Data Center REITs: Go Big Or Go Home

The growth engine of the real estate sector over the past half-decade, data center REITs, has returned to its winning ways this year following a rough 2018, surging 40% YTD.

The Big Get Bigger: Digital Realty shook the data center landscape yet again last week with its announced $8 billion acquisition of European data center giant Interxion.

Game on! Responding to the mounting competitive threats posed by the hyperscale giants – Amazon, Microsoft, and Google – data center operators have turned to M&A to regain pricing power.

Digital Realty significantly expanded its interconnection and colocation business. Interconnection, which relies on \"network effects,\" can translate into a competitive advantage owned by REITs that hyperscalers have more difficulty replicating.

While robust demand for data center usage will continue, the shareholder value creation outlook for the REIT operators themselves - particularly those operating in the competitive \"wholesale business\" and those lacking sufficient scale - remains cloudy.

In our

series, we analyze REITs within each of the commercial and residential sectors, focusing on property-level fundamentals and the macroeconomic forces driving overall supply and demand conditions. We then analyze REITs based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives.

One of the newest REIT sectors, Data Center REITs have been one of the primary growth drivers of the REIT sector over the past half-decade. Within the Hoya Capital Data Center Index, we track the five largest data center REITs, which account for roughly $85 billion in market value: Equinix (EQIX), Digital Realty (DLR), 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 14 data centers. Data Center REITs comprise roughly 8-10% of the broad-based REIT ETFs (VNQ and IYR) and comprise roughly half of the Benchmark Data & Infrastructure Real Estate ETF (SRVR).

Data Centers are the home of the "cloud, the physical epicenter of the internet. 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. Typically 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. 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.

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.

As noted above, Data Center REITs are among the largest owners and operators of data center facilities in the world. Outside of these six 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. Three of the four largest operators in the world are REITs and Zayo Group is currently exploring options to convert into a REIT in a move that would share similarities with Equinix's recent REIT conversion in 2015.

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. 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 yet again last week with its announced $8 billion acquisition of European data center giant Interxion (NYSE: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.

Since becoming a full-fledged NAREIT-recognized sector in 2015, data center REITs have been the second best-performing REIT sector. Producing an annualized rate of return that is triple that of the broader REIT average during this time, data center REITs continue to ride the thematic growth trends associated with the continued boom in outsourced IT spending, a long-term secular growth story that we believe has years to run. Compared with other real estate sectors, however, data center REITs are quite "management-intensive," typically operating at lower NOI margins and requiring a higher level of annual capital expenditure to maintain competitiveness.

As is common across most real estate sectors, these companies providing the behind-the-scenes infrastructure are not "household names" compared to their more consumer-facing tenants. The companies synonymous with cloud computing, Amazon (AMZN), Microsoft (MSFT), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Alibaba (BABA), and IBM (IBM), are among the largest and most important tenants of these data center operators. While $4 billion in annual revenues may qualify as a "giant" among data center owners, these figures look rather paltry compared to the $9 billion revenue that Amazon generated from their AWS suite of web-based enterprise software in 3Q19 alone.

Cloud revenues are expected to top nearly $75 billion from the top five cloud companies in 2019, a nearly 50% jump from 2018. While Amazon remains the dominant competitor in the cloud space, Microsoft has made inroads in recent quarters, headlined by the "upset win" of a $10 billion JEDI Pentagon contract that had been expected to be awarded to Amazon. Amazon owns roughly a 33% market share according to Canalys Research, outpacing the 15% share from Microsoft, 7% share from Google, and 5% share from Alibaba.

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% today.

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.

For now, the substantial secular tailwinds driving data demand and network densification, including 5G, artificial intelligence, and blockchain technologies are overpowering the negative effects of reduced pricing power and the relationship between these REITs and their "big-tech" tenants is still symbiotic. We see the wholesale market becoming increasingly competitive with a smaller number of larger players but see sustainable competitive advantages in the higher-barrier connectivity-based services.

(Digital Realty September 2019 Investor Presentation)

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, Data Center REITs have been among the best-performing REIT sectors this year, jumping more than 40% on a price-return basis compared to a 25% climb on the broader REIT averages. Among the more interest-rate-sensitive REIT sectors, data centers have benefited from the sharp retreat in interest rates since the 10-year yield peaked last October around 3.25%.

Heading into 2019, data center REITs were coming off an uncharacteristically weak year following a stellar run from early 2016 through early 2018. The sector dipped 14% last year after leasing activity dropped off sharply at the end of 2018 before bouncing back in the first half of 2019. Since becoming a full-fledged NAREIT-recognized sector in 2015 data center REITs have been the second best-performing REIT sector, trailing only their technology-REIT peer, the cell tower sector.

As we'll hit on in a second, data center REITs have given back some of this year's gains over the last month during 3Q19 earnings season. Equinix continues to be the strongest performer this year, climbing by more than 50% YTD, followed by QTS, which has climbed by nearly 45% after lagging in 2018. Digital Realty, which was the strongest performer in 2018, has climbed a more modest 16% so far this year.

For all the focus on interconnection and future 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 has 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 $152 million in net incremental annualized revenues was a 27% jump from 3Q18, the first year over year increase in leasing in four quarters.

Digital Realty and CyrusOne were the relative standouts in 3Q19 with solid beats on leasing figures. CyrusOne, however, seen as the most likely target for an acquisition by Digital Realty, traded sharply lower following DLR's announced acquisition of Interxion and CONE's subsequent comment that it was no longer pursuing a sale. Equinix reported strong results, beating estimates and boosting full-year AFFO per share guidance to just shy of 10%. Digital Realty revised AFFO guidance slightly lower while CyrusOne revised estimates a tick higher.

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 strong 7.2% jump in cash renewal spreads, its strongest reading since 4Q15 and sharply higher than last quarter's -5.8% dip. We'll need to see a few more quarters of positive growth, however, to be convinced that we are indeed seeing stronger pricing power after several quarters of steady declines. DLR still expects a -3% decline in full-year "same capital" NOI growth, 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 are expected to grow 10% and 9% in full-year 2019, AFFO per share is expected to grow a more modest 5.2% this year, roughly consistent with last year's 5.3% achieved AFFO per share growth rate. The interconnection-focused Equinix continues to be the relative standout, while the smaller REITs are seeing the slowest rate of 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.

Solid leasing data was a welcome relief, given the mounting signs that global IT spending has slowed in 2019 as businesses temper growth plans, citing macroeconomic uncertainty from slowing global growth and continued trade tensions between the US and China. In their most recent forecast in October, Gartner revised lower their 2019 forecast yet again for worldwide IT spending from 0.6% to 0.4%, revising lower all five of the sub-categories that it tracks. The Data Center and Enterprise categories, reflecting the critical drivers of data center spending, are expected to reaccelerate next year after significantly slowing growth in 2019.

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. Historically, cash rent growth on renewals has averaged less than 3% across the sector. In other words, the performance of these data center REITs has been fueled almost exclusively by external growth, while the underlying organic growth metrics have been average at best. 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.

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

we note that data center REITs have seen by far, the fastest rate of FFO growth over the last five years at more than 20%, 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 10% premium to NAV, up from a slight discount at the end of 2018. 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 2.5%, which is below the REIT sector average dividend yield of around 3.3%. (

.) As shown below, however, this average is dragged down by the heavily-weighted Equinix, which pays a sub-2% yield. Data center REITs pay out just 50% of their free cash flow, leaving them ample capacity to increase dividends or reinvest in growth.

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 4.1% followed by Digital Realty at 3.4% and QTS at 3.4%. Equinix remains the most "growth-oriented" REIT, paying out just 1.8% but retaining more than 60% of free cash flow.

As connectivity speed and bandwidth capacity continue to improve, the economics of utilizing cloud computing relative to onsite or on-device processing capacity is increasingly favorable for most applications, which has prompted an insatiable wave of demand for data center space. Double-digit annual growth rates are expected over the next decade in IP traffic, storage needs, and mobile computing demand, powered by emerging technologies, including 5G, blockchain, artificial intelligence, and the internet of things.

(Digital Realty September 2019 Investor Presentation)

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.

A concern for investors has been the emerging power of large-cap technology firms within the data center space. "Hyperscale" providers, including Amazon, Google, and Microsoft rent massive amounts of space from data center REITs but command significant pricing power relative to smaller, individual private, or hybrid cloud leases. While REITs and large-cap technology firms currently have a symbiotic relationship, this may not always be the case, and in recent quarters, a higher percentage of leasing has come from a smaller number of these power customers. Additionally, due to long lease terms and the triple-net structure of most leases, data center REITs are more interest-rate-sensitive than other REIT sectors despite their exposure to the high growth technology sector.

The growth engines of the real estate sector over the past half-decade, data center REITs have returned to their winning ways this year following a rough 2018, surging 40% YTD. Surging more than 40% this year, Data Center REITs have bounced back in 2019 following the worst year for the sector since NAREIT formally began tracking the group in 2015.

Storm clouds have been building around the high-flying technology-focused sector as intense competition and furious supply growth have weakened pricing power. As we have reiterated for several years now, we see consolidation as a means to regain some degree of pricing power relative to the massive hyperscale giants and applaud Digital Realty for their continued push to achieve scale, regardless of the near-term share price reaction. Given the favorable cost of capital enjoyed by these REITs, we see more consolidation likely in the quarters ahead and view CoreSite, QTS, and CyrusOne as both potential acquirers and acquirees.

Solid leasing results in 3Q19, combined with the jump in renewal spreads from Digital Realty, certainly brighten our outlook on the data center space. If these trends can be sustained, we're open to revising our thesis that the data center sector lacks any serious barriers to entry, which has kept us neutral on the space since late last year. This quarter's results indicate that data center REITs may indeed be able to enjoy some "margin" and sustainable competitive positioning from the substantial secular tailwinds driving data demand and network densification, including 5G, artificial intelligence, and blockchain technologies, which we think remain in the very early innings.

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I am/we are long EQIX, DLR, COR, VNQ.

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.

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