Market analysis by our public securities expert, Geoff Shaver
APRIL 27, 2020
Data Center REITs: Powering Connectivity Through the COVID Era and Beyond
by Geoff Shaver
Director of Public Securities
One of the byproducts of the COVID-19 pandemic is that Zoom (ZM) has entered into the mainstream vernacular, and its video conferencing technology is being utilized by a surprisingly broad swath of users. The 214% rise in Zoom Technology’s share price year-to-date(1) is evidence of the growth in demand for video conferencing which has, in a matter of weeks, replaced in-person interactions among individuals, schools, businesses and governments. According to Zoom, “at the end of December last year, the maximum number of daily meeting participants, both free and paid, conducted on Zoom was approximately 10 million. In March this year, we reached more than 200 million daily meeting participants, both free and paid.”(2)
There are additional video conferencing platforms beyond Zoom that are hosting millions of other video conferences daily, and, when combined with additional demands created by the millions of households that are streaming additional internet-based content while at home during the pandemic, the utilization of data bandwidth has never been higher. The backbone of the technology that makes much of this possible is the high-powered data centers strategically located throughout the U.S. Many of these data centers are owned and operated by a handful of public real estate investment trusts (or “REITs”) and these assets process data requests far beyond the demands of video conferencing. With an estimated spend of $7 trillion on global digital transformation between 2020-2023, the data center industry is well-positioned for growth over the coming years (3). In this REIT Report, we take a deeper dive into the sector’s fundamentals and highlight a few names that are well positioned to seize the accelerating demand for data.
How Data Centers Are Structured
The data center industry is comprised of two primary types of facilities that all serve different functions in the processing of, distribution of, or storage of data: Wholesale (sometimes referred to as Hyperscale or “Scale”) and Colocation (“Colo”).
Wholesale facilities are generally customized to accommodate larger users, and, in some cases, are leased by a single user such as Salesforce, Facebook, Microsoft, etc. Because these tenants are leasing in bulk, the lease terms are generally longer in duration and the rates are lower than what is typically achieved at a Colo facility.
In contrast, a typical Colo facility will be comprised of several smaller tenants with lower space/capacity requirements, and this inefficiency enables landlords to charge higher lease rates in exchange for shorter-lease durations. Because tenants at Colo facilities are generally smaller and, therefore, do not likely have the internal IT infrastructure that a Wholesale tenant may have, a Colo facility may also include on-site IT staff as an additional service offering.
In each of these types of facilities, which, from the outside, can appear as a standard office or industrial building, the landlord typically owns the building structure, the land, and the permanent infrastructure (cooling equipment and fans, redundant power generators, etc.). Tenants typically own the non-permanent infrastructure such as the servers, racks, and networking cables. Where a state-of-the-art industrial facility may cost $150 per square foot to build, a modern data center may cost 10 times that to develop – over $1,500 per square foot. The industry has moved away from leasing space to tenants on a per square foot basis, which is typical in other types of commercial real estate. Rather, landlords lease by the number of kilowatts or, increasingly, megawatts (1,000 kilowatts) of power that is required to facilitate the tenant’s data needs. For instance, one megawatt (MW) translates into enough power to operate 4,000 servers. Rent paid by tenants is typically measured in kilowatts, or, for larger users, thousands of kilowatts or megawatts (MW). One of the largest data center complexes in the U.S. is Digital Realty Trust’s (DLR) facility located at 350 E Cermak, a former printing warehouse located on Chicago’s South Side that contains over 1.1 million square feet of space and over 100 MW of utility power. The five public REIT data center companies in the U.S., CoreSite (COR), CyrusOne (CONE), Digital Realty Trust (DLR), Equinix (EQIX) and QTS Realty Trust (QTS), all maintain a varying composition of facility types within their portfolios throughout the United States and around the world.
Strong Tailwinds for Data Center REITs
The five data center REITs mentioned above are collectively benefitting from the secular tailwinds generated by the virtualization of the economy. These strong fundamentals have helped to propel data center REITs to outperform the broader FTSE NAREIT Index by 36% year-to-date and 49% over the past twelve months on a total return basis(4). Demand for additional data capacity is forecast to increase substantially over the coming years due to increased utilization by businesses for cloud computing, advancements in artificial intelligence, virtual reality, and the rollout of 5G cellular technology.
Within this segment, EQIX is well-positioned to benefit from the growth in cloud computing and increased demand within their colocation facilities, especially after executing a strategic partnership with Zoom (ZM) last year, prior to its meteoric rise in popularity. EQIX published a global survey earlier this month showing that 71% of respondents plan to move more of their IT functions to the cloud, with 66% of these respondents planning on doing so within the next 12 months.(5) At a Debt/EBITDA ratio of 4.8 and a footprint on five continents, EQIX is well-positioned to seize growth opportunities in a post-pandemic environment, which is reflected in its recent performance, up 40% from its March 23, 2020 low(6).
Digital Realty Trust (DLR) is also fundamentally positioned to capitalize on the growth provided by the digital transformation. Similar to EQIX, DLR maintains a diverse, global footprint by operating on five different continents. DLR’s portfolio is over 50% occupied by credit-rated tenants comprising six different industry concentrations, with an average lease duration of 5.2 years(7). The company itself maintains an investment grade balance sheet, which gives it the ability to procure attractively priced unsecured debt. While their Debt/EBIDTA ratio is a bit higher than EQIX at 5.2, DLR maintains an average debt coupon of 2.9% with a weighted average maturity of 6.5 years, suggesting that they have a healthy leverage level heading into any potential macro credit challenges. Their earnings growth in Core funds from operations (FFO) per share since 2005 has produced an impressive 12% compound annual growth rate (CAGR), and their dividend record is equally impressive, generating an 11% CAGR over the same time frame, without interruption(7). The resiliency and growth that DLR has demonstrated over the past decade and a half, combined with the secular tailwinds, a strong balance sheet and high concentration of credit tenancy are the reasons why we have chosen to include the them in our Income Block, available in the Path app.
While the portfolio assets owned and operated by EQIX and DLR do have some overlap, there are some key differences in the types of facilities within each. EQIX maintains a greater focus on Colo facilities and is also building an exposure to Edge computing, which are data processing systems located on the edge of networks that allow for data analysis to be completed at the device-level, as opposed to having to be routed back to a data center or cloud. Furthermore, they are just starting to roll out their first Hyperscale facilities. DLR, on the other hand, is more balanced across their offerings with Colo and Hyperscale facilitates, along with maintaining exposure to some legacy enterprise facilities (facilities that they own and operate and lease to corporate users) as well.
How Supply Might Impact Data Center REITs
Headwinds in the industry do exist, namely a significant amount of supply that has been delivered to certain primary data center markets over the past year, with development anticipated on the horizon. According to CBRE, in the primary data center markets of Atlanta, Chicago, Dallas/Ft. Worth, New York Tri-State, Northern Virginia, Phoenix and Silicon Valley, completion of new data center facilities in 2019 increased existing inventory by 17.3% and will increase the competition among certain markets this year, placing downward pressure on rent growth(8). Additionally, the transition to cloud computing by many companies has moved demand away from smaller Colo facilities and transitioned pricing power to many of the larger, Wholesale tenants such as AWS, Microsoft and others, which has placed additional downward pressure on rents.
While supply challenges and potential rental rate disruption are being monitored across the sector, the sheer momentum of the digitalization of the global economy will power continued operational performance over the next several years.
1 Stock quotes courtesy of Yahoo Finance
3 IDC - WW Semiannual Digital Transformation Spending Guide (Oct 2019)
4 Returns from Bloomberg as of 4/17/20
5 Company Reports
6 Stock quotes and courtesy of Yahoo Finance
7 Company Reports
Director of Public Securities
Geoff leads the construction and monitoring of the public real estate securities portfolios available in our Path by Origin app. Prior to Origin, Geoff spent the last 12+ years researching and investing in public REIT securities at both Duff & Phelps Investment Management Co. and J.P Morgan Asset Management.
Geoff Shaver and clients of Path by Origin, LLC own COR, CONE, DLR, EQIX, and QTS. Neither Mr. Shaver nor Path have a business relationship with any company whose stock is mentioned in this article.
Path by Origin, LLC (“Path”) is an SEC registered investment adviser. Mr. Shaver is the Director of Public Securities of Path. The views expressed herein are subject to change, and no forecasts can be guaranteed. The comments provided are for educational purposes only and may not be relied upon as recommendations, investment advice or an indication of trading intent. In preparing this document, the author has relied upon and assumed, without independent verification, the accuracy and completeness of information available from public sources. The stocks mentioned in this article have been highlighted based on some reported news, quality or characteristic and do not necessarily represent all of the securities recommended for a particular portfolio. Path is not soliciting any action based on this communication. Investments involve risk, including the possible loss of principal and fluctuation of value. Past performance is not indicative of future results. Mr. Shaver and Path disclaim responsibility for updating any information herein. In addition, Mr. Shaver and Path disclaim responsibility for any third-party content.