Baron Real Estate: Picking Hot Properties

Signs of a real estate recovery abound: More For Sale placards are sitting proudly on front lawns, apartment vacancy rates are sliding and high-end remodels are taking the place of essential repairs.

Real estate is back, says Jeff Kolitch, manager of the $391 million Baron Real Estate fund (BREFX). "We believe that we're in the early stages," he says. "The backdrop for real estate, despite the headwinds in the broader economy, are quite attractive."

Fueling the market are ultralow interest rates, improving conditions for commercial and residential real estate, driven by greater demand and relatively little construction over the last few years.

That's a big change for the sector - and the fund. Launched in late 2009, Baron Real Estate debuted in one of the worst-ever real estate markets. But bad times made for good buying opportunities - so whether the move represented astute vision or simply good timing, the fund has benefited enormously as the sector has roared back.

 

BREAK FROM PAST?

Kolitch - who learned about the industry from his father, a real estate developer in northern New Jersey - was Baron's real estate analyst for four years before being tapped to launch the fund. He still advises on real estate investments for other Baron funds.

There's little about this past real estate cycle that follows previous patterns, Kolitch says. That leads him to believe that the recovery won't be normal or short-lived. Typically, sector downturns last two years. This time, it's dragged on for six; so the rebound, he argues, could go on another few years. What's more, the depth of the decline means that the sector could stage just as spectacular a rebound.

The fund's performance reflects some of the gains the market has already made. Over the year ending April 3, Baron Real Estate was up 34.3%, according to Morningstar. That puts the fund in the top 1% of the real estate category for that period. For the last three years, through April 3, the fund is up 22.6% a year annualized, besting 96% of its competitors.

Residential and commercial real estate is certainly on the mend. Home prices rose 10.2% this past February over a year prior, the biggest increase since 2006, says CoreLogic, a real estate data firm. Commercial real estate has also rebounded. Vacancy rates in offices are expected to decrease 0.4% this year, according to the National Association of Realtors, while office rents are projected to rise 2.6%.

Kolitch plays these developments in ways that are not always obvious. For example, Caesarstone Sdot-Yam (CSTE), an Israeli company that manufactures engineered quartz countertops, can ride the wave of improving home sales. As more people move into homes, they have more opportunities to renovate. "It's a high-growth way to play a recovery in residential home sales and repair," he says.

What's more, the countertops, at up to $65 a square foot, are taking market share away from more traditional materials like granite, marble and laminate. "It's an opportunity to increase market share at the time when the home repair market is improving," Kolitch says.

He predicts that Caesarstone, which returned 102% for the 12 months ended April 3, will double revenues over the next five years. Meanwhile, it recently traded at a reasonable 12.5 times future earnings with 20% to 25% earnings growth.

When it comes to commercial real estate, Kolitch prefers to look at service companies - those firms that manage properties and maintain facilities. More tenants in office buildings need such services, he believes, and many prefer to outsource this function.

The two leading companies in the industry are CBRE Group (CBG) and Jones Lang LaSalle (JLL); Kolitch's fund holds both. CBRE, the largest player, has a more domestic focus, while Jones Lang LaSalle has a greater global presence. CBRE stock rose 22.7% in the 12 months ended April 3; Jones Lang LaSalle posted a 15.5% gain in that period.

 

LIGHT ON REITS

REITs are in short supply in the Baron Real Estate fund, accounting for just 13% of the fund's assets. One reason: Kolitch just isn't fond of the REIT structure, which calls for the company to distribute 90% of its taxable income to shareholders as a dividend in order to receive favorable tax treatment. That can handcuff a company's expansion plans and stymie growth opportunities, Kolitch says. "They are left with very little in terms of earnings and free cash flow," he says.

Further, because of the yield component, they're more sensitive to interest rate moves. That could be a problem if rates were to spike suddenly.

Of more concern is the recent run-up in REIT stock prices. The FTSE NAREIT All REIT index is up 9.09% in 2013 through April 3, on track for its fifth positive year.

Kolitch believes he can find better value in other real estate-related businesses - such as gaming stocks, a popular theme across several Baron funds. He likes Las Vegas Sands (LVS), whose integrated resorts bring together casinos, hotels and shopping. Sands owns and operates the Venetian in Las Vegas and the Marina Bay Sands in Singapore. In fact, 85% of its revenues come from Asian markets like mainland China and Macau.

"Gaming companies have embedded real estate in them," Kolitch says. Las Vegas Sands is also a play on an improving global economy. Shares fell 1.8% over the last 12 months, in part because the firm has acknowledged bribing Chinese officials; Kolitch began acquiring the stock last year.

Another favorite area for Baron Real Estate is hotels. "If you believe that the economic recovery is starting to take hold, there is no better category to be in than hotels," Kolitch says. Among Kolitch's favorites is Hyatt Hotels (H). "It's got a strong balance sheet with a good net cash position," he says. Further, Kolitch believes the hotelier has capacity to increase its room count by 30% in the next five years.

Hyatt stock floundered last year, due to higher-than-expected expenses; shares fell 2.4% over the 12 months ended April 3. But Kolitch believes spending will improve Hyatt's position in the long term. Hyatt has authorized a stock buyback program, which should also help boost the shares.

 

DEMOGRAPHICS BET

With considerably fewer housing bargains now than in 2009, the fund's biggest economic bet these days is the graying of America. Its two largest holdings are Brookdale Senior Living (BKD) and Capital Senior Living (CSU).

Kolitch likes the positive demographics of senior living. In 2010, there were 5.5 million people 85 and older. The Census Bureau predicts that, by 2050, there will be 19 million.

Further, the improving housing market also means older people will be able to sell their homes, something many have been unable to do recently, and move into assisted living facilities. And spending on senior housing isn't a discretionary household budget item. It's a necessity. (See "Elder Housing Options," p. 54.)

Best of all, he estimates that shares of senior living facilities trade at 10% to 15% discounts to net asset value.

Brookdale operates 650 facilities in 35 states. Because 80% of its revenue comes from private-pay patients, there's little risk from new health care regulations. The stock jumped 40% over the last 12 months; shares of Capital Senior Living, meanwhile, rose 159%.

 

 

Ilana Polyak, a Financial Planning contributing writer in Northampton, Mass., has also written for The New York Times, Money and Kiplinger's.

 

 

Jeff Kolitch

Baron Real Estate

Age: 44

Credentials: B.S. in economics, University of Pennsylvania; M.S. in management, Northwestern University

Experience: Portfolio manager, Baron Real Estate Fund (2009-present); real estate analyst, Baron Capital Management (2005-2009); managing director of Equity Capital Markets, Goldman Sachs (1995-2005)

Ticker: BREFX

Inception of fund: December 2009

Style: U.S. real estate

AUM: $391 million

One- and three-year performance as of April 3: 34.31%, 22.61%

Expense ratio: 1.35%

Front load: None

Minimum investment: $2,000

Alpha: 7.15 vs. Russell Midcap Value Index

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