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, Inc. and Brookfield Infrastructure Partners L.P. (to lower the profile of companies with complex businesses and higher balance sheet leverage). We exited Hyatt Hotels Corp. 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, Inc. The Fund also greatly trimmed its position in CaesarStone Sdot-Yam Ltd. and reallocated the proceeds to higher conviction ideas.
Outlook
Stock market performance in the first quarter of 2016 was bipolar in nature. In the first six weeks of the year through February 11, the S&P 500 Index declined by 10.3% – one of its worst starts to the year ever! Yet, in the last 7 weeks of the quarter, the S&P 500 Index reversed course, increasing by approximately 13%!
Why the volatility? In our view, the most notable concerns that weighed on the market early in 2016 included:
- China’s slowing economy and the possible spillover effects
- The more than 70% decline in oil prices since 2014
- Continued uncertainty regarding the Fed’s future action on interest rates • Underwhelming and, in some cases, slowing global economic growth
- Widening credit spreads However, many of these concerns were later viewed as “false alarms:”
- Fears of a collapse in China’s growth appear to have abated
- Oil prices have rebounded from a low of $26 per barrel to $40 per barrel
- The Federal Reserve did not increase interest rates in the first quarter, and signaled that it would be cautious and measured in its approach, given the ongoing slow pace of inflation and moderate economic growth
- Credit spreads have rebounded and debt market liquidity has improved
Our Latest Views on Real Estate:
During the last few months, we have met with the top management of numerous commercial and residential real estate-related companies, attended several real estate conferences, toured various real estate properties in several geographic markets, and have spoken with various equity and debt capital providers and investors.
Our key conclusions and most current views are as follows:
1. We maintain a favorable outlook for real estate. Why?
Our research validates that the factors that have fueled the resurgence in real estate largely remain in place:
Demand persists and continues to outstrip supply in most markets:
- Demand persists and continues to outstrip supply in most markets
- Balance sheets are generally in solid shape
- Credit remains available at low interest rates
2. We are not seeing signs of an imminent recession
The overall performance of our real estate companies and our discussions with various top managements does not portend an imminent recession.
3. We anticipate a positive yet moderating return outlook than in previous years (2010-2015).
Since the inception of the Baron Real Estate Fund more than six years ago, the Fund has generated an average annual return of 15.70% (Institutional Shares), exceeding the S&P 500 Index’s average annual return of 12.67%. In the next six years, we anticipate positive but somewhat more modest returns primarily because valuations today are generally not as attractive as they were six years ago when stock prices were severely depressed. Additionally, interest rates may head higher in the next few years.
4. Substantial capital is still in pursuit of real estate ownership. This should help to limit downside valuation and pricing.
If real estate prices were to correct meaningfully due to economic, interest rate, or other concerns, we believe large amounts of capital - from private equity investors such as Blackstone Real Estate, sovereign wealth funds, endowments, pension funds, and others – will step in and capitalize on the opportunity to buy quality real estate at depressed prices. This “embedded put” scenario should limit downside valuation.
5. Debt capital is still widely available.
In the first few months of 2016, credit spreads or borrowing costs widened for some real estate companies. The dislocation in the credit markets was largely due, in our opinion, to the woes in the energy market and general economic uncertainty. Debt costs have since improved, and debt capital is still widely available, albeit with somewhat tighter covenants and lower leverage levels than prior to the economic downturn.
6. We remain optimistic about the prospects for residential real estate.
U.S. homebuilders continue to build an insufficient number of homes relative to the demographic needs of the population. This shortage of new housing is occurring amid reasonable population growth as well as solid job growth. These factors are contributing to a meaningful increase in new household formation, and are consequently generating significantly higher demand for new homes. Of further note, mortgage rates remain at low levels with ample availability.
Despite this robust level of household formation, the U.S. continues to build an insufficient number of new homes and apartments. The current rate is approximately 1.1 – 1.2 million new homes, compared to a 60-year historical average of 1.5 million new homes annually, despite the fact that the U.S. population is much larger than it was 50 to 60 years ago!
This imbalance between housing demand and low construction levels bodes well for new home sales, prices, apartment occupancies and rents.
7. We believe commercial real estate fundamentals remain positive – albeit real estate is trending toward a more mature phase of the cycle.
The prospects for commercial real estate business fundamentals are, in our opinion, still reasonably good. We anticipate modestly improving occupancies, rents, and cash flows. However, an uptick in construction activity, less compelling valuations, and the likelihood of higher interest rates are among the indicators that commercial real estate is in a more mature phase of the real estate cycle – yet, we believe it is premature to call it the end of the cycle.
8. Although there are some “cracks in the armor”, we are not overly concerned.
Construction activity has increased in a few real estate segments and markets, lenders are requiring wider credit spreads with lower leverage, the Fed may increase interest rates further, albeit most likely in a gradual manner, and the real estate cycle is in its sixth or seventh year of a sustained recovery. While our antenna remains up, we maintain a favorable outlook as our research continues to confirm that the opportunities for real estate outweigh the issues or slight “cracks in the armor.”
9. We continue to identify companies that are attractively valued.
The Fund took advantage of the major buying opportunities that were created early in 2016 following the swift and intense stock market correction. In fact, during February, some stock prices were so depressed that valuations had become as attractive as they were in the summer of 2011 (during fears of a U.S. government credit downgrade). Some valuations in early 2016 were approaching levels last seen during the global financial crisis of 2008 and 2009!
Consequently, we identified and purchased a number of real estate-related companies whose stock valuations we believe were among the most attractive that we have seen in several years. Though many stock prices have recovered, valuations for many of our current or prospective real estate-related investments remain quite reasonable and, in some cases, particularly attractive.
10. The Baron Real Estate Fund is well-suited to navigate the next few years.
We recognize that the broad stock market, including many real estate stocks has been on a steady upward climb since the global financial crisis. We therefore anticipate that there may be periods of market weakness in the years ahead. Nevertheless, we believe that the Baron Real Estate Fund, with its differentiated approach to investing in real estate, is well suited for the twists and turns of the market that may lie ahead. The Fund’s expansive, balanced, and more diversified approach to investing in broader real estate categories – not a REIT-only approach – provides the flexibility and dimension to perform well in several different market environments. As such, we maintain that the overall prospects for real estate and the Fund remain promising.
