DCK Investor Edge: Why Money is Pouring Into Data Centers

Welcome to DCK Investor Edge, our new weekly column on all things related to data center investing authored by Bill Stoller, a financial writer and analyst and regular DCK contributor. Bill sits at the intersection of Wall Street and Main Street, where real estate intersects trends in technology, retailing, office/industrial, residential, healthcare, energy infrastructure, and green initiatives.

Read more about why we think a column on data center investing is a good idea here.

And here's the first edition of DCK Investor Edge:

Publicly Traded REITs

A quick look at the April 28, 2017 real estate investment trust (REIT) sector recap below shows that commercial real estate was essentially flat during the first four months of trading in 2017.

Data center outperformance versus more traditional real estate asset classes (office, hotels, apartments, industrial, self-storage, shopping centers, etc.) was striking (click chart to enlarge).

Source: Seeking Alpha – Hoya Capital Real Estate

The data center REIT sector price appreciation also handily outperformed the broader S&P 500 Index, by more than double. Digital Realty and Equinix are both S&P 500 companies.

This type of outperformance is what is attracting the institutional funds to the sector. Meanwhile, data center industry pros and individual investors can participate by owning shares in the publicly traded REITs. In addition to the two large-cap REITs mentioned above, CoreSite Realty, CyrusOne, DuPont Fabros, and QTS Realty round out the sector.

There are other notable publicly traded companies, including -- Iron Mountain, NTT (Raging Wire), and Corporate Office Properties Trust -- which also are active in data center development. However, the impact of their data center operations is overshadowed by their respective core businesses.

Europe and Asia

Pan-Europe: Interxion Holdings N.V. shares trade on the NYSE under the symbol (INXN) with a $3 billion market cap, and have returned ~25% for investors year-to-date. No dividend is paid. Interxion operates the broadest footprint of connectivity-focused data centers across Europe.

China: GDS Holdings, Inc. filed a US IPO last November priced at $10.00 per ADS, or American Depository Share which trade on NASDAQ. GDS is down about 3 percent year-to-date. No dividend is paid.

Read more: DCK Exclusive: Chinese Data Center Leader GDS Holdings – IPO Update

GDS operates data centers in Beijing, Shanghai, Shenzhen, Guangzhou, Chengdu, and Hong Kong. GDS is a 50/50 hybrid between wholesale and retail/colo data centers. The top three tenants, likely Alibaba, Baidu, and Tencent, account for 47 percent of annual revenues.

Transparency

The other reason that investors and industry pros should pay attention to the publicly traded REITs and data center operators is the requirement to report earnings and file quarterly and annual reports with the SEC.

REIT management teams also host quarterly conference calls to discuss results, and post presentations and Supplemental information on their investor relations websites.

It is much harder to gain access to accurate information regarding revenues and earnings from the privately held companies and non-traded REITs. Data Center Knowledge works behind the scenes to obtain accurate information from industry pros, consultants, brokers, and management, and report it to our readers in a timely fashion.

REIT Investing 101

While megawatts, N+1 resiliency, and gigabytes are familiar terms to data center professionals, the financial jargon contained in REIT earnings reports can be confusing.

The most important thing for investors to realize about REIT valuations is that the P/E, or price earnings ratio, commonly used to value traditional corporations, is not useful for real estate investment trusts.

This is the biggest mistake most new investors make, as financial portals rarely report the REIT metrics that matter: Funds from Operations (FFO) and AFFO (which is FFO adjusted for maintenance capex, straight-line rents, and other non-cash amortizations).

AFFO is also referred to as Funds or Cash Available for Distribution (FAD/CAD). This is the REIT cash flow that is used to pay the quarterly dividend. The biggest difference between GAAP earnings and FFO is that property depreciation (a non-cash expense) is added back, along with other adjustments.

It is important for investors to compare how REITs calculate and report terms like operating FFO, core FFO, normalized FFO. It can be a slippery slope. NAREIT FFO is usually considered to be the baseline, or gold standard.

Additionally, REITs which are more active on the acquisition front often report pro-forma results -- either including or excluding revenues -- with adjustments for one-time M&A fees and expenses. It can be challenging to analyze and compare year-over-year results when there have been major acquisitions, such as the Equinix $3.6 billion Verizon deal.

Show Me the Money

REITs are popular with income-focused investors because by law they must pay out at least 90% of taxable income to shareholders in the form of dividends. This means that REITs do not retain earnings and must access both the debt and equity markets on a regular basis to fund new development or grow by acquisitions.

However, new investors are often confused when they learn that many REITs payout much less than 90% of cash available for distribution as dividends. Remember, a lot of this cash flow is from "depreciation," a non-cash bookkeeping entry.

A low FFO/AFFO payout ratio provides a margin of safety for shareholders. It helps to ensure the dividend will not be cut, (and is more likely to be raised in the future), while providing operating cash flow to reinvest in growing the core business, or strengthening the balance sheet.

On top of price appreciation, if any, the six US-based publicly traded data center REITs as of this writing pay quarterly dividend distributions with annual yields of ~2%-4%. REIT investors love their dividends. One of the attractions of data centers is the ability to grow this distribution at a rapid clip relative to other real estate asset classes.

In addition to covering investing and business news for Data Center Knowledge, Bill Stoller is an Expert Contributor for REITs on Seeking Alpha. The information contained in this article is not investment advice.

Disclaimer: Bill Stoller’s REITs 4 Alpha Seeking Alpha Marketplace portfolio includes: COR, CONE and DFT. A member of his household in a retirement account owns: COR, CONE and DFT.