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 Income Fund increased. Holdings within the industrial REITs, non-REIT real estate companies, and self-storage REITs categories contributed the most to performance. Investments within the multi-family REITs, health care REITs, and other REITs categories detracted the most. Top contributor Prologis, Inc. led gains within industrial REITs. Appreciation within non-REIT real estate companies was led by Brookfield Infrastructure Corporation. Shares of this owner of global infrastructure across energy, utilities, water, rail, and data increased on strong cash flow growth, the resilient and contracted nature of its cash flows, and a robust capital recycling outlook. Shares of the three holdings within the self-storage REITs category all advanced in the quarter. Depreciation within multi-family REITs was driven by Equity Residential and AvalonBay Communities, Inc., respectively, the second and third largest detractors in the quarter. Top detractor Ventas, Inc. drove declines within health care REITs. Sole category holding Alexandria Real Estate Equities, Inc. drove weakness within other REITs.

We are mindful the economic and stock market backdrop may remain challenging in the months ahead given expectations of slower economic growth – in part due to the Federal Reserve's aggressive interest rate increases. We also suspect the spillover effect from recent bank challenges will do some of the work for the Fed in combating inflation as credit availability is likely to contract, unemployment increases, and economic growth moderates. These developments would be deflationary. As such, we suspect the Fed may be 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 REITs now offer compelling return prospects that, in some cases, may include a trifecta combination of growth, dividends, and an improvement in valuation.

Further, we believe the benefits of our broader and more flexible approach that prioritizes a full array of REITs but also invests in non-REIT income-oriented real estate companies will shine even brighter in the years ahead in part due to the evolving real estate landscape in which some companies will experience an acceleration in tailwinds and others are likely to face ongoing headwinds.

Top Contributors/Detractors to Performance

as of 03/31/23

Contributors

  • 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.
  • Equinix, Inc. is a global operator of network-dense, carrier-neutral colocation data centers. Shares contributed to performance after the company reported results that beat consensus, issued a compelling 2023 relative and absolute growth outlook, and provided robust demand/bookings commentary amid weaker macroeconomic conditions. We remain shareholders of Equinix due to a long demand runway behind cloud adoption and IT outsourcing, its unique ability to offer a global platform, and continued execution on strategic M&A transactions to enhance its moat.
  • EastGroup Properties, Inc. is a REIT that owns a portfolio of industrial warehouse properties concentrated in Texas, California, and Florida. Shares increased on continued strong business fundamentals across EastGroup's portfolio. In our view, industrial real estate has attractive characteristics, with organic growth that is among the highest across all real estate asset types. Strengthening demand, driven by the growth of e-commerce, inventory building, and the need for infill locations to service "last mile" delivery, continues to absorb elevated supply deliveries. Given EastGroup's assets, markets, management, and balance sheet, we believe the company is well positioned to continue benefiting from this favorable backdrop.

Detractors

  • Ventas, Inc. is an operator of senior housing, life sciences, and medical office buildings. While the company provided an attractive full-year 2023 growth outlook, shares were pressured by increasing investor concern over the company’s ability to take advantage of the external growth opportunity combined with a credit impairment and unfavorable resolution of a smaller mezzanine investment where the company converted its loan into equity. Although we modestly reduced our position, we believe Ventas' senior housing operations will continue to inflect positively in the years to come given the favorable supply/demand backdrop and increasing growth of the 80-year-old-plus population. The company owns high quality real estate and has a conservative balance sheet and compelling occupancy recovery story within senior housing.
  • Equity Residential owns Class A apartment buildings largely located in high-barrier-to-entry coastal markets with favorable long-term demographic trends and muted overall supply growth. Shares detracted in the quarter amid a worsening economic backdrop, continued layoff announcements in high-paying jobs, tightening lending conditions, lingering bad debt trends into 2023, and potential supply pressure in certain markets. While the Fund reduced its position and re-allocated capital due to some impeding headwinds, we continue to believe Equity Residential has an attractive real estate portfolio that should perform well over market cycles with the stock now trading at a much more favorable valuation.
  • AvalonBay Communities, Inc. owns Class A apartment buildings largely located in high-barrier-to-entry coastal markets with favorable long-term demographic trends and muted overall supply growth. Shares detracted in the quarter amid a worsening economic backdrop, continued layoff announcements in high-paying jobs, tightening lending conditions, lingering bad debt trends into 2023, and potential supply pressure in certain markets. While the Fund reduced its position and re-allocated capital due to some impeding headwinds, we continue to believe AvalonBay has an attractive real estate portfolio that should perform well over market cycles with the stock now trading at a much more favorable valuation.

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 Income Fund (Institutional Shares) was up 4.73% in the first quarter, outperforming the MSCI US REIT Index by 234 basis points due to differences in REIT category weights.

Unique exposure to non-REIT real estate companies, lack of exposure to lagging office and shopping center REITs, and investments in industrial REITs added the most value. The Fund’s unique exposure to non-REIT real estate companies contributed 100-plus basis points to relative performance, driven by double-digit gains from Brookfield Renewable Corporation, Brookfield Infrastructure Corporation, and Brookfield Asset Management Ltd. Brookfield Renewable and Brookfield Infrastructure, which own and operate unique renewable power and infrastructure assets, benefited from strong cash flow per share growth, the resilient and contracted nature of their cash flows, and robust capital recycling outlooks. Shares of alternative asset manager Brookfield Asset Management rose in response to strong capital raising and high visibility on fee-related earnings growth of 15% to 20% over the next several years. Homebuilder Toll Brothers, Inc. also performed well in the category due to improving trends in the U.S. housing market and above-consensus operating performance. We are excited about our recently established position in Toll Brothers given 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. In our view, Toll Brothers is a differentiated homebuilder with a niche focus on high-end homes and an excellent management team with high insider ownership. We think Toll Brothers is well positioned to benefit from housing growth through its sizable land bank, healthy balance sheet, and market share gains against smaller players. Within industrial REITs, higher exposure to this strong performing category coupled with the outperformance of EastGroup Properties, Inc., Rexford Industrial Realty, Inc., Terreno Realty Corporation, and Prologis, Inc. bolstered performance. In our view, industrial real estate has attractive characteristics, with organic growth that is among the highest across all real estate asset types. Strengthening demand, driven by the growth of e-commerce, inventory building, and the need for infill locations to service "last mile" delivery, has resulted in strong business fundamentals for our industrials REITs.

The above-mentioned relative gains were somewhat offset by the Fund’s unique exposure to wireless tower REITs, as these holdings were down nearly 6% for the quarter. Weakness in the category was driven by American Tower Corp., whose shares underperformed due to an equity overhang associated with its acquisition of CoreSite, elevated leverage, and rising interest rates impacting valuations of technology-related infrastructure stocks broadly. American Tower owns and operates 220,000 cell phone towers with 40,000 in the U.S. and 180,000 internationally. We retain conviction due to durable demand drivers in data growth and video plus the company’s ability to grow its portfolio and return excess capital to shareholders. SBA Communications Corp. also weighed on performance in the category before being sold in early March. We exited our position given our belief that a series of headwinds are likely to temper SBA’s growth in the next few years, including higher debt financing costs with significant upcoming maturities, wireless carrier decommissioning, headwinds from the company’s Latin American operations, and perhaps foreign currency headwinds.

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.