This article was co-produced with Dividend sensei.
REITs are a great asset class, not just for recovering and growing income, but have historically delivered market-bearing returns with lower volatility to boot. But REITs are not just the purveyors of boring and conservative income investors. There are more than a dozen industries in REITdom, including exciting and fast-growing ones like data centers.
REITs in general, and why industry blue-chips Digital Realty Trust (DLR) and Equinix (EQIX), in particular, are worth buying today.
Why You Want To Own Data Center REITs
Massive amounts of exponentially growing data without data center to house it.
(Source: DLR investor presentation)
According to analyst firm IDC today, about 25% of global IT spending is going to cloud computing transitions, but that's about 50% by 2020. 5G is going to bring up even more data than the Internet of Things.
Ericsson estimates that by 2023 alone, nearly 3.5 billion devices will be connected to the internet, including driverless cars.
According to Forbes, autonomous cars will generate about 4,000 GB of data per day or roughly 2,500 times.
(Source: Nvidia investor presentation)
It is estimated that 120 million driverless cars on the road were generating massive amounts of data that would have to be stored and analyzed via AI-powered algorithms stored in data center servers. And those are just some of the major growth catalysts for this exciting and growing industry.
(Source: EQIX investor presentation)
And when it comes to cloud computing, Equinix and Digital Realty are the two industry heavyweights.
That makes these two the best blue-chip choices for REIT investors looking at cash in a long-term mega-trend that should lead to safe and steady rising dividends for the foreseeable future.
2 Bue Chip Data Center REITs You'll Want To Own
Digital Realty Trust
With nearly 200 data centers located in 32 cities in 12 countries, Digital Realty is the world's second-largest data center REIT. It serves more than 2,300 corporate clients, which creates a fortune 500 investment companies.
(Source: Investor presentation)
Digital realty is increasingly focusing on hybrid cloud, especially colocation (of smaller clients). Clients bring their own hardware and digital reality provides the physical space, electricity, and interconnections that allow them to connect to their servers together, including Amazon (AMZN).
Digital Realty's growth and diversification efforts have been led by industry's most aggressive M & A, including 2015's $ 1.9 billion acquisition of Telx. 95% focus on wholesale cloud to a greater focus on colocation and interconnection. Colocation allows for reduced data latency and improved cybersecurity, which is the top priority for IT departments at major corporations, according to recent surveys.
Renting space to just a few major corporations who need a lot of space. This creates a smaller potential market, serving the needs of just a few giant companies. In contract colocation is a need all companies have, Digital Realty to win more market share.
Colocation thus allows for more interconnections, where companies link their servers together. DLR has 77,000 of these, generating more than $ 250 million per year (about 10% of REIT sales) in high-margin revenue.
(Source: investor presentation)
Over the years DLR has continued to acquire more rivals as it consolidates the industry and expands its geographic presence. All told the REIT has spent $ 14 billion over the past eight years achieving the industry's second largest economies of scale.
DLR can cut great deals with electric utilities. For example, in Chicago, it has a contract for 20% below 2022 below.
Digital Realty is a major purchaser of industrial grade AC equipment for which it obtains discounts as well. This has allowed itself to be historically average 25% operating margins since 2010, the highest in the industry (EQIX's have averaged 19%).
But DLR has historically enjoyed high occupancy (including 95% during the Great Recession) and about 70%.
According to Align Communications, it is about $ 23 million for DLR's typical client to set up hardware in its facilities. It then costs about $ 15 million more, in a lengthy, difficult, and risky process (in terms of business interruption) to move to a competitor's facility.
(Source: investor presentation)
Management believes that despite the challenges it wants to face in 2019 and beyond (see risk section), it can achieve about 6% to 9% long-term FFO / share growth. That should translate to dividend growth along the same lines.
AFFO Payout Ratio: 67%
S & P Credit Rating: BBB
Sensei Quality Score: 9/11 (NYSEARCA: SWAN)
Historical FFO / share growth: 9.0%
Expected five-year FFO / share growth (Analyst Consensus): 5.9%
Expected Long-Term Total Return (no valuation changes): 9.7%
Discount To Fair Value: -2%
Valuation-adjusted total return potential: 9.5% (vs 2% to 8% for S & P 500)
According to FactSet Research, analysts currently expect about 6% long-term cash flow growth, which is today's nearly 4% yield, should result in close to 10% total returns in the coming years.
Digital Realty is trading at fair value (based on its five-year average yield). Morningstar, most analysts and asset managers are expecting the S & P 500 to deliver between 2% and 8% CAGR total returns over the next five years.
(Source: Market Watch)
DLR is likely to generate smoke the broader market 's.
But while Digital Realty is indeed a great data center blue chip and SWAN, do not forget to consider Equinix as well as a place in your diversified dividend portfolio.
Founded in 1998, Equinix was one of the earliest companies to take advantage of the rise of the Internet. It's led by one of the best management teams in the industry, headed by CEO Charles Meyers. Meyers has been a senior IT executive for 25 years and joined EQIX in 2010. In 2013 he became COO, and most recently served as president of Strategy, Services, and Innovation. EQIX remains ready to serve the IT data needs of the world's corporations.
(Source: earnings presentation)
Today Equinix is the industry leader with 200 data centers in 52 cities in 24 countries on five continents, serving nearly 10,000 corporate clients.
Unlike Digital Realty, Equinix has been focusing exclusively on colocation. Today Equinix is the world's largest colocation data center provider counting among its clients all the computing giants, but also 1,700 network service clients, meaning corporations looking to connect to cloud services as well as the internet and each other. Its tenants include 46% of the Fortune 500 and 33% of the Forbes Global 2,000 meaning Equinix is the most financially sound companies on earth.
Equinix's facilities are located in the world's largest tech hubs, which creates great network effects and a relatively wide range, as far as REITs go. This has given rise to 19% (lower than DLR due to higher organic capex spending) and 12% adjusted returns on invested capital (good for a REIT).
But more importantly, AFFO yields 17% in late 2018.
(Source: investor presentation)
Basically, Equinix has positioned itself at the Internet's key hubs so that its facilities are among the most valuable in the industry, giving it more power and better retention rates, and creating a very stable and secure cash flow almost growing dividend.
The reason Equinix's facilities are so valuable to its 10,000 or so customers are willing to connect to private Internet networks, as opposed to the public net, making for better data security. And thanks to a greater focus on collocation from the start, Equinix obtains 16% of its revenues from interconnects (it has 334,000 of them), which thus helps make its data centers wide moat, via higher switching costs.
Because of its colocation focus, Equinix's customer switching costs are much lower than DLR's, but are still sufficiently high to make frequent customer defections uncommon. For example, according to Infotech Research Group, the average cost of ownership is $ 10,000 vs an average monthly rent of $ 2,000. EQIX's leases are usually for two to four years. This means that, even if the data center provider were to provide 10% less, the payback period for switching locations would be 50 months, rather than the average lease, making it uneconomical to do so.
Currently, Equinix is spending over 35% of revenue on expanding capacity, which is why its margins are lower than DLR's. 5% (to about 54%) helping translate about 8% long-term sales growth into double-digit FFO / share growth.
Equinix's yield is among the lowest of any data center REITs, however, there is a good reason for that. Pursuit of a premium and is why I consider EQIX a near perfect dividend on my Sensei Quality Score ,
The proprietary quality metrics integrates dividend safety, the riskiness of the business model (moat and future disruption risk), and management quality. SWANs, potential future SWANs, or should only be bought at steep discounts to fair value (riskier deep value investments).
EQIX's industry-leading quality metrics makes it SWAN in my book, as well as the industry's largest blue chip. That includes an upgrade from S & P to BBB- in February 2019 thanks to improving credit metrics including a leverage ratio of about 4.0 (after its Feb 27 equity raise) compared to about 5.8 for the average REIT.
That balance sheet is 86% fixed-rate debt at an average borrowing cost of 4.1%. That borrowing cost is about three times lower than the return on invested capital, meaning that EQIX's bountiful access to low-cost capital allows for rapid and highly profitable growth.
Basically, EQIX has a fortress-like balance sheet and a very safe dividend that SWAN investors can count on even in a recession.
Another big reason I'm a fan of Equinix is that, unlike DLR, the REIT seems capable of maintaining its historical growth rate.
Historical FFO / share growth: 9.5%
Expected five-year FFO / share growth (Analyst Consensus): 9% to 11%
Expected Long-Term Total Return (no valuation changes): 11.2% to 13.2%
Discount To Fair Value: 5%
Valuation-adjusted total return potential: 11.6% to 13.6%
How realistic is that double-digit growth forecast? Well, I consider it pretty reasonable given the strong 2018 EQIX just closed out including
(Source: earnings presentation)
EQIX is the largest REIT in the world data center. REIT in the world. As is the fact that EQIX has delivered 64 consecutive quarters of top line growth.
For 2019 management is guiding for
9.3% in revenue growth
9.6% AFFO / share growth
REIT period, but any REIT period. In fact, given that most analysts now expect less than 5% EPS growth for the S & P 500 (according to FactSet Research), EQIX is likely to become one of the fastest growing companies in America this year.
(Source: earnings presentation)
Steadily lowering its payout ratio so it can retain its cash flow.
DLR, making EQIX my favorite blue-chip data center REIT to buy today.
Of course, that's only if you're comfortable with the industry's overall risk profile.
Risks To Consider
REITs, the biggest possible concern is hyperscale cloud giants like Amazon, Microsoft (MSFT) and Alphabet (GOOG) (NASDAQ: GOOGL). Up to now, these have been big data for capex spenders and great customers for REITs like DLR and EQIX.
However, their cloud operations are gaining momentum. REITs. Specifically, because they might threaten to build their own data centers, thus cutting DLR and EQIX from future growth opportunities, or at the very least demand lower rents.
(Source: Hoya Capital Real Estate)
Another big risk is overcapacity. While data centers REITs are big spenders on growth capex (about $ 3 billion in 2018 among the five publicly traded names), private equity is a massive capacity boom that threatens oversupply and future margin compression.
DLR may enjoy high occupancy and renewal rates in 2019, after a 2% decline in 2018. This shows that while DLR may enjoy high occupancy and renewal rates, it does not make the law of supply and demand. 2 REIT has historically enjoyed.
Overcapacity is a bigger worry for DLR than EQIX because, while having a little less market share equinix, the REIT owns 60% more leasable space. Filling that up to 0.5% to 10.5% in 2019 could put pressure on those industry-leading margins in the future.
Equinix has stronger utilization (80% in 2018) and thus has less to worry about from overcapacity. But it should also be pointed out that the equities could not be sold out ($ 2.1 billion in 2019 and 2020).
REITs must keep in mind that technology is fast growing. That includes the data transmission capacity of fiber optics, as well as the better virtualization tech that could be expected.
And finally, REITs are highly dependent on equity markets for growth capital. That's been a major source of DLR's acquisition funding over the years and in February 2019 EQIX did a secondary for $ 1.1 billion. Should the data center industry fall out of favor (REITs costs of equity making profitable growth harder and resulting in dividend growth that's less than expected).
Bottom Line: Digital Realty And Equinix Are Great REITs To Cash On The Decades Long Data Boom
Do not get me wrong, even data center REITs, while one of the fastest industries in the REIT sector, are not going to deliver Amazon (AMZN) like returns. But they can not give you great sources of generous, safe, and growing income, and deliver double-digit market-beating returns if you buy them at the right price.
Digital Realty Trust and Equinix represent two data centers with their competitive advantages in low-cost capital, skilled management, the best economies of scale, and the strongest network effects come.
Both REITs are at about fair value today, meaning that they are "better than buy a wonderful company at a fair price than a fair company at a wonderful price" portfolio today.
DLR and EQIX on your watch lists (as I've done) to wait for a better price. As we saw in December, market corrections are a great time to open or add to positions in industry.
Author's note: Brad Thomas is a Wall Street writer, and that means he's not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his / her best to correct any errors, if they are overlooked.
Finally, this article is free, and the sole purpose for writing it is to assist with research, while also providing a forum for second-level thinking.
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Disclosure: I am / we are long DLR, EQIX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with anybody whose stock is mentioned in this article.