~ by Snehasish Chaudhuri, MBA (Finance)
Digital Realty’s preferred shares present better value for investors right now over ordinary shares, because, while the company has done well in the past few years, the sudden and extreme interest hike may hurt it badly. If that happens, ordinary shares will be at risk, but preferred shares will be protected. By my calculations, preferred shares can withstand even a 30% drop in AFFO without lowering dividends. I do not believe even the interest rate hike – which, as I have discussed earlier, is slowly easing off – will be able to reduce AFFO by over 30% in the short to medium term. Thus, preferred shares are protected.
Digital Realty Trust (NYSE:DLR) is a real estate investment trust (‘REIT’) that owns and operates nearly 300 data centers and has more than 35 million profitable square feet across the globe. Digital Realty Trust, Inc. 5.250% PFD SER J (NYSE:DLR.PJ) has a fixed coupon of 5.25 percent and generates a yield around its coupon only. It has been paying quarterly dividends for the past 20 quarters. The data center business is expected to generate steady growth over the coming years. The global data center market is estimated at $288.3 billion five years down the line. However, the benefits of such growth will be reflected in the financials of data centers like DLR over the medium and long run. So, there are uncertainties associated with the returns generated by common equities of DLR. But, investors of fixed income generating securities stand in a better position.
The Business of Digital Realty Trust
Digital Realty provides data center service, retail colocation, and interconnection solutions. It serves some of the world’s leading enterprises and service providers, such as Adobe Inc. (ADBE), AT&T Inc. (T), Emerson Electric Co. (EMR), International Business Machines Corporation (IBM), SentinelOne, Inc. (S), Telefónica, SA (TEF), etc. In retail colocation, those enterprises rent a single cabinet and rely on DRL to provide all the accommodations. These enterprises may also rent an entire power-connected building, known as ‘cold shells’. The best part of DLR’s data centers is its global presence which provides its customers access to interconnected communities worldwide. At present, DLR operates almost 300 data center facilities in 48 metro cities across 23 nations on all six continents.
Digital Realty Trust has recorded significant year-on-year (YoY) growth in revenue and funds from operations (FFO) over the past 10 years. Even during the pandemic, this data center REIT registered positive growth in revenue and only a marginal loss of FFO that also only in 2020. Financial performance was also good enough during the last quarter, on the back of an annualized booking of $176 million. The bookings were driven by a large hyperscale deal with a multinational financial enterprise. However, the firm always had steady bookings and has averaged more than $130 million in bookings each quarter since the onset of the pandemic in the first quarter of 2020. The company also generated positive operating income throughout these years, although the growth was not as consistent as that of revenue or FFO.
Data Centers Are Going to Change the Way Business is Conducted
Data centers are mission-critical physical facilities that organizations use to store data and critical applications. These infrastructures are designed and developed to process data generated by consumers and business end users. This infrastructure includes servers, storage systems, firewalls, routers, switches, application-delivery controllers, etc. and are connected to consumers and businesses through fiber optic cables via telecommunication broadband connectivity or satellites. Worldwide, data center business is expected to achieve fast growth with respect to space and power capacity. People have estimated that by 2027, data center infrastructure will spread over 53.51 million square feet and generate a power capacity of 9,719 Megawatt (MW).
Cloud adoption, Internet of Things (‘IOT), big data, smart city initiatives, social media growth, data protection laws, and content consumption, are some of the factors that are driving data center growth. Beyond the traditional world of technology-based enterprises, some factors like innovation in infrastructure, efficient resource utilization (namely power and water), curbing carbon emission (through renewable energy, hydrogen fuels, hydrogenated vegetable oils, etc.) are also driving the growth of data center infrastructure. By another 5 years, investments in hyperscale data centers are estimated to be $22.48 billion, while investments in colocation facility development is estimated to be $43.18 billion. Without a doubt, data centers are going to change the way businesses are conducted.
Growth Prospect of Global Data Center Infrastructures & Businesses
The United States is the global data center market leader and accounted for around 22 percent of the global data center investments in 2021. The North American data centers set the trend with early availability and adoption of innovative technology. Besides DLR, Equinix (EQIX), American Tower Corporation (AMT), CyrusOne (CONE), Compass Datacenters LLC, Meta Platforms, Inc. (META), Alphabet, Inc. (GOOG), Cologix Holdings, Inc., QTS Realty Trust, Inc., Switch, Inc. (SWCH), etc. are the major players operating in the North American data center market. These data centers get less cumbersome and low-cost investments from their large-scale enterprises, colocation service providers, and government agencies. The data center market of this region was $90.51 billion in 2021 and it is still growing.
The other regions follow the trend, with Asia-Pacific (‘APAC) generating maximum growth – at a compounded annual growth rate (‘CAGR) of 6.3 percent. With increased investments from colocation providers, APAC data center markets are having the highest growth potential at present. Data center market in APAC is expected to reach $94 billion in 2027. The increasing volume of internet users and use of social media, increased implementation of cloud-based services, high smartphone penetration, and the need for enterprises to migrate from server room environments to data centers act as the major growth drivers for the future. However, as the growth of these infrastructures takes time, the predicted global growth rate is not abnormally high (less than 5 percent). At the same time, data center REITs with worldwide presence get almost an assurance to grow over a longer period of time.
According to Arizona’s recent market research report on ‘Data Center Market – Global Outlook & Forecast 2022-2027:
The global data center market size was valued at USD 215.7 billion in 2021 and is expected to cross USD 288 billion by 2027, growing at a CAGR of 4.95% from 2022-2027. The major trends contributing to the market growth include procurement of renewable energy, reduction in carbon dioxide emission, edge data center deployment, M&A and Joint Ventures, and new entrants to the industry. Increased digitalization across businesses will continue to grow data center investments from colocation, cloud, internet, and telecommunication providers. Furthermore, the COVID pandemic, cloud expansion, and usage of social media and OTT services worldwide are major driving factors in the global data center market.
Why Preferred Stocks of Digital Realty Trust Are Good Investment Options?
A key metric for the growth of data centers is acquisitions and capacity building with speculation for future demand. DRL has been following this strategy for a long period. But, if it fails to raise capital with ease, then the entire growth potential falls in jeopardy. An interest rate hike from 0.25 percent to 3.75 percent within a period of 8 months, undoubtedly makes things difficult for DRL. At the beginning of this year, BAM Digital Realty, DRL’s joint venture with Brookfield Infrastructure, acquired 10-acre (435600 square feet) of land in Chennai’s Ambattur locality for almost $28.4 million. However, no progress has been made since then, and it seems expansion in emerging APAC markets will take time. Investors banking on increasing demand and high growth potential of data center infrastructure, also need to keep this factor in mind.
Current macroeconomic conditions and the state of the broader market are quite well known and can be termed bearish in one word. Like all other REITs, Digital Realty Trust is also expected to slow down on its expansion, due to tougher capital markets. And if the company still goes for high capital expenditures, then the adjusted funds from operations (AFFO) will come down. AFFO is the adjusted value of FFO, after adding the rent increases and deducting capital expenditures and routine maintenance amounts. Thus AFFO is a better predictor of this REIT’s future ability to pay dividends. The good thing is dividends at present are covered by its AFFO. But, the concern still remains, as the lack of expansion may change the scenario.
Both acquisition and greenfield expansion may take a back seat, so growth opportunities may not be as prevalent in the short term. This ultimately may impact future yields on DRL’s equity shares. It generates a yield of between 3 and 5 percent, and if that becomes questionable even for a few years, then investors have real reasons to worry. But, nobody can deny the growth potential of data center infrastructure businesses. Thus, the best way to leverage such growth potential is to invest in preferred stocks of these data center REITs. Digital Realty Trust, Inc. 5.250% PFD SER J has a fixed coupon of 5.25 percent and generates a yield of around 5 percent. The preferred dividend remains quite safe, even in a situation of a 30 percent drop from its current AFFO.
Prior to the pandemic, the AFFO payout ratio ranged between 60 percent to 68 percent. Post-pandemic, this ratio has gone marginally beyond 70 percent. Thus, preferred shares are in a position to withstand even a drop in AFFO up to 30 percent. And despite the enormous hike in interest rates, DLR certainly is in a position to resist its fall in revenue as well as AFFO to that extent. The company is consistently generating strong bookings, and the only fear comes from the fact that it may not be able to enhance its capacity at a massive pace, until the interest rate comes down. I think that the Federal Reserve has done with its monetary tightening and the rates will only come down in the future years. So, the fall in AFFO, even if that happens, will not be substantial, and will happen only in the short and medium run.
Thus, investors who foresee the future growth potential of Digital Realty Trust, Inc. should invest in the preferred stocks of this REIT.