Davis Real Estate Fund
Update from Portfolio Managers Andrew A. Davis and Chandler Spears
Annual Review 2022


Davis Real Estate Fund’s Class A shares provided a total return on net asset value for the year ended December 31, 2021 of 43.24%. Over the same time period, the Wilshire U.S. Real Estate Securities Index returned 46.11%. Over the most recent one-, five- and 10-year periods, a $10,000 investment in Davis Real Estate Fund would have returned $14,324, $17,045 and $27,898, respectively.

Publicly traded real estate securities, from a stock price perspective, have fully recovered from the pandemic swoon. In fact, some property sectors closed out 2021 at record valuations. Even where investor enthusiasm dampened, the valuation gap between the most expensive property sectors and the least expensive narrowed considerably since its zenith in the summer of 2020. Investors should be cheering that resiliency, especially in the face of such powerful exogenous events. This was, no doubt, a very different outcome than what we witnessed during the financial crisis, when bankruptcies and massive equity increases undermined confidence and shareholder returns. Still, caution is warranted. Even though valuations have recovered and broader economic activity has returned, several structural changes in the industry accelerated by the pandemic have yet to be fully vetted.

The average annual total returns for Davis Real Estate Fund’s Class A shares for periods ending December 31, 2021, including a maximum 4.75% sales charge, are: 1 year, 36.44%; 5 years, 10.18%; and 10 years, 10.27%. 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 0.97%. 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 lower or higher than the performance quoted. For most recent month-end performance, click here or call 800-279-0279.

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. All fund performance discussed within this piece refers to Class A shares without a sales charge and are as of 12/31/21 unless otherwise noted. This is not a recommendation to buy, sell or hold any specific security. Past performance is not a guarantee of future results. There is no guarantee that the Fund performance will be positive as equity markets are volatile and an investor may lose money.

Office

No topic was more heavily debated in 2021 than return to office (RTO). What began as a discussion as to when workers will return has morphed into a far more complex calculus. It is not a simple matter of when workers will return (many have, of course), but how many will return, how frequently those returning will be in the office during any given week and, perhaps most importantly, where employers will grow their workforces in the future.

Our stance continues to be that the in-person office setting is indispensable. It provides the necessary construct for collaboration that Zoom meetings cannot efficiently accommodate. Further, mentoring is not a virtual act. The immediate personal feedback loop necessary to build careers is only possible in an office setting. It is difficult for us to believe that purely remote guidance will supplant this vital human connection.

From our research, the data appears to suggest that the vast majority of office tenants believe the same. Still, headlines seem intent on trumpeting the actions of a few tech bellwethers that continually delay their RTOs. Almost without exception, office companies in our universe have seen significant growing demand over the past year. Certain companies are even observing that demand translate into meaningful increases in rent. Moreover, there appears to be a disconnect between words and actions. Consider a recent headline that read, “Google pushes back January 2022 return-to-office plans.” Never mind that the very same company recently leased an entire brand new 222,000 square foot office building in Mountain View, California and in 2021 announced its intention to purchase a $2.1 billion, 1.3 million square foot office in New York City.

Unfortunately, and what our long-time shareholders likely know well, headlines can create positive and negative feedback loops between stock prices and reality. That was certainly the case with the Fund’s office holdings in 2021. Returns simply were not as hoped because headlines worked against them despite rapidly improving fundamentals. We remain sanguine and continue to focus on those office REITs with holdings in areas of the country likely to benefit from a diversely distributed workforce and where the cost of living is relatively low. Those locations are also not heavily dependent on mass transportation, have business-friendly tax regimes and relatively few weather issues. Cousins Properties (CUZ), for example, counts cities like Austin, Tampa and Atlanta among its primary markets. During the first three quarters of 2021, CUZ management signed over 1.4 million net square feet at cash rents 16.8% higher than expiring rents. That denotes commitment to future occupancy and not what one would expect to see if demand were flagging. Again, we fully recognize that the office world has changed; we simply believe that the changes can also lead to business success. As Darwin understood, adapting is critical. Lumping the valuations of all office companies together flies in the face of the evidence.

Hotels

We saw similar fact patterns with our hotel holdings in 2021. We have remained interested, but cautious. Readers likely recall our investment strategy with hotels from prior shareholder letters: the stronger, better-financed, better-positioned hotel companies that can endure shutdowns should benefit from a surge in travel, a potential to grow through careful distressed acquisitions and less competition. This approach has proven out for the most part, even though stock price performance stalled in late spring of 2021.

Here again, the national narrative continues to drive sentiment, although with more substance in this case. Concern over COVID’s Delta and Omicron variants has certainly slowed business travel. No corporate travel department wants to be in the position of asking its employees to take risks with COVID. Leisure travel, however, has returned and surpassed pre-COVID levels. So strong was leisure demand in 2021 that the only two hotel stocks in which we have a real interest, Host Hotels & Resorts (HST) and Sunstone Hotel Investors (SHO), achieved breakeven cash flow two years before our most pessimistic forecast.

Further, it appears likely that COVID mutations will become a fact of life and the economy will probably continue to be presented with periodic “air pockets,” forcing leisure and business travel to slow. We are seeing that now in the form of Omicron. This phenomenon might present future buying opportunities for the best-positioned hotel companies should pricing dislocate sufficiently.

So where does that leave us? We have not rushed into the hotel sector despite compelling valuations. Our thinking? First, we now assume that COVID will continue to mutate and present the hotel industry with a far more variable demand profile. Second, because hotels have high operating leverage, optimal balance sheet leverage needs to be lower to buffer the potential for a COVID mutation that forces widespread shutdowns. As a result of these changes we have pared our hotel holdings, crystallizing some solid gains off the lows.

Industrial

The Fund has benefited from its holdings in the industrial property sector. In fact, the sector has really been a driver of performance for several years running. Over that time, demand for warehouse space and last-mile fulfillment centers has exploded as the consuming public has increased its reliance on e-commerce, a trend accelerated by the COVID pandemic. We continue to hold a substantial interest in the industrial sector, particularly in last-mile industrial REITs Rexford Industrial Realty (REXR) and Terreno Realty (TRNO). As of this writing, we expect the “tailwinds” for industrial real estate to continue, with robust demand over the next several years while supply remains in check. Supply has always been the Achilles heel in all real estate. We keep an ever-watchful eye on this data point as one potential area of concern.

Retail

For much of 2020 and early 2021, retail real estate suffered as stores saw rapidly slowing sales leading to a rash of store closures and retailer bankruptcies. It might be surprising to hear, therefore, that despite this, the Fund’s single best performing stock in 2021 was Simon Property Group (SPG), the largest mall owner in the U.S. If the pandemic has done anything positive for the retail landscape, it has separated the wheat from the chaff. Tenants of all kinds value well-located brick-and-mortar stores as an indispensable part of the distribution equation. Importantly, digitally native brands are expanding into actual stores. Simon has been perfectly positioned to take advantage of that demand. Even though base rents on new leases have not shown improvement over expiring rents (they have gone down in almost all instances), the pickup in occupancy has more than offset the difference and has led to improved top-line growth. It is hard to imagine that retailers that have not yet adopted the notion of “omni-channel” distribution (for which SPG is an invaluable dispenser) will survive in the long term.

Apartments

The Fund’s apartment holdings also contributed meaningfully to performance in 2021. It has taken some time for the “urban flight” fear to fail in the face of contradictory data: demand for apartments appears as strong as we have ever seen it. The power of that statement should not be overlooked. After all, the apartment sector has witnessed some incredible periods of growth over the past two decades. For the apartment holdings in Davis Real Estate Fund, year-over-year same-store net operating income growth rates throughout 2021 were without precedence. Almost without exception, properties were running at full occupancy and, for many locations, setting all-time high rental prices. This bodes well for the future of our holdings in AvalonBay Communities (AVB) and Essex Property Trust (ESS).

Inflation and Portfolio Positioning

After a year of dealing with varying degrees of COVID restrictions, the economy is more likely to enter into a period of durable inflation and resulting higher interest rates. With that in mind, we describe the portfolio’s current makeup as three components:

  • The first, comprised of about half the Fund’s assets, consists of businesses with robust demand for space, strong pricing power and superior balance sheet strength. Chief among them are industrial and apartment companies, student housing and certain retail concepts.
  • The second, about one quarter of the portfolio, is comprised of businesses facing significant structural change and material headline risk, while still realizing reasonable demand. Healthcare and retail are prime examples. These businesses are trading at discounts to those in the first bucket and should be able to realize much improved returns as the world becomes more efficient at living with COVID.
  • The third component consists of businesses facing structural changes to demand, plenty of headline risk and, additionally, an extended timeline recovery. Office and hotel holdings land squarely here. Companies in these sectors trade at significant discounts to industry averages and also relative to their historical trading ranges. They also possess significant liquidity to address capital demands necessary to reposition properties, as well as superior balance sheet strength capable of handling temporary demand vacuums. As the world learns to live with COVID, there is potential for significant future returns from this category.

In these challenging times, we are especially grateful for your confidence in us. As shareholders in the Fund along with you, we will continue to strive to achieve the best possible results for all of us. We wish you the best in 2022.

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 12/31/21, the top ten holdings of Davis Real Estate Fund were: Prologis, 6.63%; Rexford Industrial Realty, 4.20%; Equinix, 3.90%; Simon Property Group, 3.82%; Public Storage, 3.78%; American Tower, 3.77%; American Campus Communities, 3.75%; Terreno Realty, 3.75%; Welltower, 3.65%; AvalonBay Communities, 3.44%.

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, 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 4/30/22, 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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