Dividends & Income Digest: Data Center REITs - The New Tech Sector Juggernauts

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Includes: AMZN, CONE, COR, CTL, DFT, DLR, EQIX, GOOG, GOOGL, IBM, MSFT, ORCL, QTS, T, VZ, WIN
by: Robyn Conti

Summary

Data center REITs are growing, and growing fast, thanks to increased use of the cloud, big data, streaming video and mobile.

Shares in data center REITs have seen big jumps this year. Can that momentum continue?

Seeking Alpha recently reached out to Bill Stoller, who follows data center REITs closely, to get an idea of where this sector is heading.

Data center REITs have become an integral part of the digital zeroes and ones delivered to consumers and enterprise. They connect technology with real estate, offering a location for the storage and transfer of critical information to the masses, whether it's cloud services, big data, streaming video or mobile.

Shares in the six data center REITs combined are up 20% so far this year, outpacing other REIT sectors. Can this sector continue to grow?

Seeking Alpha Senior Editors Michael Hopkins and Robyn Conti reached out to REIT expert Bill Stoller for his observations on data center REITs. Stoller has more than 25 years of experience as a developer of office and industrial facilities, including: general contracting, HVAC/Energy Services projects, homebuilding, site consulting and transactional real estate services. In addition to Seeking Alpha, he also writes for Data Center Knowledge.

The following are his responses to our questions:

Seeking Alpha: What caught our attention about data center REITs are the numbers. The last time we checked, shares in the six data Center REITs combined are up 20% so far this year. You think this sector will continue to outperform in 2016 and beyond - how so? Can these companies meet lofty expectations for growth?

Bill Stoller: I appreciate the opportunity to answer questions regarding data center REITs. If you recall, at the end of last year when you invited me to discuss the REIT sector for SA readers, I suggested that the data center REIT sub-sector would be the top performer for 2016.

The data center REITs are a way for investors to ride the tidal wave of exponential data growth, and the cloud computing paradigm shift, without having to bet on any particular hardware, software or chip manufacturer.

Here is an excerpt of what I wrote in your December D&I REIT Sector preview for 2016:

"Data center REITs operate at the intersection of technology and real estate. The growth drivers include: Cloud Computing, Big Data, Streaming Video and Wireless Data. The names that focus on mainly colocation and interconnection were some of the strongest performers…"

In January 2016, I wrote a Seeking Alpha Top REIT Sector Pick article introducing my Tools4Investing Data Center REIT "DIY Smart Beta ETF" (an equal weight portfolio of the six publicly traded data center landlords).

Notably, Equinix (NASDAQ:EQIX) and Digital Realty (NYSE:DLR), with market caps of $22 billion and $13 billion, respectively, dwarf CoreSite Realty (NYSE:COR), CyrusOne (NASDAQ:CONE), DuPont Fabros (NYSE:DFT) and QTS Realty (NYSE:QTS).

A market cap-weighted view of the sector would mask the ability of the four smaller players to move the needle. Of course, the sector ~20% share price increase during the first quarter exceeded my most optimistic expectations.

I will be listening carefully on the upcoming Q1 earnings calls for earnings growth catalysts, as shares are now a bit frothy. I remain long-term bullish on the sector.

Wholesale Cloud Wins: When data center REITs reported record leasing for Q4 2015 in February, and then continued to announce huge deals during Q1 2016, it became apparent that it was the seismic shift to cloud computing which was responsible for taking down huge chunks of space.

This trend is accelerating as Microsoft (NASDAQ:MSFT), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Oracle (NYSE:ORCL), IBM (NYSE:IBM) and others race to grow, despite the huge public cloud market share of Amazon Web Services (NASDAQ:AMZN).

Large cloud leasing wins boosted shares of DuPont Fabros to first place, after lagging the sector in 2015. Because this REIT mainly operates in three key markets: Northern Virginia, Santa Clara and Chicago, it helped to decipher what was happening with public cloud leasing.

Because of non-disclosure agreements, security considerations, and competitive reasons, data center REITs often do not reveal specific customer names. When DuPont announced that users were existing cloud customers, it helped to narrow the field down to the usual suspects.

Once a decision is made to trust a third-party with valuable data, the customer relationships often grow. In a given quarter or fiscal year, usually 50% to 80% of leasing revenue growth is from existing customers in the data center business. Meanwhile, the amount of data being created continues to double every two years, helping to make data centers recession resistant.

SA: Obviously, the explosion of data and the growth of cloud computing are generating business for data Center REITs. Is there a specific data need or a part of the cloud (private, public, hybrid) that will generate growth for data centers?

Bill Stoller: Yes, to all of the above.

I had a long discussion last week with Jim Kerrigan, a broker/data center expert who carefully tracks all the North American markets. He told me:

"It is ironic that everyone is concerned that the cloud is going to eliminate the need for data center space when in reality the cloud absorbed 40% of wholesale space in 2015, and if the first quarter is indicative of the rest of 2016, it will be closer to 75% for multi-tenant data centers."

The hybrid cloud is where most of enterprise IT is headed. Hybrid architecture is a mix of on-premises data centers with public and private cloud. While new applications are often developed with the public cloud in mind, older applications run in legacy data centers often have a long shelf-life.

Data Center REITs Offer Lower Cost Solutions: Large storage and compute workloads also can be more cost-effective to keep in house. Data center REITs can offer large-footprint solutions where enterprise customers can lease state-of-the-art space more cost effectively than building their own data centers. Operational savings from more efficient cooling solutions and lower wholesale electrical rates can make the decision to lease vs buy easy for many customers.

Leasing also allows capital to be deployed at higher IRR to fund core business initiatives, and some data center REITs also offer outsourcing solutions. CyrusOne recently announced the sale-leaseback of the mega-scale 428,000 SF CME Group (NYSE: CME) Globex data center outside of Chicago.

REITs Facilitate High-Speed Access: Also, keep in mind data center REITs operate "carrier hotels" where telecom networks come together in fiber-dense nodes. Enterprise customers who collocate at these locations can directly connect to multiple networks, cloud service providers, vendors and customers. These cross-connects are secure, and avoid having to transmit data, saving time and money. The global Equinix IBX Platform is the largest of these networks, with Digital Realty (Telx), and CoreSite also cashing in on the lucrative business of leasing cages and cabinets at these valuable locations.

One of the main attractions is low-latency connectivity to public cloud providers, while offering private cloud and colocation leasing options ranging from a single rack up to large multi-megawatt deployments.

SA: How about a specific sector? Is there a specific industry or entity that will drive data center growth? (i.e., Healthcare? small business? Government?)

Bill Stoller: Content providers, streaming media, wireless data and social media, energy and Fortune 1000 enterprise customers are all driving data center growth.

Financial services firms were early adopters of third-party IT solutions, and they lease significant space from all of the data center REITs. The healthcare vertical with its HIPPA requirements, government agencies and civilian contractors are ideal cloud and data center REIT customers. One common thread here would be data center REITs help alleviate IT security and compliance concerns.

While it might seem counter-intuitive to trust somebody else with data, these resilient state-of-the-art facilities can provide service level agreement (SLA) uptime guarantees of 99.999% and higher. In most cases these multi-tenant data centers are a better bet for customers hoping to avoid becoming the next credit card or national security breach headline.

Equinix CEO Steve Smith estimated that there are over 300,000 global enterprises who employ 500 or more people and generate annual revenues of $10 million or more. These types of companies need solutions in multiple markets, spanning countries and continents. It takes global expertise to meet EU and Canadian data sovereignty laws.

SA: It seems at one point the data center space went through a phase of overbuilding. Could that happen again?

Bill Stoller: Today, the scale of the business has narrowed the playing field down to a few savvy players in most markets. The Great Recession also helped to weed out private sector developers.

Digital Realty immediately reined in speculative development after long-time CFO Bill Stein took over the helm a couple of years ago. Because of DLR's huge scale, this helped to rationalize supply/demand fundamentals in most US markets in less than two years.

The data center REIT management teams view ROIC as the key metric. Wall Street has forced the sector to be exceptional allocators of capital, which imposes development self-discipline. Additionally, streamlined construction methods allow for phased developments to provide just-in-time data halls.

There is a lot of dirt moving in Northern Virginia and Dallas. While the demand in those markets is strong, it remains to be seen how long this dramatic spike in cloud-inspired leasing will continue. However, given the scale of these REITs, having a powered shell sit idle in a market for a few quarters isn't a huge issue.

SA: To me this would appear to be a capital-intensive business. And it's competitive. Can these companies continue to grow and prosper given these challenges?

Bill Stoller: Even the smaller publicly traded data center REITs operate on a huge scale. This gives the edge to public REITs and a few large private equity-backed players. There were over a dozen large data center industry M&A deals in 2015, driven by geographic expansion, acquisition of customers and bolstering product and service offerings. I expect this trend will continue after this round is digested.

Iconic REIT patriarch, Sam Zell recently observed that smaller REITs - even those around $1.5 billion market cap - can have a tough time with liquidity. Last quarter was a challenging environment for US equity markets. This was punctuated by a complete lack of IPOs. However, DuPont Fabros, CyrusOne and QTS Realty all successfully floated large secondary stock offerings. Normally, REIT share prices dip on a large secondary offerings, but the share prices stubbornly continued to rise.

SA: What risks should investors consider before investing in this sector, particularly income and/or retired investors who rely on steady payouts to support them?

Bill Stoller: I think when it comes to income or retirement investors and data center REITs, there remains one logical choice which is sector blue-chip Digital Realty. While Equinix is an S&P 500 company, it is not investment grade rated, and has no track record as a dividend paying REIT.

Meanwhile, Digital has a BBB investment grade balance sheet and an 11-year history of having raised its distribution every year since its IPO. Notably, optimism over the Telx acquisition and wholesale leasing momentum has boosted DLR shares prices up to where they are yielding just under 4%. This is more in-line with other REIT sector blue-chips.

SA: Big names in technology are customers of data center REITs. And they include the top cloud players -- Amazon (AMZN), Microsoft Azure (MSFT) and Google (GOOG) (GOOGL). These companies have a lot of cash. Why couldn't they just build their own data centers and cut out these middlemen?

Bill Stoller: You bring up a timely question. It is really a both/and solution, rather than just an either/or situation. Owning a fleet of large, highly efficient data centers is part of the solution. However, with Microsoft Azure/Office 365 and Google Cloud Platform gearing up to do battle with AWS, the Big 3 are all trying to rapidly expand geographically. This is a bonanza for the players with existing powered shell space and entitled land.

Given enough time, the own vs. lease decision might simply come down to some traditional number crunching regarding IRR and capital allocation. However with the public cloud market share competition now in full swing, time is of the essence.

SA: Why do these tech titans rely on a third party for their data center needs?

Bill Stoller: Network density and customer density matters for many high-performance applications like streaming media, software-as-a-service providers and financial services - especially electronic trading.

It might be peachy to have thousands of servers in an Iowa cornfield, where the cost of land and power is low, when you are storing and archiving gobs of data. However, it doesn't really help Netflix (NASDAQ:NFLX) to deliver streaming video with low-latency (lag-time) in densely populated urban areas.

Even if Netflix could deliver the services in a timely manner, say from Los Angeles to Phoenix, paying the cost of transmitting that data can be more expensive than distributing it to households from a data center location in Phoenix. The larger players have also networked and linked their campuses and facilities to attract customers who require multisite solutions.

There are data center landlords like Equinix, Digital Realty (Telx), CoreSite Realty and others, which have made it a point to control valuable real estate which is located in network-dense locations. These are fiber-dense, and cloud provider dense, "on-ramps" to the public cloud. Equinix estimates that 90% of global data traffic passes through its global IBX network.

Customers can connect directly to AWS and Azure at many of these locations, as well as IBM Softlayer, Oracle, Salesforce and Office 365. That connectivity is available at those remotely located hyperscale data centers. Plus, it costs big bucks to transmit huge blocks of data over long distances.

SA: Telecom companies are getting into the data center mix - does this present another competitive threat?

Bill Stoller: I think by now readers have probably figured out that data center REITs are akin to Levi Strauss during the California gold rush days selling picks and shovels to miners who stake claims to digital real estate.

Actually telecom and other network providers were some of the first and largest data center customers. Digital Realty operates over 23 million square feet of data centers, making it by far the largest wholesale data center player. CenturyLink (NYSE:CTL) and AT&T (NYSE:T) are both Top 5 tenants by revenues.

Actually, most telecom companies are in the midst of divesting, or attempting to divest their fleets of owned data centers. Last year, Windstream (NASDAQ:WIN) generated $575 million in cash from a sale-leaseback to TierPoint at ~14.1x EV/EBITDA. Verizon (NYSE:VZ), AT&T and CenturyLink are all shopping their data center portfolios. Another trend is for the telecom companies to abandon all hope of trying to compete with AWS, MSFT and Google for public cloud customers.

SA: We're not sure "location" is a big deal in a virtual world. But we'll ask anyway: Is "location" a selling point for data center REITs?

Bill Stoller: Absolutely. Even data center REITs don't violate real estate's sacrosanct "location times three" rule of thumb. However, many factors influence the ideal solution for a particular data center requirement.

The largest data center markets are: Northern Virginia, New York/New Jersey, Dallas, Chicago, Northern California and Los Angeles. Over 70% of global data traffic passes through the MAE-East hub in Northern Virginia. This is an artifact from the 1990s, when Equinix won the RFP to provide neutral locations for the major telecom networks to hand off Internet traffic.

Secondary markets such as: Atlanta, Phoenix, Denver, Minneapolis, Houston, Portland, Seattle, Detroit and Miami can be attractive to certain industries, but lack the network density of the six tier one markets. Recently Reno, NV, has become a go-to location for some hyperscale projects due to low cost land, power and available water.

Meanwhile, low-latency required for gaming, streaming video and electronic trading may require support from local data center locations. These applications require a network of distributed data centers, including smaller "edge" data centers in tertiary markets. The Internet of Things (IoT), or machine-to-machine communication, is just in its infancy. Automobiles and smart appliances are generating huge amounts of wireless data that must be processed quickly in order to be useful.

Many IT managers prefer to lease space in an off-premises data center located in a reasonable driving distance from an existing owned facility. At the other extreme, a local requirement can become regional or a regional requirement can become national due to the lack of timely availability of sufficient space and power.

SA: Some tech investors may not be familiar with the structure of a REIT. If someone studies an investment in a REIT, especially these data center providers, what should they carefully look at? What metrics are important? What are the risks?

Bill Stoller: The good news for tech investors is that data center REITs combine the best of both worlds. On the REIT side, they must pay out at least 90% of taxable income as dividends, while the prime data center real estate provides a technology-agnostic play on exponential data growth.

EPS vs. FFO and NAV: When it comes to REITs, investors should avoid using the EPS metric. Funds available for distribution (FFO) is the key metric. FFO is a non-GAAP metric, which adds back depreciation and other non-cash adjustments. AFFO (adjusted FFO) adds back maintenance capex and other adjustments to better estimate cash available for distribution.

REITs in the same sector are typically compared by FFO/share, and the NAV (net asset value) of the real estate portfolio, which generally is much higher than book value. I put more weight on the cash flow, and less on the NAV, (which fluctuates widely depending upon real estate cap rate assumptions).

ROIC - The Secret Syrup: What I shared with you and Seeking Alpha readers in December still holds true today for REITs in general.

"I think that it is critical to identify the equity REITs that can grow their FFO/AFFO per share (even) in a rising rate environment. In many cases, these will be well-managed companies with strong balance sheets and the ability to generate outsized returns through redevelopment and new development. In other cases, it will be the ability to grow same-store rents through contractual rent increases and re-leasing spreads."

In 2015, self-storage and multifamily apartment REITS were top performing sectors because of the ability to continue driving higher occupancy and rental rates at the same time. Owning prime Class-A/A+ retail real estate can generate high redevelopment returns.

However, data center REITs are the poster-child when it comes to outsized new development returns.

Data center REITs which are able to substantially expand in existing powered shells, and adjacent land parcels are the ones who have shown they can consistently deliver 15%-19% ROIC. This helps explain why CoreSite, CyrusOne and QTS Realty have performed so well.

By comparison, more traditional real estate sectors such as retail, office, apartments, and industrial, high-single digit development yields are viewed as highly attractive. Meanwhile, Digital Realty and DuPont Fabros are "only" delivering ROIC of 10%-12% and 11%-13%, respectfully, for new projects. Equinix won't allocate capital to a new market if it doesn't pencil out at a 30% yield or more at full build-out.

Data center REITs can offer very high FFO growth, which helps to fund a growing dividend and drives the outstanding total returns. Last year CoreSite Realty was the No. 1 performing equity REIT regardless of sector. CoreSite reported year-over-year FFO growth of 31 percent and grew the annual dividend by 26%.

CyrusOne hosted an Investor Day earlier this year, where they revealed a cogent plan to double the enterprise in five years. I analyzed that for SA readers in a recent focus article.

Risks: Of course, there is always the rhetorical argument that a technology shift will render existing servers and building obsolete. That discussion is above my pay-grade.

On the facility side, the laws of thermodynamics, and location of undersea communication and fiber nodes appear to be fairly stable. However, the availability of power and water is always a potential risk. Those pesky real estate taxes, and other forms of taxation are arbitrary and subject to change as well.

I believe the greatest risk is simply the run-up in share prices. At the end of the first quarter, only QTS Realty and Cyrus One were trading below analyst consensus 12 month price targets.

The second level of risk would be if the wholesale data center model is only a Band-Aid solution over time, as public cloud providers continue building out an owned footprint. However, this will be determined a few years down the road. Wholesale leases typically have 7-10 year initial terms, and the ability for these REITs to provide "overflow" real estate and growth flexibility for hyperscale cloud providers may never truly go away.

Even Jeff Bezos does not believe that AWS, poised to do $10 billion in revenue this year, is the answer for all of corporate America's computing needs. I believe there will be plenty of pie left for data center REITs to profitably grow by providing hybrid cloud solutions.