Baron Real Estate Fund (BREIX)

Portfolio Management

JeffreyKolitch
Jeffrey Kolitch

Fund Manager since 2009

View All Commentary by Jeffrey

Fund Description

Baron Real Estate Fund invests in securities of real estate and real estate related companies of all sizes.

  

Portfolio Commentary

Institutional Performance

Review and Outlook (for quarter ended 9/30/2014)

Following solid performance in the first half of 2014, Baron Real Estate Fund declined modestly in the third quarter, along with most REIT and Real Estate funds. Positive performance was driven primarily by the Fund’s investments in select building product, hotel, and tower operators. Negative performance was partly due to our investments in senior housing and gaming companies.

Although sales and construction activity in the U.S. housing market has moderated in 2014, we continue to believe housing is near a cyclical bottom and long-term prospects are compelling. We have investments in several residential-related real estate companies that we believe will benefit from a multi-year recovery in housing. For example, we favor building product/service companies because they typically benefit both from an increase in home sales and accelerated spending for home repair and remodeling.

We believe business conditions remain strong for our hotel & leisure company investments as demand has accelerated, perhaps due to improved business confidence and economic conditions. In our opinion, as economic growth improves, hotels should perform well as a result of higher occupancy and the opportunity to increase nightly rates, both resulting in strong cash flow growth.

We remain bullish on the long-term prospects for our tower investments. Wireless data traffic is expected to continue to grow at attractive rates for several years, leading to increased levels of carrier leasing activity on cell sites. The tower companies have highly predictable recurring revenue models because carriers sign multi-year lease agreements with annual price increases, and tend to have high barriers to entry due to difficult local zoning issues.

Following strong performance in the first half of 2014, senior housing stocks declined in the third quarter. We believe these companies are poised to benefit from favorable demographic trends, an eventual improvement in the housing market and overall economy, and industry consolidation.

Our gaming investments performed poorly in the third quarter, primarily due to a slowdown in business activity in Macau. We view the slowdown as temporary. In our opinion, a number of considerations bode well for our gaming investments, including favorable demand/supply dynamics in Macau, the potential for new gaming licenses, infrastructure improvements, prudent capital allocation decisions, and favorable valuations.

We remain positive about the prospects for Baron Real Estate Fund.  Business conditions and the capital environment are generally good and supportive of higher real estate values and share prices, especially in the commercial real estate space. We believe residential real estate will pick up over time. Interest rates are low and capital availability is improving.  Further, we do not detect major warning signs, such as deceleration in construction activity, a spike in interest rates, dramatically reduced lending and underwriting standards, or a weakening economy.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 9/30/2014)
  • Home Depot, Inc. saw its stock price rise in Q3, driven by impressive Q2 results that were better than expected and a positive outlook for the remainder of the year. Home Depot is the largest home improvement retailer in the U.S. We remain excited about our investment in the company, which we believe will benefit from an increase in home repair and remodel spending as the housing market continues along the path to recovery.

  • Shares of Wyndham Worldwide Corp., a hospitality company involved in hotels and timeshares, increased in Q3 based on the solid performance of its three business segments. The company continues to generate excess cash flow, which it has been returning to investors through share buybacks. It has indicated that it is looking at potential lodging acquisitions, but prices are currently too high to make the acquisitions accretive to shareholders. In lieu of acquisitions, Wyndham has indicated that it will continue to buy back stock.

  • July 30th marked the closing of the acquisition of senior housing provider Emeritus Corp. by Brookdale Sr. Living, an all-stock transaction valued at $2.8 billion or $28.41/share, a 32% premium to Emeritus’ trading price on Feb 20th when the deal was announced. The combined companies are the largest and only nationally branded senior housing provider in the country, with about 1,200 communities in 46 states. Given demographics and increasing consumer acceptance of senior housing, we believe prospects for the combined company are positive.

Detractors (for quarter ended 9/30/2014)
  • Shares of senior housing company Brookdale Senior Living, Inc. fell in Q3. Trends out of Q2 were positive, and preliminary 2015 guidance bracketed consensus. However, occupancy fell just short of expectations. Investors seemed nervous after Brookdale pulled guidance for the rest of 2014, citing lower near-term visibility after the acquisition of Emeritus Corp. and a joint venture deal with health care REIT HCP. Longer term, we believe positive demographics, deeper senior housing penetration, and favorable supply/demand balance will benefit Brookdale.

  • Shares of Las Vegas Sands Corp., which operates casinos in Las Vegas, Singapore and Macau, fell in Q3 as China's corruption crackdown and more stringent visa restrictions dampened growth in Macau. In addition, the junkets which bring in VIP rollers, lend them money, and settle their debts, are proving less willing to extend generous credit terms, as it has become harder to collect debts. Despite these setbacks, we believe that as new supply comes online and infrastructure improves, Las Vegas Sands will continue to grow in this underpenetrated market.

  • Shares of senior housing operator Capital Senior Living Corp. decreased in Q3 due to Q2 results that were below expectations. We continue to believe Capital Senior Living is an attractive investment opportunity. Strong demographics, growth in the company’s operating portfolio, a rebound in the homebuilding market, acquisition opportunities, a quality balance sheet, and an attractive valuation have supported our favorable view of the company.

Quarterly Attribution Analysis (for quarter ended 9/30/2014)

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.

The Baron Real Estate Fund (Institutional Shares) fell 2.40% in the third quarter and trailed the MSCI USA IMI Extended Real Estate Index by 127 basis points due to stock selection.

The Fund’s significantly lower exposure to REITs, its meaningfully larger exposure to the outperforming hotels & leisure category, and outperformance of its tower operators & wireless communications investments contributed the most to relative results. Strength within the tower operators & wireless communications category was mostly attributable to the outperformance of SBA Communications Corp. and Sarana Menara Nusantara Tbk PT. SBA reported above consensus cash flow growth and Sarana Menara benefited from double-digit organic growth.

The Fund’s investments within the senior housing operators/health care service providers, building products/services, and real estate services categories were the largest detractors from relative performance. The Fund’s senior housing operators declined 5.4% as a group during the quarter and lagged their peers in the index by 17.6%. Brookdale Senior Living, Inc. and Capital Senior Living Corp. were the relative detractors within this category, and were two of the Fund’s largest overall detractors from absolute and relative performance during the quarter. Underperformance within senior housing operators/health care service providers was partly offset by the Fund’s larger exposure to this top performing category. Within building products/services, the Fund’s lower exposure to home improvement retailers, Home Depot, Inc. and Lowe's Companies, Inc., which rose 13.9% and 10.8%, respectively, hurt relative performance. Another detractor from relative performance in building products/services was Builders FirstSource, Inc. whose shares were dampened by moderating growth expectations around the pace of the U.S. housing recovery. Within real estate services, a combination of the Fund’s larger exposure to this category, which declined 4.8% in the index, and stock selection hampered relative results. Weakness in the category was mainly due to the underperformance of RealPage, Inc., a provider of software tools for the rental housing industry; Kennedy-Wilson Holdings, Inc., an international real estate investment and services firm; and CBRE Group, Inc., which has a number one market share in all of its major businesses. The Fund exited its investment in RealPage, Inc. during the quarter following a series of earnings disappointments. After increasing 21.5% in the first six months of the year, we believe Kennedy-Wilson’s shares were impacted by profit taking. CBRE’s quarterly results were modestly below expectations.

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The prospective performance of the companies discussed herein is based on our internal analysis and reflect our opinions only. We cannot promise future returns and our opinions are a reflection of our best judgement at the time of publication. Our views are not intended as recommendations or investment advice to any person and are subject to change at any time based on market and other conditions and Baron has no obligation to update them. Investing in the stock market is always risky. Current and future portfolio holdings in the Fund are subject to risk.

Source: FactSet PA.