Seeking Alpha

Data Center REITs: Sunlight Through The Clouds

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Includes: CLOU, CONE, COR, DLR, EQIX, FREL, FRI, ICF, INXN, IRM, IYR, PSR, QTS, SRVR, SWCH, TCLD, VNQ, XLRE
by: Hoya Capital Real Estate
Summary

Surging more than 40% this year, Data Center REITs have bounced back in 2019 following the worst year for the sector since NAREIT formally began tracking the group in 2015.

Storm clouds have been building around the high-flying technology-focused sector as intense competition and furious supply growth have weakened pricing power.

Global IT spending has slowed significantly in 2019 as businesses temper growth plans, citing macroeconomic and trade uncertainty. Despite this, data center REITs have outperformed.

Second-quarter earnings results brought a ray of sunlight through the clouds. Leasing activity, the most closely watched metric, was significantly better than expected.

Operating in a highly competitive industry, value creation isn't coming as easy as it once was. While robust demand for data center space will continue, the outlook for the REITs themselves remains cloudy.

REIT Rankings: Data Centers

In our REIT Rankings series, we introduce and update readers each of the residential and commercial real estate sectors. We focus on sector-level fundamentals, analyzing supply and demand conditions and macroeconomic factors driving underlying performance. We update these reports quarterly with a breakdown and analysis of the most recent earnings results.

data center reits

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Data Center Sector Overview

Within the Hoya Capital Data Center Index, we track the five largest data center REITs, which account for roughly $85 billion in market value: Equinix (EQIX), Digital Realty (DLR), CyrusOne (CONE), CoreSite (COR) and QTS Realty (QTS). Other companies operating in the space include Europe-based InterXion (INXN) and US-based Iron Mountain (IRM) and Switch (SWCH). Data Center REITs comprise roughly 8-10% of the REIT Indexes (VNQ and IYR). 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 REITs

The home of the "cloud," Data Center REITs are the physical epicenter of the internet. 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 a variety of customers with different networking and computing needs, who install and manage their own server and computing equipment in the facilities. Typically housing millions of terabytes of mission-critical data for thousands of individual customers, physical data security and operational reliability are crucial attributes of data center facilities. Data center REITs consume roughly three percent of all electricity generated on the planet.

digital realty (Digital Realty September 2019 Investor Presentation)

Since becoming a full-fledged NAREIT-recognized sector in 2015, data center REITs have been the second best-performing REIT sectors, trailing only their technology-REIT peer, the cell tower sector. Producing an annualized rate of return that is triple that of the broader REIT average during this time, data center REITs continue to ride the thematic growth trends associated with the continued boom in outsourced IT spending, a long-term secular growth story that we believe has years to run.

Compared with other real estate sectors, however, data center REITs are quite "management-intensive," typically operating at lower NOI margins and requiring a higher level of annual capital expenditure to maintain competitiveness. Operational overhead at the firm-level (as measured by G&A as a percent of gross assets) is generally above the REIT sector average. As we'll discuss below, same-store pricing on re-leases remains flat-to-negative, indicative of a sector that lacks significant pricing power.

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. 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.

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.

data center REITs 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) (GOOGL), 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.

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.

(Digital Realty September 2019 Investor Presentation)

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 Fundamentals

Despite continued evidence of a slowdown in global IT spending, second-quarter earnings for the five data center REITs results brought a ray of sunlight through the clouds. Leasing activity, the most closely watched metric, was significantly better-than-expected with all four REITs that report leasing volume beating consensus estimates. Even with the better-than-expected activity, however, the $122 million in leasing volume still represented a 20% decline from the same quarter in 2018.

It was a bit of a roller-coaster earnings season for data center REITs after CoreSite kicked off the earnings slate with a very disappointing report in which the firm significantly lowered full-year guidance, which dragged down the entire sector until Equinix and CyrusOne each reported better-than-expected results in the following week. Overall, while industry average revenues and EBITDA are expected to grow 11% and 10% in full-year 2019, AFFO per share is expected to grow a more modest 5.1% this year. The interconnection-focused Equinix continues to be the relative standout while the smaller wholesale-focused REITs are seeing the slowest rate of growth.

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 has generally tailed off since peaking in 3Q18, according to data from Synergy Research. According to Synergy, hyperscale operator capex grew by 5% in the US with the top five hyperscale spenders in Q2 being Google, Amazon, Microsoft, Facebook (NASDAQ:FB) and Apple (NASDAQ:AAPL), whose budgets far exceed the combined spending of the fifteen other hyperscale operators. However, cloud revenue growth from the "Big 5" US cloud providers continued to moderate in the second quarter as sky-high cloud growth rates have come back down to earth in recent quarters.

Solid leasing data was a welcome relief given the mounting signs of a 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 their most recent forecast, 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.

While much of the investment community remains hyper-focused on leasing metrics, which we see as volatile and prone to false signals, we remain focused on re-leasing spreads as the key forward-looking indicator of underlying pricing power and on supply/demand conditions as an indicator of any emerging barriers to entry, which we have not yet seen to any significant degree. Digital Realty, which we view as the industry bellwether, reported a -5.8% dip in cash renewal spreads, the second straight weak quarter following a -6.9% spread in Q1. DLR expects a -3% decline in full-year "same capital" NOI growth, reflecting the continued (and perhaps underappreciated) competitive challenges facing the data center sector, particularly the wholesale/hyperscale business lines.

digital realty (Digital Realty 2Q19 Earnings Slides)

Supply/demand fundamentals continue to reflect mildly oversupplied conditions in several key data center markets, including the largest data center market in Ashburn, Virginia. Digital Realty continues to believe that barriers to entry will gradually develop in major data center markets in the US, but we think we may still be several years away from seeing true constraints on supply growth. These barriers would include lack of available land, limited, or unaffordable power supply, as well as barriers associated with having sufficient scale and capital to fulfill the ever-increasing demands of hyperscale tenants. Digital Realty reported a TTM absorption to current pipeline multiple of 1.5x in the United States, a weakening from last quarter's reading of 1.6x.

data center

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 $2.6B at the end of 2Q19, down 5% on a year-over-year basis.

data center development

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 10-20% 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. Following an M&A wave from 2015-2018, however, the data center REIT landscape has been relatively quite this year even as overall data center transaction activity remains as high as ever, according to Synergy Research. In August, Bloomberg reported that CyrusOne is exploring a potential sale to private market investors.

data center reit transactions

Data Center REIT Stock Performance

After jumping 50% between 2016 and 2017, data center REITs delivered an uncharacteristically weak 2018, dipping 14% last year despite a continued boom in data center demand. Since becoming a full-fledged NAREIT-recognized sector in 2015, however, data center REITs have been the second best-performing REIT sectors, trailing only their technology-REIT peer, the cell tower sector.

data center reits Despite continued signs of slowing growth in global IT spending, Data Center REITs have been the best-performing REIT sectors this year, jumping more than 41% on a total-return basis compared to a 23% climb on the broader REIT averages. 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%.

data centers

Equinix has been the strongest performer this year, climbing by more than 50% YTD, followed by CyrusOne, which has climbed by 41%. Digital Realty, which was the strongest-performer in 2018, has climbed a more modest 18% so far this year.

data center investing

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. Powered by the iREIT Terminal, we note that Data Center REITs have seen by far, the fastest rate of FFO growth over the last five years at more than 20%. As noted above, data center REITs trade at an estimated 10-20% 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 maintaining a critical cost of capital advantage over private market competitors.

Dividend Yields of Data Center REITs

Data Center REITs pay an average dividend yield of 2.5%, which is below the REIT sector average dividend yield of around 3.6%. (Note that our REIT Average is skewed lower by our coverage universe which generally excludes externally-managed and small-cap REITs under $1B in market capitalization.) 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 50% of their free cash flow, leaving them ample capacity to increase dividends or reinvest in growth.

data center REIT dividends

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 4.3% followed by QTS at 3.5% and Digital Realty at 3.4%. Equinix remains the most growth-oriented REIT, paying out just 1.8% but retaining more than 60% of free cash flow.

dividends data center REITs

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.

data center reit

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. 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.

(Digital Realty September 2019 Investor Presentation)

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 be 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 centers 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.

internet growth

(Digital Realty September 2019 Investor Presentation)

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 centers

Bottom Line: Sunlight Through The Clouds

Surging more than 40% this year, Data Center REITs have bounced-back in 2019 following the worst year for the sector since NAREIT formally began tracking the group in 2015. Storm clouds have been building around the high-flying technology-focused sector as intense competition and furious supply growth have weakened pricing power.

Global IT spending has slowed significantly in 2019 as businesses temper growth plans, citing macroeconomic and trade uncertainty. Despite this, data center REITs have outperformed. Second-quarter earnings results brought a ray of sunlight through the clouds. Leasing activity, the most closely watched metric, was significantly better than expected.

While much of the investment community remains hyper-focused on leasing metrics, which we see as volatile and prone to false signals, we remain focused on re-leasing spreads as the key forward-looking indicator of underlying pricing power. Negative "same-capital" NOI growth power underscores competitive challenges facing the data center sector, particularly the wholesale/hyperscale business lines.

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. Until we see any clear barriers to supply growth begin to emerge, or see a slowdown in the migration of data center utilization to the hyperscale providers, we remain neutral on the sector, and think that shareholder creation won't come as easy in the 2020s as it did in the 2010s.

data center (Digital Realty September 2019 Investor Presentation)

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Disclosure: I am/we are long VNQ, DLR, EQIX. 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: It is not possible to invest directly in an index. Index performance cited in this commentary does not reflect the performance of any fund or other account managed or serviced by Hoya Capital Real Estate. All commentary published by Hoya Capital Real Estate is available free of charge and is for informational purposes only and is not intended as investment advice. Data quoted represents past performance, which is no guarantee of future results. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy.