Data Center REITs Soar Back After a Bruising 2018

Publicly traded data center REITs had earned a reputation of delivering outsized returns for shareholders in 2016 and 2017. But the global equity selloff late last year hit their investors particularly hard, racking up 14 percent losses on average for the five US-based data center REITs: Digital Realty Trust (DLR), Equinix (EQIX), CoreSite Realty (COR), CyrusOne (CONE), and QTS Realty Trust (QTS).

In the minds of most investors, these REITs as a sector started off 2018 facing a giant headwind. In a nutshell, the Federal Reserve continued a "hawkish" stance, regularly raising interest rates. Historically, this creates a short-term headwind for REIT share prices.

Unique Data Center Challenges

However, the data center sector was particularly weak in the first quarter of 2018 due to industry-specific issues, including difficulty in forecasting hyperscale demand, "shadow" supply concerns, funding capex for massive powered shells and geographic expansions, and pricey M&A deals, which were initially dilutive to existing shareholders.

As it turned out, things got better heading into summer. Data center REIT share prices rallied into June 2018, but even the most optimistic investors had their hopes dashed during a dreadful October, November, and December.

Related:Developers Lean on Joint Ventures to Fund Hyperscale Data Centers

A Perfect Storm

A slowdown in the fourth quarter in new lease signings created uncertainty in the minds of investors. The fourth quarter of any year is usually much slower for new bookings due to the holiday season and corporate budgets having been exhausted during the first nine months of the year. Plus, those pesky concerns that hammered data center shares earlier in the year reappeared at exactly the wrong time, creating a perfect storm.

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YChart by Bill Stoller

The year’s finale was an ugly stock-market selloff – few buyers were willing to put new capital to work while prices were falling day after day. The global equity selloff accelerated in December, peaking (ironically enough) right around Christmas. Investors hoping for a Santa Claus rally received a lump of coal instead. Many retail investors were dreading to look at their year-end brokerage statements – it was that ugly – and data center REITs were no exception.

Must Be Present to Win

Many retail investors sold their shares in the fourth quarter, taking advantage of "tax losses" to offset gains, which again served to exacerbate the selloff. Deep value opportunity attracted those brave enough to buy as prices fell lower each day.

And it did not take long for investors who acquired and/or held on to the data center REIT shares to be rewarded:

Related:Why CyrusOne Shares Tanked, and Why It’s Nothing to Worry About

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YChart by Bill Stoller

Data Center REITs at a Glance

While these stocks tend to trade as a group, there are some notable differences among them.

Digital Realty shares showed the best relative strength during the fourth-quarter selloff, so they didn't have as much runway for price appreciation in 2019. Digital has a global portfolio of more than 200 data centers and offers customers a complete product offering, from retail colocation and interconnection to super-wholesale leases. The company has an investment-grade rating and a 14-year track record of increasing dividends every year since its 2004 IPO.

Equinix also has a global platform consisting of more than 200 facilities. Its connectivity-focused retail colocation model has a competitive moat in the form of a large number of customers (more than 10,000) who can easily interconnect with each other. These cross-connects are a high-margin business that’s growing faster than the business of leasing space and reselling power. Equinix continues to grow its dividend while reinvesting most of its AFFO (Adjusted Funds from Operations, which is a REIT earnings metric) into organic growth.

CoreSite also has an interconnection-focused colocation business model. However, its footprint growth remains in eight US markets, including Los Angeles, Silicon Valley, Chicago, and Northern Virginia. CoreSite offers a high yield and a track record of dividend growth. The operating leverage as these campuses grow, combined with high utilization rates, continue to drive higher FFO per share to support the growing dividend.

QTS early last year pivoted away from a large offering of in-house managed services to focus on hyperscale and hybrid IT (colocation) deployments. QTS has always had a security and compliance focus and still offers those popular services inhouse. Initially, Mr. Market was skeptical about the pivot, and QTS shares were hammered down. But the company’s execution during the last five quarters and continued dividend growth have resulted in a rebound.

CyrusOne has traditionally focused on Fortune 1000 enterprise customers. But during the last three years, this data center REIT developed a powered-shell offering focused on fast speed-to-market and low cost per 1MW designed to serve the needs of global hyperscale customers. CyrusOne has been investing in international expansion, with a 2019 focus on top European markets in addition to expanding in several US markets. This rapid expansion has become a short-term headwind for AFFO growth.

Notably, CyrusOne had invested $100 million in China-based GDS Holdings and on April 12 announced that it had sold two thirds of its investment for $200 million – a move that caused its own shares to spike higher.

Investor Edge

The demand drivers that support data center growth are not dependent on consumer spending, US and global GDP growth, jobs, or the direction of interest rates. Digital Realty demonstrated this by continuing to grow FFO per share to support a growing dividend through the last recession.

Enterprise digital transformation and adoption of cloud computing are still in the early innings. Demand drivers for the future include growth of big data, AI, outsourcing of legacy on-prem data centers, as well as 5G and the Internet of Things.

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Source: Hoya Capital Real Estate, April 9, 2019. Source: Seeking Alpha

While almost all asset classes were squarely in the green in the first quarter of 2019, data center REITs led the way, outperforming the red-hot S&P 500 by about 8.5 percent, while on average offering dividend yields twice as large as the 1.8 percent earned by popular S&P 500 ETFs.