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Baron Funds

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Baron

Baron Real Estate Fund company), Park Hotels & Resorts, Inc. (the second largest hotel REIT), and Hilton Grand Vacations, Inc. (a premier timeshare operator). We are optimistic about the prospects for all three companies and plan to elaborate on our views in future letters. The shares of infrastructure-related companies Martin Marietta Materials, Inc. and Vulcan Materials Company continued to perform well in the last few months because the key demand drivers of their businesses remain strong. In fact, they may have further improved, in light of expectations that the Trump administration may pursue a major infrastructure spending program. The three key factors that should sustain strong cash flow growth for these companies include: • Government spending on infrastructure projects is expected to accelerate; • Residential construction levels though cyclically depressed are improving; and, • Non-residential construction has been rebounding moderately. Following disappointing share price performance for most of 2016, shares of CBRE Group, Inc. rebounded in the last few months, due, in part, to its discounted valuation and expectations that business prospects would improve in the year ahead. We maintain that CBRE Group is a best-in-class commercial real estate services company with strong long-term growth prospects. It is attractively valued at only 13.5 times 2017 estimated earnings per share versus a longer-term average of about 16 times earnings per share. Table III. Top detractors from performance for the quarter ended December 31, 2016 Quarter End Market Cap or Market Cap When Sold (billions) Percent Impact Brookdale Senior Living, Inc. $ 2.2 –0.80% Gaming and Leisure Properties, Inc. 6.3 –0.50 Simon Property Group, Inc. 55.8 –0.39 American Tower Corp. 45.0 –0.35 Brookfield Asset Management, Inc. 32.5 –0.23 The shares of Brookdale Senior Living, Inc. declined sharply in the most recent quarter due to management’s worse-than-expected outlook regarding the anticipated competition from new senior housing construction activity. We have chosen to exit the Fund’s investment in the company. We believe the shares of Gaming and Leisure Properties, Inc., the third largest publicly traded triple net REIT with 35 casinos and hotel facilities in 14 states, declined in the last few months due to concerns that an increase in interest rates would negatively impact the company’s growth through acquisitions. While we agree that higher rates pose a risk for the company, we believe a good portion of these concerns have already been reflected in the company’s share price, as its shares now offer an attractive 7.7% dividend yield. Further, we have confidence in CEO Peter Carlino, who has an excellent track record of generating long-term returns for shareholders. We think that he will continue to create value by acquiring additional gaming properties, or he will identify other means to drive the company’s shares higher. a sharp increase in interest rates which tend to make dividend-yielding securities such as REITs less attractive. Further, a long-term concern persists that some retail mall and shopping centers will likely be challenged by a slowdown of in-store sales due to increased online and e-commerce purchasing. Though we agree that the forecasts of higher interest rates and increased online e-commerce purchasing may be headwinds for the company’s business, we have confidence that CEO David Simon, who has a long track record of solid capital allocation decisions, will pinpoint ways to continue to create meaningful shareholder value in the years ahead. Currently, we think Simon Property Group has opportunities to increase occupancy and rents, acquire new properties and assets at attractive prices relative to the company’s cost of capital, and grow the company’s dividend. We believe the shares continue to trade at a discount to our assessment of net asset value. The shares of American Tower Corp., the largest tower operator in the world, retreated in the last few months likely due to concerns about a potential T-Mobile-Sprint wireless carrier merger, resulting in a possible loss of lease revenue (estimated at only 4% of revenues), rising interest rates, and a strengthening U.S. dollar (American Tower has some exposure in India/Brazil/Mexico currencies). We believe these concerns are largely factored in the shares’ valuation, and we maintain our optimism for the company’s long-term prospects to benefit from increasing demand for wireless data-intensive devices. Following strong share price performance for much of 2016, the shares of Brookfield Asset Management, Inc., an owner, operator, and asset manager of high quality real estate assets, retreated in the most recent quarter. We believe the shares are attractively valued and maintain that the management team, led by its capable CEO Bruce Flatt, will continue to generate excellent long-term returns. Portfolio Structure Although no one can predict with certainty what the future may hold for economic growth, interest rates, inflation, etc..., our Baron Real Estate team has begun the process of further tilting the portfolio toward those real estate-related companies that should benefit from the anticipated postelection pro-business agenda. We are also continuing to prioritize those real estate categories that are expected to benefit most from long-term secular and/or cyclical tailwinds. Key observations regarding the Fund’s portfolio structure and strategy are as follows: 1. An Increased Emphasis on Growth We anticipate that economic growth and interest rates may head higher in the next few years given the President’s and Congress’ probusiness agenda. In the past, the Fund has benefited from utilizing its “playbook” for capitalizing on accelerated growth and rising interest rates. Our Baron playbook entails implementing five strategies. They include: (i) Carefully reviewing and updating our allocations to REITs and other dividend-yielding securities. Higher bond yields can limit the attractiveness of dividend stocks such as REITs. The shares of Simon Property Group, Inc., the world’s largest mall operator, performed poorly in the fourth quarter (as did most REITs), due to 60 (ii) Focusing on short lease duration real estate companies such as hotels that can re-price more often, grow faster, and better offset

December 31, 2016 Baron Real Estate Fund increases in interest rates. Examples include: Hilton Worldwide Holdings, Inc. and Marriott International, Inc. (iii) Emphasizing real estate-related companies and sectors that will most likely benefit from an improvement in the economy. Examples include housing-related securities such as Mohawk Industries, Inc., Home Depot, Inc., The Sherwin-Williams Company, and Toll Brothers, Inc. (iv) Owning real estate companies with strong pipelines of development projects that will aid growth. Examples include: MGM Resorts International, Vulcan Materials Company, and Martin Marietta Materials, Inc. (v) Investing in companies with strong balance sheets that are less sensitive to interest rate increases. Examples include: CBRE Group, Inc. and Brookfield Asset Management, Inc. 2. REITs vs. non-REITs In the last few months, we decreased our exposure to REITs by approximately 400 basis points from 34.5% to 30.4% because faster economic growth and higher interest rates in the years ahead could serve as a headwind to REIT share price performance. Currently, approximately 30% of the Fund’s net assets are invested in REITs, and 70% of its net assets are invested in other real estate-related categories. In the last three years, the share price performance of REITs has been largely tied to the direction of the U.S. 10-Year Treasury yield (correlation of –0.87). When interest rates have decreased, REIT share prices have generally increased. Conversely, for the brief periods in recent years when interest rates have increased, REIT share prices have generally decreased. As economic conditions and interest rates begin to return to historical levels, we will continue to reassess our allocation to REITs and our other real estate categories. We maintain that having a reasonable allocation to REITs is prudent in the context of a diversified portfolio, because some REIT valuations are reasonable, and should benefit from a stronger economic environment with moderate interest rate movements. 3. Commercial and Residential Real Estate Exposure We invest in both commercial and residential real estate-related companies. During the extreme U.S. economic downturn of 2008 and 2009, the residential real estate market experienced a greater decline than the U.S. commercial real estate market. Moreover, residential real estate has yet to recover to the same degree as the commercial real estate market has. For example: The current residential annual construction rate is approximately 1.1 to 1.2 million new homes, compared to a 60-year historical average construction rate of 1.5 million new homes annually. Yet, the U.S. population is more than 90% higher in 2016 (327 million) than it was in 1956 (169 million)! We believe this large imbalance between pentup housing demand and low construction levels bodes well for new single-family home purchases, so long as mortgage rates do not spike to levels that deter would-be homebuyers. We continue to prioritize our assessment of opportunities to invest in companies that should benefit from a recovery in the U.S. residential real estate market. Examples include residential building product/ services, homebuilders, single family rental operators, and infrastructure-related companies. Currently, approximately 28% of the Fund’s net assets are invested in companies that should benefit from a continued improvement in residential real estate. Examples include: Mohawk Industries, Inc., Home Depot, Inc., The Sherwin-Williams Company, Masonite International Corp., Toll Brothers, Inc., Vulcan Materials Company, and Martin Marietta Materials, Inc. 4. A Focus on Technology and its Impact on Real Estate The impact of technology on real estate is profound. Real estaterelated companies that embrace and adopt the latest technological advances and innovations are an important focus for us. The growth in cloud computing, the internet, mobile data and cellphones, and wireless infrastructure are powerful secular drivers that should continue unabated for years. At Baron, we refer to this type of enduring development as a “megatrend.” Those companies that do not embrace the technological revolution in real estate will, in our opinion, be competitively disadvantaged. Key beneficiaries of the technology revolution should include: (i) (ii) Data center companies. Fund holdings include Equinix, Inc. and Interxion Holding N.V. Tower operators. Fund holdings include American Tower Corp. and SBA Communications Corp. (iii) Industrial real estate companies that can advance and participate in online sales and meet the demand for faster delivery. Fund holdings include Prologis, Inc. and Rexford Industrial Realty, Inc. (iv) Commercial real estate data analytic companies. Fund holding includes CoStar Group, Inc. Real estate companies that we expect to directly benefit from longterm technology growth currently represent approximately 25% of the Fund’s net assets across various real estate categories. Conversely, we continue to de-emphasize real estate-related companies or categories that may become adversely affected or face long-term headwinds from the growth of e-commerce technology. For example, some retail mall and shopping centers will likely be challenged by a slowdown of in-store sales due to the growth of online purchasing by consumers. We are also monitoring whether less office space will be needed over time as the growth of wireless communication enables more employees to work remotely. Finally, we continue to monitor whether the emergence of Airbnb is a competitive threat to hotels, but our research at this stage does not leave us particularly concerned. 5. A Prioritization on Tailwinds In addition to our focus on real estate companies that we think should benefit from the expected continued growth in technology, we are also prioritizing additional real estate categories and companies that we 61

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