This article was co-produced with Dividend Sensei.
REITs are a great asset class, not just for generating safe and growing income, but also have historically delivered market-beating returns with lower volatility to boot. But REITs aren’t just the purvey of boring and conservative income investors looking to cash in on steady rents from office properties and retail stores. There are more than a dozen industries in REITdom, including exciting and fast-growing ones like data centers.
Why You Want To Own Data Center REITs
Cloud computing is one of the biggest economic megatrends, and you can’t store massive amounts of exponentially growing data without data centers to house it.
(Source: DLR investor presentation)
According to analyst firm IDC today, about 25% of global IT spending is going toward cloud computing transitions, but that’s expected to rise to 50% by 2020. 5G is going to bring with it even more data as the Internet of Things scales up.
Ericsson estimates that, by 2023 alone, nearly 3.5 billion devices will be connected to the internet, including driver-less cars.
According to Forbes, autonomous cars will generate about 4,000 GB of data per day or roughly 2,500 times the data the typical person generates today.
(Source: Nvidia investor presentation)
And, according to analyst forecasts by 2035, there could be 120 million driverless cars on the road, generating massive amounts of data that will need to be stored and analyzed via AI-powered algorithms stored in data center servers. And, those are just some of the major growth catalysts for this exciting and rapidly growing industry.
(Source: EQIX investor presentation)
And when it comes to cloud computing, Equinix and Digital Realty are the two industry heavyweights.
That makes these two the best blue-chip choices for REIT investors looking to cash in on a decades-long mega-trend that should lead to safe and steadily rising dividends for the foreseeable future.
2 Blue-Chip Data Center REITs You’ll Want To Own
Digital Realty Trust
With nearly 200 data centers located in 32 cities in 12 countries, Digital Realty is the world’s second-largest data center REIT. It serves more than 2,300 corporate clients, which creates a diversified rental base of mostly investment-grade Fortune 500 companies.
Digital Realty is increasingly focusing on hybrid cloud, especially colocation (of smaller clients). Clients bring their own hardware, and Digital Realty provides the physical space, electricity, and interconnections that allow companies to link their servers together, including with top cloud computing providers like Amazon (AMZN).
Digital Realty’s growth and diversification efforts have been led by the industry’s most aggressive M&A, including 2015’s $1.9 billion acquisition of Telx. This allowed the company to shift from a 95% focus on wholesale cloud to a greater focus on colocation and interconnection. Colocation allows for reduced data latency and improved cybersecurity, which these days is the top priority for IT departments at major corporations, according to recent surveys.
Another benefit to this switch from wholesale to colocations is that wholesale generally involves renting space to just a few major corporations who need a lot of space. This creates a smaller potential market, serving the needs of just a few giant companies. In contract colocation is a need all companies have, opening up Digital Realty to winning more market share in the biggest part of the cloud computing market.
Colocation also allows for more interconnections, where companies link their servers together. Interconnections are a premium feature that companies are happy to pay up for, and today, DLR has 77,000 of these, generating more than $250 million per year (about 10% of REIT sales) in high-margin revenue.
Over the years, DLR has continued to busily acquire more rivals as it consolidates the industry and expands its geographic presence. All told, the REIT has spent $14 billion over the past eight years, achieving the industry’s second largest economies of scale.
While economies of scale are important for all REITs, in its case, being one of the biggest consumers of electricity in any given market means DLR can cut great deals with electric utilities. For example, in Chicago, it has a contract for power locked in at 20% below market rates through 2022.
And since data centers generate a lot of heat, Digital Realty is a major purchaser of industrial-grade AC equipment for which it obtains discounts as well. This has allowed it to historically average 25% operating margins since 2010, the highest in the industry (EQIX’s have averaged 19%).
But a big reason that DLR has historically enjoyed high occupancy (including 95% during the Great Recession) and about 70% lease renewal rates is the high switching costs associated with moving to a competing data center.
According to Align Communications, a company that specializes in helping companies move data centers, it costs about $23 million for DLR’s typical client to set up hardware in its facilities. It then costs about $15 million more, in a lengthy, difficult, and risky process (in terms of business interruption) to move to a competitor’s facility.
Management believes that, despite the challenges it will be facing in 2019 and beyond (see risk section), it can achieve about 6% to 9% long-term FFO/share growth. That should translate to dividend growth along the same lines.
AFFO Payout Ratio: 67%
S&P Credit Rating: BBB
Sensei Quality Score: 9/11 (NYSEARCA:SWAN)
Historical FFO/share growth: 9.0%
Expected five-year FFO/share growth (Analyst Consensus): 5.9%
Expected Long-Term Total Return (no valuation changes): 9.7%
Discount To Fair Value: -2%
Valuation-Adjusted Total Return Potential: 9.5% (vs 2% to 8% for S&P 500)
According to FactSet Research, analysts currently expect about 6% long-term cash flow growth, which, given today’s nearly 4% yield, should result in close to 10% total returns in the coming years.
Digital Realty is trading at about fair value (based on its five-year average yield), which means that investors shouldn’t expect to see much multiple expansion boosting future returns. But while high single-digit return potential might not sound like much, keep in mind that, according to Morningstar, most analysts and asset managers are expecting the S&P 500 to deliver between 2% and 8% CAGR total returns over the next five years.
(Source: Market Watch)
And, according to some famous valuation ratios, the stock market might do far worse over the next 10 years, which means that the returns DLR is likely to generate should smoke the broader markets.
But while Digital Realty is indeed a great data center blue-chip and SWAN, don’t forget to consider Equinix as well for a place in your diversified dividend portfolio.
Founded in 1998, Equinix was one of the earliest companies to take advantage of the rise of the Internet. It’s led by one of the best management teams in the industry, headed by CEO Charles Meyers. Meyers has been a leading IT executive for 25 years and joined EQIX in 2010. In 2013, he became COO and, most recently, served as president of Strategy, Services, and Innovation. That’s the position whose job is to stay on top of fast-changing tech trends to help ensure EQIX remains able to serve the IT data needs of the world’s corporations.
(Source: earnings presentation)
Today, Equinix is the industry leader with 200 data centers in 52 cities in 24 countries on five continents, serving nearly 10,000 corporate clients.
Unlike Digital Realty, Equinix has been exclusively focusing on colocation. Today, Equinix is the world’s largest colocation data center provider counting among its clients all the cloud computing giants, but also 1,700 network service clients, meaning corporations looking to connect to cloud services as well as the internet and each other. Its tenants include 46% of the Fortune 500 and 33% of the Forbes Global 2,000, meaning Equinix is collecting very stable rent from some of the most financially sound companies on earth.
Equinix’s facilities are located in the world’s largest tech hubs, which creates great network effects and a relatively wide moat, as far as REITs go. This has given Equinix stronger pricing power allowing for historical operating margins of 19% (lower than DLR due to higher organic capex spending) and 12% adjusted returns on invested capital (good for a REIT).
But more importantly, AFFO yield on invested capital is sky high as the company steadily scales up its capacity and hit 17% in late 2018.
(Source: investor presentation)
Basically, Equinix has positioned itself at the Internet’s key internet hubs so that its facilities are among the most valuable in the industry, giving it stronger pricing power and better retention rates, and creating a more stable stream of cash flow to support its very secure and fast growing dividend.
The reason Equinix’s facilities are so valuable to its 10,000 or so customers is they allow companies to connect to private Internet networks, as opposed to the public net, making for far better data security. And thanks to a greater focus on colocation from the start, Equinix obtains 16% of its revenue from interconnects (it has 334,000 of them), which also helps make its data centers wide moat, via higher switching costs.
Because of its colocation focus, Equinix’s customer switching costs are much lower than DLR’s, but still sufficiently high to make frequent customer defections uncommon. For example, according to Infotech Research Group, the average cost of moving a single cabinet worth of equipment is $10,000 vs. an average monthly rent of $2,000. EQIX’s leases are usually for two to four years. This means that, even if a competing data center provider could provide 10% cheaper rent, the payback period for switching locations would be 50 months, longer than the average lease, making it uneconomical to do so.
Currently, Equinix is spending over 35% of revenue on expanding capacity, which is why its margins are lower than DLR’s. However, over the coming years, analysts expect smaller capex to help boost adjusted EBITDA margin by about 5% (to roughly 54%) helping translate about 8% long-term sales growth into approximately double-digit FFO/share growth.
Equinix’s yield is among the lowest of any data center REITs. However, there is a good reason for that. One of the best management teams in the industry, which has consistently proven ahead of the curve in terms of investing capital aggressively to where the puck is going, deserves a premium and is why I consider EQIX a near-perfect dividend stock on my Sensei Quality Score.
That proprietary quality metric incorporates dividend safety, the riskiness of the business model (moat and future disruption risk), and management quality. It’s what I use to judge which dividend stocks worth owning are SWANs, potential future SWANs, or should only be bought at steep discounts to fair value (riskier deep value investments).
EQIX’s industry-leading quality metrics make it a firm SWAN in my book, as well as the industry’s largest blue chip. That includes an upgrade from S&P to BBB- in February 2019, thanks to improving credit metrics, including a leverage ratio of about 4.0 (after its Feb 27 equity raise) compared to about 5.8 for the average REIT.
That balance sheet is 86% fixed-rate debt at an average borrowing cost of 4.1%. That borrowing cost is about three times lower than returns on invested capital, meaning that EQIX’s bountiful access to low-cost capital allows for rapid and highly profitable growth.
Basically, EQIX has a fortress-like balance sheet and a very safe dividend that SWAN investors can count on even in a recession.
Another big reason I’m a fan of Equinix is that, unlike DLR, the REIT appears capable of maintaining its historical growth rate.
Historical FFO/share growth: 9.5%
Expected five-year FFO/share growth (Analyst Consensus): 9% to 11%
Expected Long-Term Total Return (no valuation changes): 11.2% to 13.2%
Discount To Fair Value: 5%
Valuation-Adjusted Total Return Potential: 11.6% to 13.6%
How realistic is that double-digit growth forecast? Well, I consider it pretty reasonable, given the strong 2018 EQIX just closed out, including:
(Source: earnings presentation)
That growth rate is consistent with the REIT’s industry-leading results of the last few years, which is especially impressive given that EQIX is the largest data center REIT in the world. As is the fact that EQIX has delivered 64 consecutive quarters of top line growth.
For 2019, management is guiding for:
9.3% in revenue growth
9.6% AFFO/share growth
That’s among the best 2019 growth rates, not just of any data center REIT, but any REIT period. In fact, given that most analysts now expect less than 5% EPS growth for the S&P 500 (according to FactSet Research), EQIX is likely to be one of the fastest growing companies in America this year.
(Source: earnings presentation)
One that happens to be growing the dividend at a rapid pace (that puts most REITs to shame) while steadily lowering its payout ratio so it can retain more cash flow into expanding its business.
Combined with a slight discount to fair value, that means that even that low yield should result in stronger long-term total returns than DLR, making EQIX my favorite blue-chip data center REIT to buy today.
Of course, that’s only if you’re comfortable with the industry’s overall risk profile.
Risks To Consider
No industry or company is without risk, and in the case of data center REITs, the biggest possible concern is hyperscale cloud giants like Amazon, Microsoft (MSFT) and Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL). Up until now, these have been big data capex spenders and great customers for REITs like DLR and EQIX.
However, as their cloud businesses grow at impressive rates, these cloud giants gain economies of scale and market power that might come back to bite data center REITs. Specifically, because they might threaten to build their own data centers, thus cutting off DLR and EQIX from future growth opportunities, or at the very least demand lower rents.
(Source: Hoya Capital Real Estate)
Another big risk is overcapacity. While data center REITs are big spenders on growth capex (about $3 billion in 2018 among the five publicly traded names), private equity is funding a massive capacity boom that threatens oversupply and future margin compression.
Combined with increased pricing power from some of its biggest clients, DLR is guiding for lease renewal rates to fall in the high-single digits in 2019, after a 2% decline in 2018. This shows that, while DLR may enjoy high occupancy and renewal rates, that doesn’t necessarily make it immune from the laws of supply and demand. At the very least, future rental escalators might come down from the 2% to 4% the REIT has historically enjoyed.
Overcapacity is a bigger worry for DLR than EQIX because, despite having slightly less market share than Equinix, the REIT owns 60% more leasable space. Filling that up to maintain strong returns on invested capital (expected to fall 0.5% to 10.5% in 2019) could put pressure on those industry-leading margins in the future.
Equinix has stronger utilization (80% in 2018) and thus has less to worry about from overcapacity. But it should be pointed out the REIT is still aggressively expanding with new cabinet additions ($2.1 billion in 2019 and 2020), which means that Equinix could also suffer if future data hardware needs prove smaller than expected.
While that’s not something to lose sleep over, investors in all data center REITs must keep in mind that technology is improving rapidly. That includes the data transmission capacity of fiber optics, as well as better virtualization tech that could mean that hardware requirements for that exponentially rising mountain of future data might not be as great as currently expected.
And finally, we can’t forget that all data center REITs are highly dependent on equity markets for growth capital. That’s been a major source of DLR’s acquisition funding over the years, and in February 2019, EQIX did a secondary for $1.1 billion. Should the data center industry fall out of favor (such as it did in late 2018), then lower shares prices could increase these REIT’s costs of equity, making profitable growth harder and resulting in dividend growth that’s less than expected.
Bottom Line: Digital Realty And Equinix Are Great REITs To Cash In On The Decades-Long Data Boom
Don’t get me wrong, even data center REITs, while one of the fastest industries in the REIT sector, aren’t going to deliver Amazon (AMZN) like returns. But they can be great sources of generous, safe, and growing income, and deliver double-digit market-beating returns if you buy them at the right price.
Digital Realty Trust and Equinix represent two data center blue chips whose competitive advantages in low-cost capital, skilled management, the best economies of scale, and the strongest network effects, will likely drive strong income growth and total returns for years and possibly decades to come.
Both REITs are at roughly fair value today, meaning that under the Buffett rule that “it’s better to buy a wonderful company at a fair price than a fair company at a wonderful price” I’m happy to recommend adding both to your diversified dividend growth portfolio today.
If you’re a committed value investor only willing to buy at high margins of safety, at least put DLR and EQIX on your watch lists (as I’ve done) to wait for a better price. As we saw in December, market corrections are a great time to open or add to positions in industry-leading blue chips and SWANs like these.
Author’s note: Brad Thomas is a Wall Street writer, and that means he’s not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors, if they are overlooked.
Finally, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking.
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Disclosure: I am/we are long DLR, EQIX. 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.