Financial Review Of The Debt Structure Of The 3 Biggest Data Center REITs

| About: Digital Realty (DLR)

Summary

Last week, the Federal Reserve leaders decided not to increase the bank's key interest rate.

Which data center REIT is best equipped to handle a possible future interest rate hike?

This article provides an overview of the debt structure of the three biggest data center REITs.

EQIX and DLR seem the least sensitive to an interest rate hike in the short term.

Last week, the Federal Reserve ("FED") leaders decided not to increase the bank's key interest rate. The FED is still waiting for the right moment to raise interest rates. Some say that a possible rate hike could occur later this year but that remains to be seen.

Recently, I wrote two articles where I discussed the debt structure of the biggest REITs in that particular subsector.

I discussed various debt and financing metrics to compare the various REITs in that particular subsector. The main premise behind these articles is that a possible future rate hike will impact short-term share prices of almost every REIT, regardless of their actual sensitivity to interest rate changes. However, these articles are meant to provide answers to the question: which REIT is best equipped, from an operational perspective, to withstand rising rates in the future?

Some readers suggested I do a similar analysis on the data center subsector. Here we go!

Data Center REITs

A data center REIT usually owns, develops, operates and/or manages data centers. Data centers are designed to protect and secure the IT infrastructure of the customers that use them. Rani Molla from Bloomberg described it nicely:

"Every time we stream video on Netflix, share photos on Instagram or listen to "Lemonade" on loop on Tidal, we add to the internet traffic glut -- and to the pocketbooks of data REIT shareholders. That's not going to stop anytime soon."

The growth of the digital universe is just mind boggling. It is expected to double in size every two years, and by 2020, the digital universe will reach 44 zettabytes, or 44 trillion gigabytes. This growth can only be supported if data center REITs provide enough infrastructure for companies like IBM (NYSE:IBM), AT&T (NYSE:T), CenturyLink (NYSE:CTL), et cetera. The three biggest players in this segment are:

  • Equinix (NASDAQ:EQIX)
  • Digital Realty Trust (NYSE:DLR)
  • Iron Mountain (NYSE:IRM)

Equinix is by far the biggest data center REIT in terms of market cap. It's two to three times bigger than the other mentioned REITs. All the data in this article are from the latest quarterly earnings reports (Q2 2016). Therefore, I did not take into account the financing activities for each of these companies between June 31 and today.

Capital structure

As a starting point in our analysis, let's take a look at the capital structure. The idea is that a REIT with high amount of debt financing (more leverage) usually is more sensitive to interest rate hikes. The table below provides a breakdown of the debt-to-equity (D/E) ratios of different REITs.

Source: data from Morningstar

We can see that all the data center REITs have high leverage ratios. The most conservatively managed data center REIT utilizes the same amount of leverage as the most risky healthcare or triple net lease REITs. DLR and IRM have even higher D/E ratios.

The next question is how much debt is variable rate debt and how much debt is fixed rate debt. The underlying rationale is that a higher amount of variable rate debt is riskier than fixed rated debt.

Source: table created by author, data from latest Q2 2016 earnings and supplemental reports

DLR has the most fixed rate debt, IRM the least. DLR actually has hedged portions of the outstanding variable rate term loans. That's partly the reason why DLR has a relatively low amount of variable rate debt. IRM has a credit facility with an outstanding balance of $1.6 billion. That's a relatively big portion of its long-term debt. One of IRM's next (financial) moves would probably be a refinance of the outstanding balance in a new senior unsecured note.

Debt maturities

The amount of variable rate debt, however, is not the only indicator. Fixed rated debt that matures in the short term is just as sensitive to rising interest rates as variable rate debt. The table below provides an overview of the amount of debt maturities between now and 2019 relative to the outstanding long-term total debt.

Source: table created by author, data from latest Q2 2016 earnings and supplemental reports

An analysis of the debt maturity schedule shows that DLR has a lower amount of short-term debt maturities than its peers. The other REITS need to refinance roughly 20-30% of their debt before 2020. A rising interest rate will impact these REITs sooner based on this indicator. The amount of debt maturities is still relatively low compared to other sectors. Healthcare REITs need to refinance on average 35% of their debt load before 2020, triple net lease REITs around 40-45%. So EQIX and IRM aren't the worst REITs based on this indicator, to say the least.

Another way to look at the debt maturity schedule is to calculate the maturity of the various debt instruments. The fixed debt issues are on average up for refinancing in six years. The variable rate debt instruments have shorter durations (3 to 4 years).

Source: table created by author, data from latest Q2 2016 earnings and supplemental reports

DLR and EQIX have the longest maturity on their debt portfolios. This coincides with the relatively low amount of debt maturities until 2020. The maturity of the variable rate portion of the debt load is actually a bit higher than for instance the healthcare REITs. This is obviously because the variable rate debt instruments have longer maturities (DLR, EQIX) but also because the credit facility is almost fully drawn.

It's also important to check what the average rate of the maturing debt is. Debt with a relatively high interest rate that matures in the short term actually offers a chance to improve the financial operations. If a company is able to refinance expensive debt with cheap debt, it is a good thing. The table below provides an overview of the average weighted debt rate of the debt that matures between 2016 and 2019.

Source: table created by author, data from latest Q2 2016 earnings and supplemental reports

On interest rate on the maturing debt varies greatly. On the one hand, IRM and EQIX have a lower interest rate for short-term debt and higher interest rate for longer-term debt. On the other hand, DLR's interest rate on short-term debt instruments is almost 6% whereas the longer-term debt portion is lower. DLR short-term debt consists of roughly $300 million in fixed rate mortgages. The long-term debt instruments are senior unsecured notes with an average rate of 4% but also the variable rate credit facilities which are much cheaper.

Other indicators

In the section above, I've discussed the capital structure and the debt maturity schedule of the three data center REITs. I will finalize my analysis of the rate sensitivity with a few more general indicators of the health of the companies as it relates to debt and interest payments.

Source: table created by author, data from latest Q2 2016 earnings and supplemental reports

The (net) debt, cash and EBITDA numbers are all in million USD.

The net debt/EBITDA multiple shows how many years it would take for a company to pay back its debt. IRM and DLR have the highest multiples which is no surprise given their high D/E ratios. EQIX definitely has the best net debt/EBITDA multiple. This is no surprise because its D/E ratios were much lower as well. However, this ratio and the D/E ratio are not exactly similar because the net debt/EBITDA ratio takes into account the earnings of a company (and thus the current operations). The D/E ratio is merely a snapshot view of the balance sheet.

The table below provides the interest rate coverage ratio.

Source: table created by author, data from latest Q2 2016 earnings and supplemental reports

The interest expense (in million USD ) is based on the first six months of 2016 and extrapolated through the end of this year. The interest coverage ratio measures a company's ability to pay the interest on its outstanding debt. On average, these companies have interest coverage ratios of roughly 3.0 to 4.0x. DLR has a somewhat higher ratio. This is due to the fact that DLR has the lowest interest rate on its outstanding debt.

Summary

The table below provides a summary of the various indicators I have mentioned in this article. The number (1 to 5) represents the rank where 1 is the best and 5 is the worst company based solely on that indicator. Obviously, this table and the ordinal ranking system do not take into account the degree of differences between them.

From the data, we can obviously see that EQIX and DLR are the best companies based on these indicators. IRM is the worst of the three in each of the examined metrics.

  • EQIX is the least leveraged data center REIT. Its debt load, however, is relatively expensive.
  • DLR utilizes more debt, but is able to issue debt at lower rates than EQIX.

So all in all, from an operational perspective, EQIX and DLR seem better equipped to withstand rising rates in the future. This does not subsequently mean that you should invest in both companies right now. I did not address future growth potential and valuation. These are both important arguments in whether you should invest in the common shares or not. This analysis provides a starting point!

Author's Note: If you have thoughts about this article or interest rate sensitivity in general, please leave your reply in the comment section below. Furthermore, if you have suggestions or requests for future articles, let me know! Finally, if you would like to be notified of my future articles, please follow me! (by clicking my name at the top of the page).

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.