Digital Realty: This Cloud-Based Blue Chip Is Raining Dividends

Summary

• We’re well aware that rising inflation is a concern for many real estate investors these days.
• DLR has taken steps to protect itself and continue to grow its cash flows by building rent escalators into its leasing agreements.
• DLR’s typical rent escalation agreement is in the 2%-4% range, which protects the company from inflation, assuming it remains in the typical historical range.
• Looking for a helping hand in the market? Members of iREIT on Alpha get exclusive ideas and guidance to navigate any climate. Learn More »

Photo by Sezeryadigar/E+ via Getty Images

This article was coproduced with Nicholas Ward.

Digital Realty (NYSE:DLR) has long been one of our favorite names at iREIT on Alpha. We’ve pegged it as a blue-chip real estate investment trust in an attractive REIT subsector for years now.

Over the years since we bought in, its performance has spoken for itself with triple-digit total returns. And, as you can see below, not only does it stack up well against its data-center REIT peers…

Its quality metrics match up well against its blue-chip competitors across multiple real estate categories. That’s why we were so pleased to chat with Digital Realty Senior Vice President of Investor Relations recently.

(Source: DLR March Investor Presentation)

2020 was a tough one for REITs, of course, with rent collection shortfalls galore as their tenants struggled to survive.

But being a crucial piece of the digital world saved Digital Realty a lot of stress. The data center space remained a defensive REIT bastion as so many businesses transferred all their operations online.

As you can see below, DLR has a very attractive tenant base. The majority of these companies already are generating massive cash flows thanks to secular growth tailwinds that shouldn’t let up anytime soon.

(Source: DLR March Investor Presentation)

A Digital Company for a Global Age

Digital Realty has a very diversified geographic tenant base, making it a true global company – a fairly unique REIT trait overall, though much less so among its data center peers.

(Source: DLR March Investor Presentation)

To quote Stewart:

“… we are in almost 50 metropolitan areas in 24 countries on six continents around the world.

“So we cover most of the major NFL cities here in North America. We're also in South America… (after acquiring) a platform called Vicente a couple of years ago with a leading provider in Brazil. And (we) branched out from Brazil into Chile and Mexico.”

As for Europe, DLR was a “distant third” player in terms of size and significance until last year. But buying up the continent’s No. 2 datacenter REIT, Interaction, changed that game.

(Source: DLR March Investor Presentation)

Today, it boasts a “significantly enhanced” platform there, to say the least.

(Source: DLR March Investor Presentation)

That’s why Stewart pegged the Asia-Pacific region as being “where we have the most room for growth.” While Digital Realty is in Japan, Singapore, Hong Kong, and Australia, those are minimal presences.

The company recently entered into a memorandum of understanding for a joint venture in India. And while that didn’t work out, Stewart believes the country remains an important target.

In fact, DLR is much more interested in India than China. It doesn’t have a single asset in mainland China, with no plans to change that for now.

It’s “obviously a trickier market to navigate from a geopolitical and investment perspective,” Stewart noted. That’s true from a real estate ownership perspective “as well as repatriating capital. That's a trickier proposition, so China's not on the front burner.”

Some Serious International Money-Making

At iREIT, we’ve been bullish on various REITs’ international expansion for a while now. Most notable is our positive outlook on W. P. Carey (WPC) – due in large part to its well-diversified asset base that includes a leadership position in Europe.

We’ve also highlighted our bullish stance on Realty Income’s (O) recent investments in the United Kingdom. Though this isn’t because of diversification for diversification’s sake.

Nope. We like these expansions because of the very low cost of capital and therefore wider spreads that companies can generate in Europe these days. With bond yields rising in the U.S., this is becoming ever-more important.

(Source: DLR March Investor Presentation)

When asked about DLR’s global positioning from a capital perspective, Stewart noted that he’s not so interested in playing the Forex derivative markets to hedge its international bets. Instead, Digital Realty wants “to match the denomination of the assets with the liabilities.”

“Because we have euro-denominated assets,” he noted, “… we have been issuing euro-denominated debt to match the assets and liabilities.”

In short, these deals have been quite attractive from a cost of capital standpoint. Stewart highlighted a recent euro green bond the company issued in January – where it locked in 10.5-year rates at 0.625%.

It isn’t difficult to make money in the real estate business when capital is nearly free.

Right now, DLR’s weighted average interest rate is below 3%. That’s low regardless, but its international focus will take it down even further.

We believe this practice is sound and sustainable over the long term. And we like how Digital Realty has the know-how to hunt attractive deals where the capital equation is most efficient.

(Source: DLR March Investor Presentation)

Digital Realty Is Ready If Inflation Is on the Rise

We’re well aware that many real estate investors are concerned about rising inflation. So we were sure to ask Stewart about Digital Realty’s thoughts on that.

What has the company done to prepare itself for an evolving economic environment?

First off, it’s taken steps to protect itself by building rent escalators into its leasing agreements. That way, year in and year out, its cash flow will increase on a reliable basis.

DLR’s typical rent escalation agreement is in the 2%-4% range, which protects it from typical inflation levels.

Stewart did mention that rising fuel costs are already factoring into construction projects. However, for the time being, inflation appears to be within the historical range overall.

Yet even if we see an environment where it goes higher, DLR’s currently rather low lease durations help protect it – and its investors – since those higher costs can then be passed on to tenants during lease renegotiations.

(Source: DLR March Investor Presentation)

Then there’s its slowing pace of bottom-line growth. As you can see on the FAST Graph below, Digital Realty – which was a strong double-digit grower for years – isn’t producing the same percentages it used to.

(Source: FAST Graphs)

Stewart rightly pointed out the law of large numbers here that it now has a $50 billion enterprise value. That makes it “harder to move the needle.” And while he aspires to re-accelerate growth:

“I don't think we're likely to return to those heady days that we saw earlier on when the base was a lot smaller and we frankly had a lot less competition. I think the times have changed.”

Admittedly, that's a bit disheartening. While we appreciate the honesty, big-tech names outside of the REIT space keep on accelerating their top and bottom lines regardless of market cap.

Granted, big-tech companies can move faster and be more disruptive because they aren’t dealing with hard assets like real estate. But in general, we’d prefer to see companies not use the law of large numbers as a scapegoat.

Digital Realty’s Dividend

In its defense, Digital Realty's Stewart has been restructuring its portfolio and recycling capital. This creates a short-term headwind in terms of adjusted funds from operations (AFFO) growth due to rent shortfall.

In the long term, we like its continued focus on interconnectivity and hyperscale, hence our continuing support. The company has a bright future, with estimations of high single-digit AFFO growth potential in the coming years.

Plus, DLR has been successful in building out a high-demand portfolio, having generated its highest-ever bookings in recent quarters.

(Source: DLR March Investor Presentation)

So, growth struggles aside, we continue to like DLR. Besides, its fortress balance sheet creates a very safe dividend and reliable dividend growth.

Here’s what Stewart said on that subject:

“… I would say that our first measure is to pay out 100% of taxable income, which we do, obviously… And then our secondary measure is we target an AFFO payout ratio of below 80%.”

Currently, Digital Realty is at about 77%, which means it has a nice cushion to rest on. Moreover:

“… we feel very good about our ability to continue to grow those cash flows and grow the dividends that we pay to shareholders each and every year, as we have done every year since we came public back in 2004.”

Source: DLR March Investor Presentation

We certainly have a lot of faith in DLR’s 3.5% yield, with growth that should continue to far exceed inflation.

Yes, the chart above shows its long-term dividend growth compound annual growth rate is 10%. And, no, we’re not expecting more than mid-single digits from now on.

However, that should still very much protect the purchasing power of investors’ passive income streams. One more reason why we believe this stock is worth owning.

In Conclusion…

All in all, Digital Realty has one of the highest iREIT IQ scores at 92 out of 100. That’s not the highest-rated data center REIT we track, but it is the lone “Buy” rating we have in this space because of its current combination of quality and value after the stock’s recent pullback.

DLR is trading in-line with our fair value estimate in the mid-$130s. And when it comes to a blue-chip holding like this, we see no issue with paying that for a long-term position.

We first invested in this REIT by buying shares in October 2013 in the Durable Income Portfolio. Since then, it has returned 23.3% per year.

We maintain a Buy recommendation.

Disclosure: I am/we are long DLR, CONE, QTS. 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.