Review and Outlook
During the third quarter, the Fund increased 6.17% for the Institutional Shares (6.11% for the Retail Shares), exceeding the negative 2.54% average return for the Morningstar US OE Real Estate Category, 1.75% for the MSCI USA IMI Extended Real Estate Index, and 5.24% for the S&P 500 Index. The Baron Real Estate Fund’s strong performance in the third quarter is largely attributable to the Fund’s current focus on non-REIT real estate companies, many of which have relatively short lease duration terms and are less sensitive to a rising interest rate environment. Most real estate funds invest predominately in REITs, and these funds performed poorly in the third quarter, largely due to the fact that the yield on the 10-Year Treasury increased nearly a full percentage point. Higher bond yields decrease the attractiveness of dividend paying stocks such as REITs. Further, REITs are more susceptible to higher borrowing costs than many other companies because REITs must pay out at least 90% of their taxable income in dividends and are therefore more reliant on access to the debt markets, which have become more expensive.
We have reduced the Fund’s non-hotel REIT exposure to 7.7% of Fund assets because we believe that more favorable valuation and growth prospects exist in other real estate categories. Among the 11 real estate categories represented in our portfolio, our four favorites remain hotel & leisure companies, residential-related real estate companies, real estate services companies, and casino & gaming operators.
We believe our hotel & leisure company investments are well positioned due to their attractive valuations, low supply forecasts, and expectations of solid demand. We believe hotels should perform well as economic growth improves due to their ability to increase occupancy and rates nightly, thus producing strong cash flow growth.
We continue to invest in several residential-related real estate companies that we believe will benefit from a multi-year recovery in housing. They include senior housing operators, building product and services companies, and land developers and homebuilders.
We believe our investments in real estate services companies offer strong open-ended growth potential at attractive valuations.
It is our view that our casino & gaming investments will continue to perform well as economic growth improves. Many of these companies have embedded real estate value that is not currently reflected in their share prices.
We remain in the midst of a multi-year real estate recovery and believe the outlook is promising. We believe the duration of the real estate recovery will continue longer than most prior recoveries partly due to the fact that the downturn lasted longer than most, and because of the limited recovery to date. In our opinion, the most attractive growth phase of the real estate recovery has yet to emerge.
In observing occupancy, rents, and home sales, we think real estate demand is headed in the right direction, and near-term construction growth remains low. The combination of improving demand and low supply growth bodes well for commercial and residential real estate cash flow growth. We also expect the benefits of still unusually low interest rates and improving credit availability to bolster commercial and residential real estate-related activity.
Top Contributors/Detractors to Performance
Quarterly Attribution Analysis
This Fund does not have a Quarterly Attribution Analysis for period ending September 30, 2013
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