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

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, 2022 of -20.85%. Over the same time period, the Wilshire U.S. Real Estate Securities Index returned -21.63%. Over the most recent five- and 10-year periods, a $10,000 investment in Davis Real Estate Fund would have grown to $13,123 and $19,344, respectively.

So far 2022 has not been kind to public real estate securities. Depending on who you ask, the reason for the declines can range from exhaustion after last year’s massive gains to Russia’s imperialistic attack on Ukraine. As value investors we certainly pay close attention to these things but, in the end, our investment strategy is all about fundamentals. And on that measure, conditions are still rather good. In fact, for most sectors it is really about how much growth will slow and not a question of fundamentals actually declining. Still, we freely admit that a more challenging environment is on offer and more volatile markets are the likely response.

The average annual total returns for Davis Real Estate Fund’s Class A shares for periods ending June 30, 2022, including a maximum 4.75% sales charge, are: 1 year, -11.89%; 5 years, 4.56%; and 10 years, 6.30%. 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.

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 6/30/22 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.

Sleepless Nights

What are we worried about? The answer might surprise you. We don’t toil over exact inflation rate predictions, endgames in Ukraine or when the next COVID wave will appear. Rather, we worry about the businesses in which we are invested and whether they can weather the good times and the bad. This is because, however unfortunate it may be, we are entering what is likely to be a tough few years. After all, the intersection of a decade-long period of extraordinarily loose monetary policy, pandemic-induced supply constraints and several massive fiscal stimulus programs was sure to create some sort of negative feedback loop. The war in Ukraine adds fuel to the fire.

Fund performance has been satisfactory so far this year on a relative basis but, as always, it’s tough to swallow absolute losses. We can point to a number of factors that helped Davis Real Estate Fund perform better than most, such as continued strength in shopping centers and resurgent hotels, where we remain overweight, but year-to-date has been a story of where we have been underweight.

Long-time investors in Davis Real Estate Fund know that we have for some time counted the industrial sector as our favorite. That preference dates all the way back to the mid-2000s when our top holding was CenterPoint Properties. Since then, the industrial sector has always had a significant presence in the Fund, but when e-commerce really started to gain traction over the past decade we increased our investment significantly. That proved to be the right call. For many years the industrial sector was a top performer, including last year when it trumped most other sectors by a considerable margin. But great performance usually results in more demanding valuations and by early 2020 the industrial sector reached valuations we had never seen in any sector. To be sure, there was a case to be made that valuations were deserved, given likely growth trajectories. We were not quite as sanguine as many.

Our research and meetings lead us to believe that for many types of large-format industrial properties, participants were getting a bit unhinged; i.e. tenants were snapping up space at an ever increasing rate at ever increasing prices. Of course that is great for owners but it appeared to us that rational bargaining was taking a back seat. For example, we heard the word “arms race” to describe demand in certain markets, a nod to how desperately some tenants were behaving in their pursuit of space. It appeared to us that Amazon was placing unsustainable pressure on pricing.

As a result, last year we began to winnow our investment in the industrial sector, particularly among developers of new bulk distribution properties. We maintained our preference for those industrial REITs that focused on last-touch delivery properties. It was a good relative call given the sector’s underperformance, even if the pain was felt by owners of bulk distribution and last-touch properties in equal measure. The pain was compounded in May of this year when Amazon announced what we suspected had become the reality: it has too much warehouse capacity.

As is often the case with announcements of this sort, the market reaction was swift and harsh. So far this year industrial REITs have lost 12 to 15 multiple turns. It is equally typical that such reactions exceed reality and that is certainly the case here. While Amazon is a driving force behind industrial space demand, it is not the totality of demand. Importantly, Amazon is not going away. Rather, our research suggests the net result will be a slowing of growth. It is important to scale Amazon’s future appetite for space against the totality of industrial space demand. Historically, industrial market rents have declined when vacancy rates reached 8-9%. Given that we are currently sitting at 4.8% vacancy nationwide, if Amazon decides to abandon 30 million square feet, a figure most agree is a reasonable estimate, vacancy will increase by about one percentage point. Sure, some markets will feel great pain, but the point is that Amazon alone will not be the tail that wags the dog. The case for a material decline needs to be more far-reaching than the actions of Amazon alone. And to hear from the companies in our coverage universe, such an argument is difficult to make. In fact, those same companies had already been preparing for Amazon to slow its demand.

Where there is difference of opinion, there is often opportunity. We actually feel better about the Fund’s industrial holdings than we did last year, not just because the stocks are cheaper but because the businesses we own aren’t reliant on the fortunes of a single tenant, even one as big as Amazon. To use Rexford Industrial Realty (REXR) as an example, the average size of its properties is 130,000 square feet. The average size of an Amazon warehouse is just under 350,000 square feet. Clearly Rexford’s properties are not going to often be found in Amazon’s sights. In fact, you will not find Amazon among Rexford’s top 10 tenants. The point is that Rexford has positioned itself in a market whose demand is certainly not wholly reliant on the fortunes of Amazon. We can say the same for Terreno Realty (TRNO), which is our second favorite name in the industrial sector. Separating signal from noise is what you entrust us to do. Rexford and Terreno are still underperforming year-to-date, but we believe that fundamental growth over the next couple of years will vindicate both with superior share price performance.

Most real estate sectors have recovered smartly from COVID, but one sector has yet to rebound. That’s the office sector, another of our worries. To say there is a return-to-office (RTO) discussion in the news every day would not be a stretch. It’s an issue about which every journalist believes his or her opinion is expert and about which every person who works in an office has thoughts. What is lost in the narrative, however, is an appreciation for what the office companies are actually reporting and saying on their conference calls. For every article or piece of research we read proclaiming the extent of value destruction in the office sector, we hear counter arguments from the companies we follow.

Take Cousins Properties (CUZ), for example. It has office properties in fast growing Sunbelt markets including Tampa, Charlotte, Nashville, Atlanta and Austin. Beginning with the second quarter of 2020, which Cousins characterizes as the COVID recovery period, the company has realized average cash rental rate growth of 13.3% on new leasing. The lowest quarterly growth, i.e. in the fourth quarter of 2021, was still 6%. This is not the sort of thing we would expect to see if news reports were the only basis for understanding what’s happening in the office sector. And this brings us to our point: it is our job to understand that averages never tell the full story. So what is going on then, if media reports are so dire in their commentary yet companies like Cousins continue to sign leases at higher rents?

The answer is multifaceted. First, we agree with the narrative that hybrid work is here to stay. Where those employees end up, however, is going to create market share changes in every office market. Companies are going to keep or relocate to buildings with the most comprehensive offerings; i.e. those with modern HVAC systems, open floor plans with ample meeting venues, and robust amenities. Leasing volume that occurs in any given market will accrue to the best buildings at the expense of older buildings with limited amenities. Indeed, our recent research trip to Atlanta confirms that. In all of Atlanta’s submarkets, new amenity-rich office buildings experienced 4.5 million square feet of absorption for the nine quarters ended first quarter 2022. All other building cohorts experienced negative absorption. That is exactly why Cousins is experiencing such strong rent growth. It owns the best buildings in its markets and it is gaining market share. This change in paradigm is happening in all the U.S. markets we follow closely.

The second consideration is one of space programming. In other words, how much space do we allocate to each employee and what is the average number of days an employee will spend in the office? Again, focusing on averages means missing the target issue. It’s not really a question of average days in office, but rather what is the peak utilization likely to be on any given day of the week? After all, if all employees want to work in the office on Wednesday, an employer can’t lease space for only half of the workforce. Of course an employer can manage space by creating cohorts within the employee base, but it is not likely that leased space can be reduced by half if employees are in the office half the time. The correct space programming is somewhere between all and half. And that is before making adjustments for the likely increase in the amount of space each employee will need to accommodate greater social distancing, meeting space, etc.

Lastly, the Field of Dreams approach to a headquarters location will not happen much in the future. Think Apple’s “space ship” building in Cupertino, CA. The idea that you can build it and they will come is likely over for very large national employers. Instead of asking potential employees to come to them, employers now need to offer the option of working in one of several locations. This is exactly what we saw with Apple, to continue the example, when it established a large presence in Austin over the past few years. We have seen similar expansions with other technology firms in cities like Austin and Atlanta. Even traditional financial firms like AllianceBernstein have decamped to cities like Nashville that appeal to a greater cross-section of potential workers.

In the end, what you are reading in the newspapers or hearing on television is a great deal of noise and very little signal. As is the case with the Amazon issue discussed above, you entrust us to separate the two. Doing so here yields a subset of REITs that are actually well positioned for profound structural changes in the office sector. We’ve mentioned Cousins Properties which remains one of our favorite office REITs, but there are also reasons to be optimistic about the fate of Douglas Emmett (DEI) and Highwoods Properties (HIW). They too are well positioned relative to the points we just made. This year has not been kind to them, nor to any of the office companies in our universe, but we believe as time passes, investors will differentiate between those well positioned for changes in the sector and those likely to be left behind.

Some Bright Spots

Even with the industrial and office holdings encumbering performance, there were a couple of bright spots that offset the laggards and helped the Fund’s relative performance year-to-date. One such bright spot stemmed from people learning how to live with COVID and wanting to return to traveling. The only sector in our universe to be a direct beneficiary of that actually coming to pass is hotels. And they have delivered. Occupancies have returned rapidly as vacationers of all stripes have sought to loosen themselves from lockdown and enjoy life. And even though we have only very recently witnessed an earnest return to business travel, occupancy growth so far has been sufficient to help hotels push rates. All of this translates into much improved top-line performance and a return to profitability for all the hotels in our coverage universe. Our hotel holdings, Host Hotels & Resorts (HST) and Sunstone Hotel Investors (SHO), performed exceptionally well until the recent market downturn, and we believe that they will recover.

And speaking of merger activity: that has been another bright spot in a difficult year. The Fund has benefited from two merger announcements and has a holding in a third that is subject to an outstanding offer awaiting shareholder approval. The first two deserve attention, but for separate reasons. In the fall of 2021 we initiated a position in CatchMark Timber Trust (CTT), a timber REIT. At the time the company was extricating itself from an unprofitable joint venture that sent many shareholders running. Having owned the company in the past, we knew it and management quite well. We believed that the stock price reaction to the joint venture pain was overwrought and the resulting valuation inconsistent with the private market valuation of the company’s timber stands. We were also searching for a bit of inflation protection, so it seemed like an opportune time to invest. The stock remained moribund until this past May when PotlatchDeltic (PCH), another timber REIT, offered to purchase CatchMark at a 55% premium to its prevailing stock price. While this was not predictable at the time of our original purchase, on a per-acre basis CatchMark was very cheap. It’s therefore no surprise that the much larger PotlatchDeltic decided to make the offer. It’s an all-stock deal, so our CatchMark shares will be swapped for PotlatchDeltic. It remains to be seen if we retain the position as we have only recently begun researching PotlachDeltic, but there is much to like about the timber business, especially in an inflationary environment.

However beneficial M&A may be at times, often providing a performance uplift and vindication of an investment thesis, there are times when it is not completely welcome. Such is the case with long time holding American Campus Communities (ACC) which agreed to be purchased by Blackstone Funds in April of this year. Sure, the price being paid represents compelling value for shareholders and added to Fund performance this year, but we are saddened to see ACC leave the public markets. To us the company represented one of the best long-term investments in the Fund with a unique risk profile that added an element of diversification we will not be able to replicate (American Campus was the only purpose-built student housing REIT). We wish the company well.

Looking Ahead

As we write to you today there are many storm clouds coalescing over the markets. The markets now realize the Federal Reserve has blundered by flooding the economy with easy money for too long, inviting inflation rates we have not seen in decades. And, while we do not fully agree that inflation is a supply-driven event that will be corrected as COVID gets further in the rear-view mirror, the most likely way for the Federal Reserve to win the war on inflation is through demand destruction. In other words, the Fed will discourage consumption through interest rate hikes and the tapering of other stimulus measures. That is not a favorable backdrop for commercial real estate.

On top of these home-grown inflation problems imperialistic Russia is making a land grab in Ukraine, putting into motion geopolitical risks that are beyond anyone’s ability to fully understand, and the likelihood of COVID continuing to be a factor is high. Fund management takes these issues seriously and appreciates that what lies ahead might present situations quite unlike any we’ve seen in the past.

Even so, we trust our process. We favor businesses we believe can thrive in the best of times and survive the worst of times. That’s why we have been methodically reducing the Fund’s exposure to companies with balance sheets we consider ill-suited for an inflationary and higher interest rate environment.

We are also reducing investments in companies with less pricing power, particularly in the urban office sector where the cost of maintaining assets compounds a weak pricing outlook. Strong capital structure has always been a necessary investment condition and it is fair to say we are taking a more conservative stance overall. However difficult the next couple of years might be, we do believe real estate securities will prove their worth. As always, we value the trust you place in us and look forward to continuing our investment journey together.

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. The investment objective of Davis Real Estate Fund is total return through a combination of growth and income. There can be no assurance that the Fund will achieve its objective. 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 6/30/22, the top ten holdings of Davis Real Estate Fund were: Prologis, 5.96%; American Tower, 4.54%; Welltower, 4.36%; Public Storage, 4.14%; Equinix, 3.96%; Brixmore Property Group, 3.72%; AvalonBay Communities, 3.64%; Equity Residential, 3.33%; Rexford Industrial Realty, 3.30%; Crown Castle International, 3.26%.

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 10/31/22, this material must be accompanied by a supplement containing performance data for the most recent quarter end.

Item #4429 6/22 Davis Distributors, LLC 2949 East Elvira Road, Suite 101, Tucson, AZ 85756 800-279-0279, davisfunds.com