Digital Realty Trust scaling up to take advantage of AI growth
Welcome to Stock Takes, my thrice-monthly take on an individual stock. I look at the big picture, unlike Wall Street analysts who are geared to earnings, and the media that focuses more on news value.
In volatile market environments, investors are more likely to appreciate the staid nature of real estate investments. Digital Realty Trust (NYSE:DLR) offers the potential for steady dividends, thanks to its real estate investment trust (REIT) status, with the potential for stock growth due to its AI exposure. The REIT sector is also interest-rate sensitive and tends to take on a lot of debt and, with the Fed’s next interest rate move likely to bring down its target rate, the prospect of lower interest rates could benefit Digital Realty Trust.
On August 5, the stock took a hit along with the rest of the market, with its price down to about $144, from its August 2 closing price of about $150. However, technology stocks leading the AI boom, such as Nvidia, were hit worse, with the NASDAQ Composite Index off more than 3.4%. Does Digital Realty Trust offer an avenue to benefit from AI growth in a safer way than going in for volatile technology stocks?
Digital Realty Trust provides data center facilities for a variety of companies and had a global portfolio of 309 data centers at the end of 2023, including 124 in the United States and 112 in Europe. According to the REIT, “We provide a global data center platform that supports our customers’ digital infrastructure and enables our customers to interconnect with their customers and partners. We solve global coverage, capacity and connectivity needs for companies of all sizes.”
Benefiting from AI growth
For the second quarter of 2024, the company reported funds from operations (FFO) per share of $1.57, compared to $1.52 in the 2023 second quarter. Funds from operations is a metric commonly used in the REIT world that makes earnings adjustments to better reflect REITs’ real estate-heavy operations. The firm also reported revenues of $1.4 billion, down 1% from the comparable period of 2023.
However, the REIT said that it signed tenant bookings that will raise its annualized rental revenue by $164 million, and renewed leases during the period that represent $215 million of annualized revenue. In the second quarter, the REIT also brought in more than $500 million through sales of interests in two properties and has also raised about $2 billion in equity this year.
On Digital Realty Trust’s second quarter earnings call with analysts, Andy Power, the REIT’s president and CEO, said, “These transactions, together with the others of the past year, have positioned our balance sheet to capitalize on this unique environment and construct the capacity that our customers demand. Artificial intelligence innovation is reshaping the global data center landscape. As new applications are developed and proliferated across industries and around the world, AI is driving an incremental wave of demand for robust computing infrastructure.”
Citing Gartner, Power noted that worldwide spending on public cloud services is slated to grow more than 20% to touch $675 billion this year and will also get a 22% boost in 2025. AI-related activity is behind a “significant portion” of this growth. “Digital transformation, cloud, and AI are fueling demand for data center capacity worldwide. These AI workloads are taking place on specialized hardware with massive parallel processing capabilities and lighting fast data transfer speeds,” according to Power, and Digital Realty Trust is able to accommodate these needs.
Moreover, this growth in demand is worldwide and International Data Corporation expects worldwide spending on digital transformation will touch $4 trillion, led by AI spending. This will mean more demand for data center infrastructure, Power said. CBRE reports that data center vacancies in North America hit new lows this year, with Chicago’s vacancy rate going to 2.4% from 6.7% last year. And Northern Virginia, a location that is seeing big demand from AI companies and public cloud providers, saw its vacancy rate drop to 0.9%, from 1.8% for the previous year (even though its inventory rose 18% over this period.
Digital Realty Trust is forecasting “core FFO” in the range of $6.60 to $6.75 per share for the full 2024 year. Core FFO is based on adjustments to FFO to better reflect the impact of a REIT’s core business activities.
Fitch Ratings, which issued a stable rating on the REIT’s debt, says it sees data center demand “as relatively defensive since deployments in data centers are typically mission-critical infrastructure.” Moreover, the cash flow is predictable as a result of “long lease duration, low churn rate and portfolio diversification across different lease types, geographies, and tenants that together reduce idiosyncratic risks.”
Heavy demand for energy, government regulation, pose risks
Although growing demand paints a rosy picture for Digital Realty Trust’s prospects, the REIT also faces risks. For one, data centers consume a lot of power and Digital Realty is dependent on power suppliers that could raise their prices. Supply of power could also vary and there could be service failures. The company also relies on outside supply to satisfy its customers’ network connectivity needs and any disruptions to this supply could negatively impact its business.
The REIT has to comply with various laws, including environmental laws, the Americans with Disabilities Act and data privacy regulations. It also has to be watchful for cybersecurity breaches that could disrupt its business. In fact, the firm discloses that it is being investigated by the Securities and Exchange Commission relating to the adequacy of the REIT’s disclosure of the cybersecurity risks it faces.
Another risk is that while Digital Realty Trust has a broad customer base, its three biggest tenants accounted for a big chunk, at 21%, of its annual recurring revenue for 2023, with one of them contributing as much as 10% of this revenue. Investing in joint ventures may also restrict the REIT’s flexibility and expose it to a joint venture partner’s financial performance.
And of course, there is growing competition from other data center providers globally, both public and private. This includes providers such as Equinix (another REIT) and NTT.
Fitch notes, “Data center competition is intense with pricing and market share dynamics constantly evolving. Cloud service providers such as Amazon.com, Microsoft Corporation and Alphabet have been meaningfully scaling their cloud businesses, capturing market share and influence the way enterprises and small business consider their data center use. This represents a long-term competitive risk even though DLR has benefitted from this trend as several of the largest cloud providers are among its top 20 tenants.”
And Digital Realty’s global network gives it “a strong competitive position which should result in continued growth given high barriers to entry and switching costs, as well as network effects.”
Seeking to bring down debt exposure
The REIT has a big debt load of about $17.5 billion (at the end of 2023)which it is trying to bring down. Issuance of equity in the second quarter, as well as capital recycling, brought its leverage down to 5.3 times at the end of the second quarter (based on debt to earnings before interest, tax, depreciation and amortization). Fitch views Digital Realty’s competitor Equinix more favorably since its leverage is in the 3.5 to 4.5 times range.
About 14% of Digital Realty’s debt carries floating rate interest, with a weighted average interest rate of 2.9%, which means the REIT could benefit as interest rates go down. Another benefit from falling interest rates is that the value of its portfolio could rise as capitalization rates go down.
The REIT has a book value per share of about $63 and a price-to-earnings ratio of more than 40 based on earnings for the past twelve months. However, this could become more favorable if forward earnings go up.
And from an investor perspective, REITs are mandated to pay out the majority of their earnings to investors to preserve their tax-advantaged REIT status. Digital Realty Trust currently has a dividend yield of more than 3% and according to the company, it anticipates its dividends will grow since it aims to grow its earnings.
According to the REIT, “The specialized nature of data centers makes these investment opportunities more difficult for traditional real estate investors to underwrite, resulting in reduced competition for investments relative to other property types. We believe this dynamic creates an opportunity for us to generate attractive risk-adjusted returns on our capital.”
As of August 5, Digital Realty turned in a one-year return of 24.5%, compared to a return of 16.9% for the specialty REIT sector, according to Morningstar. That’s an attractive return and a reason to consider investing in the stock for investors who would like to get AI exposure without taking on all the volatility that AI poses.
P.S.Want me to look into a particular stock? Reach out to stocktakes1@gmail.com and I’ll consider your suggestion.
Note: I do not own any individual Digital Realty Trust stock and I do not intend to take a position in the stock within five days of publication of this article. This write up is my unbiased opinion and not intended as financial advice. All investments carry risks and you should talk to a financial advisor to learn about the suitability of an investment for your portfolio. I did not receive any compensation for this piece that influenced my views.