Davis Real Estate Fund
Update from Portfolio Managers Andrew A. Davis and Chandler Spears
Semi-Annual Review 2020

Investment Results
Davis Real Estate Fund’s Class A shares provided a total return on net asset value for the year-to-date period ended June 30, 2020 of −18.57%. Over the same time period, the Wilshire U.S. Real Estate Securities Index returned −17.89%. Over the most recent one-, five- and ten-year periods, a $10,000 investment in Davis Real Estate Fund would have returned $8,612, $12,442 and $21,862, respectively.1

The average annual total returns for Davis Real Estate Fund’s Class A shares for periods ending June 30, 2020, including a maximum 4.75% sales charge, are: 1 year, −17.97%; 5 years, 3.45%; and 10 years, 7.60%. The performance presented represents past performance and is not a guarantee of future results. Total return assumes reinvestment of dividends and capital gain distributions. Investment return and principal value will vary so that, when redeemed, an investor’s shares may be worth more or less than their original cost. The total annual operating expense ratio for Class A shares as of the most recent prospectus was 0.98%. The total annual operating expense ratio may vary in future years. Returns and expenses for other classes of shares will vary. Current performance may be higher or lower than the performance quoted. For most recent month-end performance, click here or call 800-279-0279. The Fund recently experienced significant negative short-term performance due to market volatility associated with the COVID-19 pandemic.

This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. Equity markets are volatile and an investor may lose money. This is not a recommendation to buy, sell or hold any specific security. There is no guarantee that the Fund performance will be positive as equity markets are volatile and an investor may lose money. 1Class A shares without a sales charge. Past performance is not a guarantee of future results. The Fund recently experienced significant negative short-term performance due to market volatility associated with COVID-19 pandemic.

Fund Activity

When the credit crisis unfolded in 2008, portfolio management of Davis Real Estate Fund found itself dealing with unprecedented change in investor perceptions of real estate. At the time, it was the most dramatic and volatile re-pricing of real estate securities we had ever witnessed. That changed in March of this year when the COVID-19 pandemic became harsh reality. The virtual cessation of all but essential economic activity punished public real estate securities. After reaching a high on February 21, broad real estate sector indices dropped by over 40% in 21 trading days. As dramatic as that drop may be, it hides an unfortunate reality. Some sectors dropped significantly more, and many have questioned the long-term viability of some forms of commercial real estate.

That is not surprising. Real estate is the conduit through which all of humanity conducts every aspect of its life. We sleep in homes, often rented, fill our shopping baskets at the local grocery store and work in offices, among many other things. What does arresting the economy mean for apartment rentals? How will we shop? Is the office safe? These questions and others of equal complexity have been driving increased activity in the Fund. We freely admit that it is difficult to find a basis for decisiveness when risk and potential outcomes can be so broadly unpredictable.

When faced with the likelihood that rents might not be paid, we tried to theorize how individuals might prioritize their payments. Where prior recessions might have seen apartment renters, for example, favor car payments over rent, losing that job or working from home might change their preference. The combination of job losses, stay-at-home orders and remote working led us to believe that having a bed is the most important thing. It became a matter of estimating the possibility that some of our existing apartment investments might not receive rent due. In addition, there might be some differentiation in the sort of renter who ends up having the wherewithal to pay rent through a protracted shutdown of the economy.

We eventually settled on the counter intuitive notion that those renting higher-cost apartments are the ones likely to best survive a shutdown. They are likely employed in jobs that can be performed remotely and, more importantly, are probably persons with deeper financial resources. Workforce housing is relatively disadvantaged on both those points, even after taking into account government support programs. In other words, to underwrite an investment in workforce housing, you need to “look through” those payroll subsidies and believe jobs will return. Unfortunately, we think jobs held by those in workforce housing are coming back in fewer numbers.

Recent history supports our theory. April and May rent collections were near pre-pandemic levels for Class-A high-rent apartments, particularly those located in Sunbelt markets. Class-B workforce housing has been more challenged. While we have not taken dramatic steps with the Fund’s investment in apartments, we have refined it. We have allowed our investment in Camden Property Trust (CPT) to drift higher.2  Its investments are focused in areas where local economic activity has resumed, and it caters to higher-income renters less likely to be out of a job. We could say same similar things about Essex Property Trust (ESS) and add that its locations in many large cities in California will continue to be in demand, given the very high cost of for-sale housing. Conversely, we’ve reduced the Fund’s investment in AvalonBay Communities (AVB), but not because it lacks the things we like in Camden and Essex. Rather, we believe that the development cycle for apartments, and indeed for all property types save industrial, has reached its zenith. AvalonBay has been able to outperform its peers by delivering new apartment properties at yields far in excess of market rates. Said a bit differently, it’s been minting value for years. Now, however, as lease-up becomes more difficult, first-year development yields are going to drop, meaning value creation will slow. To be clear, even with the reduction in our overweight position, AvalonBay remains one of our favorite long-term apartment names.

Apartments’ fortunate success in rent collections is not shared among retail tenants. That is particularly true for those retail properties that cater to non-essential businesses like restaurants, theaters and luxury retailers. Because mall properties count those non-essential businesses as their primary tenants, they have realized the lowest rent collections with the exception of hotels. Mall landlords as a group have been less than forthcoming with exact figures on rent collection. Our best research suggests 20–30% of contractual rent was received during April and May. Opinions vary on how quickly those payment levels will rebound, especially since extensive bankruptcies are possible. We have eschewed the issue for the most part by asking how pandemic-induced closures might accelerate consumption by other means. (We continue to underweight the enclosed mall sector.) Long-time Fund shareholders will know that our favored retail play is actually an industrial play. Much of our performance over the past several years can be traced to investments in industrial REITs that facilitate e-commerce delivery. But how might the pandemic change fortunes for brick-and-mortar real estate?

One of the trends we’ve been watching for years is grocery delivery. Amazon’s purchase of Whole Foods was a signal. A business that was built on the idea that everything can be delivered from warehouse directly to consumers purchased a large portfolio of very well-located grocery stores. Why? At the time (late 2017), our theory was that Amazon was building a distribution network for grocery delivery. Since then, Amazon and a host of other grocery companies have leveraged their real estate by investing a tremendous amount of capital to satisfy demand for grocery delivery and curbside pickup.

Interestingly, the necessary robust demand that makes that model work did not actually materialize until the arrival of COVID-19. As a result of the pandemic, almost the entire grocery shopping world has had the option of grocery delivery foisted upon them as the most “socially distant” and potentially safe alternative for putting food on the table. For many consumers, it ended up being a forced trial run. And despite problems resulting from overwhelming demand, we think the hook has been set for many. We don’t expect everyone who tried grocery delivery to continue using it, but we believe there is now greater acceptance. That has meant an increased focus on grocery-anchored shopping centers at the expense of enclosed malls and shopping centers that don’t count grocers among their top tenants.

Even though retail fallout has yet to run its full course, the companies that we find more attractive are trading at very wide discount to our estimate of fair value and have balance sheets strong enough to weather a protracted recovery. Brixmor Property Group (BRX), for example, has a grocer in over 70% of its properties. Its proactive management team is helping tenants adapt to a world that will depend more heavily on delivery and curbside pickup. And unlike most of their peers, its average rent is far below market. That gives Brixmor considerable latitude to deal with bankruptcies or other re-tenanting costs.

Ultimately, apartment rent and groceries require a paycheck, and chances are for most people, that paycheck has been earned in an office setting. But here too the pandemic seeks to unhinge what we have come to expect as normal. In very short order, work-from-home (WFH) became the only way to conduct business, save for those businesses considered essential. Stalwart office REITs were thrown under the bus as investors scurried for the door believing WFH would become the standard. We too had to take a step back and ask ourselves, is this situation likely to materially alter the demand for commercial office space?

The obvious precondition to believing office demand will prove resilient over the long term is to build a case for workers returning to the office. We have a number of reasons to believe that will happen. From a practical standpoint it is hard to envision WFH allowing for effective recruiting and mentorship of young professionals. The tax nexus is another significant issue that quickly brings to the table municipal and state taxing authorities. That alone can create dizzying complexity sufficient to curb enthusiasm in WFH initiatives. Beyond that, however, we count ourselves among those who believe that humans are social animals who work best when surrounded by smart, motivated peers. One of the Fund’s favorite office names, Boston Properties (BXP), helps support that notion. In its most recent investor presentation, it pointed to a Gensler Research Institute study that suggested only 12% of workers want to WFH full-time. That isn’t zero, but definitely not the sort of demand decay implied by current office REIT valuations.

Of course, we are not being cavalier in our thinking. There will surely be some permanent changes in the office sector. In the past, greater employee density (read: lower square feet per employee) and proximity to mass transit hubs would earn an owner a premium valuation, all other things being equal. That might not be the case in the future. Conversely, office buildings located in suburban areas that required its tenants to drive in might not trade as cheaply as they have in the past given the current challenges and concerns with mass transit. And that is where we’ve focused our office investment activities in response to the pandemic. We recognize that increasing the amount of office space per worker with the intent to maintain social distancing could prove more beneficial to office buildings in dense urban areas.

Nevertheless, the pandemic is more to likely shift long-term demand fundamentals in favor of suburban office markets and urban office markets less reliant on mass transit. Also, these locations are likely to have a cost advantage over their urban peers not only from an occupancy perspective, but also as it relates to employee cost. To put a bit finer point on it, we believe that much of the employment base in place now will find a way to use its existing office footprint to work around pandemic difficulties, but new job growth is likely to favor lower cost markets that can better accommodate less employee density. That said, we also don’t want to forget that urban living has lifestyle advantages that, pre-pandemic, were big draws to both employers and employees. How that will change or adapt will also be key to our investment work.

Now, any shareholder paying attention (and we know you all do) will be quick to ask how our opinions might change if there is a pharmacological answer to the pandemic. Our answer might be surprising. We expect (hope for might be the better term) eventual success in the treatment and prevention of COVID-19, but we do not believe all behaviors will revert to pre-pandemic norms. Six months ago the risk and cost of a pandemic was not factored into anyone’s thinking. We believe that will not be the case going forward. Anyone in charge of making space commitments for office, retail or apartment space will now know what happens when a pandemic surfaces. Future decisions will be based on models that assume a pandemic might happen again. Only temporal factors will vary in those models, and for the next few years we believe many pandemic behaviors will prove quite sticky in that regard.

2Individual securities are discussed in this piece. While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate. The return of a security to the Fund will vary based on weighting and timing of purchase. This is not a recommendation to buy, sell or hold any specific security. Past performance is not a guarantee of future results.

Positioning

Fund management has been engaged in regular conversation with its Board of Directors during this trying time, and an issue that comes up frequently is the very wide dispersion of all possible outcomes resulting from pandemic forced changes in behavior. During normal times, if there is such a thing, investors feel at ease knowing the future is likely to unfold in a limited number of ways. The pandemic has reminded us that the future is hardly limited. After all, this is the third time in Fund management’s tenure that we’ve had to deal with a massive exogenous shock that “no one saw coming.”

As a result, Davis Real Estate Fund is positioned with a considerable percentage of its assets in businesses we think will weather this troubled time and thrive when times get better. Exceptional balance sheet strength and a deeply invested management team are integral to making that possible. For the most part, our investments in this area might not see dramatic price gains like some deeply discounted names, but do offer superior long-term risk-adjusted returns. We count among our favorite investments companies like Terreno Realty (TRNO) and CoreSite Realty Corporation (COR), an industrial REIT and data center REIT, respectively. Terreno has been in the Fund for many years and is one of the reasons relative performance has been good. CoreSite, along with our other data center holdings, is the basis for our strongest investment conviction: e-commerce consumption will continue to take market share away from conventional shopping venues.

Even though we consider most of our investments to be lower risk, we would not be true to our value roots if we did not at least investigate and research companies trading at deep discounts. The pandemic has most assuredly put some real estate companies on the brink of bankruptcy; these are not interesting. Shopping centers and hotels, on the other hand, are worth tracking. Because the selling in these sectors has been indiscriminate, some great companies are trading at values at or even below those witnessed during the great credit crisis.

Earlier we mentioned our affinity for Brixmor Property Group, a shopping center REIT trading at a punitive valuation. We can say similar things about Sunstone Hotel Investors (SHO), which might surprise some shareholders. We have stated many times in our history that the degree of operating leverage in the hotel sector causes us deep concern. Indeed, this pandemic illustrates that very point. Where most commercial property is still receiving rent, hotels are getting next to none. For the most part, they’ve been shuttered, which means we no longer talk about free cash flow growth for these hotels, but cash burn rates until Chapter 11. Fortunately for Sunstone, as of its most recent first quarter report, it has almost zero net debt. If any public hotel company can survive a prolonged period of property closure, it’s Sunstone. Nonetheless, these deep value plays are small relative to Fund assets. In other words, we are trying to take a very conservative approach when making these deep value investments. The companies themselves have lower risk, and we have also weighted them in the Fund at a lower level to further reduce risk.

In the end, we believe the Fund is well-positioned to weather poor economic conditions through the balance of the year and into early 2021. Almost all positions have very low balance sheet risk, exceptional management teams, and a business we feel confident will thrive when the economy begins to regain its footing. As fellow shareholders in the Fund, we thank you for your trust and support.

This report is authorized for use by existing shareholders. A current Davis Real Estate Fund prospectus must accompany or precede this material if it is distributed to prospective shareholders. You should carefully consider the Fund’s investment objective, risks, charges, and expenses before investing. Read the prospectus carefully before you invest or send money.

This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. These comments may also include the expression of opinions that are speculative in nature and should not be relied on as statements of fact.

Davis Advisors is committed to communicating with our investment partners as candidly as possible because we believe our investors benefit from understanding our investment philosophy and approach. Our views and opinions include “forward-looking statements” which may or may not be accurate over the long term. Forward-looking statements can be identified by words like “believe,” “expect,” “anticipate,” or similar expressions. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate.

Objective and Risks. Davis Real Estate Fund’s investment objective is total return through a combination of growth and income. There can be no assurance that the Fund will achieve its objective. Under normal circumstances the Fund invests at least 80% of its net assets, plus any borrowing for investment purposes, in equity, convertible, and debt securities issued by companies principally engaged in the real estate industry. Some important risks of an investment in the Fund are: stock market risk: stock markets have periods of rising prices and periods of falling prices, including sharp declines; common stock risk: an adverse event may have a negative impact on a company and could result in a decline in the price of its common stock; real estate risk: real estate securities are susceptible to the many risks associated with the direct ownership of real estate, such as declines in property values and increases in property taxes; headline risk: the Fund may invest in a company when the company becomes the center of controversy. The company’s stock may never recover or may become worthless; large-capitalization companies risk: companies with $10 billion or more in market capitalization generally experience slower rates of growth in earnings per share than do mid- and small-capitalization companies; manager risk: poor security selection may cause the Fund to underperform relevant benchmarks; fees and expenses risk: the Fund may not earn enough through income and capital appreciation to offset the operating expenses of the Fund; mid- and small-capitalization companies risk: companies with less than $10 billion in market capitalization typically have more limited product lines, markets and financial resources than larger companies, and may trade less frequently and in more limited volume; and variable current income risk: the income which the Fund pays to investors is not stable. See the prospectus for a complete description of the principal risks.

The information provided in this material should not be considered a recommendation to buy, sell or hold any particular security. As of 6/30/20, the top ten holdings of Davis Real Estate Fund were: Prologis, 6.9%; Equinix, 5.7%; Public Storage, 4.2%; Rexford Industrial Realty, 4.1%; Welltower, 4.0%; Terreno Realty, 4.0%; Essex Property Trust, 3.8%; Alexandria Real Estate Equities, 3.7%; AvalonBay Communities, 3.3%; Simon Property Group, 3.3%.

Davis Funds has adopted a Portfolio Holdings Disclosure policy that governs the release of non-public portfolio holding information. This policy is described in the prospectus. Holding percentages are subject to change. Click here or call 800-279-0279 for the most current public portfolio holdings information.

We gather our index data from a combination of reputable sources, including, but not limited to, Thomson Financial, Lipper, Wilshire, and index websites.

The Wilshire U.S. Real Estate Securities Index is a broad measure of the performance of publicly traded real estate securities, such as Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs). The index is capitalization-weighted. The beginning date was 1/1/78, and the index is rebalanced monthly and returns are calculated on a buy and hold basis. Investments cannot be made directly in an index.

After 10/31/20, this material must be accompanied by a supplement containing performance data for the most recent quarter end.

Shares of the Davis Funds are not deposits or obligations of any bank, are not guaranteed by any bank, are not insured by the FDIC or any other agency, and involve investment risks, including possible loss of the principal amount invested.

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