Investment Results
Be Careful What You Wish For
Credit Market Stress: The First Battle
Demand Shock: The Second Battle
Presenting a Good Defense

Investment Results

The Davis Real Estate Fund's Class A Shares provided a total return on net asset value of -14.87% for the one year period ended December 31, 2007, while the Dow Jones Wilshire Real Estate Securities Index (DJWRESI) returned -17.66% and the NAREIT Equity Index (NAREIT) returned -15.69%.1 Since inception on January 3, 1994, the Fund has delivered an average annual total return of 13.21% versus a return of 12.61% for the DJWRESI and 12.56% for NAREIT.1

The performance presented in this report 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 1.09%. 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 higher or lower than the performance data quoted. Most recent month-end performance can be obtained by clicking here or by calling 800-279-0279.

According to Morningstar, ". . . veteran managers Andrew Davis and Chandler Spears genuinely take to heart the words of Davis' grandfather, famed investor Shelby Cullom Davis, that 'You make most of your money in a bear market, you just don't realize it at the time.' That is precisely how the team here is approaching current market conditions—as an excellent buying opportunity. . . .We're not only impressed by the team's investment approach—focusing as it does on a firm's long-term prospects—and its ability to generate solid cash flow, but also by the advisor's fiduciary style. Davis Selected Advisers is an exemplary caretaker of shareholder capital, as reflected in the Fund's overall Morningstar Stewardship Grade of A." 2

1 Past performance is not a guarantee of future results. Unless otherwise indicated returns discussed are Class A shares not including a maximum 4.75% sales charge.
2 Morningstar Report, December 8, 2007. Please see endnotes for important Stewardship Grade disclosure.

Be Careful What You Wish For

That warning could have been directed at us in late 2006 when we suggested real estate security valuations were getting far too rich. The chart below illustrates how much equity risk premiums had shrunk in the apartment sector by the end of that year. We have used charts like this in the past to illustrate how risk perceptions have changed over time.

Source: Davis Advisors

We were certainly in the minority suggesting real estate pricing could not be sustained at current levels. We took to heart Alan Greenspan's observation that "...history has not dealt kindly with the aftermath of protracted periods of low risk premiums."3 We believed quite strongly that pricing was too rich. Below is the same chart as of the end of 2007.

Source: Davis Advisors

The return of equity risk premiums to historical levels (and higher) has created volatility in security prices that we have not seen since the modern real estate investment trust (REIT) era began in 1993. Given that equity risk premiums are now at attractive levels we would like to be optimistic and suggest that volatility will subside soon, but for commercial real estate things are still too uncertain. The battle for price stability is being fought on two fronts. Dysfunctional market behavior will wane only when credit markets function properly and the fate of commercial real estate demand is more certain. In other words, if demand remains sound when the credit markets stabilize, prices will rise and help equity risk premiums revert to their long-term average (closer to the 200 basis points shown in the second chart for apartment REITs). On the other hand, if demand softens after credit markets stabilize, prices will likely tread water or decline further as fears of slowing growth win the day.

3 Federal Reserve Symposium, Jackson Hole, WY, August 2005.

Credit Market Stress: The First Battle

Credit markets continue to struggle with the true depth of the financial crisis. What began as an unanticipated surge in defaults on sub-prime loans has precipitated a wave of unexpected consequences. Every corner of the credit market has seen its share of pain. Most remarkable for commercial real estate is the seizure of the commercial mortgage-backed securities (CMBS) market and a dramatic change in terms on bank and mortgage financing. The issue of capital recycling is also a concern given the way we evaluate risk in real estate. Because real estate companies, especially REITs, are very dependent on external capital, these changes present the biggest risk to the companies in which we invest.

The CMBS market served as a mechanism for transactions ranging from buyouts to cash-out financing of stabilized assets, among others. This market has been in a state of paralysis for a while and we cannot predict when the CMBS market will regain its footing. We can tell you that the few companies in the Davis Real Estate Fund that have direct exposure to the CMBS market appear well positioned to weather the storm.4

Bank and mortgage financing, which serves a much larger role for companies in the Davis Real Estate Fund, has seen a dramatic change in terms that will profoundly impact real estate financing over the next several years at least.

It is no longer possible to get 90% loan-to-value (LTV) mortgages with deferral of principal payments for five years or more. Low coverage ratios that allowed expensive real estate acquisitions to produce negative cash flow are also gone. And even though terms have changed in favor of lenders, the amount of available capital has declined dramatically as financial institutions have struggled to comply with their own capital requirements. This makes it very difficult for creditworthy companies to access capital, even if they never used the aggressive loans so often offered over the past few years.

Most troubling is the prospect that we may only be in the early stages of a long and painful adjustment for commercial real estate lending. A wave of debt will come due during 2010 through 2012 that will need refinancing. A good deal of that debt was financed on aggressive terms and refinancing may not be possible. Borrowers may be forced into the unenviable position of selling assets to satisfy lienholders. To illustrate how quickly something like this can happen, consider the Blackstone purchase of Equity Office Properties (EOP).

When Blackstone bought EOP in early 2007, it planned to sell as many assets as possible at higher prices than those at which the assets were purchased. Proceeds would be used to pay off bridge financing and effectively lower the cost basis of the assets Blackstone retained. Surprisingly to us, several investors were willing to pay more for EOP assets than the very rich price Blackstone paid. Notable among the buyers were Maguire Properties and Macklowe Properties. Maguire purchased a portfolio of assets located in southern California and Macklowe a portfolio of New York City offices. Both used aggressive financing to acquire the properties and likely assumed negative carry (i.e., property cash flow less than the cost of financing) in the process. Maguire is now in the unenviable position of having a highly leveraged balance sheet and an unfunded dividend and is facing the practical necessity of selling the business. Macklowe is facing similar prospects as short-term bridge financing comes due early this year and refinancing is an unlikely possibility. The specifics of these transactions are not as important as understanding that risk increases as prices increase. With so little cushion, a slight credit market disruption would have put these deals in jeopardy. The current huge credit market disruptions make Maguire's and Macklowe's positions all the more dire and our point about risk all the more salient.

We have always sought to invest your capital in businesses that actively manage the real estate cycle. Integral to managing the cycle is selling assets. Stress in the credit markets presents problems there too. Financing is necessary to buy assets, and when financing disappears so do buyers of real estate. We are facing a market today where sellers of assets are unwilling to lower prices to meet buyer bids. This gap has narrowed recently and will likely narrow more, but clearing prices (i.e., the prices at which transactions can be done) may be much lower. Even though active capital recycling will be challenging over the near term, it is still an important tool and necessary to maximize the value of real estate throughout the cycle.

However painful this credit market stress might be, it is not entirely a bad thing. We are ridding the system of excesses built up over the past few years and the resulting increase in equity risk premiums in commercial real estate is presenting us with some interesting investment opportunities. Equally important, it is keeping supply in check. Even though 2007 was a painful year and 2008 is starting out the same way, we are seeing some great opportunities. It is our hope that several years from now we will be much better off as a result.

4 Past performance is not a guarantee of future results. An investor may lose money.

Demand Shock: The Second Battle

Extrapolating past trends in order to predict future events is always dangerous. While history does not necessarily repeat itself, it can echo in important respects. In 2001, commercial real estate fell victim to a massive negative demand shock (i.e., a sudden, unexpected event that decreases demand) resulting from the collapse of the technology bubble. The epicenter for that event was Silicon Valley, but its ramifications were felt across the United States. Almost every major metropolitan area suffered employment shocks from major job losses that put millions of square feet of office space back on the market. Other types of property were also affected as people rented fewer apartments and spent less in stores and on vacation. Vacancies increased, rents declined and real estate companies saw an abrupt end to the meteoric earnings growth they experienced in 1999 and 2000. The 2001 commercial real estate recession felt similar to the recession of the early 1990s, but the 2001 version was not related to a supply issue as was the recession of the early 1990s.

Today we are spending a great deal of research time analyzing and thinking about the potential for another negative demand shock. This time New York City looks like it could be the epicenter and events in 2008 could echo prior recessions. Financial services firms have been shedding thousands of jobs and there is every reason to believe more job cuts are in the offing. And like the 2001 tech collapse, this collapse could have ramifications for the entire country. People today feel less wealthy because their homes are dropping in value. They are also paying more for gasoline and generally lack the confidence to spend as they used to.

We are trying to avoid simple historical extrapolation by considering how this time could be different. Even if Manhattan is on the precipice of a demand shock in real estate, is that already reflected in stock prices? In 2001, security prices dramatically outperformed despite the demand shock. During 2007 and into the first part of 2008, real estate security prices have dramatically underperformed and we do not yet know if there will in fact be a demand shock. Consider too that valuations look even more compelling because real estate companies have seen a 45% growth in earnings since 2002. Our analysis suggests that even if a demand shock is in the offing, some companies look more than fairly valued for such an eventuality. Conversely, others still look too expensive given the twin threats of struggling credit markets and the potential for a demand shock.

Presenting a Good Defense5

The two battles under way have resulted in some notable portfolio shifts.We own much less New York City office space than we did last year. In 2006, SL Green was the Fund's best-performing stock, but in 2007 we trimmed our holding to gird the portfolio against a slowing investment market in Manhattan and the possibility that demand for space could slow materially. We also sold our only hotel holding, Host Hotels & Resorts, and trimmed our exposure to class B apartments with the sale of United Dominion Realty. In both cases, our internal models were signaling the potential for imbalances between supply and demand.

Another area where we reduced our exposure is the United Kingdom. In early 2007, we sold our positions in two U.K. property companies, Capital & Regional and SEGRO. This was a judicious decision as the former lost more than 75% of its value after our sale and the latter almost 40%, but it did not immunize the Fund entirely. The U.K. holdings that remained in the portfolio also saw significant declines and cost the Fund some performance. Sour sentiment has humbled prices of U.K. property companies and is currently trumping any notion that these businesses may have superior growth prospects. We view the U.K. as a potential source of opportunity.

In our 2007 semi-annual Fund review, we discussed our "stuff on shelves" investment strategy, which we have focused on for some time. Our "stuff on shelves" theory, perhaps better known as intermodal logistics, is based on the fact that many consumer goods now come from China, ultimately reaching U.S. stores through a chain of intermodal transportation services such as shipping, rail and road services. We have identified the real estate component in every link of the logistics chain as well as real estate companies we believe are well positioned to benefit in each area: warehousing the goods in deep water ports in China, shipping them to the United States, warehousing them again in U.S. ports, and shipping the goods via rail to inland distribution centers where they are then trucked to U.S. stores.

Our "stuff on shelves" investments worked splendidly in 2007. They muted the effect of our poorly performing U.K. investments and contributed to the Fund's significant relative outperformance during 2007.6 (We freely admit that speaking of outperformance during a year when prices declined requires tremendous forbearance on your part, but good long-term records are built on results in both up and down markets.) Alexander & Baldwin was a true star in the Fund last year with an 18.9% total return. Thanks in large part to a profitable transpacific shipping business and highly successful new China route, Alexander & Baldwin fared much better than most despite a slowing in its real estate business. Burlington Northern Santa Fe Corporation was close behind with a total return of 6.2%. The company's rights-of-way, which we consider real estate, are a primary component in the logistics chain. Volumes slowed during 2007, but Burlington Northern was able to increase prices and show great profit growth.

As we enter 2008 we remain optimistic about real estate, probably more so than we have been in a while. There are reasons to be cautious, but we do not believe this exceptional period in any way diminishes the value of real estate as an important component of a well-diversified investment portfolio. A healthy adjustment is under way and is creating some great opportunities to invest your capital in excellent real estate companies trading at discounted prices.■

5 Past performance is not a guarantee of future results. The information provided in this report does not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security.
6 Class A shares, without a sales charge, outperformed both the NAREIT and the DJWRESI. Past performance is not a guarantee of future results.

For more information, please contact...

DAVIS DISTRIBUTORS, LLC
2949 East Elvira Road, Suite 101
Tucson, AZ 85706
1-800-279-0279