Review and Outlook

as of 03/31/23

While real estate stocks advanced in the first quarter, they underperformed the broader market. Bank failures, the likelihood of a further slowdown in bank lending, and the possibility of an economic recession happening sooner than consensus forecasts all pressured the real estate industry.

Against this backdrop, Baron Real Estate Fund increased. Investments within the building products/services, homebuilders & land developers, and REITs categories contributed the most to performance. Real estate service companies and tower operators & wireless telecommunication services holdings detracted. Second largest contributor Floor & Decor Holdings, Inc. led positive performance within building products/services. All three holdings within homebuilders & land developers gained, including top contributor Toll Brothers, Inc. Third largest contributor Prologis, Inc. led positive results within the REITs category. Real estate service companies had a challenging quarter, with all three top detractors within the category. Tower operators & wireless telecommunication services detracted due to a moderate decline in the share price of Cellnex Telecom S.A., the sole holding within the category.

We are mindful that the economic and stock market backdrop may remain challenging in the months ahead given the expectation that economic growth will slow – in part due to the Fed’s aggressive interest rate increases and an expected contraction in credit availability. We suspect the spillover effect from recent bank challenges will do some of the work for the Federal Reserve in combating inflation as credit availability is likely to contract, unemployment increases, and economic growth further moderates. These developments would be deflationary. As such, we suspect the Fed is near the end of its interest rate hiking cycle.

Yet, we also believe last year’s stock market recalibration wiped away much of the froth in valuations and has set the stage for a favorable multi-year outlook for real estate companies. We think 2023 may ultimately emerge as a mirror image of 2022 in that many of last year's headwinds (higher inflation, a sharp increase in interest rates, aggressive Fed tightening, widening credit spreads, valuation compression) reverse course and become tailwinds. Many real estate companies now offer compelling return prospects that, in some cases, may include a trifecta combination of growth, dividends, and an improvement in valuation.

We believe we have assembled a portfolio of best-in-class competitively advantaged real estate companies with compelling long-term growth and share price appreciation potential. We have structured the portfolio to capitalize on high conviction investment themes. Valuations and return prospects are attractive. We continue to believe the benefits of our broader and more flexible approach, which allows us to invest in both REITs and non-REIT real estate-related companies, will shine even brighter in the years ahead in part due to the new and evolving real estate landscape.

Top Contributors/Detractors to Performance

as of 03/31/23

Contributors

  • Toll Brothers, Inc. is a leading U.S. homebuilder. Shares increased on improving trends in the U.S. housing market and operating performance that exceeded Street estimates. We remain shareholders. New single-family home construction activity in the U.S. remains below the levels needed to meet current and pent up demand following a decade of under-building. We expect single-family home construction activity to continue over the medium term. In our view, Toll is a differentiated homebuilder with a niche focus on high-end homes and an excellent management team with high inside ownership. We think is well positioned to benefit from housing growth through its sizable land bank, healthy balance sheet, and market share gains against smaller players.
  • Floor & Decor Holdings, Inc. is a high-growth, differentiated specialty retailer of hard-surface flooring and accessories in the U.S. Shares rose during the quarter on strong 2023 guidance that beat consensus. Despite a weaker housing market, Floor & Decor expects revenue to grow roughly 10% this year as temporary softness in existing stores is more than offset by new unit openings. The company's direct sourcing model, low-cost leadership, and wide selection should enable it to take share from both big box retailers and independent specialty shops. We believe Floor & Decor will also benefit from lower freight rates as supply chains normalize. We remain positive about the stock’s long-term prospects and potential for double-digit unit growth in the years ahead.
  • Shares of Prologis, Inc., a fast-growing industrial REIT with a $100 billion portfolio of industrial warehouse properties, increased in the first quarter. The stock’s strong performance was driven by an unmatched global platform concentrated in major international trade markets and large population centers across the Americas, Europe, and Asia, combined with competitive advantages in scale, data, and technology. In our view, industrial real estate has attractive fundamentals, with organic growth among the highest across all real estate asset types. We believe Prologis is well positioned to continue benefiting from its favorable fundamental backdrop and solid embedded growth prospects.

Detractors

  • CoStar Group, Inc. is the leading provider of information and marketing services to the commercial real estate industry. After two straight quarters of robust performance, shares detracted during the quarter, likely due to profit taking. The company is generating robust financial performance, with net new sales growing 15% in the quarter, and margins expanding by 200 basis points excluding growth investments. We expect the company’s core businesses to continue to benefit from the migration of real estate market spend to online channels. CoStar has begun to invest aggressively in building out its residential marketing platform. We estimate CoStar invested around $230 million in this initiative in 2022, and its initial 2023 guidance implies a total investment approaching $500 million. While this is a significant upfront commitment, we believe the residential market represents a transformative opportunity. The company’s proprietary data, broker-oriented approach, and best-in-class management position it to succeed in this endeavor, in our view.
  • Jones Lang LaSalle Incorporated is a leading global provider of commercial real estate services, including leasing, capital markets, and property outsourcing solutions. Shares declined in the quarter after the failures of several U.S. and European banks led to investor concerns that lending conditions would tighten and commercial real estate transaction activity would slow, both of which would negatively impact several of Jones Lang's business lines. We take reassurance in Jones Lang's healthy balance sheet and, in our opinion, inexpensive valuation, and we remain excited about its multi-year business prospects.
  • CBRE Group, Inc. is a leading global provider of commercial real estate services, including leasing, capital markets, and property outsourcing solutions. Shares fell following the failures of several U.S. and European banks, which led to investor concerns that lending conditions would tighten and commercial real estate transaction activity would slow, both of which would negatively impact several of CBRE's business lines. We are reassured by CBRE's pristine balance sheet and, in our opinion, undemanding valuation, and we remain excited about CBRE's multi-year business prospects.

Quarterly Attribution Analysis (Institutional Shares)

as of 03/31/23

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.

as of 03/31/23

Baron Real Estate Fund (Institutional Shares) appreciated 7.07% in the first quarter, outpacing the MSCI USA IMI Extended Real Estate Index by 234 basis points due to differences in real estate category exposures and, to a lesser extent, stock selection.

Investments in building products/services companies and REITs along with meaningfully higher exposure to strong performing casinos & gaming operators and homebuilders & land developers added the most value. Within building products/services, the Fund’s limited exposure to benchmark heavyweight Home Depot, Inc. was a material driver of relative returns given the stock was down 6% in the index. Strength in the category also came from specialty flooring retailer Floor & Decor Holdings, Inc., wholesale landscape supplies distributor SiteOne Landscape Supply, Inc., swimming pool supplies leader Pool Corporation, and composite decking manufacturer Trex Company, Inc., whose share prices were lifted by improving trends in the U.S. housing market and solid operating results. Within REITs, higher exposure to better performing industrial REITs coupled with gains from Rexford Industrial Realty, Inc. and Prologis, Inc. bolstered performance. In our view, industrial real estate has attractive fundamentals, with organic growth among the highest across all real estate asset types. Rexford is a high-growth REIT that owns the largest global portfolio of industrial warehouse properties. The company’s shares rose in response to strong business fundamentals. We believe the company is well positioned to grow cash flow at a double-digit annual rate through organic means and acquisitions in a highly fragmented market. Prologis is a fast-growing REIT with a $100 billion portfolio of industrial warehouse properties. The stock’s strong performance was driven by an unmatched global platform concentrated in major international trade markets and large population centers across the Americas, Europe, and Asia, combined with competitive advantages in scale, data, and technology.

The above-mentioned gains were partly offset by weakness in the hotels & leisure and real estate service categories. Within hotels & leisure, the Fund’s lack of exposure to online travel companies Booking Holdings Inc. and Airbnb, Inc. weighed heavily on performance as these stocks were up sharply in the index during the quarter. Stock selection was also negative in the category owing to the underperformance of timeshare company Marriott Vacations Worldwide Corp. and global ski resort operator Vail Resorts, Inc. Marriott Vacations was hurt by concerns about slowing macroeconomic activity hindering timeshare sales as well as higher interest rates impacting customer purchasing power. Vail’s stock was pressured by a lack of snow at its East Coast resorts coupled with an overabundance of snow at its Tahoe resorts, which together hurt visitation and resulted in reduced EBITDA guidance for the year. Stock-specific weakness in real estate services was driven by CoStar Group, Inc., the leading provider of information and marketing services to the commercial real estate industry. CoStar was the largest detractor after earnings and guidance fell short of Street expectations due to aggressive investment in the company’s residential real estate segment. We estimate CoStar invested around $230 million to build out its residential marketing platform in 2022, and its initial 2023 guidance implies a total investment approaching $500 million. While this is a significant upfront commitment, we believe the residential market represents a transformative opportunity. The company’s proprietary data, broker-oriented approach, and best-in-class management position it to succeed in this endeavor, in our view. Commercial real estate services businesses Jones Lang LaSalle Incorporated and CBRE Group, Inc. also hampered performance, as the failures of several U.S. and European banks led to investor concerns that lending conditions would tighten and commercial real estate transaction activity would slow. Despite near-term uncertainty, we remain excited about the multi-year business prospects for both companies.

Investors should consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus and summary prospectuses contain this and other information about the Funds. You may obtain them from the Funds’ distributor, Baron Capital, Inc., by calling 1-800-99BARON or visiting www.BaronFunds.com. Please read them carefully before investing.

The performance data quoted represents past performance. Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate; an investor's shares, when redeemed, may be worth more or less than their original cost. The Fund’s transfer agency expenses may be reduced by expense offsets from an unaffiliated transfer agent, without which performance would have been lower. Current performance may be lower or higher than the performance data quoted.

Risks:All investments are subject to risk and may lose value.

The discussion of market trends is not intended as advice to any person regarding the advisability of investing in any particular security. The views expressed on this page reflect those of the respective writer. Some of our comments are based on management expectations and are considered “forward-looking statements.” Actual future results, however, may prove to be different from our expectations. Our views are a reflection of our best judgment at the time and are subject to change at any time based on market and other conditions and Baron has no obligation to update them

Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk.

The index performance is not fund performance; one cannot invest directly into an index.