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REIT Rankings: Data Centers

In our REIT Rankings series, we introduce and update readers to 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.

(Hoya Capital, Co-Produced with Brad Thomas through iREIT on Alpha)

Data Centers REITs are the home of the "cloud," the physical epicenter of the internet. Within the Hoya Capital Data Center Index, we track the five largest data center REITs, which account for nearly $100 billion in market value: Equinix (EQIX), Digital Realty (DLR.PK), CyrusOne (CONE), CoreSite (COR), and QTS Realty (QTS). While not included in the index, business storage operator Iron Mountain (IRM) also operates a relatively small portfolio of data centers as well as non-REIT Switch Inc (SWCH).

One of the newer REIT sectors, Data Center REITs have been perennial outperformers since bursting onto the scene in the middle of the last decade, serving as one of the primary growth drivers of the commercial real estate sector. Data Center REITs comprise 4-12% of the broad-based Core REIT ETFs, but comprise roughly a third of the Benchmark Data & Infrastructure Real Estate ETF (SRVR), which also includes cell tower and billboard REITs. SRVR was one of the best-performing real estate ETFs in 2019 - despite its relatively low dividend yield of around 1.5% - driven by the 44% average total returns from these data center REITs, outpacing the 28% total return Core REIT ETF average.

As is common across most real estate sectors, the companies providing the behind-the-scenes infrastructure and real estate are not "household names" compared to their more consumer-facing tenants. The companies synonymous with cloud computing, Amazon (AMZN), Microsoft (MSFT), Google (GOOG), Alibaba (BABA), and IBM (IBM), are among the largest and most important 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 a smaller handful of tenants. Amazon owns roughly a 32% market share according to Canalys Research, outpacing the 18% share from Microsoft, 6% share from Google, and 5% share from Alibaba.

External growth has been the modus operandi for these companies as Data Center REITs have been relentless developers and acquirers over the last half-decade. Consolidation remains a continuing theme in the data center sector as these data center operators attempt to fend off mounting competitive pressures from their ever-powerful tenants. Data Center REITs own roughly 30% of investment-grade data center facilities in the US and command roughly a fifth of data center capacity globally. Outside of these five REITs, other companies operating in the space include a mix of international, private, and "c-corp" entities, including Zayo Group (ZAYO), Switch (SWCH), Flexential, Cyxtera, TierPoint, and Cologix.

Data center REITs operate in three primary lines of business: wholesale, colocation, and interconnection. 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 generally have significantly 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 and primarily rent these facilities to wholesale customers who pay lower per-SF rent.

The competitive landscape, particularly in the lower-barrier wholesale data center market, is shifting as these hyperscale providers are responsible for a steadily growing share of total leasing activity. These "public cloud" providers continue to build out their enterprise software suite, allowing enterprises to ditch their independent managed servers within the data center facilities and instead operate exclusively through a public cloud. Effectively, more customers are able to forego any direct relationship with these data center operators and contract instead with one of the handful of "public cloud" operators. Digital Realty expects half of all data center servers to be operated by just a half-dozen hyperscale tenants by 2021, up from 25% in 2018.

Responding to the mounting competitive threats posed by "hyperscale" giants - Amazon, Microsoft, and Google - 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. Digital Realty significantly expanded its interconnection and colocation business through its Interxion acquisition but remains a mostly wholesale-focused entity with roughly two-thirds of revenues coming from that lower-barrier business line. Interconnection, which relies on "network effects," can translate into a competitive advantage owned by REITs that hyperscalers have more difficulty replicating. Equinix has the highest "quality" portfolio of network-dense assets followed by the smaller CoreSite. CyrusOne, QTS, and the majority of non-REIT data center operators focus primarily on more competitive wholesale assets.

Typically housed in windowless industrial-style 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, who generally install and manage their own server and computing equipment in the facilities. 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. As noted above, data center REITs have been among the fastest-growing REIT sectors, but are also some of the most "expensive" and the lowest-yielding companies across the REIT space.

As discussed in our REIT Decade in Review, at the real estate sector-level, three themes dominated the 2010s: 1) The Housing Shortage, 2) The Retail Apocalypse, and 3) The Internet Revolution. Producing an annualized rate of return that was more than double that of the broader REIT average from 2015-2019, data center REITs have ridden the thematic growth trends associated with the boom in outsourced IT spending, and have been the third-best performing REIT sector over the past five years, trailing only manufactured housing and cell tower REIT sectors.

Heading into 2019, data center REITs were coming off an uncharacteristically weak year - dipping 14% in 2018 - but produced total returns of 44% in 2019. 2020 has picked off nearly exactly how 2019 left off with the "eREIT" sectors (Data Center, Cell Tower, Industrials) leading the charge yet again. Gaining 10% so far this year, the Hoya Capital Data Center Index has outpaced the 6.5% gains on the broader REIT average. This outperformance comes despite signs of slowing growth in global IT spending and choppy leasing activity from the hyperscale providers that we'll discuss in more detail below.

Network-dense portfolios produced superior performance in 2019, led by Equinix, which surged nearly 70%. Wholesale-heavy REITs including longtime sector stalwart Digital Realty were laggards last year as competition and pricing pressure from hyperscalers remain intense, while Digital Realty was also pressured by a luke-warm reaction to their plans to acquire InterXion - particularly from INXN's shareholders. QTS has been the leader out of the gates so far in 2020 following solid earnings results, while CyrusOne has lagged despite a nearly 8% pop last week after the firm reportedly retained Morgan Stanley after receiving M&A interest. In January, CyrusOne announced plans to cut 12% of their workforce, citing "continued moderation in demand from hyperscale customers."

For all the focus on M&A possibilities, the performance of the data center REIT sector continues to be at the mercy of the quarterly net leasing activity figures - the most closely-watched metric for the sector. Data center leasing activity surged in the first-half of 2018, but dipped sharply into the end of the year, dragging with it the stock prices of these REITs. While still choppy, leasing bounced back nicely in 2019, as have the REIT stock prices, and this past quarter's results were generally in line or slightly better the estimates. The $116 million in net incremental annualized revenues was a 45% jump from 4Q18, bringing the full-year leasing activity among these four REITs to $495 million, down only slightly from the $512 million in 2018.

Solid leasing data was a welcome relief given the continued uncertainty over global IT spending - particularly in the European and Asian markets - and over domestic hyperscale demand. In their most recent forecast in January, Gartner revised lower their 2019 estimates and their 2020 Worldwide IT Spending forecast. Gartner tracked just a 0.5% rise in overall global IT spending, the slowest rate of growth since the recession, but sees a pickup in 2020 to 3.4% growth. The Data Center and Enterprise categories, reflecting the critical drivers of data center spending, are expected to reaccelerate slightly next year after significantly slowing growth in 2019.

Digital Realty and QTS were the relative standouts in 4Q19 with solid beats on leasing figures, combining for $97 million of the $116 million total. CyrusOne and CoreSite, however, fell shy of leasing estimates. From an AFFO standpoint, Digital Realty, Equinix, and CyrusOne all topped prior guidance in the fourth quarter while QTS fell just shy, but the story has been the continued deceleration in AFFO growth - particularly among the wholesale-focused REITs - since the middle of the decade. Escaping the wholesale hyperscale weakness has been Equinix, which led the way with 10% AFFO per share growth in 2020 and expects to see 8% growth in 2020.

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 0.6% decline in cash renewal spreads, falling back into negative territory after recording its strongest reading since 4Q15 last quarter. DLR reported a 4% decline in "same capital" NOI growth in 2019, reflecting the continued (and perhaps underappreciated) competitive challenges facing the data center sector, particularly the wholesale/hyperscale business lines.

Overall, while industry average revenues and EBITDA grew roughly 10% in 2019, AFFO per share rose at a more modest 5.5% in 2019, roughly consistent with last year's 5.3% achieved AFFO per share growth rate. 2020 guidance was generally in-line with analyst estimates but call for a continued deceleration in AFFO per share growth to an average of 3.2%. (DLR plans to provide 2020 guidance after the InterXion acquisition.) The interconnection-focused Equinix continues to be the relative standout, while the smaller wholesale-focused REITs continue to see decelerating growth. We expect the trend of interconnection outperformance to continue for the foreseeable future, but will be interested to see whether consolidation will begin to stabilize the downward pressure on same-store pricing on wholesale leasing.

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. Digital Realty shook the data center landscape last October with its announced $8 billion acquisition of European data center giant Interxion (INXN), the eighth largest operator in the world. The fourth major acquisition for DLR since 2015, the firm acquired Telx in 2015, fellow REIT DuPont Fabros in 2017, and Ascenty in 2018. The combined entity will own more than 275 data centers and earn close to $4 billion in annual revenues in 2019. While not reflected yet in the chart below, the $8.4 billion deal will be the largest data center transaction ever, topping the $7.6 billion DFT deal in 2017.

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. The development pipeline has come back down to Earth over the last few quarters after briefly exceeding $3 billion at the end of 3Q18 and finishing 2018 at $2.9B. While development remains fairly disciplined and responsive to demand, it's unclear whether there are any real barriers to supply growth in the wholesale segment, a segment flush with cash from the hyperscale giants.

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 some of the fastest rates of FFO growth over the last five years at roughly 8%, but we expect growth to be closer to the REIT average over the next half-decade. As noted above, data center REITs trade at an estimated 20-30% premium to NAV. 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.

Data Center REITs pay an average dividend yield of 2.3%, which is below the REIT sector average dividend yield of around 3.4%. Data center REITs pay out just 50% of their free cash flow, leaving them ample capacity to increase dividends or reinvest in growth. In our recent report, "The REIT Paradox: Cheap REITs Stay Cheap", we discussed our study that showed that lower-yielding REITs in faster-growing property sectors with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding counterparts.

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 4.2% followed by Digital Realty at 3.3% and CyrusOne at 3.0%. Equinix remains the most "growth-oriented" REIT, paying a yield of just 1.6% but retaining more than 60% of free cash flow.

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.

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.

Data Center REITs - the physical epicenter of the "cloud" - continue to ride the substantial secular tailwinds behind the big-data" and cloud computing boom, surging nearly 50% in 2019 and are off to another hot start in 2020. Storm clouds have been building around the high-flying technology-focused sector, however, as intense competition and furious supply growth have weakened pricing power, underscored by Digital Realty's 4% decline in "same capital" NOI growth in 2019.

Responding to pressure from the hyperscale giants Amazon, Microsoft, and Google data center operators have turned to M&A to regain pricing power, a trend we expect to continue. As we told National Real Estate Investor in January, "Given the favorable cost of capital enjoyed by these REITs, we see more consolidation likely in the early 2020s, and would be shocked if there were still five REITs in their current form by 2025. Given the recent "merger mania" trends in the REIT sector over the past month, we'd say that at least one acquisition is likely by the end of 2020.

While we expect continued robust demand for data center space, the outlook for the REITs themselves remains cloudy given the increasingly competitive landscape. With negative same-store growth, these companies are highly dependent on external growth, underscored by the moderation in AFFO growth in 2020 to levels below the broader REIT average. That said, we believe that incremental demand associated with the "next generation" of cloud computing - applications like artificial intelligence, the internet of things, and augmented reality - could shake-up the competitive dynamics in a way that could ultimately benefit these REITs and will be the "wild-card" that will determine if the 2020s are as strong as the 2010s for the data center REIT sector.

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Disclosure: I am/we are long DLR, COR. 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: Hoya Capital Real Estate advises an ETF. In addition to the long positions listed below, Hoya Capital is long all components in the Hoya Capital Housing 100 Index. It is not possible to invest directly in an index. Real Estate and Housing Index definitions and holdings are available at HoyaCapital.com.

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. Real Estate and Housing Index definitions and holdings are available at HoyaCapital.com.

Excerpt from:
Data Center REITs: Battle Of The Clouds - Seeking Alpha