Alert: Resolution to a long-standing overhang
- Proposed overall package solution towards portfolio diversification and positioning for growth
- Transactions involving asset recycling and leases amendment a trade-off between near-term dilution to DPU for more certainty and improved portfolio diversification; net positive
- Leveraged on Sponsor’s pipeline to mitigate further dilution to earnings while building on future growth prospects
- Current BUY recommendation with TP of US$0.90; will review once transactions and Cyxtera’s Chapter 11 process are firmed up
What has happened?
Digital Core REIT (“DCREIT”) has just made significant announcements regarding its response to the Chapter 11 filing of its second largest tenant, Cyxtera Technologies. In a move aimed at resolving Cyxtera’s bankruptcy, Brookfield Investment Partners has inked a deal to acquire a substantial portion of Cyxtera’s portfolio (including some of the data-centers (“DC”) that are held by DCREIT). Notably, Brookfield is currently engaged in discussions with multiple data centre landlords as part of this transaction. Below are the strategic actions that reflect DCREIT’s proactive approach in navigating the complexities of Cyxtera’s Chapter 11 filing, ensuring the stability and growth of its data centre portfolio:
- (+) Lease amendment at two Los Angeles Data Centres. This involves shortening the lease to Sept’24 (from 2033/2035)
- (-) Lease termination at Frankfurt Date Centre. The lease at Frankfurt DC, which accounts for approximately 4% of the property, is being terminated where the REIT, together with the sponsor will assume operations at the property.
- (-/+) Divestment of two data centres in Silicon Valley. Two facilities in Silicon Valley are set to be divested to Brookfield.
- (+) Retention of one lease in Silicon Valley. DCREIT is affirming the lease for its remaining Silicon Valley asset, with no adjustments to existing lease terms and rents.
- (+) Acquisition of additional stake in Frankfurt. In a noteworthy move, DCREIT is acquiring an additional 20% stake at Frankfurt DC from its Sponsor, Digital Realty.
- (+) Expansion into Japan. DCREIT is also making its maiden entry into Japan by securing a 10% stake in the Osaka Data Centre from Mitsubishi Corporation.
Our views.
Trading off between diversification and slight dilution in DPU. Based on our estimates, these transactions may potentially result in a c.3% dilution to FY24 DPU of c.3.72UScts. However, we view this as a net positive for DCREIT as it actively investors’ concern of its over-concentration risk of its tenant profile towards selected large tenancies, bringing its exposure to Investment Grade customers to c.87% (vs 77% before). Regarding its exposure to Cyxtera, the overall transactions will effectively remove the cloud of uncertainty surrounding the tenant’s bankruptcy and represent a strategic trade-off that enhances DCREIT’s geographical and tenant diversification. Furthermore, the entry into the Japanese market through the Osaka DC acquisition offers DCREIT a new growth pipeline, leveraging its Sponsor’s continued 50% stake in the asset, while Mitsubishi Corporation holds the remaining 40%. Although the lease amendments and terminations may introduce leasing risks in the near-to-medium-term, they also position DCREIT to potentially command higher rents at the affected properties, in our view. This is in line with our understanding that the data centre industry continues to benefit from structural tailwinds driven by technologies such as machine learning and artificial intelligence.
In summary, while we acknowledge that these transactions might result in near some earnings dilution, it’s important to note that DCREIT’s access to its Sponsor’s pipeline has significantly mitigated a potentially larger dilution (-6.5% in DPU without these acquisitions). Moreover, these moves will lead to a more diversified portfolio with reduced tenant concentration, maintaining stable gearing at c.34% and also a valuation yardstick with the divestment, giving investors comfort that its net asset value (“NAV”) of US$0.80 is achievable. In the medium term, we see DCREIT increasing its stake in Osaka DC as a promising future acquisition pipeline. On a cautious note, it’s worth mentioning that the acquisition yield of the Osaka DC seems a little tight (estimated yield of c.3.2%). Additionally, the latest valuation of the Frankfurt DC that the property’s value has decreased by around 11.5%, pointing to a likely dip in DCREIT’s portfolio valuations at year-end. Our current recommendation is a BUY with a TP of US$0.90. We will be closely monitoring and updating our projections as these transactions are approved and executed upon.
Summary of implications and DBS views of each transaction.
| No. | Transaction | Affected property | Details | Positive implication | Potential negatives | DBS view | Positive / Negative |
| 1. | Lease amendment(Los Angeles DCs) | 3015 Winona Avenue200 North Nash Street | Lease expiration will be amended to 30 September 2024; thereafter DCREIT assumes operation of the property with an underlying occupancy rate of 50% | Immediate lifting of overhang on the Chapter 11 filingPotential to diversify tenant base and rental uplift which we understand to be up to 10%-15% (vs current market levels) | Leasing risk in September 2024 when master-lease expiresDrop off in revenues from both properties in September 2024 if unable to backfill vacancies or convert underlying tenant leases | Positive: Overhang lifted, tenant diversification, potential to lift underlying rents | + |
| 2. | Lease termination(Frankfurt DCs) | Frankfurt DC | Lease (4% of asset) will be terminated early and DCREIT assumes underlying backfilling of half of the space | Immediate lifting of overhang on the Chapter 11 filing from Cyxtera. | Leasing risk for vacated space (c.4% of property)Has to pay an early termination fee of US$2.5m | Negative: Immediate leasing risk, early termination fee | – |
| 3. | Lease Assumed(Silicon Valley) | 1500 Space Park Drive | No change to lease terms or rents | Income stability generate from asset | Unable to lift rents as the property is understood to be under-rented | Positive: Income visibility and stability | + + |
| 4. | Divestments(Silicon Valley) | 2401 Walsh Avenue2403 Walsh Avenue | Both assets sold at book value for a total of US$150.2m (4.4% cap rate) | Immediate lifting of overhang on the Chapter 11 filingFree up capital for acquisitions to diversify portfolioReduce tenant concentration risk | Income void from the 2 properties divestedDecline in overall portfolio WALE as both assets are on long leases | Neutral: Assets sold at cap of 4.4% and book value is a positive affirmation of its book value but the REIT is selling their “crown jewels”. | – |
| 5.6. | Acquisition(Stake in Frankfurt and Japan) | 20% stake in Frankfurt DC10% stake in Osaka DC | 20% Frankfurt DC stake for US$98.7m 10% Osaka DC stake for US$51.5m | Diversify portfolio and tenant baseEntirely funded by divestment proceedsAdditional future pipeline in Japan | Acquisition yield of Osaka DC seems tight (c.3.2%)Valuation of Frankfurt DC suggests that valuations have declined (-11.5%) since last year | Neutral: Potential savings in finance cost but yields seem tight, may not be sufficient to offset income void from the string of transactions | +/- |
Source: Digital Core REIT, DBS Bank
Estimated impact of above transaction to FY24 DPU
Source: DBS Bank estimates
* It is important to note that the divestments of the two Silicon Valley assets and termination of lease at Frankfurt DC are conditional upon the sale of Cyxtera’s assets to Brookfield.
