Bill Stoller Positions For 2017: Why Data Centers Should Continue To Outperform Broader REIT Sector

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Includes: AMT, AMZN, CCI, CONE, COR, DFT, DLR, EQIX, GOOG, GOOGL, INXN, MSFT, NSA, QTS, S, SBAC, STWD, T, TMUS, VZ
by: Bill Stoller

Summary

REITs, and data center REITs specifically, we're flying high for most of 2016. However, talk of a rising interest rate environment grounded these investments late in the year.

Bill Stoller thinks REITs can rebound next year.

He also suggests data center REITs may represent a GARP (growth at a reasonable price) opportunity in 2017.

Stoller shares his outlook on the REIT sector for the New Year.

Data center REITs and REITs in general were flying high in 2016. Then talk of a jump in interest rates surfaced, and these investments lost favor, fast.

But the knee-jerk move may have been an overreaction. Bill Stoller, who covers the REIT space including data center REITs, suggests a fast-growing economy and an increasing need to support cloud and data needs should help propel these REITs back into the good graces of investors. And as data demands for technology companies continue to climb, these tech titans will increasingly rely on data center REITs for help. In fact, many high-speed on-ramps to the public cloud giants are operated by data center REITs.

Stoller spent some time assessing the state of REITs, including data center REITs, with editor Michael Hopkins:

Michael Hopkins (MH): First, a question on REITs in general. These investments have been attractive to investors looking for yield. With interest rates on the rise, and a talk about a rotation out of dividend stocks, have REITs fallen out of favor?

Bill Stoller: REITs quickly fell out of bed after the election result calculus quickly translated into a spike in the 10-year US Treasury interest rate. Mr. Market tossed REITs out the window in a knee-jerk reaction to a rising interest rate environment in 2017. However, the realization began to hit home that a faster-growing GDP and US business expansion is good for landlords.

Commercial real estate is an asset class that has traditionally been viewed as a hedge against inflation. Additionally, as the selling continued the negative sentiment resulted in some attractive yields being offered by some high-quality REIT names.

(MH): How about data center REITs? The sector was flying high the first half of the year and now is down. What's the 2017 investment case for this niche?

(Bill): While data center REIT shares are trading down from their July 2016 all-time highs, they are still up considerably for 2016, with an average return of ~25% YTD.

In fact, I recently alerted SA readers about an inflection point when CoreSite Realty (NYSE:COR) shares dropped ~3.5% on Dec. 1, 2016, on the same day CoreSite management announced a 50.9% increase for the quarterly distribution! Mr. Market had over-reacted and tossed out the million dollar baby with the proverbial bathwater.

During the following week, the data center REITs began to rally. Notably, CyrusOne (NASDAQ:CONE) spiked on good news, which helped to confirm that the irrational sell-off was coming to an end.

During December, investors began to realize that the big picture for the data center REITs had not changed regarding the exponential growth of steaming video, wireless data and enterprise paradigm shift to cloud computing.

Notably, Equinix (NASDAQ:EQIX) and Digital Realty (NYSE:DLR), with market caps of $25.3 billion and $15.2 billion, respectively, still dwarf CoreSite Realty, CyrusOne, DuPont Fabros (NYSE:DFT) and QTS Realty (NYSE:QTS). The larger balance sheets can assist with M&A opportunities, but the smaller data center REITs have an easier time moving the growth needle.

In a nutshell, data center REITs generally still represent a GARP (growth at a reasonable price) opportunity going into 2017. I'm still bullish for the long-term prospects, and I don't see a better opportunity in the REIT sector for long-term investors. I plan to write them up individually in a Top Picks article scheduled for early January.

(MH): How do you make the case for data center REITs to the traditional tech investor? The risks? The opportunities?

(Bill): It is hard to pick technology winners. The data center REITs are a way for investors to profit from the exponential growth of data and the paradigm shift of cloud computing, without having to bet on any particular hardware, software or chip manufacturer. Data center REITs are a way to profit from exponential data growth while remaining agnostic regarding the flavor of the year for storage, compute and networking solutions.

In the past, I have used Levi Strauss selling supplies to the gold miners as an analogy to the data center REITs providing space, reliable power and security to help fuel the digital land grab of the planet-scale cloud service providers.

Frankly, there are very few enterprise companies that can justify building a new on-premises owned data center. The rationale used to justify the construction of older data centers is no longer valid in many situations. It is a widely held belief that the end-state for most enterprise IT stacks will be a hybrid cloud architecture, which integrates shared public and dedicated private clouds with legacy owned data centers. This drives leasing for the six data center REITs.

The pace of innovation being announced by the hyperscale public cloud providers is just staggering. Amazon Web Services launched over 1,000 new innovations for its public cloud in 2016. Silicon Valley start-ups can often utilize public cloud providers to test and scale applications and run their businesses entirely in the cloud. New applications for enterprise can be launched in a similar fashion. However, as applications grow it can also become more cost effective to lease wholesale or colocation space.

The data center REITs can all benefit from leasing space to Amazon (NASDAQ:AMZN) and AWS, Microsoft (NASDAQ:MSFT) and Microsoft Azure, and Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) and the Google Cloud Platform. This can be large wholesale deployments and/or by providing high-speed on-ramps to multiple public cloud providers for their colocation tenants. IBM (NYSE:IBM) Softlayer and Oracle (NYSE:ORCL) have also been major players, taking down large chunks of space from third-party data center landlords.

(MH): Is the data center REIT space ripe for consolidation? Look at the recent deal between Equinix and Verizon (NYSE:VZ).

(Bill): There were over a dozen M&A transactions during 2015 spread among the six data center REITs. The activity slowed down a bit during 2016. One notable exception was Equinix and Digital Realty working together to reel in TelecityGroup. Both Equinix and Digital Realty are S&P 500 companies with the ability to access capital markets to get large deals done quickly.

Equinix has grown through about a dozen M&A transactions during the past 19 years. The acquisition of TelecityGroup boosted Equinix's market share as the dominant data center operator focused on connectivity in Europe. Digital was able to opportunistically purchase several Telecity data centers and related business operations to help Equinix satisfy European Commission divestiture requirements.

The $3.6 billion Verizon Americas data center acquisition announced toward the end of this year was by far the largest deal: Equinix Pulls The Trigger On Verizon Data Centers - Now What? Notably, Equinix purchased the Americas assets from Verizon, who had been looking to sell its entire portfolio. Equinix had already been working to integrate Bit-isle (Japan) and Telecity (EU and UK), but still has ample resources to focus on the closing and integration of the Verizon portfolio located in North and Latin America.

DuPont Fabros had been unsuccessfully attempting to lease up the balance of its Northern New Jersey NJ1 data center for years. The price of power and other high operating costs make this market unattractive to larger wholesale customers. The NJ1 campus had already been written down by DuPont, allowing them to sell the property to QTS Realty Trust at a discount without booking a huge loss.

QTS picked up a high-quality facility with existing tenants, which QTS is retrofitting it to lease in smaller increments to colocation tenants. Buying infrastructure-rich facilities at a discount is part of the QTS "secret sauce."

Those deals were the exception for 2016, as all six REITs primarily chose to expand by buying land and existing building shells for new development. Additionally, CyrusOne was able to structure a 15-year sale-leaseback of the CME Group Globex data center outside of Chicago, and acquire land for expansion.

(MH): What data center REITs are an acquisition target or possibly targeting acquisitions?

(Bill): Looking forward to 2017, Amsterdam-based InterXion (NYSE:INXN) is a connectivity-focused data center operator which could be an acquisition target for one of the US REITs, (other than Equinix due to EU competition rules). However, as a practical matter the data center REITs are deploying new capital at mid-to- high teens ROIC for expansions and ground-up development. This makes it far more difficult for management to justify paying high EBITDA multiples to acquire an existing business.

There are privately held data center operators rumored to be for sale, but the REITs can build less expensively in many markets. One exception could turn out to be Vantage Data Centers, which owns a large portfolio of wholesale data centers in high-barrier to entry Santa Clara, CA, in the Silicon Valley. This is a market where office/industrial building are typically bought and demolished to build new ground-up data centers.

I recently interviewed Iron Mountain (NYSE:IRM) data center executives for Data Center Knowledge. IRM has an 83 acre campus underway in Northern Virginia, its first major US development in a Tier 1 market. SVP Mark Kidd expressed the need for Iron Mountain to scale its data center operation to be competitive. This could involve a strategic acquisition in the future. Iron Mountain is looking to leverage its global brand for information storage, tape back-up, and disaster recovery, with an evolving Iron Cloud offering designed to appeal to government and enterprise customers focused upon security and compliance.

(MH): Data center REITs, and other REITs such as your "REIT landlords," work within tech in numerous ways, from cloud computing to supporting e-commerce. Why watch this space?

(Bill): Michael, the data center REITs and "REIT landlords" you are describing were part of a hypothesis I proposed at the end of 2015. I felt there were profits to be made investing in REITs which can support AWS public cloud growth and/or Amazon.com e-commerce order fulfillment, from supply chain through package delivery. Investors could essentially piggyback on the growth of Amazon by owning shares in the REIT landlords most likely to benefit from these trends.

I recently looked back at the results in Amazon Is Growing Like A Weed: Cash-In On REIT Landlords - 2016 Recap. The industrial REITs own facilities leased to fulfillment centers, supply chain warehouses, third-party logistics companies and smaller infill "last mile" package delivery options. The six companies I identified averaged a total return in excess of 35% for 2016 YTD. The six data center REITs averaged close to 25% total return, despite the sell-off during the second half of 2016.

(MH): Why don't these tech behemoths just cut out the REIT middleman and do these activities on their own?

(Bill): Owning and operating data centers is a capital intensive business. Given the current US tax code owning corporate real estate in a REIT allows for shareholders to receive a larger chunk of free cash flow in the form of dividends. REITs are a logical "home" for well-located Class-A (modern) real estate leased to creditworthy tenants.

However, another part of the answer has to do with allocating the capital. If Amazon doesn't have a better use for cash than owning real estate, why are the AMZN shares trading at such high multiples? The same could be said for many of the other technology names that can generate higher ROIC and stock multiples by investing in core business initiatives.

(MH): But doesn't Microsoft have cash to burn. Why would they lease?

(Bill): Leasing from a trusted third-party vs. owning is a time-to-market advantage that the data center REITs can provide. They own large powered shells, and entitled land in strategic locations in key data center markets. Google Cloud Platform, Microsoft Azure, IBM/Softlayer, Oracle and others are trying to offer enterprise customers a better mousetrap, in order to try and earn market share away from Amazon. One way they can compete is to provide cloud services with lower latency, closer to the end user. Speed to market is the reason Microsoft was a huge data center lessee in 2016.

Additionally, there are special cases where Equinix, CoreSite, Digital Realty/Telx, and others can provide access to hundreds of customers located in carrier hotels. These are network dense and cloud dense campuses which just can't be replicated. They are often one-off iconic facilities located at the nexus where legacy fiber optic backbones intersect. During the past decade they have evolved into high-speed "on-ramps" to the public cloud. Equinix estimates that 90% of global data traffic passes through its global IBX network.

Data center REITs receive monthly recurring revenues from interconnections at these locations, which happens to be a high margin business. Cross-connections can be between tenants in related industries like content/media, or ports to cloud service providers.

(MH): Wireless tower REITs - are they an overlooked sector? What REITs stand out in this area?

(Bill): I think that telecom investors and analysts are still the main drivers for American Tower (NYSE:AMT), Crown Castle International (NYSE:CCI), the two REITs and SBA Communications (NASDAQ:SBAC), which recently announced that it would be converting into a REIT. Since SBAC does not currently pay a dividend, it rarely gets on the radar screen for dedicated REIT investors.

Wireless tower REITs offer a shared infrastructure solution to the wireless carriers in a given market. In the US, the Big 4 carriers: Verizon, AT&T (NYSE:T), Sprint (NYSE:S) and T-Mobile USA (NASDAQ:TMUS) account for about 90% of revenues. In other countries, there are usually three or four dominant wireless carriers.

Crown Castle owns a large footprint consisting 100% of US towers as well as fiber optic networks and small cells in many urban areas. I view CCI as a solid dividend growth stock for investors to consider with a CAGR of ~7% per year and a distribution currently yielding 4.34%.

American Tower and SBA Communications both operate internationally in many markets which can offer higher constant currency growth rates than the more mature North American markets. However, the strong US dollar means that AFFO growth can get dinged by FX headwinds. Investors in AMT and SBAC have historically looked to price appreciation for the majority of total return. American Tower currently pays a well-covered quarterly distribution currently yielding 2.17%.

(MH): What is your highest conviction picks - or pick - among REITs other than data center REITs?

(Bill): I am still bullish on self-storage REIT National Storage Affiliates (NYSE:NSA), despite generating ~25% price appreciation for investors 2016 YTD. NSA offers investors GARP, and currently pays a distribution yielding 4.48%. If the safest dividend is the one that has recently been raised, NSA has bumped its quarterly distribution multiple times since its 2015 IPO.

In a rising rate environment, commercial mortgage lenders Starwood Property Trust (NYSE:STWD), and Blackstone Mortgage Trust (NYSE:BXMT) are two names for income-focused investors to consider. Both of these commercial mREITs are well-managed by sponsors with deep pockets and relationships. However, my main reason for mentioning them here is they both own portfolios which predominately consist of floating rate loans. These two REITs benefit from rising interest rates, and an expanding economy.

(MH): Any additional considerations you would like to share with readers as they ponder their REIT investing strategy in 2017 and beyond?

(Bill): Yes. The election in November has created quite a stir in the markets. However, markets hate uncertainty and President-elect Trump has demonstrated that he can be impulsive and unpredictable. This is a situation which may result in some choppy trading, especially during Q1 2017.

The big picture for most equity REITs is that rising rates will create some near-term headwinds. However, the REITs that are able to grow FFO/AFFO per share the fastest will continue to outperform on a relative basis in a disciplined rising rate environment.

Healthcare REITs and net-lease REITs with longer lease terms are generally are viewed as being bond substitutes, and will be most sensitive to rising rates. Notably, the contractual rent bumps, and ability to sign new leases at higher rates, plus growth through accretive acquisitions, can make these REITs better choices than bonds for investors who need income.

Macro areas to watch carefully: A massive Trump infrastructure stimulus plan could overheat the economy and cause the Fed to become hawkish. Rising rates will also cause the Federal deficit to rise, which could also fuel inflation going forward. However, if Congress does not agree to the cut taxes, and raise spending for infrastructure plan, it could help moderate Fed rate increases planned for 2017.

The latest Fed data revealed low unemployment and accelerating GDP growth. Janet Yellen said last week that she intends to serve out her full term as Fed chairperson. The timing and number of future rate increases will remain "data dependent" under her watch. This is a time where having some dry powder and patience may pay off for REIT investors.

I relentlessly hunt for diamonds in the rough and rising stars, in addition to closely following data centers, covering REIT blue chips and breaking news. Please consider following me as a Seeking Alpha author if you would like to be notified when my future articles are published.