Why Would You Short Digital Realty Anyway?

Summary

• Over my 11 years writing here, I’ve never seen a hedge fund short a REIT and get rich.
• Take Bill Ackman’s 2009 battle against Realty Income because it had allegedly poor credit quality.
• Or when, in 2013, Highfields Capital shorted Digital Realty because it was allegedly trading for around $45 more than it should be.
• Looking for more investing ideas like this one? Get them exclusively at iREIT on Alpha. Learn More »

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Back in 2018, I wrote an article titled Lesson Learned: Don't Short A Blue Chip REIT, which included this:

“I find it amazing that some of the wealthiest REIT investors – the hedge funds – claim to have a vast knowledge and understanding as to the nature of their complex strategies. Yet (their) overall performance often turns into fool's gold.”

And this:

“... hedge funds by nature are opportunistic… designed to pool people's money to invest in a diverse range of assets. Because hedge funds are lightly regulated (and are not sold to retail investors), they typically buy riskier positions and they often employ the use of short selling and leverage.”

To be blunt, over the 11 years I’ve been writing here – now with over 100,000 followers – I’ve never seen a hedge fund short a real estate investment trust ('REIT') and get rich. Despite how many have tried.

Hedge funds have unique risk-return characteristics. So it’s difficult to evaluate their performance against other investments.

Still, I’m baffled about why so many try to short stocks that are anything but distressed. Or even showing signs of weakness!

It makes no sense to me whatsoever.

It Didn’t Work Out Shorting Realty Income

Take Bill Ackman’s 2009 battle against REIT Realty Income (O) due to mispriced risk. Its dividend yield was around 7.5% while its private market cap rate values were closer to 10.5% – a 40% premium.

Ackman didn’t think Realty’s fundamentals could support the dividend and that a cut was imminent. But boy, was he wrong!

(Source: Yahoo Finance)

Remember that the outcome of a short sale is basically the opposite of a regular buy transaction. It’s just that the mechanics behind it result in extremely volatile risks.

It's somewhat like the law of gravity. But the law of investing is inflation, which means that betting against upward momentum is inherently risky.

When you do – and you keep that position for a long period of time – your odds get worse. You also don't enjoy the same infinite returns you get as a long buyer would.

A short sale loses when the stock price rises. And since a stock is (theoretically, at least) not limited in how high it can go - you can lose more than you initially invest.

Whereas the best you can earn is 100% if the company goes out of business and its stock loses its entire value.

Finally, the most concerning risk is leverage or margin trading. When short selling, you open a margin account, which allows you to borrow money from the brokerage firm using your investment as security.

Just as when you go long on margin, it's easy for losses to get out of hand. You must meet the minimum maintenance requirement of 25%, after all. And if your account slips below this, you'll be subject to a margin call…

Which means you'll be forced to either put in more cash or liquidate your position.

Nor With This Blue-Chip REIT Shorting Attempt

Here’s another example for you, this time from May 2013.

That’s when Highfields Capital decided to short shares of Digital Realty (NYSE:DLR). It reasoned that shares were too expensive at $65.50 and should be trading for around $20.00 per share instead.

Highfields CEO Jonathon Jacobson stated at the 18th Ira Sohn Investment Conference that pricing was “going lower, competition is increasing, and (Digital Realty) is tapping into capital markets as aggressively as they can.”

At the time, the REIT was working with a total capitalization of around $14 billion.

(Source: Yahoo Finance)

Highfields claimed at the time that DLR’s fundamentals were deteriorating. That and it was a commodity business with no barriers to entry.

Simply put, he was speculating that the REIT would fall without any true catalyst supporting the movement. It was simply an act to manipulate prices for personal gain.

Simply said, Highfields was shorting Digital because it thought it knew something others didn't know. I, of course, took the other side of the trade, writing:

“… it's time to jump on this cloud. Digital has a most attractive valuation of 13.6x, and I consider the fundamentals sound. Driven by growing worldwide demand and a very high-quality tenant base, Digital has evolved into a best-in-class global data center platform.”

In the end, it turned out I was right and Highfields was wrong. And, with all due respect to the hedge fund, that outcome should have been obvious.

Why Attacks on Digital Realty Are Probably “Short” Sighted

Analysts expect that the REIT sector saw 9% per-share funds from operations (FFO) growth in 2021. But we believe they should deliver even better growth of around 12% in 2022.

As such, iREIT on Alpha has recommended parts of these preferred property sectors:

• Hotels
• Healthcare
• Apartments
• Self-storage
• Net lease (including gaming)

We also like the so-called “technology trifecta” that includes:

• Datacenters
• Cell towers
• Industrials (logistics)

So far this year, we’ve seen these sectors perform as follows:

(iREIT)

As you can see, cell tower REITs – American Tower (AMT), Crown Castle (CCI), and SBAC (SBAC) – sold off the most at -21.8% year-to-date. On that note, we wrote a detailed article on the giant of the bunch, American Tower, a few days ago.

Moving on to the data center subsector, we can see that Digital Realty has dropped the hardest:

(iREIT)

Yet we recently added shares to our Durable Income Portfolio, recognizing the adequate margin of safety shown below…

(Source: Yahoo Finance)

You may recall that in my last deep-dive article about Digital Realty in March 2021, shares were trading in line with a fair value estimate in the mid-$130s. Today, they sit at just about the same price:

(Source: Yahoo Finance)

Essentially, DLR’s share price has gone nowhere as the company digested the financial repercussions of its $8.4 billion merger with Interxion.

That deal – which gave it a solid foothold in Europe – was completed in March 2020, right when the shutdowns spurred increased demand for bookings on the REIT’s cloud computing capacity.

Then, last year, DLR once again begun to scale its business model, into new markets.

(Source: DLR Investor Presentation)

More Reasons to Doubt Any DLR Shorts

These days, Digital Realty especially seems to be turning its sights to India as its next big growth market. Plus, in December, it announced the successful listing of Digital Core REIT as a standalone publicly-traded company on the Singapore Stock Exchange.

DLR contributed a 90% interest in 10 datacenters concentrated in top-tier markets across the U.S. and Canada to that venture. Valued at $1.4 billion with a 4.25% cap rate, the portfolio generated net proceeds of over $950 million.

Digital retains a 35% equity interest in Digital Core REIT, which it both sponsors and externally manages.

(Source: Yahoo Finance)

For the record, that offering was very well received and continues to look promising. The spinoff REIT has a long-term investment horizon and a global mandate to invest in stabilized income-producing data centers.

Another one of DLR’s global initiatives – which was announced on Jan. 3 – is the definitive agreement to acquire a 55% stake in Teraco, Africa’s leading carrier-neutral colocation provider. This will immediately establish Digital Realty as the leading colocation and interconnection provider on that high-growth continent.

Teraco complements the U.S. REIT’s other connected facilities in the Mediterranean. It hosts the strategic landing endpoints for subsea cables circling Africa from:

• Marseille and Athens in the North
• Mombasa and Maputo along the East Coast
• Durban and Cape Town in the South
• Lagos along the West Coast

Teraco has seven state-of-the-art datacenters across three key metros in South Africa alone. It serves more than 600 customers, including 275-plus connectivity providers, 25-plus cloud and content platforms, and approximately 300 enterprises.

Plus, it facilitates approximately 22,000 interconnections between customers, hosts seven cloud on-ramps, and provides direct access to seven subsea cables. Teraco has historically generated healthy double-digit growth in revenue and earnings before interest, taxes, depreciation, and amortization (EBITDA).

The company’s current development pipeline will expand its existing asset base by over 25%. And it owns land adjacent to its highly connected campuses in Johannesburg and Cape Town that will support another doubling of in-place capacity.

In short (no pun intended), it has a lot of good stuff going on.

January was also when Digital Realty opened its first South Korean datacenter and the country’s first carrier-neutral facility.

Digital Seoul 1 will serve as a connectivity gateway for latency-sensitive customer workloads. But it can be connected to hyperscale applications hosted in DLR’s second facility planned for Korea as well, totaling more than 60 megawatts of capacity currently under construction.

The two facilities will be tied together with fiber to create a connected, complementary campus. Together, they’ll provide solutions for the full customer spectrum, from small performance-sensitive colocation customers to huge hyperscale deployments.

Meanwhile, in North America, DLR’s development pipeline is diversified by product mix and geography, with projects underway in seven markets.

(Source: DLR Investor Presentation)

Breaking Down Digital Realty’s Balance Sheet

As of year-end 2021, Digital Realty reported its leverage ratio at 6.1x, while fixed charge coverage was 5.4x. Pro forma for settlement of the $1 billion September forward equity offering, those numbers both improve to 5.7x.

DLR also recast its credit facility during Q4-21, upsizing from $2.35 billion to $3 billion. That maturity date is extended by three years with a five basis-point price tightening.

After that, DLR raised approximately $850 million from its 10.5-year euro bonds at 1.375%. It used a portion of the proceeds to redeem all $450 million of its outstanding 4.75% U.S. dollar bonds due 2025.

(Source: DLR Investor Presentation)

As shown above, DLR’s weighted average debt maturity is over six years with a weighted average coupon just over 2%. A little over three-fourths of its debt is non-U.S. dollar-denominated, reflecting the growth of its global platform…

While also acting as a natural Forex ('FX') hedge for investments outside the U.S.

Also, 94% of its debt is fixed-rate, guarding against a rising rate environment. And 99% is unsecured, providing the greatest flexibility for capital recycling.

Summed up, Digital Realty has a clear runway with nominal near-term debt maturities – not to mention a balance sheet that can weather a storm but also fuel growth opportunities around the globe.

Reviewing the Latest Earnings Results From DLR

In Q4-21, DLR’s core FFO per share was up 4% year-over-year and 1% sequentially. That was driven by solid operational execution and cost controls. Those and a reduction in financing costs due to proactive balance sheet management over the past 12 months.

For the full year, per-share core FFO was up 5% year-over-year and $0.03 above its initial guidance range.

(FAST Graphs)

This year then, DLR expects $6.80-$6.90, including the 1% dilution from Teraco. That range also factors in 100-200 basis points of expected FX headwinds due to the dollar’s strength relative to 2021.

(FAST Graphs)

DLR expects to deliver revenue between $4.7 billion and $4.8 billion in 2022 and adjusted EBITDA of approximately $2.5 billion. Overall portfolio occupancy should remain within the current range despite the significant new capacity scheduled to come online during 2022.

The REIT also sees itself raising $500 million to $1 billion from capital recycling whether through:

• Contributions to Digital Core REIT
• Noncore asset sales to third parties
• A combination of both

Also, worth mentioning is how DLR anticipates continued growth in its dividend, just as it’s had each and every year since going public in 2004.

(FAST Graphs)

Never Short a Blue Chip (Especially Digital Realty)

For the same reasons I pointed out in 2013, you should never short a blue-chip REIT. Especially not a REIT like Digital Realty that has one of the widest moats on the planet.

The long-term growth trends that drive cloud computing demand are safe from inflation, Fed policy, and even consumer spending trends. More importantly, with the world upgrading to 5G wireless communications technologies, demand for data storage will only accelerate from here.

That being the case, the only major question regarding this blue-chip REIT concerns its fair price.

Since its 2004 IPO, DLR has increased its annual dividend payments by a 9% compound annual growth rate. Over the same span, its share price has grown at about 8% CAGR.

(FAST Graphs)

The net result has been a 17% average annual total return over the past 17 years. And with this year’s pullback.

We consider it an ideal time to begin accumulating shares in this global data center powerhouse.

(FAST Graphs)

DLR’s dividend yield is around 3.4%. And, as referenced earlier, it expects to grow by around 5% this year, while analysts are forecasting 7% for 2023. This provides us with a good roadmap to model returns, which we estimate to be around 15% per year.

(FAST Graphs)

Deja vu?

Admittedly, we don’t see the same short interest in Digital Realty today as we saw in 2015. Even so, we can clearly see the mispricing of this blue-chip REIT.

While Mr. Market clearly sees value in logistics landlords – which are trading at multiples of 34x or higher – crypto, and NFT, he doesn’t recognize that the glue holding all these things together are the datacenters.

These are mission-critical folks! Without them, you wouldn’t be reading this Seeking Alpha article in the first place.

In Conclusion…

As seen below, DLR is now yielding 3.4%, almost 50% more than Equinix (EQIX).

(iREIT)

Of course though, its payout ratio is also higher than EQIX. So that only makes sense:

(iREIT)

Also consider how its price to adjusted FFO (AFFO) multiple of 21.6x is much lower than EQIX's:

(iREIT)

As viewed below, EQIX's analyst growth estimates for 2022 and 2023 are a tad better than DLR. (Incidentally, keep an eye on Switch (SWCH)):

(iREIT)

All things considered, we’re maintaining our buy below target of $150, which means DLR is trading at a 10% discount. We're also maintaining our $180 trim target.

The stock hit an all-time high of $176.87 on December 27. But then 2022 happened, and back down it slid.

(iREIT)

Note: We recently bought a stake in the Real Money Portfolio. And we bought another tranche on Tuesday morning for the Durable Income Portfolio.

Disclosure: I/we have a beneficial long position in the shares of DLR, AMT, CCI, O, SWCH 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.