3 Data Center REITs For Income Generation

|
Includes: CONE, COR, DLR
by: Valuentum
Summary

REITs have rallied more recently due to an increasingly dovish tone being taken by the Fed as it relates to the current trajectory of interest rate hikes.

Cash-releasing spreads for data center REITs are expected to decline in 2019 as releasing rates become increasingly dependent on moves made by large cloud operators.

The top tier of hyperscale data center operators will only grow in terms of influence over data center landlords in coming years.

Let's take a look at three intriguing data center REITs and their income generation potential.

Image Source: Paul Sableman

By Valuentum Analysts

Introduction

In its fourth quarter earnings report, Digital Realty Trust (DLR) reiterated the guidance it released earlier this year, which brought with it meaningful implications for the data center REIT space. Shares of Digital Realty and a number of its peers have since rallied as a result of an increasingly dovish tone being taken by the Fed as it relates to the current trajectory of interest rate hikes, but the fundamental concerns raised by the REIT's guidance remain in place.

Digital Realty's guidance for 2019 included expectations for a high single-digit decline in rental rates on renewal leases on a cash basis and core funds from operations (FFO) guidance of $6.60-$6.70, the latter of which came in below the market’s expectations. However, cash-releasing spreads being expected to decline in 2019 is indicative of the pricing environment for wholesale data center capacity across the industry as releasing rates become increasingly dependent upon moves made by large cloud operators such as Amazon (AMZN), Apple (AAPL), and Alibaba (BABA).

According to the Cisco Global Cloud Index report, hyperscale data centers will account for ~53% of all installed data center servers by 2021, which is a material increase compared to an estimated ~38% at the end of 2018, and such a concentration makes the current 24 global hyperscale operators of high importance to data center landlords such as Digital Realty. Fortunately, for such landlords, however, is the generally impressive credit quality of these operators and the long-duration leases that help to mitigate the negative impact of poorer pricing power.

REITs are also inherently sensitive to changing interest rates. Because an investor’s required return will always be a spread above the risk-free rate, cap rates and interest rates will be tied together. In periods of rising interest rates, for example, property values can be expected to fall to reflect the higher required rates of returns by investors, all else equal. In periods of falling interest rates, property values can be expected to rise to reflect lower required rates of returns by investors, all else equal. In the most general sense, the real estate markets and interest rate cycles are inextricably linked and inversely correlated for this very reason.

In addition, many investors have used REITs as a substitute for bonds in their income portfolios, and higher-yielding alternate opportunities brought about by increased interest rates may impact their decisions to keep holding these positions. In this light, it is only reasonable to expect some investors to shift out of REITs as their individual interest rate thresholds are breached and alternate higher-yielding opportunities are preferred. However, in the vast majority of cases, retaining diversified exposure to REITs in most portfolios is still practical and prudent for many types of investors. The asset class shift may be minimal.

As it relates to the dividends of REITs, we highlight the inherent risks of the capital market dependence of their payouts continuously to ensure investors are aware of their inorganic nature. Here's what we have to say about the situation in each REIT dividend report:

Potential Weaknesses

Real estate investment trusts pay out 90% of annual taxable income and therefore are unable to meaningfully reinvest internally-generated funds, resulting in external capital-market dependence. The weak internal cash-flow retention of most REITs translates into poor raw, unadjusted Dividend Cushion ratios, which could become severe during the depths of the real estate cycle. Even though a REIT’s operating cash flow may be robust, the lack of cash accumulation on the balance sheet and the massive debt needed to purchase/develop new properties can become restrictive. The adjusted Dividend Cushion ratio, accounts for expectations of continued access to the capital markets, which while “normal,” cannot be guaranteed in times of tight credit.

With that in mind, let's take a look at three intriguing data center REITs worth considering for income generation.

CoreSite Realty (COR) - Dividend Yield: ~4.7%

Image Source: CoreSite Realty Presentation

CoreSite Realty owns, operates and develops data centers which house networking, storage, and communications technology infrastructure. It also offers collocation and interconnection solutions for networks, cloud services, and industry solutions. The firm was founded in 2001, and is headquartered in Denver, Colorado.

Generally speaking, we like the idea of owning data centers given the secular trends in the ever-evolving tech landscapes as cloud and hybrid IT strategies continue to gain momentum. Concerns regarding releasing spreads have cropped up as hyperscale data center tenant concentration is expected to increase. The company's exposure to larger entities could be better, as approximately 30% of total revenue is generated from Global 1,000 firms. We would like to see the REIT add stability to its business by capturing business on the higher end of the enterprise scale. However, it is worth noting the growing negotiating power of companies on the higher end of that spectrum.

CoreSite Realty has a diverse and growing customer base. It ended the third quarter of 2018 with 1,350+ customers, up from ~760 at the end of 2011. Its leverage ratios are solid for a REIT (net principal debt/LQA adjusted EBITDA was 3.5x as of June 2018), and it does not have any debt maturities until 2020, giving it some room to continue focusing on its dividend in terms of capital allocation priorities. The strength of CoreSite's financial performance in recent years has been undeniable. From 2011 through expected 2018 results, revenue has advanced at an 18% CAGR, adjusted EBITDA at a 24% CAGR, FFO at a 23% CAGR, and dividends per share at a 36% CAGR. Edge users are expected to continue driving growth in its key markets.

Here's what we say about its dividend in the dividend report, and as for its valuation, we think there could be upside based on the high end of our fair value estimate range (see image that follows):

Key Strengths

CoreSite Realty is taking advantage of the secular trends surrounding the ever-evolving tech landscapes as cloud and hybrid IT strategies continue to gain momentum. It is estimated that by 2021, 94% of all workloads will be processed in some form of cloud environment. The firm's financial performance in terms of revenue, adjusted EBITDA, and FFO growth over the past several years has been nothing short of impressive and has helped it grow dividends per share at a 36% CAGR from 2011 to 2018. It does not have any debt maturities until 2020, giving it some breathing room in the near term. The health of CoreSite's payout remains tied to its ability to raise new capital, however.

Image shown: CoreSite Realty is currently trading at $98 per share, but we think the company's valuation upside potential could reach $116+ based on our estimate of its intrinsic value.

CyrusOne (CONE) - Dividend Yield: ~3.6%

Image Source: CyrusOne Presentation

CyrusOne owns, operates, and develops enterprise-class and multi-tenant data center real estate properties. The firm provides data center facilities that protect and ensure ongoing operations of information technology infrastructure. As of the end of 2017, it owned 45 data centers in the US, Europe and Asia. The company was founded in 2012 and is headquartered in Texas. Generally speaking, we like the idea of owning data centers given the secular trends in the ever-evolving tech landscapes as cloud and hybrid IT strategies to gain momentum. However, the concentration of the hyperscale data center tenant space is expected to pressure releasing spreads moving forward.

CyrusOne has a reasonably diverse portfolio geographically within the US, and it is working to grow its international presence. The firm does have a degree of customer concentration risk as one customer accounts for 18% of total annualized rent, and its top 10 customers account for just over 40% of annualized rent as of 2017. At the end of the third quarter of 2018, CyrusOne had a weighted average remaining lease term of 59 months, and customers with investment grade credit ratings make up ~73% of portfolio rent. The recent acquisition of Zenium bolsters its presence in Europe, specifically London and Frankfurt.

CyrusOne recently received an issue-level credit rating upgrade (applies to one issue) from S&P to BBB-, but its issuer credit rating remains in junk territory. However, the REIT has no debt maturities until 2023, offering it some near-term financial flexibility. Despite the positive near-term environment, technological advances (shrinking hardware) could impact demand over the long haul.

Here's what we say about the company's payout in the dividend report, and as for our estimate of its intrinsic value, upside may very well exist for shares, which are changing hands roughly in line with our fair value estimate (see image that follows):

Key Strengths

CyrusOne has positioned itself nicely to take advantage of the secular trends surrounding the ever-evolving tech landscapes as cloud and hybrid IT strategies continue to gain momentum. Some estimates suggest that by 2021, 94% of all workloads will run on some form of cloud environment. We like recent growth trends in its customer base, which continues to advance in terms of credit quality. The recent Sentinel Data Center acquisition has extended the company's weighted average remaining lease term to roughly double the level at the time of its IPO. Normalized FFO has compared favorably to annual run rate cash distribution obligations of ~$146 million in 2017, but we still warn of capital market dependence.

Image shown: CyrusOne is currently trading at ~$54 per share, which is roughly in line with our fair value estimate. We think shares have the potential to reach the ~$65 range based on the upper bound of our estimate of its intrinsic value.

Digital Realty Trust (NYSE:DLR) - Dividend Yield: ~3.8%

Image Source: Digital Realty Presentation

Digital Realty develops and manages technology-related real estate. The firm targets high-quality, strategically-located properties containing applications and operations critical to technology industry tenants and corporate data-center users. It operates as a REIT for tax purposes. The company was founded in 2004 and is headquartered in San Francisco. Generally speaking, we like the idea of owning data centers given the secular trends in the ever-evolving tech landscapes as cloud and hybrid IT strategies continue to gain momentum. However, the concentration of large cloud operators (its tenants) has impacted releasing expectations moving forward.

Digital Realty merged with DuPont Fabros in an all-stock transaction valued at approximately $7.6 billion in enterprise value. The deal was intended to enhance Digital Realty's offerings in top US data center metro areas, expand its hyper-scale product offering, and solidify its blue-chip customer base. Improved customer and geographic diversification are also key positives of the deal. We like Digital Realty's focus on return on invested capital. Its investment-grade credit ratings also offer nice support for the REIT's dividend payout, if need be. Despite the attractive credit ratings, its payout is still dependent on capital market access.

Digital Realty has a number of competitive advantages: a high-quality portfolio that is difficult to replicate, presence in key markets, demonstrated acquisition capability, flexible data center solutions, and differentiating development advantages. Taken together, Digital Realty is a formidable foe. We assign the REIT a neutral Economic Castle rating.

Here's what we say about its dividend in the dividend report, and as for its valuation, we think there could be upside based on the high end of our fair value estimate range (see image that follows):

Key Strengths

Digital Realty Trust has rewarded its investors with a steady and growing dividend over the past decade or so as its dividend has grown at a ~12% CAGR since 2005. The firm is levered to long-term secular demand drivers via the use of its leased data centers in the proliferation of the Internet, video, cloud, and mobile, and it holds investment grade credit ratings (Baa2/BBB/BBB). Its dividend policy stipulates that the company will pay out a minimum of 100% of taxable income via dividends and maintain a payout ratio of less than 90% of AFFO. FFO averaged more than $855 million from 2015- 2017, well in excess of annual run-rate cash common and preferred dividend obligations of just over $715 million.

Image shown: Digital Realty Trust is currently trading at ~$107 per share, which is in the upper half of our fair value range. We think shares have the potential to reach the ~$118 range based on the upper bound of our estimate of its intrinsic value.

Conclusion

While we generally like the idea of owning data centers and the exposure to a segment of the economy that is poised for long-term growth, there are risks embedded in the space, not the least of which is the growing negotiating power of hyperscale data center operators. Despite its warning of near-term releasing spread weakness, we like Digital Realty Trust out of these three data center REITs. The company boasts a number of competitive advantages and looks to pay a healthy dividend, though it remains dependent upon access to the capital markets.

The recent acquisition of DuPont Fabros has been well absorbed and increased its exposure to the ever-important Northern Virginia data center market. We think the upper bound of our fair value range is within reach for shares, especially if the Fed continues to take a dovish stance related to interest rate hikes.

Disclaimer: This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: Digital Realty is an idea in Valuentum's simulated Dividend Growth Newsletter and High Yield Dividend Newsletter portfolios.