Trick Or Treat? The Data Center REITs

Summary

• Companies experiencing strong secular growth tailwinds should experience fundamental growth, regardless of the strength of the macro economy.
• These are the investment types that often outperform during uncertain times while the rest of the market lacks clear growth.
• In this article, we’ll focus on the data center REITs, a sector that represents 9% of our core portfolio… so far.
• Looking for more investing ideas like this one? Get them exclusively at iREIT on Alpha. Learn More »

Juanmonino/E+ via Getty Images

This article was coproduced with Nicholas Ward.

Here's where we are today from an investment perspective…

Interest rates continue to rise. And the U.S. 10-year Treasury crossed back up above the 1.6% threshold recently.

At this point, it's common to see renewed calls for a 2%+ yield on it by year's end.

Moreover, the bond market weakness we're seeing is leading to a similar selloff in the equity space. That's especially true when it comes to some of the more capital-intensive areas of the market…

Including the real estate sector.

We've pointed this out numerous times in recent weeks, and it holds true today too. We're starting to see very attractive values pop up within the real estate investment trust ("REIT") space.

Even some of our highest-rated quality stocks at iREIT on Alpha are now trading at discounts to their fair-value estimates. This isn't something we object to one bit.

Contrary to popular belief, REITs can perform well in rising-rate environments. Current price drops don't change that fact one bit.

It's actually not uncommon at all to see some short-term REIT selloffs whenever the Fed reports hawkish news. However, blue-chip management teams have proven their ability to generate positive fundamental growth throughout a myriad of economic conditions.

The Truth About REITs and Rising Rates

Do rising rates make things more difficult for REITs?

Sure they do. Just about every company on Earth loves operating in an economic environment where debt is essentially free.

It provides investors with a lot of solace when it comes to risk-taking and forward-looking growth prospects.

However, there's a real argument to be made that zero-interest-rate debt policies make risk-taking too easy. It's hard to tell who's properly managing their businesses when moneymaking is so effortlessly achieved through inordinate amounts of debt.

There's a famous Buffett line regarding this: "Only when the tide goes out do you discover who's swimming naked." And investors are starting to remember this now the Fed is playing "he loves me, he loves me not" with such policies.

Once it decides to bump up interest rates and slow down quantitative easing, investors will likely see numerous sights they'd rather not. Investors in general, that is. Not us.

Overall, we remain confident that our highest-conviction picks especially won't look any less pleasant tide out as tide in. The sun can shine where it wants, we'll still almost certainly enjoy the view.

Even so, let's address current concerns…

One way investors can protect themselves from here is to focus on companies with strong secular tailwinds. Those entities should experience fundamental growth, regardless of the strength of the macroeconomy.

These are the types of investments that often outperform during times of uncertainty while the rest of the market struggles.

For instance, technological innovation is one of the strongest deflationary forces in the world today. When times get tough and companies have to run a tighter ship, they're going to make some cuts. Or at least spend less.

But they're probably not going to cut initiatives that are already proven to help them save money…

Technology to the REIT Rescue

In the REIT space, we've got a clear winning subsector in this regard. Technological advancement, 5G connectivity, digitalization, the cloud, the internet of things, artificial intelligence, the metaverse...

They all point the way to datacenter REITs.

International Business Machines (IBM) recently hosted its 2021 Investor Briefing Conference, where its CEO, Arvind Krishna, made an interesting remark.

"Five years ago, when people talked about 45 zettabytes of data, people rolled their eyes. There couldn't be that much data. A zettabyte for the quants out there is 21 zeros after a 1… just for you to know how much data that is. Now the 45 is old news. IDC, a consultancy, predicts 175 zettabytes by 2025."

He also discussed IBM's focus on a hybrid cloud and AI strategy to help clients sort through all that data. That sounds like it could make meaningful inroads into businesses' ability to better analyze what they're working with.

This article isn't about Big Blue though. It's about that immense amount of data it brought up. Data that has to be stored somewhere.

Data that's only going to grow from here, which means data storage will have to grow too.

There have been talks of major semiconductor breakthroughs. The kind that would drastically reduce data-storage operations' size constraints and energy demands.

However, those are still in the works. What we're already certain of is that data collection necessities are growing just as fast - if not faster - than semiconductor innovation.

Which means the data center business isn't go away anytime soon. On the contrary, we expect to continue to see this space expand further.

That's why it's one of our favorite subsectors of REIT-dom.

An Overview of Our REIT Techies

Of the four datacenter REITs we track - CyrusOne (CONE), CoreSite Realty (COR), Digital Realty Trust (DLR), and Equinix (EQIX) - all but one have an iREIT IQ (quality) score of 91/100 or more.

(These scores are based on a series of fundamentals we track and measure.)

CoreSite is the weakest, at 68, and we actually see it as a potential takeover target, perhaps for Equinix. That's why we're only focusing on the stronger three today.

Equinix, for its part, boasts a 97 IQ score, making it one of the highest-quality REITs we cover. And the 91 and 92 scores that CyrusOne and Digital Realty feature are certainly nothing to be ashamed about either.

Now, that hasn't saved them from selling off with the rest of the REIT sector recently.

CONE, for instance, is down 1.61% during the last month (which means it outperformed). And DLR and EQIX have fallen by double digits (which means they underperformed), falling 10.07% and 11.14%, respectively.

Part of this weakness is fundamentally justified. The latter two stocks were overvalued with poor margins of safety at previous prices.

However, they're now trading much closer to their fair-value estimates, along with CONE. And if they selloff further…?

They'll likely receive Buy ratings, which we'd love to see.

Again, we're not quite there yet. They're still Holds for now since they continue to trade with negative margins of safety. But at last check…

• CONE is trading just 1% above our Buy Below threshold of $75
• DLR is trading just 5% above our Buy Below threshold of $135
• EQIX is trading just 6% above our Buy Below threshold of $715.

Admittedly, Thursday's actions probably changed those numbers somewhat. But it hopefully shows you that they can come around.

We just have to be patient.

A Deep Dive Into CyrusOne

CyrusOne shares were trading at 18.95x full-year 2021 adjusted funds from operations (AFFO) estimates at last check. We consider this near 19x threshold to be an attractive place to begin accumulating shares and building a position (shares are trading just above our buy target).

As you can see below, CONE has proven itself to produce very reliable AFFO growth in the past. So we expect that trend to continue into the future as well.

(Source: FAST Graphs)

Admittedly, analysts expect to see that pace slow down a bit to the low single-digit area in 2022. Then again, this company has made a habit of outperforming analyst estimates…

So we certainly wouldn't be surprised to see management clear Wall Street's consensus once again by a wide margin again after all.

Fan Favorite Digital Realty at Your Service (Somewhat)

Digital Realty has been a favorite of ours for years. So any time shares trade with an attractive margin of safety attached, we're looking to accumulate.

Our $135 fair value estimate coincides with an approximate 21.5x multiple attached to 2021 AFFO estimates. That and a discounted approximately 20x multiple attached to 2022 estimates.

We expect to see DLR's AFFO compound at a high single-digit pace over the coming years. Therefore, we're happy to place a premium multiple on shares with regard to our fair value estimate.

Just not too much of one.

This company offers unique global size and scale… a strong balance sheet… and the most attractive dividend yield of the blue-chip datacenter REITs. As such, we suspect it's a stock that income-oriented investors looking to add technology-centric growth to their portfolios might be interested in.

(Source: FAST Graphs)

Equinix Has the X Factor, and Then Some

As we said before, EQIX is quite the company.

In the chart below, you'll see this company's management team has generated very consistent strong growth over the past five years. And we expect it to continue to compound its bottom line at a double-digit clip.

EQIX's forward-looking growth is best-in-class. So we're content placing the highest fair-value premium of the bunch here on EQIX shares.

Our $715 price target is associated with an approximate 26x multiple applied to 2021 AFFO estimates. That and a discounted ~24x multiple being applied to next year's AFFO expectations.

We certainly don't take placing a mid-20s p/AFFO premium on shares of any company lightly. However, when it comes to reliable growth, you're not going to find many REITs doing it better than EQIX.

Moving forward, we expect the attractive trajectories this company has set out on to continue.

(Source: FAST Graphs)

Dividend Growth in the Datacenter Subsector

Lastly, we'd like to highlight the strong dividend growth metrics each of our datacenter REITs have been providing.

One of the major complaints that income-oriented investors have about the tech space is that many of its blue-chip growth companies don't pay dividends. Clearly though, CONE, DLR, and EQIX don't have that problem.

CONE shares currently yield 2.75% - an admittedly light yield, as REITs go. But it's still well above the S&P 500's 1.3% and 10-year Treasury's approximate 1.6%.

What's more, CONE is on a nine-year increase streak with a five-year dividend growth rate of 11.7%.

During the last two years, CONE has slowed down its dividend growth rate, providing 2% raises in both 2020 and 2021. But we don't mind seeing that conservative stance during these uncertain times.

DLR, for its part, yields an even better 3.32%. Its most recent dividend increase was 3.6%, which was also below its five-year average of 5.5%.

Even so, we're pleased with the very reliable raises it's provided dividend investors over the years… and its 17-year dividend increase streak. Due to DLR's operations and very shareholder-friendly management team, we expect that trend to continue.

Then there's EQIX, which yields just 1.53%. That's very low for a REIT, but it's still outpacing the yields associated with the broader market.

Investors can find higher yields attached to U.S. Treasuries, it's true. But those yields aren't growing/compounding year in and year out.

EQIX is on a seven-year dividend growth streak. The stock's five-year DGR is 9.5%. And even this February, EQIX raised it by 7.9%.

At that rate, investors will see their passive income double every nine years or so.

We expect its AFFO will grow at a low double-digit rate moving forward. So continued high-single-digit annual raises appear to be sustainable.

All in all, this group of stocks checks a lot of boxes... from quality scores to strong fundamentals; from attractive growth prospects to strong shareholder returns.

In Conclusion…

For our closing thoughts, here are some iREIT Snapshots (powered by REIT Base). They include Iron Mountain (IRM) in the peer analysis:

EBITDA/Interest

Fixed-Charge Coverage

Debt/Total Market Cap

Dividend Payout Ratio ("AFFO")

Dividend Yield

Total Market Capitalization

Disclosure: I/we have a beneficial long position in the shares of IRM, DLR, CONE either through stock ownership, options, or other derivatives. 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.