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Adapting to a Dynamic Real Estate Landscape for Sustained Growth

Evaluating Fund Performance and Strategic Challenges in 2025

The Davis Real Estate Fund's Class A shares registered a total return of -5.72% for the year ending December 31, 2025, falling short of the Wilshire U.S. Real Estate Securities Index's +3.47% return. This marks the third consecutive year of underperformance, prompting a thorough reevaluation of the fund's investment methodology and objectives. A critical look at the long-term track record reveals that a $10,000 investment in DREF would have yielded $9,428, $11,464, and $14,965 over one, five, and ten years, respectively. These figures underscore the recent challenges and the imperative to refine strategies for improved future outcomes.

Unpacking the Performance Discrepancy: Omission and Inclusion Errors

The underperformance of DREF in 2025 can be attributed to two main strategic missteps: a "sin of omission" and a "sin of inclusion." The omission involved being significantly underweight in Welltower (WELL), a senior housing REIT, while the inclusion involved an overweight position in Alexandria Real Estate (ARE), a life science real estate developer. These two holdings were pivotal in explaining the fund's divergence from its benchmark. The benchmark, traditionally top-heavy, has seen its top 10 constituents grow from over 40% to nearly 50% of total market capitalization over the past two decades. This concentration, especially in recent years, has amplified the impact of large-cap performance on index returns.

The Rise of Large-Cap REITs and Passive Investment Dominance

A deeper analysis revealed that company size and rapid growth, particularly for large-cap REITs, have become increasingly critical drivers of market performance. Welltower exemplifies this trend. Battered during the COVID-19 pandemic, its valuation plummeted. However, a post-pandemic recovery, coupled with strategic capital raising to acquire senior housing assets, propelled Welltower into a virtuous cycle of growth and multiple expansion. It swiftly became the largest company in the benchmark, accounting for almost 9% of its total market capitalization, up from 4% in 2022. This meteoric rise, despite its high valuation, was significantly fueled by passive investment inflows. In 2025, passive strategies attracted $1.5 billion, while active strategies, like DREF, experienced $2.8 billion in outflows. This valuation-agnostic flow disproportionately benefited rapidly growing large-cap companies, creating a powerful market force that DREF underestimated.

Alexandria Real Estate: A Valuation Challenge

Conversely, DREF's significant overweight position in Alexandria Real Estate (ARE) proved detrimental. Alexandria, once a strong performer for the fund, saw its market value halve in 2025, reminiscent of the Great Financial Crisis. Its trajectory mirrored Welltower's in reverse, falling from the seventh-largest company in the index in 2023 to the forty-second, representing a mere 57 basis points of the benchmark. This decline was exacerbated by passive funds rebalancing out of shrinking companies, adding selling pressure. The unexpected delay in the life science sector's recovery, coupled with Alexandria's decision to accelerate asset dispositions and cut dividends, further complicated its situation. Despite these challenges, DREF maintains its conviction in Alexandria's long-term value, viewing its current valuation as a historic discount for a high-quality business navigating a cyclical downturn.

Refining the Investment Process: Learning from Adversity

In response to these trying times, DREF has committed to refining its investment process. This includes more frequent reviews of the benchmark to better understand relative movements among constituents. Additionally, the fund is increasing the estimate ranges for key variables in its fair value calculations, such as market rent, occupancy rates, and new development delivery schedules. This enhanced approach aims to provide a more comprehensive understanding of potential outcomes for companies facing cyclical downturns, thereby mitigating future "sins of omission" and "sins of inclusion."

Detailed Performance Analysis: Sector-Specific Insights

DREF's performance was significantly impacted by its underweighting of Welltower and overweighting of Alexandria. Although DREF had a position in Welltower prior to 2025, its complete exit by January 2025 meant missing a substantial portion of its impressive gains. Conversely, holding onto Alexandria, despite mounting fundamental pressures and a market increasingly focused on short-term earnings momentum, proved costly. The fund's substantial overweight in the apartment sector also faced headwinds due to lingering concerns about market rent recovery, particularly affecting top holding AvalonBay (AVB).

Glimmers of Success: Industrial and UK Office REITs

Despite the overall challenges, DREF saw positives in the industrial sector. Prologis (PLD), EastGroup Properties (EGP), and Rexford Industrial Realty (REXR) performed well as supply additions decreased and market rents stabilized. The fund also benefited from its investments in London-based office REITs, such as Great Portland, which demonstrated robust performance in its submarkets. The investment potential in UK office REITs is considered even more compelling than their US counterparts due to deeper valuation discounts, though benchmark limitations restrict DREF's exposure to US-listed real estate companies.

Future Positioning: Apartments, Office, and Data Centers

Looking ahead, DREF is confident in its overweight position in the apartment sector, particularly Sunbelt-focused REITs like Camden Property Trust (CPT) and Mid-America Apartment Communities (MAA). The fund anticipates a rental market inflection that will eventually drive positive results. In the office sector, DREF remains a strong believer in BXP Inc. (BXP) and Cousins Properties (CUZ), whose premium spaces continue to outperform. While acknowledging some West Coast office REITs like Hudson Pacific (HPP) and Douglas Emmett (DEI) face protracted recoveries, 2026 will be a critical year for these holdings. The fund also continues to hold Digital Realty (DLR) and Equinix (EQIX) in the data center sector, aligning with its benchmark. Demand for data center space remains robust, driven by AI, but DREF is cautiously monitoring valuation risks, power availability, and potential technological shifts that could impact long-term demand.

Steering Towards Long-Term Value: A United Journey

For over 50 years, Davis Advisors has remained committed to enhancing the value of entrusted funds. With more than $2 billion invested by Davis Advisors, the Davis family, employees, and fund directors alongside clients, the firm emphasizes a shared commitment to this long-term investment journey. The fund is grateful for its clients' trust and remains well-positioned to navigate future market complexities, always guided by its unwavering North Star of long-term value creation.