Baron Real Estate Income Fund
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June 30, 2020 Baron Real Estate Income Fund Dear Baron Real Estate Income Fund Shareholder: The Baron Real Estate Income Fund (the “Fund”) generated strong performance for the most recent quarter ended June 30, 2020. During this period, the Fund gained 17.02% (Institutional Shares), exceeding its primary benchmark index, the MSCI US REIT Index (the “REIT Index”), which rose 11.39%. For the six-month period ended June 30, 2020, the Fund modestly declined 1.41%, yet significantly outperformed the REIT Index, which declined 18.95%. According to Morningstar, the Fund was ranked in the top 3% among 258 for its trailing one-year performance through June 30, 2020. Morningstar rankings are based on total returns and do not include sales charges. As of 6/30/2020, the Morningstar US Fund Real Estate Category consisted of 258 and 234 share classes for the 1-year and since inception (12/29/2017) periods. Like our first quarter shareholder letter, we have chosen to modify our typical format for this shareholder letter. We will, instead, prioritize and address your “top of mind” questions. We will address the following topics in this letter: 1. An explanation of why the share prices of many REITs performed poorly in the first six months of 2020 JEFFREY KOLITCH Retail Shares: BRIFX 2. Thoughts regarding the outlook for REITs (preview: we believe many REITs Institutional Shares: BRIIX are a current bargain) PORTFOLIO MANAGER R6 Shares: BRIUX 3. A review of the Baron Real Estate Income Fund’s differentiated approach to investing in REITs and other income-oriented real estate companies AN EXPLANATION OF WHY THE SHARE PRICES OF MANY REITS 4. Portfolio construction and key investment themes PERFORMED POORLY IN THE FIRST SIX MONTHS OF 2020 5. Our outlook for the broader real estate market and the Baron Real Estate Income Fund (preview: we are bullish) REITs have lagged the broader market by a wide margin in 2020. In the first six months of this year, the REIT Index has declined 18.95% versus the S&P Baron Real Estate Income Fund Performance 500 Index’s decline of 3.08%. Table I. Year-to-date, income seeking investors have shied away from dividend- Performance yielding REITs despite the plummet in interest rates to historically low levels. For periods ended June 30, 2020 Further, traditional REIT attributes – attractive dividends, contracted cash Baron Baron flows, and largely domestic portfolios – have not provided adequate shelter Real Estate Real Estate Income Fund Income Fund MSCI US during the Coronavirus pandemic. Retail Institutional REIT Shares1,2 Shares1,2 Index1 Three Months3 17.09% 17.02% 11.39% Six Months3 (1.50)% (1.41)% (18.95)% One Year 11.62% 11.57% (13.92)% Since Inception (December 29, 2017) (Annualized) 7.34% 7.48% (2.07)% Since Inception (December 29, 2017) (Cumulative) 3 19.37% 19.77% (5.10)% Morningstar calculates the Morningstar US Fund Real Estate Category Average using its Fractional Weighting methodology. Total returns do account for management, administrative, and 12b-1 fees and other costs automatically deducted from fund assets. Morningstar ranked Baron Real Estate Income Fund Institutional Share Class in the 3rd and 4th percentiles, respectively. © Morningstar 2020. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may notbe copied, adapted or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results. Performance listed in the above table is net of annual operating expenses. Annual expense ratio for the Retail Shares and Institutional Shares as of December 31, 2019 was 6.87% and 5.63%, respectively, but the net annual expense ratio was 1.05% and 0.80% (net of the Adviser’s fee waivers), respectively. The performance data quotedrepresentspast 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 Adviser reimburses certain Baron Fund expenses pursuant to a contract expiring on August 29, 2030, unless renewed for another 11-year term and 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. For performance information current to the most recent month end, visit www.BaronFunds.com or call 1-800-99BARON. 1 The index is unmanaged. The index performance is not Fund performance; one cannot invest directly into an index. The MSCI US REIT Index is a free float-adjusted market capitalization index that measures the performance of all equity REITs in the US equity market, except for specialty equity REITs that do not generate a majority of their revenue and income from real estate rental and leasing operations. The index and the Fund include reinvestment of interest, capital gains and dividends, which positively impact the performance results. BARON 2 The performance data in the table does not reflect the deduction of taxes that a shareholder would pay on Fund distributions or redemption of Fund shares. FUNDS 3 Not annualized. Baron Real Estate Income Fund So, why have many REITs lagged in the first six months of 2020? 3. Balance sheet concerns In the first quarter of 2020, concerns regarding tenant rent payments, credit Most REITs maintain higher leverage levels than more traditional market turbulence, highly levered balance sheets, and the possibility of a companies. This is due, in part, to the requirement that REITs must pay prolonged economic downturn weighed on the performance of REITs. Specifically: at least 90% of their taxable income as dividends. 1. Concerns that many tenants may not pay their rent obligations Unwarranted concerns about REIT debt levels has likely contributed to the share price weakness of many REITs. REITs are the landlord to the overall economy. They provide physical real estate to many businesses and individuals in the form of office In our opinion, REIT balance sheets are stronger than ever, and buildings, apartment buildings, retail malls and shopping centers, concerns are overblown. industrial warehouses, self-storage facilities, hotels, senior housing For example, REITs, on average, currently maintain debt levels of only facilities, data centers, and other niche real estate categories. 5.4 times net debt to cash flow (EBITDA). These levels compare Early in the year, there was fear that some REITs may face the stark favorably to the 8 times net debt to cash flow levels that were reality that many of their tenants may not be able to pay rent due to maintained during the Global Financial Crisis of 2007-2008 (the Great the shutdown of the economy and the possibility of a slow economic Recession). recovery. Most REITs have refinanced debt at extremely favorable interest rates Although some commercial real estate segments – most notably retail over the last few years and extended and staggered future debt malls and shopping centers – are experiencing a high percentage of maturities. their tenants not paying rent, we believe the fear of a major 4. The fear of a prolonged slowdown in commercial real estate abandonment of rental payments by most commercial real estate business fundamentals categories is unwarranted. In our opinion, concerns that the pandemic may result in a prolonged Rent collections for most commercial real estate categories have been economic shutdown resulting in a lengthy slowdown in demand for encouraging. In June, we anticipate that most commercial real estate commercial real estate pressured REITs in the first quarter of 2020. categories – apartments, office, industrial warehouse, single-family rental homes, manufactured housing, data centers, wireless towers – More recently, as the long-term implications of the Coronavirus have will collect, on average, 90% to 95% of rent obligations. We expect been contemplated and debated, additional concerns have pressured rental payments to continue to improve as the economy recovers and certain REIT categories. For example: more people return to work. a. Retail malls and shopping centers 2. Credit market turbulence In the years prior to the Coronavirus, malls and shopping centers In the first quarter of 2020, a plunge in oil prices and the abrupt faced the shift to e-commerce shopping, and their need for new slowdown in the economy led to stresses in the credit market and capital expenditures to reconfigure their malls and shopping more expensive financing costs for many companies. centers into alternative uses. The growth in online shopping during the pandemic will likely accelerate the challenges for retail Earlier in 2020, the prospect of more stringent credit conditions real estate and fast track the pace and number of retail store weighed disproportionately on REITs given their dependence on closings. accessing the debt markets. b. Office buildings Encouragingly, the Federal Reserve and U.S. Treasury acted powerfully with a “do whatever it takes” approach to provide liquidity, keep This year’s necessity to work from home may cause a more interest rates low, and make loans to small- and mid-sized businesses permanent shift in how and where people live and work. Recent and state and local governments. They are also proving support by work from home experiences have been largely positive and buying debt. embraced by many companies. Demand prospects for office landlords may suffer if more businesses decide that all or a In early April, Fed Chairman Powell summarized the Federal Reserve’s portion of their workforce may work remotely.