Singapore Data Centre S-REITs: Down but not out
- Data centre REITs and cloud players are more collaborators than competitors
- DCREIT’s long WALE and support from its sponsor are second to none
- Addressing trio concerns of earnings risk, asset value risk, and acquisitions
- We remain buyers of DCREIT on further downside in price
Are data centre S-REITs worth a shot? An article making the rounds lately, featuring views of a well-known short-seller, states that “legacy” data centres are facing increasing competition from technology giants that have been their biggest customers. The report has a negative impact on data centre-focused players like Digital Realty (DLR US), Equinix (EQIX US), and Iron Mountain (IRM US), which were down by 3% to 5% on 29 June 22. In Singapore, Digital Core REIT (DCREIT) also saw a c.7% decline in its share price.
Our view:
(+) Impact of hyperscalers on data centre operators not as feared, as we see a symbiotic relationship between both.
In recent years, there has been a rise in the number of hyperscale data centres, mostly developed by the big cloud providers (Google, Amazon Web Services, Microsoft Azure, etc.) for their own use. As these hyperscale data centres come online and these major cloud providers move into their own facilities, it will no doubt put pressure on some of the older data centres as they vacate their space. However, net absorption in most of the major data centre markets in the US remains positive, mainly due to the growth of the digital economy. We believe that as more hyperscale data centres come online, it could potentially put pressure on occupancy rates at the older data centres in the short term. However, the secular growth of the digital economy and cloud services will continue to drive positive net absorption and support back-filling fairly quickly.
Even as these hyperscalers develop and operate their own data centres, we see limited risk of them “cannibalising” demand from data centre operators for their end users.
Firstly, hyperscalers develop and operate data centres for their own use and continue to seek new capacity to keep up with their customer growth. We understand that they are still struggling to fulfil their own demand and capacity. Secondly, the big cloud providers are large and sophisticated technology companies that are in the business of driving profits from their core expertise and not as data centre operators. Moreover, end users of data centres prefer carrier-neutral infrastructure that provides them with the flexibility to switch between carriers when necessary.
(+) Long WALE and support from parent provide comfort of revenue visibility.
For DCREIT, its long WALE of c.5.5 years ensures longterm occupancy and income. Its sponsor’s capability to operate data centres efficiently and deliver sufficient value to continuously entice and attract tenants was what helped Digital Realty establish itself as one of the world’s largest operators. As the data centre sector continues to thrive in this new digital age, and as DCREIT unceasingly works on improving its offering, we believe that demand for its properties will remain robust.
Addressing key risks:
(-) Rising interest rates continue to pose a risk for DCREIT.
Having already hedged 50% of its borrowings to fixed rates, the borrowings that are still on floating rates
remain susceptible to rising interest rates. Based on the current interest rates in the US, we estimate that
DCREIT’s all-in cost of borrowings could creep up from 2.1% (reported in March 2022) to as much as 2.7%.
We ran a sensitivity analysis on the impact of rising interest rates on DCREIT’s earnings (Figure 1). Based on our estimates, the correction of DCREIT’s share price to US$0.77 provides an opportunity to seek yields. Even if its all-in cost of borrowings rises to 3%, DCREIT is expected to generate forward yields of c.5.2% and c.5.7% in FY22 and FY23, respectively. In the unlikely case its all-in borrowing costs spike to 4%, forward yields of c.4.8% and c.5.2% for FY22 and FY23 are still on offer.
(+) Acquisitions – not a foregone conclusion.
The rise in the funding costs in the US and 10-year UST have also called into question DCREIT’s ability to make acquisitions and also the sustainability of its asset values. In terms of acquisitions, we believe that while the US market may seem out of reach for now, due to the spike in funding costs, given the sponsor’s global footprint, we think there could be possible avenues in Europe, where the spreads between acquisition yields and funding costs are still wide.
(-) A keen eye on asset valuations – is NAV safe?
The data centre space has seen significant cap rate compression over the past couple of years of close to c.100 basis points, according to Real Capital Analytics. A recent 2022 CBRE Global data centre investment survey indicates that investors (which include global institutional real estate investors) continue to look to increase their data centre investments through 2022 with close to half of the respondents expecting continued compression in cap rates, given the heightened capital allocations in a relatively limited supply of for-sale assets.
While the spike in bond yields and funding costs in the US may have doused some of this enthusiasm, unless a significant downward repricing in yields occurs, we suspect that capital values should remain fairly stable and any potential movements should not result in material impacts from the current levels. Based on our estimates, DCREIT now implies a cap rate of c.5.0%, which is a c.60bps expansion in yields from FY21A initial yield of 4.4% (Figure 3).
