Data Center REITs: Merger Madness

Nov. 17, 2021 10:30 AM ETCONE, EQIX, DLR, DBRG, SWCH, IRM, AMT, KKR, BX, CYXT, LMRK, RXT, VNQ, RQI, RNP, IYR, XLRE, RFI, KBWY, SCHH, NRO, FREL, SRVR, JRS, DRN, USRT, ICF, RWR, DRV, URE, SRS, SEVN, FRI, REK, PSR, BBRE, PPTY, VRAI, IARAX17 Comments

Summary

  • The Data Center REIT sector has been substantially and rapidly transformed as the three largest data center portfolio acquisitions in history have been announced in just the past several months.
  • We predicted an impending M&A boom but expected Digital Realty and Equinix to scoop up their smaller peers. Instead, CyrusOne and QTS have been taken private while American Tower acquired CoreSite.
  • While we'll bid farewell to these three data center REITs, Switch announced plans last week to convert to a REIT while Cyxtera sees a REIT conversion as a "medium-term" goal.
  • The lack of serious interest from DLR and EQIX - which are sitting on a mountain of dry powder - suggests that these REITs are working on a major M&A deal of their own and a mega-merger between the two isn't outside the realm of possibility.
  • Scale is critical amid intense competition from the hyperscale giants – Amazon, Microsoft, and Google. Pricing power remains soft, but external growth through building and buying continues to fuel solid FFO and dividend growth.
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African American IT Engineer in Data Center

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REIT Rankings: Data Centers

data center reits

The Data Center REIT sector has been substantially and rapidly transformed as the three largest data center portfolio acquisitions in history have been announced in just the past several months with CyrusOne (CONE), CoreSite Realty (COR), and QTS Realty each being acquired. Within the Hoya Capital Data Center Index, we track the three remaining data center REITs - Equinix (EQIX), Digital Realty (DLR), and DigitalBridge (DBRG) - and recently added Switch (SWCH), which announced plans last week to convert to a REIT. While not included in the index, business storage operator Iron Mountain (IRM) also operates a growing portfolio of data centers.

data center REITs

Housed in windowless buildings surrounded by massive generators and cooling equipment, data centers provide the critical infrastructure - power, cooling, and physical rack space - to a variety of enterprise customers with different networking and computing needs. Data Center REITs own roughly 600 data centers - 30% of investment-grade data center facilities in the US - and command roughly a fifth of data center capacity globally. As we'll discuss in more detail below, responding to the mounting competitive threats, data center operators have turned to M&A to regain some degree of pricing power, with a particular focus on the higher-value interconnection-focused facilities.

data center REITs 101

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, or more precisely at the "intersection" of various networks, are able to provide higher-value network-based colocation and interconnection services, which command higher rent-per-MW and have higher barriers to entry due to the inherent "network effects." Properties on the periphery or those lacking a critical mass of interconnection tenants typically provide more ubiquitous enterprise-based wholesale services, including storage and cloud-based software applications.

data center business lines

Earlier this year in Go Big or Go Home, we predicted an impending M&A boom and identified the three smaller data center REITs as prime acquisition targets. Several months later - all three REITs have indeed been taken out - including two this week as CoreSite finalized a deal to be acquired by cell tower REIT American Tower (AMT) in a $10B deal at $170/share in cash while CyrusOne finalized a deal to be taken private by KKR (KKR) and Global Infrastructure Partners for $90.50/share in cash - representing a total deal value of roughly $15B including debt. These deals follow Blackstone's (BX) $10B acquisition of QTS Realty earlier this year.

Notable REIT M&A of 2019-2021

While we correctly predicted the wave of M&A, we thought that surely Digital Realty and Equinix would be leading the charge as both major data center REITs are "overdue" for a major M&A move based on their historical cadence and both are sitting on a mountain of dry powder. The point is underscored by the acquisition chart below which shows that these REITs have been as "quiet" as they've ever been on the acquisition-front despite favorable valuations that give the "green light" for external growth. The lack of serious interest from DLR and EQIX suggests that these REITs are working on a major M&A deal of their own that would preclude these pursuits and we increasingly believe that a mega-merger between the two isn't outside the realm of possibility.

data center REIT acquisition

While DLR and EQIX have been awfully quiet - and we'll soon bid farewell to the three smaller data center REITs - there has been no shortage of activity across the rest of the sector as several new players enter the REIT universe. Switch - which operates 16 wholesale data centers with 5 million square feet of space - announced plans last week to convert to a REIT in 2022. Cyxtera (CYXT) - which owns 61 data centers with a similar high-quality interconnection-heavy portfolio as CoreSite - sees a REIT conversion as a "medium-term" goal. CYXT went public via a Special Purpose Acquisition Vehicle ("SPAC") and began trading in late July.

data center reit landscape

Meanwhile, DigitalBridge - formerly Colony Capital - has delivered strong performance since its "digital transformation" and acquired Landmark Dividend this year, which will soon own its subsidiary, Landmark Infrastructure (LMRK) - which owns a range of digital communications-related assets including ground leases to cell towers and billboards. Outside of these aforementioned data center operators, other companies operating space include a mix of international, private, and "c-corp" entities, including Rackspace (RXT), TierPoint, Flexential, TierPoint, and Cologix.

largest data center operators

Interconnection, which relies on "network effects," can translate into a competitive advantage that new entrants have difficulty replicating. Equinix has the highest "quality" portfolio of network-dense assets followed by the smaller CoreSite. Digital Realty significantly expanded its interconnection and colocation business through its Interxion acquisition but remains a mostly wholesale-focused entity. CyrusOne, QTS, and the majority of non-REIT data center operators focus primarily on more competitive wholesale assets.

data center REITs 101

Data Center REITs Performance

Despite the wave of M&A activity across the sector this year, data center REITs have uncharacteristically underperformed most of their REIT peers this year and until gains this past week - were the single worst-performing sector. The underperformance comes after two strong years of outperformance as data center REITs were the top-performing REIT sector in 2020 and the fourth-best-performing sector in 2019. Data center REITs are higher by 16.4% so far this year compared to the 30.0% returns by the Vanguard Real Estate ETF (VNQ) and the 25.0% returns from the S&P 500 ETF (SPY).

REIT returns 2021

The larger data center REITs - EQIX and DLR - have notably lagged this year while CONE and COR have each surged about 20% over the past quarter as M&A speculation mounted ahead of their announced deals. Of note, the four large data center REITs are among the best-performing REITs across all sectors since 2015 with COR delivering the strongest 5-year total returns, followed by EQIX and CONE. DigitalBridge - which has made strong progress on its "digital transformation" - has led the way this year with gains of 70%.

data center REIT performance

Go Big Or Go Home - The Need for Scale

While cloud spending continues to boom, it is increasingly concentrated in a smaller number of providers. The companies synonymous with cloud computing - Amazon (AMZN), Microsoft (MSFT), Google (GOOG) (GOOGL), Alibaba (BABA), Oracle (ORCL), Salesforce (CRM), and Snowflake (SNOW) - are among the largest and most critical tenants of these data center operators, and have become even more critical tenants in recent years as a growing share of leasing activity has accrued to these "hyperscale" tenants which have increasingly dictated the terms of leasing agreements and pricing.

public cloud market share

Leasing activity - the most closely-watched earnings metric - remains on a long-term favorable trend driven by this hyperscale leasing demand and was slightly stronger than expected in the third quarter despite concerns that ongoing chip shortages may put downward pressure on data center demand. As discussed in our REIT Earnings Recap, Digital Realty led the way with $113M in annualized bookings for the quarter while CyrusOne reported a respectable $38M in bookings while we're also beginning to see some meaningful contribution from Iron Mountain and DigitalBridge as well.

data center leasing

While it's better to be in a sector with secular tailwinds than headwinds, data center pricing remains increasingly competitive and is likely to remain so for the foreseeable future as an ever-growing share of leasing activity is accruing to a shrinking quantity of increasingly powerful tenants. We focus on releasing spreads as the closest comparable to the "same-store NOI" metric common to other REIT sectors, which is a key forward-looking indicator of underlying pricing power and on supply/demand conditions. Re-leasing spreads - which averaged -3.3% in Q3 for DLR - indicate that pricing power remains soft.

data center leasing 2021

With flat-to-negative "same-store NOI" growth rates, external growth continues to be the modus operandi and primary driver of growth for these companies as Data Center REITs have been relentless developers over the last half-decade. After cooling in 2019, the development pipeline has shot up to new record-highs in 2021. Data center REITs now represent almost 15% of all development activity within the REIT sector, the highest on record. Supply growth remains a continued headwind, and while development remains fairly disciplined and responsive to demand, it's unclear when - if ever - we'll see any meaningful barriers to supply growth emerge, as technological advancements make the correlation between demand and physical space required far less predictable that comparable sectors like industrial REITs.

data center development pipeline

Overall, third quarter results were fairly lukewarm for a sector where "beat and raise" had become the standard. Digital Realty and CyrusOne were the lone data center REITs that raised their full-year outlook as DLR increased its 2021 AFFO growth guidance by 80 bps to 4.9% while CONE hiked its growth up 120 bps from its prior outlook. Equinix slightly lowered its full-year revenue outlook on currency adjustments and held its FFO outlook steady - which calls for sector-leading growth of 9.6% - while CoreSite maintained its full-year outlook for revenues and FFO. Overall, while pricing power remains soft amid stiff competition, external growth through building and buying continues to fuel solid mid-single-digit FFO and dividend growth.

data center REIT affo per share growth

Data Centers 101: Inside The Cloud

Per an analysis from Canalys Research, cloud spending increased 35% worldwide to a record $50B in Q3. Amazon Web Services spending grew 39% year-over-year and accounted for 32% of total cloud infrastructure services. Microsoft Azure grew over 50% for a fifth-consecutive quarter, accounting for 21% of cloud spending. Google Cloud, the third largest cloud provider, grew 54% year-over-year and took 8% of the market share. Last quarter, research firm Gartner predicted public cloud spending will climb 23.1% this year and 19.6% in 2022, up from the 11.3% growth in 2020.

public cloud forecast

Major players on the hardware side include Intel (INTC), Advanced Micro Devices (AMD), Nvidia (NVDA), and IBM (IBM), which collectively provide the majority of networking equipment utilized by data center tenants. Interestingly, while spending on the "public cloud" by hyperscale providers continues to surge, spending on the physical hardware - servers and chips - has seen relatively lackluster growth, due in part to the lingering global chip shortage. In their most recent forecast in July, Gartner revised down their growth outlook for IT spending on devices and data center systems but still sees moderately solid growth over the next two years.

public cloud service revenue 2021

Data Center REIT Dividend Yields

Each of the major data center REITs have all increased their dividend in 2021 following a similarly perfect record of dividend increases last year as well. Still very much a "growth-oriented" property sector, data center REITs pay an average dividend yield of 2.1%, which is below the REIT sector average dividend yield of 2.7%. Data Center REITs pay out only 60% of their available free cash flow, however, leaving ample capacity to increase dividends or reinvest in external growth.

dividends data centers

Within the sector, we note the differences in distribution strategies for these five REITs and their approximate FFO payout ratios. Soon-to-be-acquired CoreSite yields a sector-high of 3.05% followed by Digital Realty at 2.97% and CyrusOne at 2.43%. Equinix remains the most "growth-oriented" REIT, paying a yield of just 1.48%. These REITs have achieved dividend growth of more than 10% over the past five years, among the best in the REIT sector.

dividend yield data center

Takeaways: M&A Boom Isn't Done Yet

The Data Center REIT sector has been substantially and rapidly transformed as the three largest data center portfolio acquisitions in history have been announced in just the past several months. Scale is critical amid intense competition and while pricing power remains soft, but external growth through building and buying continues to fuel solid FFO and dividend growth. The lack of serious interest from DLR and EQIX in pursuing their smaller peers suggests that these REITs are working on a major M&A deal of their own.

data center REITs

Future growth won't come as easy in the 2020s as it did over the prior decade and will require continued operational execution, but a mega-merger between the two isn't outside the realm of possibility, which would do wonders to solidify their competitive positioning relative to the big-tech giants and surely have reverberations across the technology ecosystem.

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