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 9/30/2016)

Baron Real Estate Fund gained in the third quarter of 2016. Real estate service companies, casinos & gaming operators, and infrastructure-related & MLPs were the top contributing sub-industries to performance. Real estate service companies rebounded strongly in the third quarter, led by third largest contributor Kennedy-Wilson Holdings, Inc. Casinos & gaming operators benefited from a double-digit share price increase in the Fund’s sole sub-industry holding, top contributor MGM Resorts International. The second largest contributor, Macquarie Infrastructure Corp., drove performance of the infrastructure-related & MLPs sub-industry.

REITs, building products/services, and data centers led detractors in the quarter. The two biggest detractors, Equinix, Inc., and Digital Realty Trust, Inc., led the decline in REITS. These two data centers, along with data center Interxion Holding N.V., all gave up some gains after strong runs in the first half of the year. The third largest detractor from Fund performance, Lowe’s Companies, Inc., led the decline in building products/services.

Looking forward, we remain optimistic that we are “righting the ship,” and hope to improve our recent performance. Our bullish view is due to the following:

1)  We expect the highly unusual environment of the last few years (most notably the collapse in interest rates to all-time low levels) will slowly begin to “normalize.” We think an eventual “reversion to the mean” and return to a somewhat more normal interest rate and economic environment should bode well for the Fund.

2)  Dividend-yield securities such as REITs have benefited significantly from the unprecedented declines in interest rates. We believe these outsized gains for REITs are unlikely to be repeated, which should potentially benefit the Fund, given our broader real estate categories, and more balanced approach to real estate-related investing.

3)  The Fund is comprised of “best-in-class” companies that we believe (a) are well-managed, (b) are market leaders, (c) generally possess quality balance sheets, (d) own well-located real estate, and (e) grow cash flow at a faster rate than most peers. Our view is that these companies should generate superior returns over the long term.

4)  The Fund’s holdings are attractively valued, in our view. Examples include Mohawk Industries, Inc., InterXion Holding N.V., Gaming and Leisure Properties, Inc., CBRE Group, Inc., Brookfield Asset Management, Inc., Hilton Worldwide Holdings, Inc., Jones Lang LaSalle, Inc., and Toll Brothers, Inc.

We continue to believe that the Fund, with its expansive, balanced, and differentiated approach to investing in real estate, provides the potential to perform well over the long term in several different market environments.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 9/30/2016)
  • Shared of MGM Resorts International, an operator of casinos mainly in Las Vegas and Macau, increased in Q3 on gaming revenue and growth in revenue per available room that exceeded street expectations. We think these strong results, combined with continued execution of the company’s $400 million profit growth plan, will allow MGM to increase earnings and free cash flow and help pay down debt on its balance sheet. We think the planned December opening of its National Harbor casino in the DC area will potentially help reduce leverage as well.

  • Macquarie Infrastructure Corporation owns a diversified group of U.S.-based infrastructure assets. Shares increased in Q3, driven by increased investor appreciation for the company’s stable cash flow, normalization of its valuation multiple, and increased capital deployment guidance. We are investors because of Macquarie’s high barriers to entry, predictable cash flows, and ability to deploy $350 million of capital a year at attractive low double-digit returns, and expense rationalization programs that help margin accretion.

  • Kennedy-Wilson Holdings, Inc. is an international real estate investment and services firm, with assets in the U.S. and Europe. Shares of the company contributed to Q3 performance as business fundamentals held up better than analyst expectations after the stock dipped in Q2 over “Brexit” concerns. We believe the outlook for commercial real estate is attractive and remain optimistic regarding the long-term prospects for Kennedy-Wilson.

Detractors (for quarter ended 9/30/2016)
  • This quarter saw pressure in the data center segment, and Equinix, Inc. was no exception. Slowing industry activity and cautious management commentary spurred some profit taking ahead of Q3 earnings. We like the growth prospects for Equinix and think management has a clear and sensible plan to keep growing at a relatively higher pace while improving efficiencies and demonstrating margin leverage. We view 2016 as a digestion year, with two acquisitions and a divestiture, and expect 2017 to show significant leverage to shareholder profitability.

  • Shares of Digital Realty Trust, Inc., a leading global provider of data center solutions, detracted from Q3 performance. Weak performance was driven by a slight deceleration in leasing combined with a full valuation. We retain conviction as we believe Digital is positioned to be a primary beneficiary of strong secular tailwinds in cloud adoption and IT sourcing. The company is also expanding its global footprint, having recently acquired eight assets in Europe, and is expanding its offerings to include colocation and interconnection services.

  • Shares of home improvement retailer Lowe’s Companies, Inc. detracted from performance in Q3 after the company reported underwhelming financial results for Q2. We remain positive regarding the outlook for home improvement spending, and view Lowe’s as a reasonably priced company that will benefit from this trend.

Quarterly Attribution Analysis (for quarter ended 9/30/2016)

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 increased 2.21% in the third quarter and outperformed the MSCI USA IMI Extended Real Estate Index by 211 basis points. During the quarter, the Fund’s relative real estate category weights and, to a lesser extent, stock selection contributed to relative results.

Real estate services, infrastructure related & MLPs, and senior housing operators & health care facilities investments and larger exposure to outperforming real estate operating companies contributed the most to relative results. Within real estate services, outperformance of Kennedy-Wilson Holdings, Inc., Jones Lang LaSalle, Inc., and CBRE Group, Inc. and larger exposure to this better performing category aided relative results. Kennedy-Wilson was the third largest contributor to absolute performance, while leading commercial real estate services companies Jones Lang and CBRE benefited from Q2 financial results that exceeded Street expectations. Strength in the infrastructure related & MLPs category was due to outperformance of Macquarie Infrastructure Corporation, the second largest contributor on an absolute basis. Within senior housing operators & health care facilities, outperformance of the Fund’s only holding in the category, Brookdale Senior Living, Inc., added value. Shares of Brookdale, the leading owner and operator of senior housing communities in the U.S., rose as management continued to execute on its turnaround plan. The company’s operations appear to have stabilized, synergy savings flowing from the Emeritus merger are being realized, and rate growth has remained solid. The company also announced the planned divestiture of certain underperforming facilities with proceeds going towards debt repayment.

Hotels & leisure and tower operators & wireless telecommunication services investments were the largest detractors from relative performance. Within hotels & leisure, underperformance of cruise line operator Norwegian Cruise Line Holdings Ltd. detracted the most from relative results. Norwegian’s shares declined after the company lowered 2016 yield and EPS guidance due to continued challenges in Europe with terrorism, recent challenges in the Caribbean with the Zika virus, and ongoing concerns about increases in capacity in China where the company is building a ship to be deployed late next year. Weakness in the tower operators & wireless telecommunication services category was due to the underperformance of Indonesian tower operator PT Sarana Menara Nusantara Tbk., whose latest quarterly earnings report continued to reflect a period of low organic lease-up demand by its wireless carrier customers. We believe that wireless network spending in Indonesia will eventually climb as operators contend with significant growth in wireless data consumption.

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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.