Data Center REITs: Sunlight Through COVID Clouds

REIT Rankings: Data Centers

(Hoya Capital Real Estate, Co-Produced with Brad Thomas)

Data Center Sector Overview

A “cloudy” future lies ahead, but that’s good news for data center REITs. Data centers are the home of the “cloud,” the physical epicenter of the internet. Within the Hoya Capital Data Center Index, we track the five data center REITs, which account for roughly $125 billion in market value and own nearly 600 data centers across the world: Equinix (NASDAQ:EQIX), Digital Realty (NYSE:DLR.PK), CyrusOne (CONE), CoreSite (COR), and QTS Realty (QTS). While not included in the index, business storage operator Iron Mountain (IRM) also operates a relatively small portfolio of data centers as well as non-REITs Switch, Inc. (SWCH) and RackSpace (RXT). data center REITs

Clear winners of the “work-from-home” era and COVID-related social and economic shifts, data center REITs have thrived amid the disruption. In an increasingly virtual world, data centers are the essential infrastructure that prevented a catastrophic drop in productivity amid the coronavirus-related economic shutdowns by enabling the relatively seamless transition to the “work-from-home” era. Housed in windowless buildings surrounded by massive generators and cooling equipment, data centers provide the critical infrastructure – power, cooling, and physical rack space – to a variety of enterprise customers with different networking and computing needs. Data centers enable high-speed networking and house millions of terabytes of mission-critical data for thousands of individual customers.

data center REITs 2020 1

As we’ll explain throughout this report, we view the “essential” property sectors – technology, housing, and industrial/logistics – as the lone areas of reliable growth within the REIT sector over the next half-decade. On that point, leasing activity, the most closely-watched earnings metric for data center REITs, surged in the second quarter to the highest level on record as the sector continues to ride substantial secular tailwinds associated with the shift in spending from physical office space towards “digital” space. Together, these REITs combined to report $210 million in incremental leasing activity, representing a 72% jump from 2Q19, highlighted by Digital Realty’s best quarter on record with incremental leasing revenues of $144 million.

data center leasing

Data Center REITs have jumped more than 20% so far in 2020 even as most property sectors were ravaged – at least temporarily – by the coronavirus pandemic. Dividend cuts have been a major theme across the REIT sector this year with 64 of 170 equity REITs reducing or eliminating their dividends since the start of the pandemic. Data center REITs have not only been immune from this wave of dividend cuts, but have instead led the charge in dividend increases in 2020. Four of the five data center REITs have increased their dividends this year while CoreSite has so-far maintained distributions at pre-pandemic levels. All told, 27 equity REITs have raised dividends this year, primarily in the aforementioned “essential” property sectors.

dividend increases REITs 2020

Deeper Dive: Data Center Sector Fundamentals

Data center REITs operate in three primary lines of business: wholesale, colocation, and interconnection. The value of each data center is largely a function of its position along the internet backbone, the physical fiber-optic network that links every connected-device across the world. Properties within the backbone, or more precisely at the “intersection” of various networks, are able to provide higher-value network-based colocation and interconnection services, which command higher rent-per-MW and generally have significantly higher barriers to entry due to the inherent “network effects.” Properties on the periphery or those lacking a critical mass of interconnection tenants typically provide more ubiquitous enterprise-based wholesale services, including storage and cloud-based software applications.

data center business lines

As is common across most real estate sectors, the companies providing the behind-the-scenes infrastructure and real estate are not “household names” compared to their more consumer-facing tenants. The companies synonymous with cloud computing – Amazon (AMZN), Microsoft (MSFT), Google (GOOG) (NASDAQ:GOOGL), Alibaba (BABA), Oracle (ORCL), Salesforce (CRM), and IBM (IBM) – are among the largest and most important tenants of these data center operators, and have become even more critical tenants in recent years as a growing share of leasing activity has accrued to a smaller handful of tenants. Meanwhile, major players on the hardware side include Intel (INTC), Advanced Micro Devices (AMD), and NVIDIA (NVDA), which collectively provide the majority of networking equipment utilized by data center tenants.

public cloud

Responding to the mounting competitive threats posed by these “hyperscale” giants, data center operators have turned to M&A to regain some degree of pricing power, with a particular focus on the higher-value interconnection-focused facilities. Interconnection, which relies on “network effects,” can translate into a competitive advantage owned by REITs that hyperscalers have more difficulty replicating. Digital Realty significantly expanded its interconnection and colocation business through its InterXion (NYSE:INXN) acquisition but remains a mostly wholesale-focused entity. Equinix has the highest “quality” portfolio of network-dense assets followed by the smaller CoreSite. CyrusOne, QTS, and the majority of non-REIT data center operators focus primarily on more competitive wholesale assets.

data center reit landscape

Through consolidation and internal development, we believe that data center REITs continue to make the right moves to fend off the competitive threats from their ever-more-powerful tenants. While their “big-tech” tenants are literally some of the largest companies the world has ever seen, the size and scale of these REITs are nothing to scoff at either. Data Center REITs own roughly 30% of investment-grade data center facilities in the US and command roughly a fifth of data center capacity globally. Outside of these five REITs, other companies operating in the space include a mix of international, private, and “C-corp” entities, including Zayo Group (ZAYO), Switch, Flexential, Cyxtera, TierPoint, and Cologix.

largest data center operators

One of the newer REIT sectors, Data Centers have been perennial outperformers and one of the primary growth engines of the REIT sector since bursting onto the scene in the 2010s. Data center REITs comprise between 4-12% of the broad-based “Core” Equity REIT ETFs and comprise roughly a third of the Pacer Benchmark Data & Infrastructure REIT ETF (SRVR), which owns a blend of data center REITs, cell tower REITs, and billboard REITs, which often host cellular equipment. As tracked in our Real Estate ETF & CEF Tracker, SRVR has been the top-performing real estate ETF of 2020.

srvr

Data center REITs are not only among the fastest-growing property sectors, but are also some of the most well-capitalized REITs, operating with some of the lowest debt ratios across the sector, which has been rewarded by investors amid the pandemic. As a result, data center REITs are also some of the most “expensive” and the lowest-yielding companies across the REIT space, but that’s not necessarily a bad combination of investment characteristics for a REIT. In our recent report, “The REIT Paradox: Cheap REITs Stay Cheap,” we discussed our study that showed that lower-yielding REITs in faster-growing property sectors with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding counterparts.

data center REIT balance sheets

Data Center REIT Stock Performance

As discussed in our REIT Decade in Review, at the real estate sector-level, three themes dominated the 2010s: 1) The Housing Shortage, 2) The Retail Apocalypse, and 3) The Internet Revolution. Producing an annualized rate of return that is more than double that of the broader REIT average since 2015, data center REITs have ridden the thematic growth trends associated with the boom in outsourced IT spending. The coronavirus pandemic has done little to slow down these secular trends as the Hoya Capital Data Center Index is one of just five REIT sectors in positive territory for the year, gaining 24.7% compared to the 13.5% decline by the broad-based Vanguard Real Estate ETF (VNQ) and the 5.2% gain on the S&P 500 ETF (SPY).

data center REITs

The strong outperformance this year comes after a 44.2% surge in 2019, outpacing the 28.6% total returns from the NAREIT All Equity REIT Index. Notably, all these five REITs are among the best-performing REITs across all sectors since 2015. All five data center REITs are in positive territory this year, led by Equinix, Digital Realty, and QTS Realty. Of note, however, data center REITs have pulled back roughly 10% over the last month amid the recent “tech wreck” as investors have rotated into some of the more beaten-down property sectors and as the Nasdaq 100 ETF (QQQ) dipped into correction-territory with declines of roughly 10%.

data center REIT performance

Two of the five REITs offer preferred securities, tracked in our new iREIT Preferred REIT & Bond Tracker. These include a suite of five preferred issues from Digital Realty (DLR.PC, DLR.PJ, DLR.PG, DLR.PK, DLR.PL), all of which are standard cumulative redeemable preferred securities that currently trade with an average yield of roughly 5.4% and trade at modest premiums to par value. A suite of two issues from QTS Realty (QTS.PA, QTS.PB) are also listed, the latter of which is one of the few convertible preferred securities issued by REITs while the former is a standard cumulative redeemable security. Data center REIT preferred shares are higher by an average of 4.5% in 2020, also the tops in the REIT sector, but have lagged their respective common shares by 15% this year, the widest underperformance gap in the REIT sector.

data center REIT preferreds 2020

Data Center REIT Fundamentals Getting Less Cloudy

Despite evidence of a slowdown in global IT spending, second-quarter earnings for the five data center REITs’ results brought a ray of sunlight through the clouds. As noted in the introduction, leasing activity, the most closely watched metric, was significantly better than expected. Solid leasing data was a welcome relief given the continued uncertainty over global IT spending – particularly in the European and Asian markets – and over domestic hyperscale demand. Together, these REITs combined to report $210 million in incremental leasing activity, representing a 72% jump from 2Q19. Three of the five data center REITs boosted AFFO per share guidance in Q2 – DLR, COR, and QTS – while two REITs maintained prior guidance.

data center earnings AFFO

For REIT investors, some growth is better than negative growth, and data center REITs should be one of the few sectors to record full-year growth in 2020. Overall, while industry average revenues and EBITDA are expected to grow another 8-9% in 2020, AFFO per share is expected to grow by 2.1% in 2020, down from the 5.5% rate in 2019. DLR’s recent acquisitions – and roughly 30% expansion of shares outstanding to fund them – have pressured the per-share metrics, but these deals are expected to take some time to be accretive and we ultimately believe that these were strategically important acquisitions that will add significant value over the next decade.

data center REIT affo per share growth

While much of the investment community remains hyper-focused on leasing metrics, which we see as volatile and prone to false signals, we remain focused on re-leasing spreads as the key forward-looking indicator of underlying pricing power and on supply/demand conditions. The downward pressure on data center pricing has stabilized in recent quarters after several years of weakness. Digital Realty, which we view as the industry bellwether, reported a 2.8% decline in cash renewal spreads, but this compared favorably to the -5.8% decline in cash renewal spreads in 2Q19 and was enough to bring the trailing-twelve-month average back into positive territory.

data center leasing 2020

With flat-to-negative “same-store NOI” growth rates, external growth continues to be the modus operandi and primary driver of growth for these companies as Data Center REITs have been relentless developers and acquirers over the last half-decade. After cooling in 2019, the development pipeline has shot up to new record-highs in Q2, climbing to $4.5 billion, representing roughly 5% of REIT market value. Supply growth remains a continued headwind and while development remains fairly disciplined and responsive to demand, it’s unclear whether there are any meaningful barriers to supply growth in the wholesale segment that could lead to a positive inflection in same-store pricing metrics.

data center development pipeline

Consolidation remains a continuing theme in the data center sector as these data center operators attempt to fend off mounting competitive pressures. Digital Realty shook the data center landscape last October with its announced $8 billion acquisition of European data center giant InterXion, the eighth largest operator in the world. The fourth major acquisition for DLR since 2015, the firm acquired Telx in 2015, fellow REIT DuPont Fabros in 2017, and Ascenty in 2018. Equinix announced last quarter that it will acquire 13 data center sites across Canada for $750 million from Bell Canada. Transaction activity was quiet – in fact, nonexistent – in the second quarter amid the pandemic, but the recent momentum remains on the upside as data center M&A seemingly picked up again in late 2019 and into early 2020 after a lull.

data center M&A

Valuation & Dividend Yield of Data Center REITs

As they have for most of the past half-decade, data center REITs continue to trade at premium valuations to the REIT averages based on FFO (Funds From Operations) based metrics. Data center REITs are the third most “expensive” REIT sector based on forward FFO, but appear far more attractive using valuation metrics that incorporate recent and projected growth rates, as the sector has achieved roughly 12% FFO and dividend growth over the past three years, among the highest in the REIT sector. We note that data center REITs trade at an estimated 20% premium to NAV, also one of the highest in the REIT sector. Maintaining this NAV premium is critical to accretively funding these REITs’ external growth ambitions and maintaining a critical cost of capital advantage over private market competitors.

data center REIT valuations

As noted above, we have tracked 64 equity REITs out of our universe of 170 equity REITs that have now announced a cut or suspension of their common dividends, but data center REITs have not been one of them. Data Center REITs pay an average dividend yield of 2.2%, which is below the REIT sector average dividend yield of around 3.2%. Data center REITs pay out just 53% of their free cash flow, however, leaving ample capacity to increase dividends or reinvest in growth.

dividends data centers

Within the sector, we note the differences in yield for these five REITs and an estimation of their approximate payout ratios. CoreSite yields a sector-high of 4.2% followed by Digital Realty at 3.1%, QTS at 2.9%, and CyrusOne at 2.6%. Equinix remains the most “growth-oriented” REIT, paying a yield of just 1.4% but retaining more than 60% of free cash flow.

dividend yield data center

Key Takeaways: “Work-From-Home” Catalyst

A “cloudy” future lies ahead, but that’s good news for data center REITs. The physical epicenter of the “cloud,” data centers have been the best-performing property sector amid the pandemic, surging nearly 25% so far in 2020. Emerging technologies including artificial intelligence, the “internet of things,” and autonomous driving continue to be on the horizon, but the pandemic has accelerated demand for the “core” business of data center REITs: enterprise cloud computing. Clear winners of the “work-from-home” era, corporations will increasingly shift spending on physical office space towards “digital office space” through investments in cloud computing infrastructure.

office survey results

Leasing activity – the most closely-watched earnings metric – surged in the second quarter to the highest level on record as the sector continues to ride substantial secular tailwinds. Data center REITs have made the right moves to fend off competitive threats through consolidation and internal development. While expensive, the “essential” property sectors – technology, housing, and industrial – are the lone areas of reliable growth within the REIT sector.

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Disclosure: I am/we are long DLR, COR, EQIX, INTC, AMZN, GOOG, HOMZ, AMT, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Hoya Capital Real Estate (“Hoya Capital”) is an SEC-registered investment advisory firm that provides investment management services to ETFs, individuals, and institutions, focusing on portfolio and index management of publicly traded securities in the residential and commercial real estate industries. A complete discussion of important disclosures is available on our website (www.HoyaCapital.com) and on Hoya Capital’s Seeking Alpha Profile Page.

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