Digital Realty Taking its Medicine

On its earnings call toward the end of the month we will likely hear some details about the properties Digital Realty Trust (NYSE: DLR), one of the world’s largest data center real estate companies, is going to sell.

Describing its “new path forward,” the San Francisco-based company’s senior executives announced some big strategic changes after it wrapped up the first quarter. The new path included pruning the real estate investment trust’s massive portfolio to get rid of “non-core” properties. But the word has been mum since.

“It seems like not a lot’s happening because you haven’t heard an announcement or seen a building transact,” Jim Smith, Digital Realty’s CTO, said. “The reality is that the team that does dispositions has been really cranking at full speed, because we wanted to make sure we did it right.”

As painful as it may have been for the company’s management to admit to investors, not all buildings in the portfolio are gold mines exactly, and time has come to trim the fat.

“We haven‘t sold anything in the whole life of the company, and that has been a mistake,” Smith said. “We have sort of 10 years of deferred maintenance on pruning. We should be selling a little bit every year. It’s just good real estate behavior.”

What’s for sale?

So what constitutes a “non-core” property for Digital Realty? In the early years after the private equity fund GI Partners spun it out in an IPO, the company’s management had not drawn a hard line between types of assets it would and wouldn’t own. Some buildings in the portfolio aren’t even data centers.

One is a training facility for semiconductor equipment in an office park, for example. It’s high tech, with lots of expensive infrastructure, but it’s not a data center, Smith said. Another example is an office building that houses a technology company’s headquarters.

There are non-core data centers as well. Some of them are facilities with thin operational teams – buildings Digital Realty acquired in markets where the management thought they would bulk up but didn’t. Having a single data center in a market is not a bad thing on its own, but if it needs some redevelopment work or a tenant’s lease is approaching expiration, it doesn’t fit the company’s current strategy.

If the landlord has a good lease deal going in a building, but the tenant’s credit profile changes, that too may be a good reason to sell. Another good reason to sell would be having a building that’s currently overvalued because it is in a hot market, Smith explained.

No shortage of buyers

How easy or hard it will be to sell and how well the company will make out on each deal will vary widely. “Some of them will be easy, some of them will be hard, some of them will make money, some of them we may take some haircuts on,” Smith said.

At the moment, there are plenty of bidders and valuations are high, so it’s a good time to be a seller in the market. “Anything that has ‘data center’ associated with it and has some cash flow is very interesting to many buyers,” he said.

There are developers out there looking to reposition themselves for the data center market and willing to take on some risk. There are also local entrepreneurs in some markets for whom a partially occupied data center that is specific to their local market is attractive.

Pamela Garibaldi, vice president of global marketing at Digital Realty, said there were also institutional investors shopping around. “There are some private equity funds out there that focus on the technology sector that want to acquire data center assets,” she said.

If a data center has a tenant with decent credit, it will be fairly easy to sell. “There’s never been a shortage of buyers looking for credit tenants,” Jim Kerrigan, who has worked on high-tech real estate deals since the early 90s, said. A client with a double-A credit or above and a good lease term is important, however.

Most recently Kerrigan was part of Avison Young’s data center practice and worked in a similar role at Grub and Ellis before that. He now runs his own real estate company called North American Data Centers.

From private buyers to other REITs, pension funds and private equity players, the pool of buyers is far and wide, Kerrigan said.

Taking one’s medicine is a sign of maturity

That Digital Realty is taking a hard look at its portfolio after a decade in business is a sign of maturity, Chris Crosby, one of the company’s early employees who now has his own data center development business called Compass Data Centers, said. “It’s very solid strategy.”

As any company ages, it runs the risk of suffering from past investments it has neglected to part with. Any time a company take its medicine is a good sign of mature management, Crosby said.

And Digital Realty can afford to take the time to do it thoughtfully. “We’re not in some sort of crisis, like ‘these things have to be disposed of,’” Smith said. “We want to optimize the value and maximize the value, and it’s a process that will take some time.”