REIT Report

Market analysis by our public securities expert, Geoff Shaver

May 1, 2020

Two Preferred Ways to Generate Income from a Growing Data Center REIT

Geoff Shaver, Director of Public Securities

by Geoff Shaver
Director of Public Securities

Summary:

  • QTS is a growing data center REIT that currently has two series of preferred stock outstanding.
  • While we have a favorable outlook both near- and long-term for data centers, both series of QTS preferred should offer better downside protection than owning QTS common stock.
  • QTS has conservative leverage, no debt maturities for several years, and significant free cash flow to service both their debt and continue paying dividends on both their preferred and common stock.

QTS Realty Trust (QTS) is a growing data center REIT that currently has two series of preferred stock outstanding. These two series of preferred are different, but each has something to offer depending on your personal investment objectives. The series A preferred (QTS.PA) offers an attractive current yield of 7.0%, but doesn’t offer much upside participation, while the series B (QTS.PB) with a lower current yield at 4.6% is convertible into QTS common shares with the potential for upside equity participation. While we have a favorable outlook both near- and long-term for data centers, both series of QTS preferred should offer better downside protection than owning QTS common stock.

About QTS

QTS is a Kansas City-based owner, operator, and developer of carrier-neutral and multi-tenant data centers. They became a public REIT in 2013, and while they have a current equity cap around $4.3B, they are the smallest of the five data center REITs in the FTSE Nareit Equity Index. As of the end of 2019, they owned or controlled 3.2 million square feet across twenty-four different data centers.

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   Data Centers

It’s worth noting that while they do have an international presence, having entered Toronto and Amsterdam in 2015 through their acquisition of Carpathia, they are a smaller and relatively newer player in markets outside the U.S. compared to their larger data center REIT peers. While they have recently made additional acquisitions in the Netherlands, less than 10 percent of their overall revenue comes from facilities outside the U.S., though this is an area of their business they would like to grow.

Anyone that follows the data center space knows there is a wide spectrum in the different types of facilities and the services offered at each, but these can generally be boiled down to two classifications: hyperscale and colocation. If colocation was described as renting out a PO box at the post office or a safety deposit box at the bank, then a hyperscale lease would be described as renting out an entire warehouse: different sizes, different needs. QTS currently generates about two-thirds of their revenue from colocation and one-third from hyperscale.

While QTS appears to be on a good growth trajectory today, they had a dark moment in February 2018. Along with their fourth quarter earnings results for 2017, they announced they were going to shed their existing cloud and managed services business, one of their “growth engines” at the time, to focus on the business model we know today. Investors at the time were displeased and punished the stock price down 23% in a single day, and it continued to drift lower until bottoming out at $32.27 per share on Feb 28, 2018. During this time when management’s capabilities were being questioned, their stock saw many downgrades and activists even became involved. Essentially locked out of issuing new equity, but in need of capital to continue their development pipeline, they decided to issue preferred stock in early March 2018. This inaugural series A preferred stock was soon followed by an offering in June of Series B preferred stock, which came with a slight twist, namely convertibility.

What is Preferred Stock?

Preferred stock sits between a company’s debt and their common equity. They are typically issued at a $25 par value, with a fixed coupon payment, and no maturity date, though they can usually be redeemed by the issuer at par plus accrued dividends after five years. The dividends of preferred stocks have priority over common dividends, and most of the preferred stock issued by REITs is cumulative, meaning any missed preferred payments must be made in full before the common shareholders can receive any dividends. Preferred generally have liquidation preference over common stock as well. Due to their fixed coupon payments, preferred stock generally trades more like fixed income securities rather than equities, but not always, as we’ll see in a minute. Some preferred stock may have additional features such as convertibility into common stock or a coupon that switches from a fixed to a floating rate at some point in time.

QTS’ Two Series of Preferred Stock

The QTS 7.125% Series A Cumulative Redeemable Perpetual Preferred Stock, as it’s formally known, was priced on March 8, 2018 with a $25 par value and a fixed annual 7.125% coupon that pays quarterly.  The Series A is generally not redeemable until March 15, 2023. There are some caveats to that, such as change of control, or to protect the company’s status as a REIT, but you should generally consider 2023 date as the earliest the company could redeem the preferred. This is an option for QTS to redeem the securities any time after this date. Whether they choose to redeem it or leave it outstanding will depend on current market interest rates and their capital needs at the time. If new prevailing preferred rates are lower than 7.125% for QTS, maybe by even 25 or 50 basis points, there would be a good chance QTS would call the Series A and issue a new series of preferred with a lower coupon.

Today the series A trades above par at a price of $25.35, which equates to a current yield of 7.0% and a strip yield of about 7.1%. If they were to call it on the earliest call date, also known as the yield-to-call, the effective yield would be about 6.7%. If it is called any time after the initial call date, the yield lands somewhere between strip yield and the yield-to-call, depending on how much time passes.

The QTS 6.50% Series B Cumulative Convertible Perpetual Preferred Stock was priced on June 21, 2018 with a $100 par value and a fixed annual 6.5% coupon that pays quarterly. As should be noticeable in its title right away, with the use of “Convertible” rather than “Redeemable” that this security has a convertible feature. At the time of issuance, this security was convertible into 2.1264 shares of QTS common stock, which represents a conversion price of $47.03, which was 20% higher than QTS common stock’s previous close of $39.19 on June 20, 2018. It can be converted by the holder at almost any time into common shares of QTS. While there is no maturity date and no provision for QTS to redeem this series, they can, starting on July 20, 2023, force a conversion to common shares if their common stock trades at 150% or greater of the conversion price for twenty trading days during a thirty consecutive trading days period. The conversion rate is subject to adjustment following certain events. These include:

          § The issuance of stock dividends on our common stock;

          § The issuance of certain rights options, or warrants;

          § The distribution of capital stack, indebtedness or assets, securities or property;

          § Certain subdivisions and combinations of our capital stack;

          § Certain cash dividends on our common stock; and

          § Certain tender or exchange offers.

One of these items requires QTS to adjust the conversion rate if they increase the cash dividend on their common stock beyond the 41 cents per share per quarter they were paying at the time of issuance. QTS has increased the cash dividend on their common stock twice since the issuance of the series B preferred, and thus today’s conversion rate is 2.1306 shares of common stock per series B share, or a conversion price of roughly $46.94.

Today the series B trades above par at a price of $140.54, which equates to a current and strip yield of about 4.6%. However, as QTS common stock closed at $62.53, well above the current conversion price, we would consider this convertible preferred to be “in the money” and will trade more in step with QTS common shares rather than on its fixed income characteristics. If you converted your QTS series B preferred shares, you would receive about $133.23 worth of QTS common shares. Why would you spend $141 to purchase a security that only converts into $133 of another security? Because of the difference in dividend yield. The current dividend yield on QTS common stock is right around 3%. Investors get a better dividend yield and optionality on conversion with the series B preferred, and that is what’s driving the pricing differential. Lastly, it’s worth noting that with QTS common shares trading at $62.53, it’s not terribly below the new 150% threshold for forcing conversion at $70.40, but the good news is QTS cannot force this conversion for over three years.

Does QTS Have the Ability to Continue Making their Preferred Dividend Distributions?

It’s great to understand the characteristics of these two preferred series, but what’s really important is whether or not QTS has the capacity and credit worthiness to continue making the dividend distributions on these preferred. While a positive long-term outlook for QTS common stock might be needed to get comfortable with the convertible series B at its current prices, this credit capability is almost all that matters for the series A.

Let’s first look at QTS’ capital structure. This graphic from a QTS presentation that accompanied their first quarter 2020 earnings release shows us the composition of their enterprise value. There are a few things to note. The equity cap of $4.0B is based on their March 31, 2020 common stock price of $58.01 and it also includes shares they issued under a forward agreement as well as some in-the-money options and partnership units that are convertible into commons shares. Using today’s closing stock price would increase the equity cap to $4.3B. The preferred stocks are listed at liquidation preference, that is $25 for the Series A and $100 for the Series B. The Series B, if marked to market price, would be increased by over 40%. Even without these market adjustments, we can see that their total debt of $1.7B makes up about 28% of their capital structure. This would be just slightly worse than our calculation of the data center REIT average of 25% at year end, but better than the overall REIT average of 33%. Using today’s stock prices would show the data centers REITs even better positioned, including QTS, as all five of them are up in price from the start of the year, while overall REITs are down.

Capital Structure

Not only has QTS been judicious with their use of debt, they have virtually no debt maturing before 2023. The majority of debt they do have coming due in 2023 is their revolving credit facility. This revolver has a total borrowing capacity of $1B, and QTS can even extend the maturity for another year subject to meeting certain conditions. This debt can be paid off at any time without penalty, but as it had an interest rate of just 1.96% at March 31, 2020, QTS is likely not in a hurry to pay it back. We would assume QTS will likely renew or recast their credit facility before maturation, possibly even on more beneficial terms.

Debt Maturities

For the full year 2019, QTS reported “Adjusted Operating FFO” of $154.8M. Think of this number as the free cash flow generated after paying all expenses, servicing debt and maintaining their facilities, but before new development spending and paying dividends on both common and preferred. We estimate QTS will need $127M to pay their common dividend, including all shares to be settled under the forward sale, and $28M to pay both series of preferred for the full 2020 year. This sums to $155M of cash needed to make dividend payments. While this is just about covered by “Adjusted Operating FFO,” it doesn’t leave anything to pay for new development. QTS spent $237M on new development in 2019, though they plan to ramp this to around $575M in 2020. About $145M was spent in the first quarter, leaving a balance of $430M for the remainder of the year. If we assume that 30% of this development is funded with debt, perhaps on the revolver, it still leaves a little over $300M to fund. The $154.8M of “Adjusted Operating FFO” in 2019 doesn’t account for the growth they expect over the course of 2020. Their guidance for 2020 includes an expectation of 10% revenue growth, 12% EBITDA growth, and while not listed in this graphic, about 5% FFO growth which should drop to “Adjusted Operating FFO” as well. In another positive sign, we just saw QTS re-affirm this guidance for 2020. In typical times, you’d like to see a REIT increase guidance, but with most REITs withdrawing or reducing guidance in the face of the COVID pandemic, a re-affirmation from QTS truly stands out in a positive light. Nonetheless, this would still leave a pretty large shortfall in development funding; however, per their first quarter earnings call, QTS states they have around $342M to collect from settling the forward stock sale. This essentially funds the rest of their development pipeline for this year and into 2021. We would not be surprised if they issue additional equity given where their common stock currently trades.

2020 Growth Outlook Summary(2)

With REITs forced to pay out 90% of their taxable income as dividends to preserve their status as a REIT, this ongoing external funding requirement isn’t unique to QTS, but rather a characteristic of almost all REITs that do development. As mentioned earlier, we believe QTS will continue to raise equity to fund development, which also puts the preferred stock in a safer place, but development can also be curtailed. They don’t have to spend $575M on development this year if market conditions change for the worse, but as it was noted on their last earnings call, over 70% of this development is tied to leases that have already been signed. In fact, QTS currently has the largest booked-not-billed backlog they have ever had in their history. This amounts to $101M of recurring annual revenue that has been signed, but the lease has not yet commenced. Not only are these development deals significantly pre-leased, they also come with highly accretive yields, as QTS looks for a range of 9 to 11% on new development yields. That means this year’s development spend becomes next year’s FFO or cash flow. As long as QTS can achieve these yields, and keep the pipeline well pre-leased, we are not concerned with the current funding gap, though it is something to watch.

Overall, we see that QTS has conservative leverage, no debt maturities for several years, and significant free cash flow to service both their debt and continue paying dividends on both their preferred and common stock. So far, the data center REITs have been the bright spot during the COVID-19 pandemic, but if that changes and their stock prices were to plummet, you would be better protected in a preferred position than the common stocks. Even the convertible series B would begin to trade on fixed income characteristics if QTS common stock was to fall closer to the present conversion price.

Conclusion

We will leave it to the reader to decide if they like a 7.0% yield, or a 6.7% yield if the series A is called as early as possible, or a 4.6% yield with upside equity participation as can be found in the series B. With the 10-year treasury rate around 0.6% today, and bank savings account paying virtually nil, these both seem like excellent opportunities.

We can also compare the QTS series A preferred stock to similar preferred stock issued by the larger data center REIT Digital Realty Trust (DLR). For instance, the DLR Series J (DLR.PJ) has a strip yield of 5.2% and a yield-to-call of 4.6%, and the DLR Series K (DLR.PK) has a 5.6% strip yield and a yield-to-call of 4.4%. Yes, DLR is a bigger entity and has an investment grade credit rating, and while their preferreds are also fine investments, we believe the extra yield from the QTS series A more than compensates an investor for the modest increase in risk, or the QTS series B allows an investor to participate in future upside appreciation in QTS common stock.

Answering which of the QTS preferred is a better investment will depend on your investing goals.  Investors looking for a higher yield but with limited upside might consider the series A. Investors who’d rather participate in the potential upside of QTS common stock and receive a higher yield than the common stock might consider the Series B.

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Geoff Shaver, Director of Public Securities

Geoff Shaver

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.

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Disclaimer

Geoff Shaver and clients of Path by Origin, LLC own QTS.

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.