Digital Realty Trust, Inc. (NYSE:DLR.PK) Bank of America 2022 Global Real Estate Conference Transcript September 14, 2022 2:55 PM ET
Executives
Jordan Sadler – Senior Vice President, Public and Private Investor Relations
Analysts
David Barden – Bank of America
David Barden
Being with us here today, continuing to join us at the 2022 Global Real Estate Conference. I hope everything is going well for everybody. My name is David Barden. You did not see me here last year. I took over data center coverage from my colleague, Mike Funk, who got promoted to cover the Internet and I am left to cover Comm Infrastructure. So I head Comm Infrastructure Research for Bank of America based in New York with my team, John Crawford and Alex Waters. And so hopefully, we will all get to know each other better. To my right is someone you probably all do know very, very well, the new Head of IR for Digital Realty, Jordan Sadler. So, Jordan, thank you for joining us.
Jordan Sadler
Yeah. Thanks, David, and good afternoon, everybody, and thank you, David and Jeff [ph] and Bank of America for hosting Digital Realty.
David Barden
Okay.
Jordan Sadler
I am the new Head of — not so new anymore, I guess, Head of Investor Relations, Public and Private Investor Relations for Digital Realty. We are a data center REITs. I can probably spend a couple of minutes updating, if I can.
David Barden
Yeah.
Jordan Sadler
Where we are at in terms of the world, we have had a number of conversations with investors today and a lot of folks are focused on a handful of things. Obviously, the macro environment is tenuous to say the least and we had an interesting inflation print and there’s been some significant volatility in the capital markets.
That said up, how is that affecting your business, and I am here to say, we continue to be a pretty resilient business with secular drivers supporting demand. And I know that’s probably somewhat disappointing to some folks who are looking to see — looking for cracks and looking for changes at the margin.
But as we talked about on our second quarter call, our pipeline remains very strong and as large as it’s ever been in terms of the demand funnel and while we did not print the most significant quarter — in the second quarter…
David Barden
Right.
Jordan Sadler
… of overall bookings, relative to the records we put up in the fourth quarter and the first quarter, we still have a strong line of sight to pretty good performance on the leasing front. We have had some nice traction on the rate front that’s resulted in an improvement in renewal spreads and the outlook towards that has continued to be pretty good given the overall net absorption and the falling vacancy that we have seen pretty globally and then the constraints around the ability to bring on new supply across the industry.
So, overall, we feel like the business is in a reasonably good position and despite the overall volatility and some of the performance we have seen in the market.
Question-and-Answer Session
Q – David Barden
Great. So I want to make sure this is interactive. You guys feel free to jump in if I am like taking all the oxygen in the room, feel free to knock me back. I would — I don’t want to necessarily ask you my very first question, being the Head of IR, Digital Realty, and you and I having met for the first time just now. But the stock is at a 52-week low today. It got up to almost $180 before. We are now at $116. Can you kind of elaborate a little bit on why you think that is?
Jordan Sadler
So when the stock was almost at $180, the yield on the 10-year treasury bond was 1.5% and today, the yield on the 10-year treasury bond is a couple of hundred basis points above that. And based on the historical correlations between REITs and rates, REITs overall should be down quite a bit.
David Barden
Yes.
Jordan Sadler
I think, rule of thumb, if we saw 2000 basis points of sell-off relative to 100 basis points of upward move in interest rates, it’s probably not terribly far off.
David Barden
Yeah.
Jordan Sadler
So I think that’s probably number one, right? There’s been significant change, obviously, in the cost of capital and the risk free rate. Number two, there’s probably been some idiosyncratic stuff to point to for ourselves and some of our competitors in the space.
One thing I’d point out is, at some point this year, we announced — earlier this year, I should say, we announced a large transaction, large investment in the leading colo and connectivity provider in Africa.
So we bought Teraco. We closed on it. That was a significant use of capital. It was not a terribly accretive deal. In fact, it was an initially dilutive deal. It will be growth accretive and it will be a nice driver of growth over the next several years.
But that’s definitely something that’s worth noting relative to the performance this year and idiosyncratic to Digital. And the other aspect is, there’s been some things going on, on the energy front. I don’t know if you are aware.
David Barden
I heard something.
Jordan Sadler
Yeah. So the availability and the cost of power along with what seems to be a troubled or challenged utility in the Northern Virginia region has caused some uncertainty around, let’s just say, all things data center ability to procure impact on — flow-through impact on tenants, et cetera.
David Barden
So thank you for that and I — there’s probably more to explore and unpack there. But just on that topic around Northern Virginia, Dominion Energy, the transmission power line limitations and concerns about the next five-year settlement. I met with Andy and Bill at our Telecommunications Conference in L.A. last week, and Andy was saying, that you expected more news this week from Dominion. Is there any update that you can share on what’s happening in Nova?
Jordan Sadler
No. That’s correct. We do expect more news from Dominion this week. So that is a good update. So and in truth we do this a lot on the comm. So and I have been here, frankly. So I don’t know if we heard anything today. But it is a very real-time dialogue.
So the — we told folks around the time of our earnings call — during our earnings call that we had been communicated to and they were going to go back and scrub the model and figure out how much would be able to be delivered based on this transmission issue, not generation issue.
They have come back to us after that initial scrubbing and given us some initial guidance as to where we are headed. And similar to what we talked about on the July call, it turns out it’s less than we expected originally.
So there is — the question is how much less relative to what we were previously expecting and that’s — are we going to see 50% less development or 80% less development over the 2023 to 2025 — 2023 to 2025 timeframe?
And we don’t know, we don’t have a great sense for exact with precision where that’s going to fall out, but it’s going to be in that range or thereabout and then it will probably happen pretty broadly about the market.
David Barden
So I have a question about that, which is Digital Realty is an enormous equity global company and if three years from now that one market happened to be 50% less developable than you thought it might have been on your planning process in 2021, does that mean anything?
Jordan Sadler
No. So that’s the short answer. We have a significant land site. Obviously, Western Lands, Digital Dallas, where we can build a gig of capacity, in Eastern Loudoun County next to the airport or used to be airport too. The transmission constraints are going to delay the pace of the development we could bring on.
That pinch point in Loudoun County may cause a delay in that development and those development deliveries, which really weren’t slated. You don’t see any of that development really teed up on our development schedule.
We don’t have a gigawatt being delivered or underway in Digital Dallas or in the Western Lands. We have 78 megawatts under construction, a little bit here, a little bit there and have a handful of buildings. Some of that will get completed, leased and will commence.
And then there’s other stuff that was longer dated that’s probably going to get pushed out, right? Some of it we will be able to bring on, some of it’s going to get pushed out. So the question is, what are we going to do instead because that could lead to reduced signings.
David Barden
Let me ask you a follow-up on that because…
Jordan Sadler
Yes.
David Barden
Can we not assume that in the absence of more V that it gives you the power to price at a greater P and that is kind of an offset to that piece of the puzzle?
Jordan Sadler
So I think that’s a present observation. I think at the end of the day, this is going to cause — because it’s market-wide, we are not bigger than the market. It’s going to happen to everybody. It’s tantamount to a supply shock in the largest market in the world.
And people should understand the scale of this market relative to all the other markets, right? This is a 3-gigawatt market where there are regular 100-megawatt type requirements, whereas the next largest markets in this country at least and really globally, but in this country are 600 megawatts, 20% the size of, right, so 80% smaller than this market.
So you can’t necessarily take these requirements and just stick them in other markets that easily because it will quickly fill up all of those other markets. And so, yes, you are probably going to have — the supply shock will probably cause a rise in P.
David Barden
So there’s offsets and there is dynamics that are going to support that. And I think that’s something else that we haven’t — that the market hasn’t kind of really tried to think about or maybe Dominion Energy hasn’t, is all the buying infrastructure money that’s going to get poured into this sector in the next five years. I mean if this is a pinch point for the national data center grid, the global infrastructure, global Internet grid, money is going to go there. I mean this problem is going to get solved?
Jordan Sadler
I mean, I don’t have great insight into how that money will be invested, but that I think that’s probably a good insight. I think money probably will be invested and I think we have seen a lot of concern over the course of the summer over what would happen or could potentially happen in Germany and then Europe at large.
And now we are starting to see some of the potential cures come to fruition. We saw a lifting of a ban on fracking. We saw — we have seen some other things start to happen and I would imagine you are right, probably going to see some additional resources come to bear from essentially the politicians.
David Barden
Sorry, just to kind of close out on the power issue just because it’s such — it’s been something we have been talking about for a whole year. The Nova situation kind of brought home the conversation that we were having about Europe for most of the year. We have the Nord Stream pipeline shutdown from Russia and Germany. That infects the natural gas distribution. Now my understanding, Digital Realty has more of a power pass-through model, right? It doesn’t — it just is what it is. You can — if they are not paid, but most people will pay it, because they want to keep their computers running. So how vexing is the European power situation for Digital Realty in terms of expectations around growth and sustainability?
Jordan Sadler
Yeah. So, it’s a good question. So you captured it correctly in that most of our utilities, sorry, the utility expenses being passed through throughout our particular — portfolio, but particularly in Europe to our customers ultimately. We have the ability to push through pricing broadly throughout the European portfolio.
And what’s happening now in terms of real-time, what people are paying, what our customers are paying is a reflection and large of hedged pricing that was put in place and communicated and hedged a year ago.
So we are hedging today for 2023. We have been hedging all year for 2023 and that will be communicated to customers, is being communicated now and will be over the course of the next, call it, 30 days, 45 days. This is what you will be paying come January 2023. So there will be an impact.
One of the things about our European portfolio tends to be more of the colo and connectivity-oriented portfolio. So if you think about the price of electricity or the electricity relative to the overall cost for the customer as these are more colo-oriented customers, it’s a smaller percentage relative to the hyperscaler, right, because the hyperscaler is paying less in terms of rent, right?
So there’s going to be an impact, but I think it’s, like you said, these data centers are in place, because these customers are driving or driving revenue. They are saving money or enhancing their efficiency or productivity across their businesses and there’s probably not a tremendous amount of leeway to just turn them off.
David Barden
So I want to talk a little bit about that. I mean I have got a little story, which is we had an investor meeting with our Global Head of Data Centers. And he shared that Bank of America has cut our IT budget 20% to reflect the nature of the world that Bank of America is facing as a business, but our data center budget has doubled. And he basically said, I can go ask for any number, because we can’t say no to mobile utility. We can’t say no to digital transformation. We can’t say no to market volatility. We just have to do it. So it’s an incredibly robust demand set from our seat as customers. But I think that power thing is kind of an idiosyncratically noisy for the data center market. I think that it seems manageable. I think the two other conversations people want to have is inflation, and I think, Bill Stein, your CEO, has been pretty optimistic that moderate inflation could be a big positive, but we are seeing a little bit more than moderate inflation. So, if you could talk us through how inflation is affecting the business and then let’s talk recession next?
Jordan Sadler
Okay. So the way that inflation is affecting the business, obviously, in certain instances where our leases are tied to CPI and to the extent that they are not, we are trying to make sure that they are in our renewals and our new leases that are getting signed. So we are working toward that.
In terms of where that can be a dele — have a sort of deleterious effect is, if inflation is really high relative to in-place escalators that are fixed at much lower rates, right? So that can have an impact.
We have been able to control costs typically a bit better so far outside of electricity, which is borne by the customer, but we have been able to control costs a little bit better than the inflation we have seen or the headline inflation we have been able to see.
But in terms of the overall impact of inflation, at the end of the day, this inflation is causing a rise in development cost, right, for us and for our peers and the community at large. And so in order to be able to procure this, if you have demand, if demand remains stable and secure, this is going to continue to have to be built.
And our issues are not helping out necessarily and so this inflation is causing to the extent that people want to secure this space, it’s causing this rising cost and it’s causing ultimately a rise in rent a corresponding or attendant rise in rent.
David Barden
So you have — would you say you have pricing power in this inflationary climate?
Jordan Sadler
Yes.
David Barden
And would you say that that’s relatively universal across Europe, Americas, Asia, you have that pricing power to…
Jordan Sadler
I have said…
David Barden
… inflation?
Jordan Sadler
I would say it’s broad-based. It’s — it entered the discourse at Digital probably before I joined in April. But it’s definitely, even over the course of my five months on Board, the battle cry to make sure that we are not the cushion to support the customer in this rising rate environment has definitely grown and seems to be more institutional, if you will, where everybody is starting to understand that we are all absorbing these costs.
And the VMI program, while that’s helping to offset and balance some of these costs for some of our customers and for us, at the end of the day, we have to re-up that VMI program and looking down the road, those costs are rising.
David Barden
Yeah. So we have got pricing power, we are managing through the energy pricing issues. The concern of the margin then is we get to recession that somehow there’s a discretionary component to the demand piece either because newly IPO tech companies all collapse and go out of business and move out of the data center like they did in 2000 or that businesses simply don’t have the budget any longer to spend on IT. I don’t think either one of those is right, but I’d love to hear your…
Jordan Sadler
Yeah.
David Barden
… perspective on it?
Jordan Sadler
So inevitably there’s going to be some disruption related to what’s going on. We saw it with one tenant we talked about in April.
David Barden
Yeah. Sungard.
Jordan Sadler
I believe they sound like that and so that happened. I don’t think that was necessarily germane to anything really specific to what’s going on in the environment beyond I think they were in a legacy business that wasn’t exactly a strong business, not all aspects of their business and so germane to that customer with nearly 5,000 customers.
So we are going to have customers who go bankrupt regularly or periodically, I should say, and we are going to have customers that are struggling and we are going to have customers that are winning, and hopefully, the customers that are winning are more than offsetting the churn caused by the customers who are losing or going out of business.
And I would say, as a related, so will there be another Sungard? Possibly. There’s nobody I’d like to flag or identify and nobody that’s really on the watch list like that. But could that happen? Inevitably, eventually, it will.
And as it relates to the other aspects of the business, it’s — when power in Europe or otherwise, that rising cost, we are going to have — we will wait and see the effects. Right now on the consumer side, we have already seen. We have seen the government step in and try and support. There could be some fallout as it relates to that as well.
But so far, as you started the question, there’s been pretty resilient source of demand as these customers are continuing to drive their businesses and they see, and I am sure Bill and Andy may have even related to you last week, there’s a line of sight to pretty significant growth for extended term, meaning beyond this year and next.
David Barden
Yeah. I think one of the thematic things that people were concerned about is how many new IPOs and how many tech companies. I think people when you think back 20 years ago when Pets.com went under, they had to go rip their server out and they turned the data center into a condo. What happens these days is that’s not how businesses work anymore. The cloud exists today and so this is that IPO and don’t take up space in the Digital Realty facility. So they are not even there. They are operate in the cloud, and if they start to fail, Microsoft’s cloud growth will go from 70% to 55% or something like that. So I think that that’s a big part of it. And also in terms of recessionary climate, if you remember, like 2007, 2008 or 2009, if you guys don’t, it was actually kind of the 2008, 2009, 2010 was actually one of the best periods for data centers in the U.S., because what happened was no one wanted to put new capital into the supply side of the business, but everybody wanted to save money by not putting their own capital into their own data centers. So there’s huge amounts of demand, very limited supply and prices skyrocketed to probably the highest levels I have seen in the U.S., probably, 7%, 8%, 9% on an annual basis. Right now they run about zero, 1% or 2% here in the U.S. and they are probably going up based on what I heard from Andy and Bill, whatnot, but I think it’s all pretty strong.
Jordan Sadler
Yeah. I would sort of echo that. I remember that period as well. And the other aspect of that, that was important in addition to the tenants not wanting to build it their own or put the capital in, all the supply that was anticipated in 2007 kind of paused for about three years as…
David Barden
Yeah.
Jordan Sadler
… everybody who has anticipated to build a bunch of data centers really mothballed those plans, and so, yeah, that caused that same tightening. So I remember that period. And I think there is an analog, because the capital markets have cut and the volatility we are seeing in the rise in the cost of certain capital and maybe even the opportunities that are presenting themselves to some of these customers. There’s been a lot of change around that.
And so do they still want to employ capital to build their own data centers as much as they did six months or a year ago. You could make the case that they view capital as being more scarce today as well as do we.
David Barden
So I wanted to just quick hit, I mean I feel like we have to talk about it just because Jim Chanos came out with his data centers he got short. I disagree with that. But in the last month or two, he’s kind of made money on that trade. But the premise of the trade was that the hyperscalers who are your customers are essentially your enemy, and eventually, they will just simply digest your core business and bring it into the cloud and the necessity of the kind of hybrid private, public cloud, public provider won’t be there anymore.
Jordan Sadler
Yeah.
David Barden
Would — how do you — people have heard that or read about it in the Journal or Barron’s or whatever. How do you guys — what’s your kind of like punch back at that?
Jordan Sadler
Yeah. So I haven’t seen Jim’s deck or anything that supports any of the claims he’s made in the financial times. But if anybody has it or Jim, you are listening, you would like to send it to us, please do, I’d love to refute it actively, because otherwise it just seems a bit off relative to what we have actually seen in the market. It’s interesting that he’s made some of those claims around some of these large customers.
I would point out some of the customers he’s focused on and flagged in particular, probably, if you were to deduce who they were or if they were customers of ours from our supplemental, probably, a lot smaller relative to what he thinks they are relative to our overall portfolio. We are a pretty diverse customer base of 5,000 customers and lots of them are taking space with us, not just three.
And there seem to be, especially in the first six months of this year, the last six months of last year an acceleration in demand from these same customers that are being referenced in the cloud service providers generally.
And that really continues and I know that Bill was out visiting specifically with a couple of these customers, few of these customers just a couple of weeks ago and the messaging is directly in contrast with what Jim is maintaining in terms of the partnership that they seek and how much they are relying on us as a partner.
And whether or not we want to partner with them is obviously our — at our option. We — that’s — as I said, they are a portion of our business, but we have lots of other customers to serve and service and it’s not just going to be three customers who are going to one day eat our lunch.
And the other thing I would sort of point out is, if the end customer, the cloud user is going to situate themselves in a cloud data center or a data center that’s owned by Amazon or Microsoft or Google, for instance, what — is that going to put that end customer at a disadvantage, right?
Where they — that provider has all the power in pushing rate? Would you put all of your eggs in one basket? We maintain and we operate cloud neutral data centers, much the way 10 years ago, you and I talked about these data centers as being carrier neutral.
They are carrier neutral. They are cloud neutral. So enterprise customers can use any cloud they choose and they are all architecting towards hybrid multi-cloud architectures, right, and you can’t do that in an Amazon data center.
David Barden
So we have got about 5 minutes left and I know that Jeff has a speed round of lightning questions he wants to ask at the very end, but I want to kind of maybe just back to the core business. We have talked about the noise around hyperscale power, rising power, recession, inflation. But one of the truly fundamentally positive things that’s been happening is we have had positively renewal spreads in the last two quarters and I think that you guys see that, that is pivoted from a couple of years but that was definitely criticism. I am sure as a former sell sider you have noted it and now it’s kind of pivoted. And can you kind of talk about the trajectory of the business when we put all the things we talked about together, are we launching towards?
Jordan Sadler
Yeah. So it’s a great point to sort of wrap up on, because — and I think that folks like Jim Chanos have noticed by looking at our historical financials that return on invested capital may have come down or asking rents or in-place rents or same-store growth has come down or gone negative and I think in hindsight, it’s very easy to predict the past.
David Barden
Yeah.
Jordan Sadler
But I think if you go back about a decade, I think, guys like you or me were able to see that several companies were coming public. The banks were lending to this space, that the bond market was flourishing around data centers and infrastructure development and there was quite a bit of capital spilling into this space, chasing very good returns on an unlevered or even levered basis on very good credit and that maybe some of the existing players or the incumbents were generating excess return.
And so at that time, it was easy to predict watching CyrusOne and CoreSite and QTS that there was more capital coming into the space and that returns and rents were probably going down and had you made that call 10 years ago, that would have been pretty pressured.
But what’s happened now is these — all these players, these smaller players like CyrusOne and CoreSite, QTS, they have been recapitalized with significantly more leverage than the previous structures, cost of capital has gone up, availability of debt has gone down, and at the same time, the cost of development has risen. And so, unless these investors are willing to take lower returns, price needs to go up or demand needs to go down and we are not seeing the demand go down.
So it feels like for the first time in a decade, rents have i6nflected positively off of sort of a rebasing that happened in the back half of last year and that trend seems to be continuing as we discussed. So it seems like a little bit of a different regime, a little bit of a more positive regime, and hopefully, it will continue.
David Barden
Yeah. Jeff, do you want to up with your lighting round?
Unidentified Analyst
[Inaudible] Jordan, what attracted you to this job? What was the draw besides just wanting to leave the sell side?
Jordan Sadler
I need money. So it’s a great question. So I started my career on Wall Street REITs under a guy who’s in the room over there was bring to our Chairman by name of Jon Litt. And I learned a lot from him and I spent 22 years buying my trade, enjoyed it immensely.
And this was where the opportunity to get on board something that I believed in long-term that has legs that’s going to — in an interesting industry that offers pretty long-term growth and to see the other side of things.
And so on top of that, there are some pretty great people working at this place and it’s a little bit underappreciated, because you get a view of three, four, five, six, seven people. There’s well over 3,000 people working at Digital Realty today and many of them are very high caliber, qualified, shock people and there’s a lot to learn. So it is an interesting opportunity to do something different, change it up a little and here I am.
Unidentified Analyst
Great. Congratulations.
Jordan Sadler
Thanks.
David Barden
All right. Great. Just a very quick…
Jordan Sadler
Yeah.
David Barden
… three rapid fire questions. Which of the following is the greatest macro challenge facing U.S. public REITs today; A, risk of higher rates; B, risk of recession or C, the rise of private equity and non-traded REITs.
Jordan Sadler
Rates.
David Barden
Number two, which of the following is the greatest sector specific risk, first, labor issues; two, supply or three, liquid capital markets?
Jordan Sadler
Is that the risk — idiosyncratic risk to the sector?
David Barden
Yeah.
Jordan Sadler
Okay. Need liquids. I guess, liquid capital markets but…
David Barden
Yeah.
Jordan Sadler
… we don’t need them.
David Barden
And then last, are you seeing any signposts of weakening demand, just yes or no.
Jordan Sadler
No.
David Barden
Perfect. Thank you, Jordan. Good to hear. It’s a good way to end it.
Unidentified Participant
Thank you so much, Jordan.
Jordan Sadler
We appreciate you for doing this.
David Barden
Thanks.
Jordan Sadler
Thank you, everybody.
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