Digital Realty Trust: Still Worth Buying Today Despite The Nose Bleed Valuation

| About: Digital Realty (DLR)

Summary

Data center REITs have been some of the best performing stocks of the last 2.5 years.

Share prices have soared to seemingly insane levels.

However, Digital Realty Trust, the only SWAN blue chip in this sector, may still make sense to buy at today's share price.

BUT there are two risks you need to keep in mind before you buy.

Click to enlarge

Source: Digital Realty Trust

Ultra-low interest rates and the third longest bull market in history have combined to make for some VERY good times for REIT investors. For example, the Schwab US REIT ETF (NYSEARCA:SCHH), the hands down best REIT ETF to own, has strongly outperformed the S&P 500 over the past 2.5 years. However, within the sector data center REITs such as Digital Realty Trust (NYSE:DLR), Equinix (NASDAQ:EQIX), DuPont Fabros Technology (NYSE:DFT), Cyrusone (NASDAQ:CONE), CoreSite Realty Trust (NYSE:COR), and QTS Realty Trust (NYSE:QTS) have been on an absolute tear; rising between 133% and 200% since Q4 of 2013.

DLR Total Return Price Chart DLR Total Return Price data by YCharts

With data center REITs now at nosebleed valuations dividend investors need to be more careful than ever when it comes to putting new money to work. Find out why Digital Realty Trust is a true sleep well at night, or SWAN, stock in this fast growing sector. More importantly, find out why, unlike some of its rivals, Digital Realty may not be as overvalued as you may think.

Digital Realty: Time tested blue chip

Click to enlarge

Source: Digital Realty Trust investor presentation.

The reason that data center REITs have done so well is that the industry is riding a secular mega-trend in which the combination of mobile data, cloud computing, and the burgeoning internet of things are creating a vastly larger need for companies in every industry to access vast fleets of servers and data storage technology.

Click to enlarge

Source: Digital Realty Trust investor presentation.

With 140 properties spanning four continents Digital Realty is one of the largest REITs in its industry. And at 12 years old, it's also the oldest and most battle tested when it comes to surviving challenging economic conditions.

Click to enlarge

Source: Digital Realty Trust investor presentation.

Not only was Digital Realty able to continue growing strongly during the worst financial crash since the great depression, but it was also able to continue rewarding investors with strong dividend growth.

Click to enlarge

Source: Digital Realty Trust investor presentation.

More importantly, having survived a complete collapse of the credit markets Digital Realty management has continued to take a conservative view towards leverage. Not only has this resulted in the second strongest balance sheet among its peer group, (bested only by CoreSite Realty), but also one that can stand toe to toe with some of the biggest blue chip REITs in any sector. In fact, thanks to the only investment grade credit rating in its peer group, Digital Realty has the third lowest cost of debt capital.

Source: Morningstar
REIT Debt/EBITDA EBITDA/Interest Debt/Equity S&P Credit Rating Average Debt Cost
Digital Realty Trust 5.54 5.05 2.0 BBB 3.57%
Equinix 5.11 3.07 1.49 BB 6.37%
DuPont Fabros Technology 7.51 3.38 1.59 BB- 3.92%
Cyrusone 5.28 4.2 1.10 B+ 4.51%
CoreSite Realty 2.30 21.25 1.50 NA 2.05%
QTS Realty Trust 6.13 6.09 1.50 B+ 2.68%
Industry Average 7.17 NA 1.30 NA NA
Click to enlarge

Click to enlarge

Source: Digital Realty Trust investor presentation.

Perhaps as impressive as its rock solid balance sheet and long growth record, Digital Realty's quality management has generated some of the best returns on investor capital as seen by its profitability profile.

Sources: Morningstar, Gurufocus
REIT Operating Margin Net Margin Return on Assets Return on Equity Return on Invested Capital
Digital Realty Trust 19.9% 8.3% 1.5% 5.3% 4.37%
Equinix 18.1% 2.7% 0.8% 2.3% 3.82%
DuPont Fabros Technology 11.4% -3.6% -0.6% -2.3% 9.39%
Cyrusone 9.1% -1.3% -0.3% -1.7% 3.38%
CoreSite Realty 20.6% 9.4% 2.9% 13.2% 8.4%
QTS Realty Trust 10.4% 6.4% 1.5% 4.2% 4.36%
Industry Average 27.4% 14.0% 1.6% 4.3% NA
Click to enlarge

Obviously a REIT of Digital Realty's caliber deserves some kind of share price premium, however, given the recent mega-rally, it's understandable why many investors might think Digital Realty has run up too far, too fast.

Valuations are absolutely frightening

Sources: Fastgraphs, Ycharts
REIT P/AFFO Historic P/AFFO P/NAV Historic P/NAV Average Historic Premium
Digital Realty Trust 24.0 17.2 11.66 3.71 126.9%
Equinix 26.7 17.1 43.99 10.95 178.9%
DuPont Fabros Technology 17.7 16.2 4.78 2.38 54.7%
Cyrusone 22.5 17.4 10.41 8.05 29.3%
CoreSite Realty 34.4 24.7 11.80 5.66 73.9%
QTS Realty Trust 23.6 19.3 8.55 4.01 67.8%
Click to enlarge

When compared to their historic price to AFFO and price to NAV ratios, all data center REITs are extremely overvalued right now. However, Digital Realty Trust's average historical premium is especially high, second only to Equinix's seemingly insane valuation.

So how is it that I can claim that Digital Realty could still be a potentially good buy at today's price? The answer lies in its likely fair value based on a discounted cash flow analysis.

Sources: Fastgraphs, Morningstar, Gurufocus
REIT TTM AFFO/Share Projected 10 Year AFFO Growth Rate DCF Fair Value Estimate Reverse DCF Implied Growth Rate Q1 2016 YoY AFFO/Share Growth Margin of Safety
Digital Realty Trust $4.74 6.3% $79.00 11.7% 21.9% -40%
Equinix $14.44 19.0% $591.45 13.0% -21.0% 34%
DuPont Fabros Technology $2.68 15.0% $87.11 4.9% -2.0% 45%
Cyrusone $1.95 13.7% $55.20 13.8% 21.0% 0%
CoreSite Realty $2.73 14.9% $85.70 15.9% 34.4% -7%
QTS Realty Trust $2.36 25.2% $154.90 9.5% 19.2% 64%
Click to enlarge

At first glance it seems like this DCF analysis just proves that Digital Realty Trust is the most overvalued of all the data center REITs. However keep in mind 3 things.

First, DCF analyses always need to be taken with a grain of salt and should NEVER be the sole basis on any buy, sell, or hold decisions. That's because they are based on long-term analyst growth projections, which are merely educated guesstimates.

Second the discount rate used can greatly alter the fair value estimate. In this case I used the S&P 500's historic 9.1% CAGR since 1871, to give investors a general idea of what share price should result in market matching performance over the next 20 years.

Finally, and most importantly, this analysis used the most up to date current analyst growth forecasts for these REITs. However, I think most of those are wildly over optimistic. For example, Equinix and DuPont Fabros Technology are expected to have some of the highest growth rates of the next decade, yet have recently struggled to grow their AFFO per share.

While CoreSite and Cyrusone did report the kind of AFFO/share growth that might make those growth assumptions reasonable, note their high reverse DCF implied growth rates.

This means that, at their current share prices, CoreSite and Cyrusone have priced in AFFO/share growth of 15.9%, and 13.8%, respectively. In comparison QTS Realty and Digital Realty Trust are only priced for respective growth rates of 9.5%, and 11.7%. These much easier targets, which are far below the latest quarter's reported figures, means that QTS Realty and Digital Realty Trust should have far easier times meeting Wall Street's expectations.

Why should long-term investors even care about that? Normally they shouldn't, however, in this case beating analyst estimates might be the key to whether or not Digital Realty is a potentially good long-term buy at today's share price.

Dividend profile shows analysts are potentially WAY too optimistic regarding growth of DLR's rivals

Sources: Earnings releases, Earnings presentations, Yahoo Finance, Fastgraphs, Multipl.com, Factset Research, Moneychimp.com
REIT Yield Q1 2016 AFFO Payout Ratio 10 Year Projected Dividend Growth Q1 2016 YoY Dividend Growth 10 Year Projected Total Return
Digital Realty Trust 3.2% 68.8% 6.0% 3.5% 9.2%
Equinix 1.8% 58.7% 16.6% 3.6% 18.4%
DuPont Fabros Technology 3.9% 73.4% 11.4% 11.9% 15.3%
Cyrusone 2.7% 59.4% 13.4% 20.6% 16.1%
CoreSite Realty 2.3% 61.6% 12.9% 26.2% 15.2%
QTS Realty Trust 2.6% 57.1% 20.6% 12.5% 23.2%
S&P 500 2.1% 37.9% 5.8% NA 9.1%
Click to enlarge

A good rule of thumb for estimating long-term total returns is yield + dividend growth. In this case, the seemingly fantastic returns expected from Digital Realty's rivals goes a long way in explaining why investors have bid up their shares to such high levels.

However, based on the most recent AFFO/share growth, Digital Realty is the only digital REIT I think has a decent chance of not just meeting, but beating its dividend growth forecast. Don't get me wrong, Cyrusone, CoreSite, and QTS are indeed growing like weeds, thanks to their much smaller sizes. In addition to its tiny size, QTS is expected to benefit greatly from its dominance in the niche high security clearance data center industry.

However, I think assuming that CoreSite, QTS, and Cyrusone can maintain those kinds of high growth rates for that long puts investors at high risk of being disappointed, especially at today's historically high share prices.

In contrast, while Digital Realty's latest dividend hike was rather paltry, its low payout ratio, continuing impressive AFFO/share growth, and recent big acquisitions (discussed below), make me think that it will be far more likely to live up to its far more modest expectations.

Risks to consider

There are two risk factors I think current and prospective investors in Digital Realty need to watch out for. First is the potential commoditization of the industry.

Click to enlarge

Source: Digital Realty Trust investor presentation.

With so many data center REITs now competing for business, Digital Realty has seen its retention rates fall below its historic norm in recent quarters. That has the potential to result in less profitable lease terms once its long-term leases begin rolling off. That could potentially hurt AFFO per share and making strong dividend growth harder to come by.

Second, Digital Realty recently acquired 8 premium data centers in Europe from Equinix for $874 million. That represents a multiple of 13 times projected 2016 EBITDA, a relatively cheap price potentially brought on by concerns over Brexit. While I applaud management for what could very well prove a highly profitable and opportunistic acquisition, this purchase will, none the less, greatly increase Digital Realty's exposure to the European Economy.


Source: Digital Realty Trust investor presentation.

Before the acquisition Digital Realty was already getting 21% of its rent from the EU after its 2015, $1.9 billion acquisition of Telex. After this deal there will be an even bigger potential for a weak European economy to put a crimp in Digital Realty's future dividend growth plans.

Bottom line: Digital Realty is the gold standard of data REITs and could be fairly valued based on REALISTIC growth prospects

Digital Realty Trust is my favorite large data center REIT. Its quality time tested management team has shown itself to have a conservative approach to sustainable growth that should serve long-term dividend investors well for many years to come.

More importantly, despite its sky-high valuations, I believe Wall Street is underestimating how quickly Digital Realty can continue growing over the next decade, especially relative to some of its peers such as Equinix, and DuPont Fabros. In other words, I think Digital Realty has the potential to outperform expectations, and deliver stronger than expected dividend growth. Combined with the second highest yield in the industry, this might still result in market beating returns even at today's high share price.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.