced, we believe the key driver for a year of solid market performance is that the fundamental backdrop for earnings growth is expected to be strong. Demand conditions are mostly favorable against a backdrop of muted new real estate supply. While some headline valuations screen rich, we believe there are several attractively valued real estate opportunities beneath the surface. Our biggest concern is a resurgence in inflation which would limit the potential for improvements in valuations. We will, of course, be monitoring this closely.

CONTRIBUTORS

• GDS Holdings Limited is a leading data center operator within Tier 1 cities in China with a growing presence in other Asian countries. Shares increased on favorable business fundamentals, the improving pace of customer move-ins, and the securing of an additional $1.2 billion of capital for its international segment. We retain conviction in GDS due to durable secular tailwinds in cloud adoption, increasing demand from AI deployments, growth visibility, and its status as a provider of choice to leading technology companies in China and the U.S.
• Shares of Equinix, Inc., the premier global operator of network-dense, carrier-neutral data centers, performed well following solid quarterly results. We remain 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 has multiple levers to drive robust bottom-line growth with operating leverage. We believe Equinix will compound earnings per share at approximately 10% over the next few years and the prospects for outsized shareholder returns remain compelling given superior secular growth prospects and a discounted valuation.
• Digital Realty Trust, Inc. is a global provider of data center services to enterprises, cloud service providers, network providers, financial services, media and other customers. Shares increased during the quarter due to strong leasing demand, a favorable pricing environment, and growth in the evolving AI demand vector. We retain conviction due to strong secular tailwinds in cloud adoption and IT sourcing and further scaling of the company's retail colocation business.

 

DETRACTORS

• Ventas, Inc. is an operator of senior housing and life science and medical office buildings. Shares gave back some gains from the prior quarter as real estate companies in general came under pressure due to a meaningful increase in long-term interest rates. We retain conviction in Ventas, as we are optimistic about the prospects for both cyclical and secular increases in senior housing demand against a backdrop of muted supply that should lead to several years of favorable growth alongside an evolving external growth pipeline.
• Iron Mountain Incorporated offers records storage management along with an evolving fast-growing data center segment. Following several quarters of strong performance, shares pulled back during the quarter. After meeting with CFO Barry Hytinen, we believe the company can increase cash flow by approximately 10% overall and by high single-digits on a per-share basis over the next several years. We expect predictable and stable growth in its core records management business to be buttressed by outsized growth in its data center business, with the potential to more than triple its operational capacity from today’s in-place base. While we took some near-term tax losses, we remain encouraged by the company’s growth prospects and may revisit position sizing in the future.
• American Tower Corporation was a detractor during the quarter due to moderating near-term growth expectations after finalizing the disposition of its assets in India combined with the meaningful increase in long-term interest rates serving as a headwind to valuations of real estate companies broadly. American Tower owns and operates 220,000 cell phone towers with 40,000 in the U.S. and 180,000 internationally. We exited our position and reallocated capital to higher conviction ideas but may revisit the idea should the valuation become more attractive.

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 Income Fund (the Fund) posted a modest gain (Institutional Shares) in the fourth quarter, meaningfully outpacing the MSCI US REIT Index, which fell 6.39%. Active REIT category exposures and, to a lesser extent, stock selection contributed to outperformance in the period.

The Fund’s unique exposure to non-REIT real estate companies added almost 270 basis points of relative gains, driven by another strong quarter from Chinese data center operator GDS Holdings Limited, whose shares appreciated 16.5% in the period. GDS was the top contributor for a second consecutive quarter owing to favorable business fundamentals, the improving pace of customer move-ins, and the securing of an additional $1.2 billion of capital for its international segment. We retain conviction in GDS due to durable secular tailwinds in cloud adoption, increasing demand from AI deployments, growth visibility, and its status as a provider of choice to leading technology companies in China and the U.S.

Alternative asset manager Blackstone Inc. also performed well in the category due to strong quarterly results and investor expectations for enduring and compelling long-term growth prospects. We believe prospects for 2025 are attractive. Management is forecasting growth in fees to be driven by meaningful opportunities in private wealth, AI and data centers, a cyclical recovery in real estate, and other areas. In addition, after several years of depressed levels, we see signs that transaction activity is poised to come back, which would allow the company to realize carried interest, provide clarity on valuation marks, and return capital to limited partners, feeding the “flywheel” of capital formation for additional fund vehicles.

Lack of or lower exposure to lagging self-storage, industrial, and triple net REITs, higher exposure to better performing data center REITs, and solid stock selection in office and mall REITs also contributed to relative gains in the period. Strength in office and mall REITs came from Vornado Realty Trust and The Macerich Company, respectively. Vornado owns a portfolio of trophy office and street retail properties mostly concentrated in Manhattan. Shares increased on continued improvement in the demand for office space in New York City, which helped Vornado surpass its leasing goals for the portfolio at large as well as its recently completed development in the Penn district. The company also benefited from strong demand for street retail in New York City. Macerich owns an exceptionally high-quality portfolio of malls and shopping centers in the U.S. Shares increased as Macerich continued to make impressive progress on a multi-year business turnaround under its new management team. The company also completed a successful equity raise earlier and on better terms than originally anticipated.

Somewhat offsetting the above were adverse impacts associated with the Fund’s lower exposure to strong performing shopping center REITs and unique exposure to wireless tower REITs, where American Tower Corporation was a drag on performance. American Tower’s shares declined due to moderating near-term growth expectations after finalizing the disposition of its assets in India. The meaningful increase in long-term interest rates also served as a headwind to valuations of American Tower and the broader REIT category. We exited our position and reallocated capital to higher conviction ideas but may revisit the idea should the valuation become more attractive.

Yearly Attribution Analysis (for year ended 12/31/2024)

Baron Real Estate Income Fund (the Fund) was up 17.36% (Institutional Shares) for the year, significantly outperforming the MSCI US REIT Index by 987 basis points principally due to active REIT category exposures.

The Fund’s unique exposure to non-REIT real estate companies accounted for about three-quarters of the outperformance in the period, with Chinese data center operator GDS Holdings Limited leading the way in the category. GDS’ shares appreciated almost 250% due to improving business fundamentals, an inflection in customer lease signings with key U.S. cloud providers, and the securing of an additional $1.2 billion of capital from highly regarded investors for its international segment. A handful of other holdings also performed well in the category, led by residential homebuilder Toll Brothers, Inc. and alternative asset managers Brookfield Corporation and Blackstone Inc. Notwithstanding a volatile backdrop for the U.S. housing market in 2024, Toll Brothers consistently reported solid financial results and expressed optimism for continued strong consumer demand. Brookfield and Blackstone benefited from strong fundraising results along with a step-up in capital deployment during the year.

Additional tailwinds to relative performance came from lower exposure to triple net, industrial, and self-storage REITs, higher exposure to better performing data center and mall REITs, and strong stock selection in office and health care REITs. Strength in office and health care REITs was driven by Vornado Realty Trust and Welltower Inc. Vornado owns a portfolio of trophy office and street retail properties mostly concentrated in Manhattan. The company’s shares increased on continued improvement in the demand for office space in New York City. Welltower is an operator of senior housing and life science and medical office properties. Shares increased during 2024 on robust cash flow growth in its senior housing portfolio driven by strong occupancy and rent growth, an improving full-year growth outlook throughout the year, and solid execution on highly accretive, proprietarily sourced capital deployment opportunities.

Partially offsetting the above were detrimental effects from the Fund’s lower exposure to outperforming shopping center and other REITs and higher exposure to lagging hotel and single-family rental REITs.