Baron Real Estate Fund's 1st-Quarter Letter Part One

Dear Baron Real Estate Fund Shareholder:

The first quarter of 2016 was among the most challenging periods in recent memory. In the first six weeks of the year, the S&P 500 Index fell 10.3%. However, in the second half of the quarter, the market stabilized and recovered all of its losses from the beginning of the year. During this unsettling period, the Baron Real Estate Fund (the "Fund”) had a disappointing beginning to the year, declining 4.53% (Institutional Shares), underperforming the MSCI USA IMI Extended Real Estate Index and Standard & Poor's 500 Index.

Despite the challenges of the first quarter of 2016, we are optimistic regarding the Fund’s investments. We urge you to review our perspective on the outlook for real estate in the “Outlook” section toward the end of this letter.

We continue to have a favorable view of the long-term prospects for data center real estate companies, InterXion Holding N.V. (INXN, Financial), Digital Realty Trust Inc. (DLR, Financial) and Equinix Inc. (EQIX, Financial). The share prices of all three companies performed well in the first quarter of 2016.

Real estate data center companies are benefiting from secular demand that is currently outpacing supply growth. These beneficial tailwinds include accelerating Internet traffic, growing outsourcing of corporate data center department functions and needs, greater consumption and utilization of data on mobile devices and the growth and proliferation of digital photos and video.

Data center tenants have become more sophisticated, and consequently a growing number are requiring data center landlord/operators to have the ability to offer a full suite of data center services, and to maintain several locations, preferably with a global presence. For these reasons, we expect a more rational and contained new construction outlook than in prior cycles. Currently, there are only two data center companies that offer both global and comprehensive product offerings – Digital Realty Trust and Equinix – both of which are owned in the Fund.

InterXion Holding N.V., an owner and operator of 40 data center companies across 11 countries in Europe, has several positive attributes:

First, we believe the European data center market has several advantages in contrast with the U.S. market. The European data center market is growing approximately twice as fast as the U.S. market because it is in the earlier stages of outsourcing information technology, including the cloud. Also, the barriers to entry in Europe are quite significant as it can take three to four years to obtain the various approvals and to build a data center, plus an additional three to four years to fill the data center with clients. Consequently, in the last 10 years, there have been no new entrants into the European colocation data center market.

Second, we believe InterXion will continue to grow cash flow in its operating portfolio through increased occupancies and rents and may accelerate its growth with the acquisition of additional data centers. We suspect that the company may be interested in acquiring some of the European data center assets that Equinix will be required to divest as part of its merger with European data center company Telecity (TCY, Financial).

Third, we believe the company’s valuation is attractive relative to other data center companies because its cash flow multiple is the lowest among the data center companies.

Additionally, we anticipate that the data center market may continue to consolidate. InterXion represents an attractive acquisition candidate for non-European data center companies.

The Fund recently acquired shares in Digital Realty Trust, an REIT that owns a $17 billion global data center portfolio (the second largest after Equinix), located in North America, Europe, and Asia. We believe the company is well situated to maintain its position as a key beneficiary of the high demand for data centers (as a result of increased Internet traffic and outsourcing of data center needs that are currently outpacing supply growth). In our opinion, the company’s key competitive advantage that should drive long-term leasing and cash flow growth is its ability to serve as a one-stop shop to customers – both geographically and through its diversified service offerings.

More specifically, Digital Realty’s key attributes include:

(i) Scale advantages: Digital owns 139 real estate properties worldwide – across the U.S., Europe, Asia, and Australia. Further, the company has more than 1,600 customers or tenants (including IBM [IBM], Facebook [FB], AT&T [T], JPMorgan Chase [JPM], Morgan Stanley [MS]), many of whom value the company’s ability to provide a broad range of global solutions to their data center requirements.

(ii) A comprehensive customer focused product offering: Following its recent $2 billion acquisition of Telx Group (a privately held provider of “network dense” data center space across the U.S.), Digital Realty now offers its customers a greater and comprehensive assortment of solutions for their data center needs. For example, many customers require dual data center services in the form of large wholesale product offerings as well as a smaller retail offering format of colocation and connectivity services.

(iii) Attractive growth prospects: The company is well positioned to increase occupancy and rents, not only due to its scale and comprehensive product capabilities but also because of the long-term secular demand that drives the growth of the Internet, video, cloud and mobile traffic. Further, given the company’s favorable cost of equity and its desire to expand its product offerings and foster its growth in Europe and elsewhere, we anticipate that management may search for acquisitions in the future.

(iv) Strong management team and attractive dividend yield: We have known CEO Bill Stein for quite awhile and consider him to be a highly capable and strategic leader. We believe Bill and his team are committed to continuing the growth of Digital Realty prudently, including its attractive 4% dividend yield and the overall cash flow of the company.

We recently acquired shares in a nontraditional real estate-related company, Martin Marietta Materials Inc. (MLM, Financial). The company mines, processes and transports crushed stone, sand, and gravel (collectively, “aggregates”) and also produces concrete, asphalt, cement and chemicals. Its products are sold and utilized throughout the U.S. for infrastructure projects, such as highways as well as residential and nonresidential construction.

We believe the long-term outlook for Martin Marietta is attractive due to the following considerations:

(i) A leading market share position: Martin Marietta has a No. 1 or 2 competitive position in 85% of its real estate markets.

(ii) Aggregates (82% of sales): We believe that aggregates are an attractive long-term business because:

• a. High barriers to entry: Permits are difficult to obtain, and the approval process typically takes five to 10 years;
• b. Consistent pricing power: Given the difficulty in opening new quarries, and the transportation constraints attributable to the high weight of rocks, the producers of aggregates have historically enjoyed great pricing power. In the last 30 years, pricing of aggregates has increased, on average, 4% per year. Most recently, in 2015, Martin Marietta raised prices by 8%;
• c. Preponderance of local monopolies primarily due to the steep transportation costs of this high-weight cargo: Therefore, the sale of heavy rock is primarily a local business, and quarry location is a key determinant of value. Martin Marietta is entrenched and well positioned as it owns 274 aggregate facilities in 29 states.

(iii) The three key demand drivers for its business all appear to be moving in the right direction:

• a. Government spending on infrastructure projects is expected to accelerate: In December 2015, a transportation bill was passed (the FAST Act) that will increase transportation funding by 5% in 2016 and in line with inflation afterward. State governments have also committed billions in new funding to road construction;
• b. Nonresidential construction is beginning to rebound. Following little or no growth since the recession, nonresidential construction spending rose 8.7% in 2015 and is expected to further increase in 2016;
• c. Residential construction continues to improve as building permits are now at an annual rate of approximately 1.2 million — up from a trough of approximately 500,000 annual permits during the recession.

(iv) Attractive growth prospects: We believe Martin Marietta can grow cash flow by at least 25% in each of 2016 and 2017 and is positioned to be acquisitive given its strong balance sheet (net debt to cash flow is only 1.9 times).

The shares of the two leading commercial real estate services companies, Jones Lang LaSalle Inc. (JLL, Financial) and CBRE Group Inc. (CBG, Financial), retreated sharply in the first quarter of 2016. We believe their performance were largely due to concerns that business prospects for commercial real estate (primarily leasing and investment sales activity and real estate values) had peaked and would deteriorate meaningfully in the months ahead.

While we anticipate that the buying and selling of commercial real estate buildings (“investment sales”) may remain challenged for the balance of this year, we believe business conditions are stronger than recent share price performance would indicate. We remain optimistic about the prospects for both companies.

In our opinion, current valuations for CBRE and Jones Lang LaSalle are among the most attractive in the entire universe of real estate. Since the beginning of 2011, both companies have typically been valued at a premium to the S&P 500 Index’s P/E multiple. Now, however, both companies are valued at a steep discount to the S&P 500! Jones Lang LaSalle’s and CBRE Group’s shares are currently valued at only 11.4 times and 12.8 times, estimated 2016 earnings versus the S&P 500 Index at 17 times. Even if business conditions were to deteriorate, we believe the valuations for both companies remain too low and offer compelling value.

In addition to each company’s attractive valuation, we believe both are well positioned for growth:

1. Both companies have significant businesses that should continue to benefit from the growing secular trend of companies outsourcing their commercial real estate needs. CBRE Group estimates that the commercial real estate outsourcing business is a large addressable market opportunity of $100 billion, yet it has the No. 1 market share at only 6% to 7%. The commercial real estate outsourcing business is not only a secular growth opportunity, but it is a generally predictable cash flow business given the contract nature of the business.
2. Each company’s leasing business should benefit from employment growth and, given its broad global footprints, is well positioned to gain market share. Further, we believe the recurring nature of the leasing business is underappreciated. It is our understanding that the majority of leasing revenues is predictable and recurring, given that 80% of overall leasing are renewals of existing leases.
3. While each company’s sales brokerage business (“investment sales”) may be slowing, we believe both are well positioned long term as institutional ownership of commercial real estate (pension funds, endowments, sovereign wealth funds, etc.) continues to increase.
4. Both companies maintain strong and liquid balance sheets and are positioned to go on “offense” and acquire companies.

The shares of cruise line operator Royal Caribbean Cruises Ltd. (RCL, Financial) declined sharply in the first few months of 2016 due to concerns about its business outlook – recession fears, the possible negative impact from the Zika mosquito virus, geopolitical unrest in the Eastern Mediterranean and increased new ship capacity in China. We have met with management a number of times in the last few months and believe that business conditions and prospects, once again, are stronger than recent share price performance would indicate.

We maintain our generally favorable view for cruise line companies due to: a favorable industry structure wherein the three largest cruise lines control approximately 80% of the industry; manageable new ship additions; high barriers to entry given that a new ship typically costs between $800 million and $1 billion; lower oil prices; favorable valuations; rational pricing strategies, and emerging growth opportunities (especially in China and Cuba).

Royal Caribbean operates 42 ships with an additional eight under construction. The company serves 480 destinations on all seven continents. Management is targeting to more than double its earnings per share from $3.39 in 2014 to $7 in 2017 through moderate capacity growth, cost containment and improvements in occupancy and rates. We believe the company could exceed those goals and generate $7.25 in 2017, representing an average annual growth rate of approximately 29% between 2014 and 2017.

In our view, the shares are attractively valued at approximately 13 times 2016 estimated earnings. At only 15 times our estimated 2017 earnings per share of $7.25, the price would reach $109 per share in the next 12 to 18 months versus a current price of $80 per share or 36% upside.

Portfolio structure

The first quarter of 2016 was an active period for the Fund. We took advantage of the largely indiscriminate market selloff in the beginning of the year. In fact, as a result of this unusual buying opportunity, we are most enthusiastic about the Fund’s investments.

Our strategic initiatives regarding portfolio positioning and structure:

1. We purchased a number of “best in class” companies that have been “on sale” (examples include Mohawk Industries Inc. [MHK], American Tower Corp. [AMT], Toll Brothers Inc. [TOL] and Simon Property Group Inc. [SPG]).
2. We lowered the overall leverage of the Fund’s holdings by trimming or exiting our positions in the companies with somewhat more highly leveraged balance sheets (examples include Forest City Realty Trust Inc. [FCE.A][FCE.B], Builders FirstSource Inc. [BLDR], ClubCorp Holdings Inc. [MYCC] and Summit Materials Inc. [SUM]). Accordingly, we believe the overall debt levels and interest expense obligations of the Fund’s investments compare very favorably to the broader real estate universe.
3. We decreased our exposure to smaller and less liquid companies. At Dec. 31, 2015, companies with a market capitalization of less than $3 billion comprised only 19% of the Fund. At March 31, these companies comprised only 14% of the Fund, and the weighted average market capitalization of the entire portfolio was $20.4 billion.
4. We continue to de-emphasize complex companies that may have a narrower investor audience and are less likely to receive full credit for the company’s intrinsic value. Examples can include companies with several business lines, externally managed fee streams and/or less than stellar corporate governance.
5. We trimmed the Fund’s exposure to companies located in geographic markets that may face headwinds due to low oil prices (e.g., Houston), elevated real estate construction activity (e.g., New York City hotels) or unfavorable international exposure (e.g., Brazil).
6. We increased the Fund’s exposure to REITs. In the fourth quarter of 2015, we increased the Fund’s allocation to REITs from 20.7% to 27.0% (includes Forest City Enterprises Inc. [FCY], which began operating as a REIT on Jan. 1). In the first three months of 2016, we further increased our investments in REITs to 34.2% of the Fund. We did so because we believe the near-term prospects for REITs appear relatively attractive.

Most REITs are largely domestic and, with current average dividend yields of approximately 4%, may continue to benefit from low interest rates. Additionally, they should benefit from occupancy growth and increased rents during this time of limited new construction activity. Many REITs have improved balanced sheets that can support corporate growth and have continued access to unprecedented low cost capital and accretive investment opportunities. Further, we believe having a larger “yield and defensive orientation” of approximately 35% in REITs is prudent given the current modest economic growth and historically low interest rate environments.

We continue to maintain that our philosophy of structuring a more inclusive and unique real estate fund – one that includes REITs but is more expansive, balanced and diversified than a typical “REIT only” fund – is a sensible long-term strategy that has the potential to produce superior results over time.

We are mindful, however, that although we believe some REIT valuations are “reasonable,” many of the Fund’s non-REIT real estate-related companies’ valuations are generally more compelling (and have become even more compelling as more “equity-like” rather than “bond-like” securities such as REITs have corrected disproportionately so far in the early part of 2016). At some point, REITs may become more vulnerable than non-REITs to an eventual rise in interest rates. We continue to carefully monitor.

At March 31, the Fund maintained 37 positions. Our 10 largest holdings comprised 39.5% of the Fund, with an average position size of 4.0%, and our 20 largest holdings accounted for 68.1% of the Fund, with an average position size of 3.4%.

We recently increased the Fund’s investment in Gaming and Leisure Properties Inc. (GLPI). This company was spun off from Penn National Gaming (PENN) in November 2013.

Gaming and Leisure Properties will become the third largest publicly traded triple net REIT, with 35 casino and hotel facilities in 14 states, upon the completion (second quarter of 2016) of its $4.4 billion acquisition of Pinnacle Entertainment Inc.’s (PNK) real estate assets. (In a triple net REIT, tenants typically pay rent, real estate taxes, maintenance, insurance, utilities and other related charges).

We are optimistic about Gaming and Leisure Properties because:

1. The long-term nature of its leases produces highly stable and predictable cash flow. For example, the company’s lease with Penn National Gaming is for an initial 15-year term, plus four tenant-optional five-year extension periods. Additionally, the company’s lease with Pinnacle is for an initial 10-year term, plus five tenant-optional five-year extension periods. Both leases have 2% annual escalators.
2. The company may acquire additional gaming properties to fuel growth. During the next few years, we believe management is likely to pursue additional accretive acquisitions. Notably, for example, several U.S. gaming companies such as Caesars Entertainment Inc. (CZR), Isle of Capri Casinos Inc. (ISLE) and Boyd Gaming Corp. (BYD) have each publicly discussed the possibility of asset sales.
3. We have great confidence in CEO Peter Carlino. He previously generated excellent long-term returns for the shareholders of Penn National Gaming prior to its spinoff of Gaming and Leisure Properties. Now, we believe he will once again achieve strong returns. Peter Carlino is its largest shareholder, and accordingly we are pleased that his interests are aligned with ours.
4. Compelling valuation and dividend. We believe these shares are one of the more attractively valued securities in the entire real estate universe. Gaming and Leisure Properties offers a 7.7% pro forma dividend yield for the expected completion of the company’s acquisition of Pinnacle Entertainment and sale of its Meadows Racetrack and Casino. This dividend yield compares favorably to its publicly traded bonds which mature in five, seven, and 10 years that offer yields of only 3.91%, 4.70% and 4.85%. Further, the company’s 7.7% pro forma dividend yield exceeds several other publicly traded triple net REITs which offer lower dividend yields of 5.6%, (market capitalization weighted average).

We recently began acquiring shares in Macquarie Infrastructure Corp. (MIC) following a 30% decline in its share price from approximately $85 to $60 per share (largely due to noncompany-specific reasons, in our opinion). We are optimistic about the company’s prospects for the following reasons:

1. Macquarie owns and/or operates high-quality real estate-like infrastructure assets. Approximately 48% of Macquarie’s cash flow is generated from bulk liquid storage terminals along the New York Harbor and Lower Mississippi River (Louisiana). The company stores petroleum, chemical and vegetable/animal oils for its customers typically under 2½- to three-year contracts, thereby securing contracted and visible cash flow. In our opinion, the company has acquired and developed well-located and hard-to-replicate real estate assets along some of the largest shipping and distribution channels in the U.S. with significant barriers to entry and limited competition.

In New York, Macquarie operates in a major demand center for business activity and owns the only port that can accommodate large ships due to its deep water depth. It is estimated that it would cost a potential competitor billions of dollars to dredge water to satisfy the water-depth requirements of larger shipping vessels. Further, environmental permitting requirements typically take several years, thereby limiting future competition.

In Louisiana, the desirable location of Macquarie’s terminals along the Mississippi riverbeds is appealing to many of its customers on the Gulf Coast. The company controls 60% of the shipping market in Louisiana.

Approximately 32% of Macquarie’s cash flow is generated from its Atlantic Aviation business. Atlantic operates 69 fixed base operations (FBOs) at airports, typically under 20-year ground leases. The company provides fuel, hangar and other services primarily for private planes. We believe the company’s FBO business is attractive because Atlantic and its key competitor, Signature, have the dominant market share in a largely oligopolistic industry. Amid very limited physical space in airports, the two companies have acquired the majority of the most desirable FBOs in the U.S. In fact, Atlantic is the sole operator in 50% of its locations. The business generates tremendous free cash flow, and we believe there may be opportunities for Atlantic to acquire additional FBOs.

Finally, approximately 20% of Macquarie’s cash flow is generated by contracted power and energy and regulated natural gas businesses that also generate predictable and steady cash flows.

2. Attractive double-digit annual total return potential given strong estimated free cash flow and dividend growth. Since 2007, the company has grown free cash flow per share each year by approximately 14%. Management continues to believe it has a good opportunity for low- to-mid teen annual free cash flow growth for the next two years due to the contracted nature of the revenues of its storage terminals, power and energy and gas businesses, expectation of modest GDP growth and $500 million of growth capital deployment. Management typically pays a dividend to shareholders that equates to 75% to 85% of its free cash flow. In 2016, management expects to pay a dividend of approximately $5.05 per share, which at the current share price equates to an attractive 7.6% dividend yield.

3. High regard for CEO James Hooke. In the last few months, we have spent considerable time with Hooke and other members of Macquarie’s management team. Since joining the firm in 2009, Hooke and his team have done an excellent job improving the company’s balance sheet, operations and business mix. We believe management will continue to create value in the years ahead by allocating capital to disciplined and prudent growth initiatives.

In the most recent quarter, the company acquired shares in Digital Realty Trust. The shares have performed well since the Fund’s purchase. Please refer to the “Top Contributors to Performance” section earlier in this letter for our thoughts on the company.

The first quarter of 2016 was an active period for the Fund. We believe we made several improvements to the portfolio. We exited both Forest City Realty Trust and Brookfield Infrastructure Partners L.P. (BIP) (to lower the profile of companies with complex businesses and higher balance sheet leverage). We exited Hyatt Hotels Corp. (H) as part of our desire to reduce the Fund’s overall hotel exposure. Following its strong share price performance over the last few years, we trimmed our position in Equinix The Fund also greatly trimmed its position in CaesarStone Sdot-Yam Ltd. (CSTE) and reallocated the proceeds to higher conviction ideas.