Wait For A Drop Before Buying This 3.8%-Yielding Data Center REIT
Summary
- Digital Realty Trust is a fast-growing data center REIT.
- The REIT has international exposure, a strong customer base and operates in an attractive growth industry.
- Digital Realty Trust has seen strong FFO/share growth in recent years as its data center business took off, yet has maintained a conservative FFO payout ratio.
- Shares are on the expensive side, though, reflecting investor expectations of above-average FFO/share growth going forward. I'd wait for a drop before buying.
- An investment in DLR yields 3.7 percent.
Digital Realty Trust, Inc. (NYSE:NYSE:DLR) is a promising data center REIT set to profit from strong growth in emerging tech sub-sectors such as machine learning and virtual reality, but I believe shares are a little bit on the expensive side now. Investors already price in a good amount of FFO/share growth going forward. Though the REIT operates in a growth industry and has grown FFO/share at good rates in the past, I think income investors may want to wait for a drop before buying. An investment in Digital Realty Trust yields 3.7 percent.
Like most real estate investment trusts, Digital Realty Trust's share price has trended down in the last several months as investors digested yet another interest rate hike on the part of the Federal Reserve and rotated out of the high-yield sector. Higher interest rates tend to be viewed as a negative for REITs as their yields become less competitive in a rising rate environment.
Digital Realty Trust's share price has dropped 5.4 percent this year. That being said, though, I still think the REIT's shares are on the expensive side.
Source: StockCharts
Digital Realty Trust - Business Overview
When investors read about real estate investment trusts, they tend to think about residential or traditional commercial REITs, companies that invest in brick-and-mortar properties such as offices, hospitals, skilled-nursing facilities, shopping centers, retail space and industrial real estate. However, the REIT universe also includes other properties that produce recurring cash flow, for example data center REITs.
Data center REITs like Digital Realty Trust provide space for computer servers and network equipment that are at the heart of today's technology-driven economy. Data center REITs play a crucial part in hosting and maintaining IT-infrastructure that many other businesses in turn rely on.
Data center REITs typically consist of four elements: A building shell, electrical systems, mechanical systems and site work.
Source: Digital Realty Trust Investor Presentation
The key thrust of the investment thesis is that Digital Realty Trust is at the heart of the ongoing tech revolution. Whether its machine learning (a.k.a. artificial intelligence), the internet of things, virtual reality or self-driving cars, Digital Realty Trust faces multiple positive catalysts for growth.
Source: Digital Realty Trust
Global Reach And Strong Customer Base
Digital Realty Trust has 205 data centers in its portfolio representing more than 32 million rentable square feet. The company has a data center presence in twelve countries, but North America is Digital Realty Trust's core market representing 80 percent of annualized base rent. Europe is Digital Realty Trust's second most important market, reflecting 15 percent of contractual rents. Asia comes in third, accounting for 5 percent of annualized base rent.
Source: Digital Realty Trust
Digital Realty Trust is a first-class data center REIT that has attracted high-quality clients for its data center properties. Tenants include IBM, Facebook, Oracle and a lot of other high-profile tech companies. I value Digital Realty Trust's customer base highly because large, deep-pocketed tech companies are unlikely to go out of business during the next recession.
Source: Digital Realty Trust
Investment-Grade Rated Balance Sheet
Digital Realty Trust has a strong balance sheet and investment-grade credit ratings from major credit rating agencies.
Source: Digital Realty Trust
Digital Realty Trust has a moderate degree of debt sitting on its balance sheet (relative to its market capitalization of ~$22 billion), most of which is unsecured debt (~99 percent).
Source: Digital Realty Trust
As far as debt maturities are concerned, the data center REIT has no significant debt repayments to make in 2018 and 2019. Debt maturities will become more of an issue in 2020 and 2021, though, when the company will need to refinance a combined $3.5 billion.
Source: Digital Realty Trust
Strong FFO Growth And Good Dividend Coverage
Digital Realty Trust has seen strong growth in recent years, thanks to the increasingly widespread use of the internet, smart phones and Social Media.
From 2006 to 2018 (including guidance for this year), Digital Realty Trust has produced ~12 percent growth in FFO/share each year. This performance period includes the Great Recession which was triggered by the financial crisis in 2007. Digital Realty Trust has widely outperformed its REIT peers in terms of FFO/share growth, which is the primary reason why shares today sell for a rich FFO multiple.
See for yourself.
Source: Digital Realty Trust
Taking a look at Digital Realty Trust's dividend coverage stats reveals that the company has not only grown FFO/share, but also maintained a rather conservative payout ratio over time.
Digital Realty Trust has consistently overearned its (growing) dividend rate with both core FFO and adjusted funds from operations.
Here are Digital Realty Trust's core FFO, AFFO and going dividend rate in each of the last eleven quarters.
Source: Achilles Research
Digital Realty Trust's AFFO payout ratio averaged only 69 percent in the last eleven quarters, making the dividend relatively low-risk. Hence, Digital Realty Trust has a considerable margin of dividend safety and a lot of room to grow its dividend going forward.
Digital Realty Trust has raised its dividend in lockstep with growing funds from operations in the last several years. The data center REIT just raised its quarterly dividend payout from $0.93/share to $1.01/share, reflecting an increase of 8.6 percent.
Here's Digital Realty Trust's dividend growth trend.
Guidance, Valuation And Entry Yield
Digital Realty Trust has guided for core funds from operations to fall into a range of $6.50-$6.60/share in 2018 (previous guidance called for FFO/share of $6.45-$6.60). Based on this guidance, Digital Realty Trust's shares cost income investors ~16.5x 2018e core FFO. This is a little bit on the expensive side, in my view, and a reflection of expected above-average FFO/share growth in the next several years. Based on today's share price of $107.80, an investment in DLR yields 3.7 percent.
Risk Factors Investors Need To Consider
Digital Realty Trust is heavily dependent on the U.S. market and on U.S. tech companies, which makes the company vulnerable to a U.S. recession or a sector downturn in tech. On the other hand, Digital Realty Trust's properties are state-of-the-art and house crucial IT infrastructure, which limits downside risks. The biggest risk at this point, in my view, is that the company won't be able to maintain high double digit FFO/share growth rates in the future, which would likely cause the valuation multiple to contract.
Your Takeaway
There is a lot to like about Digital Realty Trust: The data center REIT has an international portfolio of data center properties, which helps reduce dependence on the U.S. market. The company also counts the best IT companies in the world as its tenants. Digital Realty Trust has grown FFO/share at a fast clip in recent years, and growth drivers such as artificial intelligence and self-driving cars could sustain the momentum going forward.
Since Digital Realty Trust has a conservative payout ratio below 70 percent, the data center REIT has plenty of room to further grow its cash dividend.
On the flip side, Digital Realty Trust is no longer a bargain as investors are already baking above-average FFO/growth into the REIT's valuation. Though investors will likely continue to see strong dividend growth over the short haul, the valuation surely is elevated and leaves little room for error. I'd wait for a drop below $100 before gobbling up shares for my income portfolio.
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