REIT Rankings: Data Centers
In our REIT Rankings series, we introduce and update readers on one of the fifteen real estate sectors. We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We update these rankings every quarter with new developments for existing readers.
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Data Center Sector Overview
Data Center REITs comprise roughly 10% of the REIT Indexes (VNQ and IYR). Within our Hoya Capital Data Center index, we track the five data center REITs, which account for roughly $75 billion in market value: CoreSite (COR), Digital Realty (DLR), Equinix (EQIX), CyrusOne (CONE) and QTS Realty (QTS).
We note the strategic focus of each of the five REITs above. The value of each data center is largely a function of its position along the internet backbone, the physical fiber optic network that links every connected-device across the world. Properties within the backbone are able to provide higher-value network-based "co-location" and interconnectivity services, which command higher rent-per-MW and generally have higher barriers to entry. Properties on the periphery typically provide more ubiquitous enterprise-based services, including storage and cloud-based software applications, and primarily rent these facilities to wholesale customers who pay lower per-SF rent.
Equinix has the highest "quality" portfolio of network-dense assets (roughly 65%) followed by Digital Realty and CoreSite (each roughly 30%). CyrusOne and QTS focus primarily on lower-valued enterprise assets. We also note that Digital Realty and Equinix have a global data center platform while the other three REITs are primarily US-focused. Finally, we note that unlike the other four REITs, EQIX owns less than 50% of the real estate that it leases and thus has slightly different investment characteristics than the other REITs.
Recent Stock Performance
Riding the secular boom in technology over the last decade, Data Center REITs have been a perennially top-performing REIT sector in the post-recession period, returning more than 25% in each of the last two years. The sector underperformed in early 2018 as rising interest rates and a weak 4Q17 sent the sector down as much as 15% on the year. The sector has come roaring back over the last quarter and has regained all of the lost ground this year.
The smaller data center REITs, CyrusOne and QTS, have been the top performers this quarter following strong leasing results amid continued demand from hyperscale customers. QTS has jumped nearly 25% over the last thirteen weeks but remains lower on the year following the unveiling of an unexpected restructuring plan earlier this year.
Recent Fundamental Performance
Following disappointing results in the final quarter of 2017, investors grew concerned that data center demand was waning amid several consecutive quarters of missed leasing expectations. Perhaps aided by corporate tax reform, data center demand has reaccelerated in 2018. Following solid results in 1Q18, 2Q18 generally results topped estimates. The highlight of the quarter was the robust level of leasing activity, which nearly doubled from the second quarter of last year as Digital Realty and Cyrus One both smashed through expectations.
Combined, the five REITs reported more than $182 million in net annualized leasing following a similarly strong $130 million last quarter. We were pleasantly surprised by another quarter of solid renewal rates, margins, and occupancy metrics, which indicate that pricing power may turn more favorable in the second half 2018 as there are signs that incremental demand may be outpacing new supply. We note, however, that leasing and pricing metrics remain very choppy and difficult to compare due to the increased share of activity going towards larger leases to hyperscale providers. Digital Realty continues to provide pricing guidance of "slightly negative" on cash renewals.
Revenues continue to grow a healthy 16% with AFFO per share rising 10% over the second quarter of 2017, which continues to be among the fastest rates of AFFO growth within the REIT sector. Guidance was boosted by Digital Realty, CoreSite, and QTS with full-year AFFO per share now expected to rise 8.3% which appears to be conservative given the strong start to 2018.
Hyperscale cloud providers are responsible for a steadily increasing share of new leasing activity for these data center REITs. Thus, the performance of the sector is increasingly intertwined with the growth of the cloud services divisions of the traditional technology powerhouses including Amazon (AMZN), Microsoft (MSFT), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Intel (INTC), Salesforce (CRM), Alibaba (BABA), and IBM (IBM). The "big three" hyperscale providers, along with hardware providers Intel and IBM, all exceeded revenue expectations in their respective "cloud" segments in the second quarter.
Supply/demand fundamentals were roughly balanced in 2017, but improving occupancy, pricing, and operating margin metrics indicate that fundamentals may improve in further in the second half of 2018. Despite high levels of construction activity in recent years, REIT executives report that supply/demand conditions appear roughly balanced across most markets. Some markets, however, have seen downward pricing pressure from oversupply while several markets are beginning to see signs of tight supply and strong potential for same-store rent growth.
Digital Realty reported an LTM absorption to current pipeline multiple of 2.8x in the United States, a fourth consecutive quarter of improvement following 2.4x last quarter, and a 1.7x average for 2017. Occupancy ticked higher to 91% despite a 21% rise in megawatts commissioned. While the US has seen steadily improving supply/demand conditions, Digital Realty reports slightly weaker demand growth in the European and Asian markets.
Digital Realty believes that barriers to entry continue to develop at the national level in the United States. These barriers include lack of available land and lack of adequate power supply. Other markets, particularly those in California, are also quite difficult to develop because of tight zoning restrictions, high energy costs, and other costly regulation. From this quarter's Digital Realty earnings call:
The data center sector has been prone to oversupply in the past, but demand is rapidly outpacing supply and on current form, we see a greater risk of running out of inventory and missing the opportunity to support our customers' growth than risk of oversupply. We are taking proactive steps to secure our supply chain and replenish our inventory balance.
Notably, last quarter, Digital Realty significantly raised its 2018 guidance for server shipment from 3.5% to 7.5%, an affirmation that demand continues to be relentless for both the public and hybrid cloud. Earnings results from the hyperscale cloud providers beat expectations across the board, providing a strong macro demand tailwind for the data center sector.
Historically, cash rent growth on renewals has averaged less than 3% across the sector. In other words, the performance of these data center REITs has been fueled by external growth while the underlying organic growth metrics have been average at best. Development continues to be the primary means of value-creation for these REITs as internal growth fundamentals remain at roughly inflation-matching levels. The development pipeline remains full at roughly $2 billion, just off the recent peak above 2.3 billion in early 2016.
The furious pace of M&A activity that began in 2016 is expected to continue into 2018. Size and scale have proven to be competitive advantages in the data center space, and these REITs have used acquisitions as a means to stay in front of competitive threats from hyperscale providers. Unlike most other REIT sectors, data centers REITs continue to trade at sizable premiums to Net Asset Value, giving these companies the fuel to grow through acquisitions and consolidations.
As hyperscale has exploded in size and popularity and their applications have become an increasingly viable option for mid-size and larger businesses, the industry dynamics have shifted. Average lease sizes have increased dramatically and rental rates have reflected this shift towards wholesale pricing. While private cloud solutions have also seen steady growth and integration into a "hybrid cloud" model, the general sentiment is that the runway for growth is far longer for the hyperscale model and these providers are expected to take an increasingly larger share of the pie.
Bull and Bear Thesis for Data Center REITs
Data centers are the home to the cloud: the outsourcing of computing processing and storage capacity from one's own device to an off-site data center. The economics of utilizing cloud computing is highly favorable for most consumers and businesses, which has prompted an insatiable wave of demand for data center space. Double-digit annual growth rates are expected over the next decade in IP traffic, storage needs, and mobile computing demand.
Business spending on cloud infrastructure is still in its infancy, as nearly 75% of global IT spending is still on traditional IT. According to IDC, cloud deployment is expected to steadily accelerate over the next decade, and by 2020, more than 50% of IT spending will be on cloud-based infrastructure. The economics of cloud deployments are expected to remain highly favorable for the foreseeable future. Below we outline the five primary reasons that investors are bullish on the data center REIT sector.
A concern for investors has been the emerging power of large-cap technology firms within the data center space. "Hyperscale" providers including Amazon, Google, and Microsoft rent massive amounts of space from data center REITs, but command significant pricing power relative to smaller, individual private or hybrid cloud leases. While REITs and large-cap technology firms currently have a symbiotic relationship, this may not always be the case and in recent quarters, a higher percentage of leasing has come from a smaller number of these power customers. Below we outline the five primary reasons that investors are bearish on the data center sector.
Valuation of Data Center REITs
Before the early 2018 pullback, data center REITs traded at the widest premium of any real estate sector at nearly 30x current Free Cash Flow (aka AFFO, FAD, CAD). Data center REITs now trade at a more attractive 24x forward FCF, a modest premium to the REIT sector average of 21x. Data centers appear more attractive based on our FCF/G metric which incorporates their expected growth rate. Data center REITs trade at an estimated 25-35% premium to NAV. Maintaining this NAV premium has helped to accretively fund their external growth ambitions and maintain a critical cost of capital advantage over competitors.
Within the sector, we see the market places a premium on network-dense portfolios. Equinix trades at the richest valuations, followed by CoreSite and Digital Realty. The smaller wholesale Hyperscale providers trade at discounts to the sector.
Dividend Yield and Payout Ratio
Two years ago, before the 100% rally in share prices, data center REITs were among the highest-yielding REIT sectors. At 2.7%, the sector is now one of the lowest-yielding REIT sectors. Data center REITs, however, pay out just 69% of their free cash flow, leaving them ample capacity to increase dividends or reinvest in growth.
Within the sector, we note the differences in yield for these five REITs. QTS yields a sector-high of 3.7% followed by CoreSite and Digital Realty.
Interest Rate & Equity Sensitivity
Outside of Equinix, which trades more like a technology stock than a REIT, data center REITs are among the more interest-rate sensitive REIT sectors, which is a surprise to many investors. High interest rate sensitivity is a result of the sector's long lease terms and relatively high dividend yields. The low Beta to the S&P 500 (SPY) shows that these REITs are not particularly sensitive to movements in equities.
Within the sector, we note that there are significant divergences in factor sensitivities. Digital Realty and CoreSite are among the most interest-rate sensitive REITs in any sector. Equinix, on the other hand, is among the least interest-rate sensitive and has one of the lowest correlations to the overall REIT index. Investors seeking bond-like characteristics with higher income yields would be better suited with Digital Realty, while investors seeking growth characteristics and lower income yields would be better suited with Equinix.
Bottom Line: Data Centers Come Roaring Back
Following a brutal start to 2018, data center REITs have come roaring back over the last quarter. The perennially top-performing REIT sector delivered strong results in the second quarter. 2Q18 results topped estimates as demand for cloud services has accelerated in recent quarters. Leasing activity nearly doubled from last year, powered by insatiable demand from hyperscale providers.
The growth of the hyperscale public cloud providers, including Amazon, Google, and Microsoft, continues to be a long-term competitive risk. For now, they have a symbiotic relationship with these REITs. The boom in demand for data center space has been met by an equal boom in construction activity. AFFO growth has moderated as competition has heated up significantly since 2014. Supply/demand fundamentals were roughly balanced in 2017, but improving occupancy, pricing, and operating margin metrics indicate that fundamentals may improve in 2018.
We continue to see the most value in the network-dense portfolios including Equinix, Digital Realty, and CoreSite. To see where data center REITs fit into a diversified REIT portfolio, be sure to check out all of our quarterly updates: Apartments, Cell Towers, Manufactured Housing, Net Lease, Malls, Industrial, Shopping Center, Hotel, Office, Healthcare, Industrial, Single Family Rental, Storage, Homebuilders, and Student Housing.
Please add your comments if you have additional insight or opinions. Again, we encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.
Disclosure: I am/we are long VNQ, DLR, EQIX, COR, INTC, AMZN.
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.
Additional disclosure: All of our research is for educational purposes only, always provided free of charge exclusively on Seeking Alpha. Recommendations and commentary are purely theoretical and not intended as investment advice. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. For investment advice, consult your financial advisor.