Data Center REITs: Positioned For Cloud Competition (Equinix And Digital Realty)

REIT Rankings: Data Centers

This is an abridged version of the full report published on Hoya Capital Income Builder Marketplace on November 30th.

Data Center REITs have been one of the best-performing property sectors over the past quarter as property-level fundamentals have strengthened despite the broader pressure on large-cap technology names and a downshift in cloud-related spending alongside the reversion to pre-pandemic levels of consumer and business device sales. Ironically, just as Data Center REITs became a trendy “short” idea centered on a thesis of weak pricing power and competition from hyperscalers, rental rate trends have meaningfully improved. Within the Hoya Capital Data Center Index, we track the two major data center REITs – Equinix (NASDAQ:EQIX) and Digital Realty (NYSE:DLR) – alongside a handful of former REITs, potential future REITs, and real estate operators.

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.

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.

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. Earlier this year, short-selling firm Chanos & Company launched a fund that bets against US-listed REITs with a particular focus on data centers. Described as the firm’s “big short,” Chanos argued that “value is accruing to cloud companies, not the bricks and mortar data centers” and believes that “their three biggest customers are becoming their biggest competitors.

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 remains relatively strong – rising nearly 30% year-over-year in the latest Canalys Research report – 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 October, Gartner downward revised its growth outlook for IT spending across the board – underscored by an 8.4% expected decline in device spending this year. Spending on data center systems has held-up far stronger than other categories, however, and is still expected to record double-digit growth this year at 10.4%.

Chanos’ short thesis received significant pushback from data center REITs and the majority of the data center industry’s sell-side analysts, who point out that while Chanos accurately characterizes the overall competitive dynamics over the past five years, the degree to which the cloud is a “zero-sum” game is overstated. In fact, the pricing power of these data center REITs has meaningfully strengthened in recent quarters as strong absorption and moderating supply growth have sent vacancy rates towards record lows and has started tilting the negotiating leverage back towards the landlords for the first time before the pandemic. CBRE reported that “demand for capacity more than tripled year-over-year in H1 2022 as companies continued to shift toward hybrid cloud environments… but developers can barely keep up with demand. Among primary markets, almost 75% of under-construction capacity in H1 was already released. Vacancy rates fell in all seven primary markets.”

While a larger share of leasing activity is indeed accruing to a smaller number of tenants, the overall pie continues to grow and it increasingly appears that there is enough economic value to be shared by tenants and property operators alike. Consistent with the “Go Big or Go Home” theme we’ve discussed for the past half-decade, data center REITs haven’t been sitting idle amid the looming competitive threats from hyperscalers as the industry has seen a wave of consolidation and M&A over the past half-decade. Three data center REITs were acquired last year including Blackstone’s (BX) acquisition of QTS Realty, KKR’s (KKR) acquisition of CyrusOne, and cell tower REIT American Tower’s (AMT) acquisition of CoreSite. We’re now down to two major REITs after DigitalBridge (DBRG) announced that it will transition to a conventional C-Corp as it focuses its strategy on its fee-based investment management business. DBRG also reached a deal in May to acquire Switch (SWCH) – an operator that had planned to convert to a REIT by 2023.

Cyxtera announced earlier this month that it will delay its REIT conversion to January 2024 instead of January 2023 which the firm noted is “not due to any issue impacting the company’s ability to meet the requirements to elect REIT status, but rather to maintain flexibility as it considers alternatives for the company and its capital structure.” CYXT has been thoroughly beaten-down this year – caught up in a broader small-cap tech downdraft with SPAC-related names hit particularly hard – plunging more than 80% this year. Other major publicly-traded players in the space include Iron Mountain (IRM), which operates a growing portfolio of data center alongside its business storage portfolio. Other companies operating space include a mix of international, private, and “c-corp” entities, including Rackspace (RXT), TierPoint, Flexential, Cologix, Lumen (formerly CenturyLink), and Global Switch.

Data Center REIT Fundamentals

As discussed in our REIT Earnings Recap, Equinix – which was one of our three “Best Ideas in Real Estate” before its recent rally that pushed valuations towards less compelling levels – was an upside standout after reporting strong results and raising its full-year 2022 outlook driven by a sixth consecutive quarter of record leasing activity and strong pricing trends. Of note, EQIX reported same-store revenue growth of 7% in Q3, continuing an acceleration in rent growth since early 2021. EQIX now sees full-year FFO growth of 7.7% (10.5% on a constant-currency basis) – up 100 basis points from last quarter which the firm attributed “a favorable pricing environment, lower-than-expected churn, and the strength of our digital services offerings.”

Digital Realty reported mixed results – highlighted on the upside by a record level of leasing volume – but offset by slightly softer pricing trends following a meaningful acceleration in the first half of the year. During the quarter, DLR signed total bookings expected to generate $176M of annualized GAAP rental revenue – its strongest quarter of bookings on record. Rental rates on renewal leases signed during the quarter rolled down 0.5% on a cash basis – down from the 3.3% average in the first half of 2022. Foreign currency headwinds prompted a downward revision to its full-year FFO growth target, which is now expected to rise 3.0% this year – down from 4.1% Iron Mountain, meanwhile, executed new and expansion leases totaling $9M in annualized revenue – and reiterated its guidance calling for total additions of 130MW this year, up from 50MW in its initial outlook earlier this year, an impressive total that establishes IRM as a series player in the space.

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. The development pipeline reached fresh record highs in the third quarter despite a broader pullback in development spending among non-REIT players that have helped to tighten market fundamentals. Adding further color to the improving market conditions and pricing dynamic, Digital Realty commented on its earnings call that “the pricing power pendulum is shifting back towards us. I think we’ll continue this trend of more positive cash releasing spreads, which were positive in the first 2 quarters this year and remain positive on a full-year basis for 2022.”

While we correctly predicted the wave of M&A in the sector in 2021, we thought that surely Digital Realty and Equinix would be leading the charge as both major data center REITs have been “overdue” for a major M&A move based on their historical cadence and both are sitting on a mountain of dry powder. Digital Realty did close on a modestly-sized deal in the quarter to acquire a 55% stake in Teraco, Africa’s leading data center provider for roughly $2B in a deal that is expected to be 1% dilutive to Digital Realty’s FFO in 2022, breakeven in 2023, and accretive beginning in 2024. DLR was also busy last year working on the public listing of Digital Core REIT as a standalone publicly traded vehicle listed on the Singapore Stock Exchange. Equinix, meanwhile, recently closed on a $705M deal to acquire four data centers from Entel as it expands into the Chile and Peru markets which is expected to be immediately accretive to Equinix’s AFFO this year.

While Equinix and Digital Realty were notably quiet on the acquisition front amid the frenzy of M&A activity during the pandemic, their patience appears to be quite prudent in hindsight, allowing these REITs to further de-lever their balance sheets and avoid a more pronounced drag from higher rates, while also positioning them to be aggressors as other more-highly-levered private players seek an exit. On that note, Blackstone – which was the most aggressive buyer of REITs during the pandemic including its $10B takeout of QTS – announced this week that it will sell its $5.5B stake in MGM Grand and Mandalay Bay to VICI Properties (VICI) as BX’s nontraded REIT platform has been pressured by redemptions. Notably, the three data center REIT acquisitions last year were acquired at “top dollar” when the data center REIT Index was 40% above its level today.

Data Center REITs Performance

A perennial outperforming in the REIT sector throughout the prior decade, Data Center REITs have uncharacteristically lagged this year, pressured the aforementioned headwinds related to weakening chip demand, the broader tech sell-off, FX headwinds, along with the pressures related to the widely-covered short thesis. So far in 2022, the Hoya Capital Data Center Index is lower by 24.5% compared to the 24.1% decline by the Vanguard Real Estate ETF (VNQ) and the 14.2% decline from the S&P 500 ETF (SPY).

Despite the sell-off, data center REITs are still among the best-performing REIT sectors over most longer-term measurement periods with 5-year total returns of roughly 6.6% – roughly three percentage points above the broader REIT average during that period. Future growth won’t come as easy in the 2020s as it did over the prior decade and will require continued operational execution, but we believe that current valuations appear quite attractive as similar setbacks in 2014 and 2018 amid rising rate concerns and industry-specific headwinds ultimately proved to be rewarding buying opportunities.

Data Center REIT Dividend Yields

Few property sectors have delivered more consistent dividend growth than data center REITs, and both Equinix and Digital Realty have continued their track record of dividend growth this year. Each of the major data center REITs increased their dividend in 2021 as well following a similarly perfect record of dividend increases in the prior year as well. Still very much a “growth-oriented” property sector, data center REITs pay an average dividend yield of 3.0%, which is below the REIT sector average dividend yield of 3.7%. Data Center REITs pay out only 55% of their available free cash flow, however, leaving ample capacity to increase dividends or reinvest in external growth.

Within the sector, we note the differences in distribution strategies for these data center operators and their approximate FFO payout ratios. Specialty REIT Iron Mountain – of which data center assets comprise roughly 10% of its revenues – pays a dividend yield of 4.55%. Among the pure-play data center REITs, Digital Realty yields a sector-high 4.34% while Equinix pays a yield of 1.80%. DigitalBridge, meanwhile, reinstated its cash dividend at $0.01 in the third quarter, fulfilling a pledge made to reinstate the dividend that the firm made before its decision to operate as a C-Corp instead of a REIT.

Takeaways: Cloud Is Not ‘Zero Sum’ Game

Ironically, just as Data Center REITs became a trendy “short” idea centered on a thesis of weak pricing power and competition from hyperscalers, rental rate trends have meaningfully improved. Competition from the hyperscale giants– Amazon, Microsoft, Google– has been a well-established risk and the “growing pie” related to cloud computing spending has created more than enough economic value to be shared. While property-level fundamentals are not as compelling as the cell tower space where REITs have effectively corned the market, the concentration of data center REITs shouldn’t be discounted either as Equinix and Digital Realty have built relatively dominant platforms. We see current valuations as quite compelling for both major data center REITs, but would lean more heavily toward Digital Realty at these valuations following Equinix’s 25% rally over the past month.

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