In my recent two-part article published on 6/5/2012, which was the Property REIT installment of my "Yield, Value, Safety" series, I had identified Digital Realty Trust (DLR) as a potential holding, based upon the first-pass review presented in the article. I noted at the time that it was not a stock I could recommend at the price it was then commanding, having just crossed the $70 mark.
The stock subsequently advanced to an all-time high of $80.59 on 7/17/2012, which pushed the annualized yield down to 3.62%. Since I require a yield of around 5% from a REIT before I will consider it, my interest in DLR faded, and I focused my attention elsewhere. Since reaching that high, the stock has declined steadily, accelerating to the downside with the recent weakness in the market, to the mid-sixties as of this writing.
The yield is not quite up to 5%, but at 4.5%, it is close enough to be worth another look. In this article I will review the REIT in more detail, evaluate the safety of the dividend and the prospects for continued growth, and arrive at a conclusion as to the advisability of starting a position.
Digital Realty Trust went public in October, 2004. CEO Michael Foust has been in that position since 2004, as has CFO William Stein. The Chairman of the Board is Dennis Singleton, who has been a director since 2004. These facts indicate that continuity in the management ranks is not a concern, and the separation of the CEO and Board Chairman positions is always a plus for corporate governance. The REIT is classified as an Office / Industrial REIT, specializing in technology Data Centers, which in my opinion is an ideal sector to be in if the economy turns down.
The REIT's website Investor Relations section provides an excellent Company Overview. A few basic data points taken from the Overview are:
- DLR is one of the 15 largest REITs by market capitalization, exceeding $8 billion. The REIT employs over 500 full-time employees.
- The REIT owns a diversified portfolio of over 100 properties in the U.S. (79%), Europe (20%), and Asia, including Australia (1%).
- Over 1,800 leases are in force, with a diversified tenant base of 550+ tenants, including many leading global companies across various industries. No single tenant accounts for more than 9.6% of annualized rent.
- The REIT offers various Data Center solutions, from Turn-Key to Colocation / Maximum Flexibility plans.
- DLR experiences high tenant retention and occupancy ratios, both over 90%.
- Since inception, the REIT has delivered strong and consistent Funds From Operations (FFO) growth, which has enabled dividend growth. From 2005 through 2011, FFO increased at a 19.8% compounded annual growth rate, and the dividend increased at a compounded annual growth rate of 16.6%.
- DLR employs a conservative capital structure, and is rated as investment-grade and stable, by S&P, Moody's, and Fitch.
In the earlier article on REITs, I outlined an approach to evaluating a REIT as presented by Josh Peters, editor of the Morningstar Dividend Investor newsletter, in his book, the Ultimate Dividend Playbook. See my earlier two-part article here for more information. At that time, DLR easily passed all tests, based on the most recent quarterly data available, from Q1 2012.
In the paragraphs following, I will revisit and update all REIT-unique metrics presented in the earlier article, based on the subsequent earnings release, for Q2 2012. The primary resource I have relied upon is the Quarterly Earnings Supplement, available from the Financials section under Investor Relations on the firm's website. I have also used the corresponding data from the MSN Money website presentation of the same quarter's results in some cases. Also, note that the MSN Money website shows a value for Minority Interest ($50,220) as a liability.
I could not find any reference to this in the filed 10Q or the Supplement. I am ignoring this value in the calculations following, because it is a small number relative to the others, and it is not really a liability, it just represents a partial re-allocation of ownership from the common shareholders to minority interests.
As per the Supplement, DLR calculates Funds From Operations, or FFO, in accordance with the standards established by the National Association of Real Estate Investment Trusts, or NAREIT. A detailed definition is provided in the Supplement. Also defined in detail is the REIT's version of Adjusted Funds From Operations (AFFO), which is not nearly as standardized as FFO. After reviewing the definitions, I will accept FFO and AFFO, as defined by the company, as the basis for determining the Payout Ratios and hence the relative safety of the dividend.
In the following discussion, all dollar values are in thousands, excepting the per share values.
Determining Payout Ratios
The Supplement provides Funds From Operations and Adjusted Funds From Operations for the quarter just ended, 6/30/2012, both in total and per share (diluted), as follows:
FFO: $130,409 / $1.09 AFFO: $101,167 / $.86
The Diluted FFO Payout Ratio is provided, as 67.1%. The Diluted AFFO Payout Ratio is also provided, as 85.4%. The Payout Ratios for common dividends actually paid, $80,480, are a bit less than the diluted ratios, as would be expected. The values as calculated are 61.7% for FFO, and 79.5% for AFFO. Note that the gross dividends actually paid figure I used came from the MSN Money website's quarterly results for DLR. I could not find this value broken out in the DLR Supplement. .
As long as the AFFO Payout Ratio does not exceed 85%, or at least stays below 90%, the REIT is generating enough cash to service the dividend. Further, the REIT has numerous growth initiatives under way, and the history of revenue increases indicates that DLR is a growth-focused REIT, and is likely to support continued increases in the dividend, if the future is anything like the past.
Determining Debt plus Preferred % of Total Capital, Using Two Methods
After reviewing the Consolidated Balance Sheet for the quarter in the Supplement, and the corresponding data from the MSN Money website presentation, I determine that Long Term Debt ($3,400,210) plus Payables/Accrued ($372,970) yields Total Debt ($3,773,180). The Balance Sheet breaks out the Preferred Equity ($621,780). I then add the Total Debt and Preferred Equity together to determine the total of Fixed Obligations ($4,394,960).
Now, I want to determine the Common Stockholder's Equity using Total Assets as a starting point, and then subtracting out Total Debt, Preferred Equity, and Other Liabilities.
Common Equity = Total Assets - Total Debt - Preferred Equity - Other Liabilities
Common Equity = $6,717,110 - $3,773,180 - $621,780 - ($92,850 + $112,890)
Common Equity = $2,116,410
Next, I compute Adjusted Common Equity as Common Equity plus Cumulative Depreciation, or $2,116,410 + $1,033,130 = $3,149,540.
Now, I compute the percent that Fixed Obligations represents of Adjusted Common Equity plus Fixed Obligations, which is referred to as FFO Basis Debt/Equity.
FFO Basis Debt/Equity % = Fixed Obligations / (Adjusted Common Equity + Fixed Obligations)
FFO Basis Debt/Equity % = $4,394,960 / ($3,149,540 + $4,394,960) = 58.2%
This value should not exceed 80%. DLR passes easily.
Next, another method is followed to calculate what is termed the Market Value Basis Debt/Equity. The numerator is the same, and the denominator merely substitutes the Market Capitalization for Adjusted Common Equity. Thus, the result for DLR is:
Market Value Basis Debt/Equity % = $4,394,960 / ($8,300,000 + $4,394,960) = 34.6%
This value should not exceed 60%, and again DLR passes with ease.
Determining Fixed Charge Coverage Ratio
This step requires access to the Income Statement, from which I obtain Interest Expense ($37,681), and Preferred Dividends ($10,313). I add these together to get the Total Fixed Obligations for the Period ($47,994). I then calculate the Fixed Charge Ratio for the quarter, using AFFO as reported ($101,167), as:
Fixed Charge Coverage Ratio = (AFFO + Total Fixed Obligations) / Total Fixed Obligations, or ($101,167 + $47,994) / $47,994 = 3.1079, or expressed as a ratio after rounding, 3.11 : 1.00.
Available cash should cover fixed charges by at least 2 : 1, so DLR is in fine shape from the standpoint of Fixed Charge Coverage, at least for the quarter just ended.
Note that the REIT's Supplement provides Coverage Ratios for Debt Service and Fixed Charges as 6.6 to 1 and 4.3 to 1, respectively. So, however you look at it, the REIT is able to service debt and preferreds issued with ease.
Determining FFO based ROE
First, retrieve the Adjusted Common Stockholder's Equity as calculated ($3,149,540). Then, take the FFO quarterly figure, and multiply by four to annualize it:
Annualized FFO, based on most recent quarterly FFO = $130,409 * 4 = $521,636.
Now, compute the FFO based ROE as the Annualized FFO ($521,636) / Adjusted Common Stockholders Equity ($3,149,540).
FFO Based ROE = $521,636 / $3,149,540 = 16.5%
There is no set acceptable value, but higher is better, when comparing REITs. DLR comes out very high on the scale on this metric.
Before I conclude, in the interest of full disclosure, I want to note that I am not a financial professional, nor am I certified in any way as a financial advisor. I am an independent, individual investor, focusing on dividend-paying stocks exclusively.
In addition to the growth history and favorable REIT metrics, I favor Digital Realty because of the types of facilities the REIT owns -- technology Data Centers. These types of tenants are very "sticky", unlikely to close down or default regardless of the vicissitudes of the economy. In fact, I believe the risk of a significant retrenchment and loss of income from the DLR tenant base is less than would be the case for a typical medical facilities REIT, usually considered to be the safest type of REIT.
I therefore recommend Digital Realty as a REIT investment suitable for an income portfolio, when shares can be acquired at $65 or less, providing a yield near or exceeding 5%. As always, I favor an incremental acquisition approach, particularly in the present environment, with a market decline in progress, with possibly more to come.
I started a position on 10/15/2012 at $65.25. After a quick pop back up (I was a trading genius for a couple of days), the stock has now declined below my initial buy level, as of 10/22/2012. I plan to add to the position upon a decline to the $62 or so range, and will add further upon a decline below $60, with all averaging-down subject to a quick review, to ensure nothing has come to light to change my longer term outlook for the stock.
The REIT is scheduled to report very soon, on 10/26/2012, before the open. The opportunity to add to my position may be coming on that date, or a better than expected report could send the shares back up, out of range.
Disclosure: I am long DLR.