Davis Real Estate Fund’s Class A shares provided a total return on net asset value for the year ended December 31, 2022 of -26.74%. Over the same time period, the Wilshire U.S. Real Estate Securities Index returned -26.75%. During the most recent one-, five- and ten-year periods, a $10,000 investment in Davis Real Estate Fund would have returned $7,326, $11,531 and $17,491, respectively.

In 2022, we approached the annual letter with no shortage of issues to address. Typically, we find ourselves in this position when performance is just average. The absolute return last year was steeply negative, which made our fund’s performance (along with others’) particularly difficult in 2022. Most investors tend to focus on absolute return, and that makes average relative performance all the more unsatisfying.

The long-term investment strategy that is the hallmark of the Davis Investment Discipline requires patience during volatile times, especially when opinions vary widely. Commercial real estate is undergoing just such a time, as investors align themselves on opposing sides of a number of issues. Our thoughts on some of these issues should help you understand fund performance in 2022, and how we are positioning for the future. We continue to believe that sticking with the Davis Investment Discipline will help carry us through what likely will be a tough few years ahead in commercial real estate.

The average annual total returns for Davis Real Estate Fund’s Class A shares for periods ending December 31, 2022, including a maximum 4.75% sales charge, are: 1 year, -30.22%; 5 years, 1.89%; and 10 years, 5.24%. 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. For most recent month-end performance, click here or call 800-279-0279. Current performance may be lower or higher than the performance quoted. The total annual operating expense ratio for Class A shares as of the most recent prospectus was 0.95%. The total annual operating expense ratio may vary in future years. Returns and expenses for other classes of shares will vary.

Nothing shakes up a market like a difference of opinion. To say that the future of office demand has fostered such divergence is an understatement. Hardly a day passed in 2022 without our research leading us to an article about the timing of return-to-office and its implication for future demand. What confuses the debate for most is a near-religious belief that office space is a homogeneous product. It isn’t. We agree that demand for office space has changed permanently, but that doesn’t mean that demand for every type of office building is going to be weaker in the future. In fact, we believe that demand will grow for certain office assets in select markets. We also think that the prevailing sentiment for this type of asset may be unjustly negative.

Over time, we’ve held steadfast to our belief that office space is a tough business. Assets are expensive and require considerable sums for upkeep, plus the cost of procuring tenants is onerous. None of that has changed. From that perspective, we agree with the negative consensus. In addition, we believe that long-term growth rates, on average, are going to be much lower in the office sector, perhaps even zero for a time. However, even in rivers where the average depth is over your head, parts of the river are no deeper than your knee. In that metaphor lies the opportunity, and where we look to toe carefully into the office sector in a specific way.

Our research leads us to believe that a durable bifurcation is unfolding in the office sector. Certain types of buildings are winning incremental demand at the expense of others. The winning buildings have certain characteristics. First, they offer an exceptional range of amenities such as dining and fitness. Second, the usable space in those buildings is designed to accommodate individual work as well as collaboration, often with considerable attention paid to indoor-outdoor work. Third, they tend to be connected with or close to robust transportation infrastructure. Lastly, those buildings are LEED certified and designed to minimize carbon footprints. That last bit is particularly important in places like New York City where looming carbon regulation likely would obviate huge swaths of office space going forward. For the sake of keeping the narrative simple, let’s call these buildings “prime.”

For any given prime building, we also need to consider location as a second differentiator. We believe that future office demand is going to be as much about users (i.e. tenants) rationalizing existing footprints as it is about creating room for a growing workforce. Implicit in this argument is our belief that even if a recession unfolds over the next couple of years, the U.S. labor force will grow in the long term. As employers seek to scale up, we think they will try to appeal to the best and brightest by offering options for location. The option to work in a number of different locations is a powerful incentive. Recent history suggests that Sunbelt markets are winning incremental demand at the expense of large business districts such as New York City and San Francisco, where employers are tending to downsize their space requirements.

Investing in these sorts of prime assets in markets where demand is growing might be seen as comparable to purchasing the cow just to obtain the tenderloin. There is a way to profit from such a strategy, however. We have built positions in a few office REITs that have prime assets located in markets where demand is growing. Cousins Properties (CUZ) is a perfect example. Cousins has considerable exposure to growing Sunbelt markets Atlanta and Austin. These relatively low-cost metro areas appeal to an increasing number of workers who seek better housing options and, dare we say it, much better weather.

We have also found an opportunity with Douglas Emmett, Inc. (DEI) even though it is concentrated in Los Angeles, which is more expensive than other Sunbelt markets. What makes Douglas Emmett unique is its tenant base.

The size of its average tenants is quite small for the sector, typically leasing 10,000 square feet or fewer. To hear it from the company’s CEO, Jordan Kaplan, these are employers that could have worked from home before the pandemic hit, but for various reasons, chose to have an office presence. Another advantage of smaller leases is their much-reduced cost for replacing or renewing tenants. Douglas Emmett has the lowest such cost by a considerable margin.

None of this is to say that investing in the office sector is without risk. One needs to believe that communal workspace will be necessary to recruit and nurture a hybrid workforce. To anticipate a likely question: Yes, we believe that hybrid work is here to stay and it is factored into our thinking and models. Still, we acknowledge it might take years for our office investments to outperform. As a result, it is imperative that we invest in companies that not only can make it from here to there, but which can come out strong. That means having low leverage, a top-notch management team and a valuation that reflects a wide range of possible outcomes. Cousins Properties and Douglas Emmett satisfy both those requirements.

There were plenty of bright spots in 2022. In fact, 2022 was the year in which the greatest number of fund investments in our history were taken private. While M&A activity often provides an unexpected boost to performance, it can be a mixed blessing. As an example, we said goodbye to one of our favorite investments, American Campus Communities (ACC). It has been a holding in the fund (at some level) every single day since June 2005. The privatization of ACC helped the fund’s performance a great deal, but the fund lost a unique business whose student-housing portfolio behaved quite differently than conventional apartments. Where the latter is subject to wide swings in performance year-to-year, ACC’s student-housing rents grew almost every single year, albeit at a steady rate below the episodic peaks achieved by conventional apartments. There are no more public student-housing companies, so that diversifying element is no longer available to us. Gone too is a management team we considered one of the best in the REIT universe.

Aiding the Fund’s performance in 2022 was our investment in Host Hotels & Resorts, Inc. (HST). Its earnings accelerated meaningfully with the robust return of leisure travel as the Omicron wave faded into the end of 2022. In fact, HST achieved breakeven cash flow far faster than our most optimistic forecast and by the third quarter of 2022 was comfortably growing free cash flow. Shareholders who have been with us for a few years will recall that we suggested in 2020 there was deep value in hotels despite considerable negative press. That ran counter to the consensus of the time that liked to characterize future hotel demand as uncertain. We believed that travelers returning to hotels was never in doubt. The real issue was when. As long-term investors, we like to tease out opportunities from temporal debates and, as we have discussed above, draw a parallel to the office sector. We believe that it is just a matter of time before investors acknowledge that some types of office buildings are indispensable. Our hope is that returns in the office sector will eventually mimic those earned with investment in Host Hotels.

As we step into 2023, there is little doubt that real estate securities will be faced with an environment very different from any that has existed since the Global Financial Crisis of 2007–2008. Publicly traded real estate has weathered significant exogenous shocks and proven its mettle as a durable part of well-diversified portfolios but for a very long time, it did so in a low interest rate environment. That backdrop has changed as inflation has become entrenched. As a result, we spent the latter part of 2022 making some adjustments to the fund to better reflect the effects of higher inflation and increased cost of capital.

The immediate consequence of the Federal Reserve’s monetary actions in 2022 has been a dramatic increase in the cost of capital, debt capital in particular. Cost of equity capital has increased as well by virtue of stock price drops, but the cost of debt capital presents the most pressing issue for real estate earnings. After all, we expect that companies we own will only issue equity when a compelling reason presents itself. It might be tempting to say the same thing about debt, but that is not the case. Debt reaches maturity at regular intervals for all companies under our coverage. Some have more debt than others to be sure, but all need to deal with debt refinancing. Further, some debt, whether maturing soon or not, might have variable rates of interest that can reset frequently—think months, not years.

That is what we see in our modeling. Companies whose valuations are most affected by the recent rise in rates are those whose debt level is higher than average or whose debt is of short duration and/or subject to variable interest rates. Unless one is willing to assume that the current rate environment is temporary—which we are not willing to do at present—earnings will adjust downwards. Indeed, as we underwrite the higher cost of capital, we expect that all companies in our coverage universe will see slowing cash flow growth. Some will see earnings decline.

It is this increase in the cost of capital that drove real estate valuations lower in 2022. Even though several sectors, such as industrial and storage, are powering ahead with strong fundamentals, company stock prices and earnings still need to swim against the tide of higher carry costs. To complicate matters, a recession could mean that fundamentals (i.e. demand for space) might crest quickly, adding additional pressure to earnings. The sequence of these pressures likely would keep valuations moribund, at least until there is consensus as to when the Federal Reserve will take its foot off the brake.

Even though we have not had to deal with this sort of environment for well over a decade, we continue to view real estate in a lower-risk light, despite all the recent headlines to the contrary. We constantly remind ourselves that stock price volatility is not synonymous with earnings risk. In fact, stock price volatility can provide cheaper entry points toward owning a company with the fundamentals we prize—i.e., proven management; durable, financially strong business models; and sustainable competitive advantages.

Given the difficult economic backdrop, we have taken a barbell approach to positioning Davis Real Estate Fund, albeit an asymmetric one. As noted earlier, we believe in the long-term viability of certain parts of the office sector and have built positions in several office REITs. We maintain a significant weighting in the apartment sector, although rental rates likely will pause over the next year as job layoffs accelerate and wages are apt to slow. This scenario is offset by discounted valuation and short-term leases that will allow rents to reset higher when demand improves. Collectively, these positions are the small side of the barbell.

The other, larger side of the barbell includes positions in sectors we believe will continue to benefit from pricing power even if a recession takes hold. Demand for industrial space in select markets continues to impress, and most public industrial REITs are sitting on considerable rental loss-to-lease. This means that, even if industrial rent growth slows (or even stagnates), the industrial REITs will continue to grow cash flow as leases renew to higher rates. Industrial companies Terreno Realty (TRNO) and Rexford Industrial (REXR) are our favorites in the sector given their U.S. focus and pristine balance sheets.

We have also increased our position in Alexandria Real Estate (ARE). Some analysts will say that Alexandria is an office REIT. It is not. The vast majority of the company’s space is designed for life science tenants whose work cannot be done remotely. They need to be in the lab. Supported by a solid balance sheet, Alexandria’s triple-net leases should help it offset inflationary pressures as it continues to harvest loss-to-lease in its rent roll. As an aside, Alexandria has the distinction of being the longest-tenured investment in Davis Real Estate Fund, at more than 25 years.

Finally, we always like to remind our investors that no matter the investment, balance sheet strength remains a pervasive focus. It is all too easy to forget how important the balance sheet remains, especially when economies and outlooks are rosy. That particular metric will always be a factor in determining whether we are willing to invest in an enterprise. As we have written at length about this in the past, we commend those prior annual reports to you.

We wish you the best in 2023 and thank you for your trust in us.