Data Center REITs: It's Getting Cloudier

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by: Hoya Capital Real Estate
Summary

The home of the "cloud," Data Center REITs are the physical epicenter of the continued boom in outsourced IT spending, a long-term secular growth story with years to run.

5G will only accelerate the offloading of computing power from physical devices to "insanely efficient" data centers, allowing devices to be smaller, less powerful, and be less prone to obsolesce.

On the back of a record-setting 2018, however, global IT spending has slowed in 2019 as businesses temper growth plans, citing macroeconomic uncertainty. Despite this, data center REITs have outperformed.

While we expect continued robust demand for data center space, the outlook for the REITs themselves remains cloudy. With negative same-store growth, these companies are highly dependent on external growth.

While development remains disciplined and responsive to demand, it's unclear whether there any real barriers to supply growth in a sector flush with cash from the Hyperscale Giants.

REIT Rankings: Data Centers

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Data Center Sector Overview

Data Center REITs comprise roughly 8-10% of the REIT Indexes (VNQ and IYR). Within the Hoya Capital Data Center Index, we track the five largest data center REITs, which account for roughly $80 billion in market value: Equinix (EQIX), Digital Realty (DLR), CyrusOne (CONE), CoreSite (COR), and QTS Realty (QTS). Other companies operating in the space include European-based InterXion (INXN) and US-based Iron Mountain (IRM) and Switch (SWCH). Investors seeking diversified exposure to the technology real estate sector, including cell tower REITs, can do so through the Benchmark Data & Infrastructure ETF (SRVR).

data center REIT overview

Typically housed in windowless industrial-style buildings surrounded by massive generators and cooling equipment, data center REITs provide the infrastructure - power, cooling, and physical rack space - to enterprise customers, who install and manage their own server and computing equipment in the facilities. Data center leases are typically long term (5-15 years) with fixed or CPI-based annual escalators with larger wholesale customers often leased under a triple-net structure. As a result, the sector has high cash flow visibility but more limited potential for organic same-store growth between renewal terms. Data center REITs derive essentially all of their AFFO growth externally through development and acquisitions.

data centers

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 significantly 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. While development remains disciplined and responsive to demand, it's unclear whether there are any real barriers to supply growth in the wholesale segment, a segment flush with cash from the Hyperscale Giants. As we'll discuss below, same-store pricing on re-leases remains flat-to-negative, indicative of a sector that lacks significant pricing power.

data center REITs

REITs are among the largest owners of investment-grade data centers in the United States and around the world, owning roughly 30% of data centers in the US, based on our estimates. It's important to note that the competitive landscape, particularly in the lower-barrier wholesale data center market, is quickly shifting as "big tech" hyperscale providers - Amazon (AMZN), Microsoft (MSFT), Google (GOOG), Alibaba (BABA), and IBM (IBM) - are increasingly dictating the terms of the still-symbiotic relationship between REITs and these large tenants. Digital Realty expects half of all data center servers to be operated by just a half-dozen hyperscale tenants by 2021, up from 25% today. As we discussed in our last report, while we expect continued robust demand for data center space, the outlook for the REITs themselves remains cloudy. With negative same-store growth, these companies are highly dependent on external growth. We think that this rapidly shifting competitive environment warrants a reevaluation of the longer-term outlook for the data center REIT sector, especially the REITs that focus exclusively on wholesale data center services.

data centers

(Digital Realty June 2019 Investor Presentation)

For now, the substantial secular tailwinds driving data demand and network densification including 5G, artificial intelligence, and blockchain technologies are overpowering the negative effects of reduced pricing power and the relationship between these REITs and their "big-tech" tenants is still symbiotic. We see the wholesale market becoming increasingly competitive with a smaller number of larger players but see sustainable competitive advantages in the higher-barrier connectivity-based services. Equinix has the highest "quality" portfolio of network-dense assets followed by Digital Realty and CoreSite (each roughly 30%). CyrusOne, QTS, and the majority of non-REIT data center operators focus primarily on more competitive wholesale assets. We believe that these wholesale-focused REITs may benefit from continued consolidation as an effective way to curtail the pricing power of hyperscalers as we saw with Digital Realty's acquisition of wholesale-focused DuPont Fabros in 2017.

Data Center REIT Fundamental Performance

On the back of a record-setting 2018, global IT spending has slowed in 2019 as businesses temper growth plans, citing macroeconomic uncertainty from slowing global growth and continued trade tensions between the US and China. In a just-released report, Gartner revised lower their 2019 forecast for worldwide IT spending from 1.1% to just 0.6%, led by the US at 3.7%. Data Center Systems is expected to see the most significant slowing following robust growth in 2018, fueled by a surge in hyperscale leasing.

global IT spending data centers

As we discussed last quarter, data center leasing smashed records in 2018, jumping more than 30% for data center REITs, powered by a nearly 50% surge in capex spending from hyperscale providers. Data center revenue from the "Big 5" cloud giants was off-the-charts in the first half of 2018, but tailed off towards the end of the year, and slowed again in 1Q19. As detailed in Digital Realty's chart below, cloud revenue growth from the "Big 3" continued to moderate in the first quarter as sky-high cloud growth rates have come back down to earth in recent quarters.

With more than two-thirds of leasing volume now coming from this small sub-set of hyperscale providers, quarterly leasing is likely to remain choppy. Regardless, 1Q19 leasing was roughly in-line with estimates with the five REITs reporting a combined $95 million in net annualized leasing, down 18% on a year-over-year basis. Pricing continues to be a key focus of ours and while there were extraneous factors at play, the -6.9% cash renewal leasing spread from Digital Realty for 1Q19 is tough to ignore. It's clear that competition remains intense and supply remains fairly plentiful. We expect continued flat-to-negative internal same-store growth across the data center space for the foreseeable future.

data center leasing

Outside of concern regarding re-leasing spreads, 1Q19 results were decent with four REITs maintaining full-year AFFO/share guidance while CyrusOne boosted estimates. Revenues continue to grow double digits, but with the share-count growing more than 4% year-over-year, AFFO/share rose a more modest 4.5% in the first quarter. AFFO/share growth is expected to continue to slow this year to just over 4%, likely below the broader REIT average of roughly 4-6%. The interconnection-focused Equinix continues to be the relative standout while the smaller wholesale-focused REITs seeing the slowest rate of growth.

affo growth data center REITs

While weak pricing power is nothing new for data center REITs, it becomes more of a concern as external growth rates begin to naturally cool across the sector following several years of above-trend growth. 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 almost exclusively by external growth while the underlying organic growth metrics have been average at best. The development pipeline remains essentially as large as ever, briefly exceeding $3 billion at the end of 3Q18 and finishing 2018 at $2.9B and currently standing at $2.8B at the end of 1Q19, up 20% on a year-over-year basis.

data center REIT pipeline

Consolidation remains a continuing theme in the data center sector as smaller firms attempt to fend-off mounting competitive pressures. Strong share price performance across the data center sector has brightened the outlook for acquisition-fueled growth in 2019 as the average data center REIT now commands a roughly 25% premium to NAV. 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.

Recent Data Center Stock Performance

Despite signs of slowing growth in global IT spending, Data Center REITs have been among the best-performing REIT sectors this year, jumping more than 35% on a total-return basis compared to a 22% climb on the broader REIT averages. Powering this performance has been, in part, surging cryptocurrency prices and strong performance from broader semiconductor sector with the VanEck Semiconductor ETF (SMH) up by nearly 30% YTD. Among the more interest-rate-sensitive REIT sectors, data centers have benefited from the sharp retreat in interest rates since the 10-year yield peaked last October around 3.25%.

Equinix has been the strongest performer this year, climbing by nearly 50% YTD, followed by CoreSite at nearly 40%. Digital Realty, which was the strongest-performer in 2018, has climbed a more modest 14.6% so far this year. The smaller wholesale-focused REITs - CyrusOne and QTS - have lagged over the last two years.

Bull and Bear Thesis for Data Center REITs

As connectivity speed and bandwidth capacity continue to improve, the economics of utilizing cloud computing relative to on-site or on-device processing capacity is increasingly favorable for most applications, which has prompted an insatiable wave of demand for data center space while also fundamentally disrupting the consumer electronics business, a growing concerns at firms like Apple (AAPL) and Samsung. Because computing power can be offloaded to the cloud, devices can be smaller, relatively less powerful and, generally, need to be upgraded less frequently. Double-digit annual growth rates are expected over the next decade in IP traffic, storage needs, and mobile computing demand, powered by emerging technologies including 5G, blockchain, artificial intelligence, and the internet of things.

growth in data

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. While our base-case is that data center pricing remains soft due to intense competition from hyperscale providers, Data Center REITs may able to retain pricing power through consolidation if or when barriers to supply growth develop. We believe that scale is a competitive advantage that may lead to accretive acquisition-fueled growth. Below, we outline five reasons that investors are bullish on the data center space.

bullish data center REITs

Flush with cash, "big-tech" has invested enormously over the last five years in enterprise cloud services and building out network capacity, primarily by leasing massive quantities of space from these data center REITs. While certainly a short-term win for these REITs, these "public cloud" offerings are increasingly winning business from larger corporate customers that may have historically deployed a more traditional hybrid cloud solution that involved these clients renting space directly from these data center REITs. While Digital Realty only projects out to 2021, we see hyperscale players commanding a growing share of total data center traffic and processing power and that more firms will work more exclusively in the "public cloud." We see the industry evolving into a model more akin with the cell tower REIT sector whereby a small number of "carriers" have an effective duopoly or triopoly due to the cost advantages of scale and network effects.

capex data centers

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. Additionally, due to long lease terms and the triple-net structure of most leases, data center REITs are more interest-rate-sensitive than other REIT sectors despite their exposure to the high growth technology sector. Below, we outline five reasons that investors are bearish on the sector.

bearish data center REITs

Valuation of Data Center REITs

As they have for most of the past half-decade, data center REITs continue to trade at premium valuations to the REIT averages based on free cash flow (aka AFFO, FAD, CAD) based metrics. As noted above, data center REITs trade at an estimated 20-30% premium to NAV, up from a slight discount at the end of 2018. Maintaining this NAV premium is critical to accretively funding these REITs' external growth ambitions and maintain a critical cost of capital advantage over private market competitors.

valuation data center REITs

Dividend Yields of Data Center REITs

On a market-capitalization-weighted basis, Data Center REITs rank below the REIT average when it comes to dividend yield, paying an average yield of 2.6% compared to the REIT average around 3.5%. As shown below, however, this average is dragged down by the heavily-weighted Equinix, which pays a sub-2% yield. Data center REITs pay out just 70% of their free cash flow, leaving them ample capacity to increase dividends or reinvest in growth.

dividend yield data center REITs

Within the sector, we note the differences in yield for these five REITs and an estimation of their approximate payout ratios. CoreSite yields a sector-high of 4.0% followed by QTS at 3.8% and Digital Realty at 3.5%. Equinix remains the most growth-oriented REIT, paying out just 1.9% but retaining more than 40% of free cash flow.

dividends data centers

Data Center REITs & Interest Rates

Excluding the growth-oriented Equinix, data center REITs exhibit interest rate sensitivity that is above the broader REIT average, which is a surprise to many investors considering the sector's strong expected growth rates and high correlation to technology stock performance. High interest rate sensitivity is a result of longer-than-average lease terms and triple net lease structure on typical wholesale data centers. When including Equinix, however, the sector exhibits more growth-like characteristics with a high sensitivity to movements in the S&P 500 and relatively muted sensitivity to changes in interest rates.

We separate REITs into three categories: Yield REITs, Growth REITs, and Hybrid REITs. Within the sector, we note that there are significant divergences in factor sensitivities. Digital Realty, CyrusOne, and QTS are among the more interest-rate sensitive REITs. Equinix, on the other hand, is among the least interest-rate sensitive and has one of the lowest correlations to the overall REIT index.

Bottom Line: It's Getting Cloudier

The home of the "cloud," Data Center REITs are the physical epicenter of the continued boom in outsourced IT spending, a long-term secular growth story with years to run. 5G will only accelerate the offloading of computing power from physical devices to "insanely efficient" data centers, allowing devices to be smaller, less powerful, and be less prone to obsolesce.

On the back of a record-setting 2018, however, global IT spending has slowed in 2019 as businesses temper growth plans, citing macroeconomic uncertainty. Despite this, data center REITs have outperformed, climbing more than 30% this year and significantly outpacing the broader REIT averages. While we expect continued robust demand for data center space, the outlook for the REITs themselves remains cloudy.

With negative same-store growth, these companies are highly dependent on external growth. Luckily for the sector, the REIT Rejuvenation has given these REITs the cost of capital advantage that they lacked over the last 18 months, which should help to drive external growth in 2019, and we think AFFO metrics will come in ahead of guidance when all is said and done. We think continued consolidation is key to fending-off negative pricing pressure from the hyperscale providers.

While development remains disciplined and responsive to demand, it's unclear whether there are any real barriers to supply growth in the wholesale segment, a sector flush with cash from the Hyperscale Giants. Compared with other real estate sectors that are seeing very real and tangible supply constraints that are likely to persist well into the 2020s, it's hard to predict what the competitive dynamics of the data center will look like in 2022, much less 2030. As a result, we are neutral on the data center REIT sector but see value in the more network-dense REITs with a national or global footprint including Equinix, Digital Realty, and CoreSite.

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Disclosure: I am/we are long EQIX, DLR, COR, VNQ. 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.

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