Data Center Overview
Data Center REITs acquire real estate and build servers that offer data storage services. The costs associated with these REITs beyond the actual real estate are building and maintaining the equipment that is needed such as the building shell, cooling systems, and electronic systems. The largest cost of building these data centers are the electronic equipment. The REITs that will be compared within the data center peer group are CoreSite Realty (NYSE:COR), Digital Realty Trust (NYSE:DLR), DuPont Fabros Technology (NYSE:DFT), Iron Mountain (NYSE:IRM), CyrusOne (NASDAQ:CONE), QTS Realty (NYSE:QTS), and Equinix (NASDAQ:EQIX). Below is a graph that displays the one year return of the different REITs in the peer group with COR being the best performer and IRM being the poorest.
Differentiated Service Offerings
The REITs within this peer group differentiate themselves through their service offerings. For example, DLR and COR provide interconnection services which quickly allow companies to securely connect with their partners and network providers. In contrast, DFT is a pure play wholesale provider. Furthermore, QTS and EQIX differentiate their focus by offering their service through a global platform. The data centers also vary in the extent they offer cloud services such as SaaS and IaaS. Additionally, these companies differ in the security services that are offered at their centers. As the data storage industry grows, customers will demand higher strength security which is another way that these companies can differentiate themselves from one another. The differentiated service offerings are how these companies gain a competitive advantage and attain new leases. Due to the variety of services offered, some customers are not exclusive in the leases they sign with these centers and choose to diversify their needs among the different companies.
The main reason that these REITs have been outperforming has been due to the large increase in internet traffic and the digital economy in the last decade. Below is the growth trajectory of the industry drivers from 2015-2020.
This data was modeled by Cisco research and displays the expectation of exponential growth in the coming years. As traffic picks up, companies will need to ramp up the servers they need to keep up with the storage demand of managing higher traffic. This indicates that the data center subgroup will be poised for increased growth in the coming years. However, a threat in this industry is that the large companies that lease these data centers are beginning to build their own data centers to house their data storage needs. Although this is harmful to the industry, the demand trajectory is more than enough to compensate for the IT vertical integration of those companies.
YTD Subsector Performance
Since the demand for data storage has grown, these data center REITs have been outperforming other REIT sub sectors as well as the S&P 500. Two portfolios were created to compare the performance of data center REITs with other equities. One portfolio represents an equal weight and the other represents a market weight of the data center peer group. The performance of these portfolios were compared to the S&P 500 (NYSEARCA:SPY) and the Vanguard REIT Index (NYSEARCA:VNQ).
While DLR and EQIX held almost 70% of the weight in the market weight portfolio, the market weight portfolio performed better than the equal weight portfolio by almost 100bps. Furthermore, data center REITs have been beating the market by more than double digit percentage points. Additionally, data center REITs have been greatly outperforming the REIT index that has been beaten down due to the recent sell off of retail REITs. The five year performance of the portfolios and the benchmarks display the same story as data center REITs have been outperforming.
Due to the length of leasing terms in the data center space, the concentration of customers is noteworthy. Within the peer group, DLR, IRM, EQIX, and QTS are the only companies that operate outside of the United States. The other companies derive 100% of their revenue within the United States. The revenue is broken down by geography below. Interestingly, QTS, followed by EQIX, are by far the most geographically diverse which also means they are the most prone to global and country specific systematic risk. The other REITs, COR, CONE, and DFT, are only subject to domestic systematic risk.
Another important thing to analyze is the concentration of the tenant profile. A graph that highlights the makeup of the top ten tenants for each REIT as a percentage of total revenue is displayed below. Almost all of the REITs in the peer group do not have an issue with tenant diversity. However, DFT's 87% concentration in its top 10 tenants could be dangerous if the company experiences issues with lease renewals.
Credit and Analysis
To compare the debt maturities of the peer group, each individual company's debt maturities were laid on a graph extending from 2017 to 2023 displayed below. To normalize for the size of the companies, the debt maturities were taken as a percentage of total long term debt. None of the REITs in the peer group had any LT debt due in 2017. The debt maturities are moderately spread out and do not pose an immediate concern. However, it is important to note these facts: COR has 42% of its LT Debt due in 2019, DFT has 42% of its LT Debt due in 2021, QTS has 53% of its LT Debt due in 2022, and CONE has 62% of its LT Debt due in 2022.
Additional credit metrics are displayed below. The leverage ratios among the peer group do not vary greatly other than IRM's relatively high leverage ratio. As for Debt/FFO, COR has the best metrics while CONE and IRM have the poorest. COR also has the highest interest coverage ratio while EQIX and IRM have the lowest. EQIX and DLR have the best credit rating with the latter being the only investment grade REIT in the peer group. It is important to note that while COR is not currently rated by any rating agency, it has a strong credit profile compared to its peer group.
Public Comps Analysis
To conduct the public comps analysis, P/FFO was used as the leading indicator of the current stocks valuation and is compared alongside with dividend yield, FFO growth, and P/B. In the peer group, IRM demonstrates that it has the best value on the basis of its P/FFO multiple and dividend yield. Although this looks attractive compared to the other REITs in the peer group, it could be due to the fact that IRM has had underperforming returns compared to the peer group. Since the yield and multiple are both calculated as function of the price, IRM could be a value trap given its underperformance and FFO growth trajectory. EQIX has the highest multiple and lowest yield, but also has been performing best in terms of FFO growth. In terms of P/B, QTS has the best and COR has the poorest.
Data center REITs have been outperforming not only the REIT index, but the S&P 500 as well. It is a REIT Subsector that is poised for large growth in the coming years. Although it does not provide yields as high as some that are observable in other REIT subsectors, it provides capital gains appreciation that is higher than most REIT subsectors. Furthermore, it is one of the most resilient REIT subsectors as observed during the 2008 financial crisis. With big data growing faster than we can keep up with, it would be wise to hold one of these REITs in a portfolio for the long term.
Disclosure: I am/we are long COR. 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.