Data Centers Are a Leading REIT Sector in 2016

This article is republished with permission from REITCafe.

Six data center real estate investment trusts (REITs) are posting outsized returns this year. The sector has a market cap of $45.6 billion and year-to-date returns have totaled 13.06 percent, including a 3.01 percent dividend yield. One of these REITs, Digital Realty Trust, was listed among the “Top Defensive Growth Ideas for Q2” by Merrill Lynch this week. Growth in data use and cloud computing is the driving force behind the sector’s expansion.

Use of cloud services has become mainstream, and demand is growing at double-digit rates. As businesses expand their use of cloud services, providers’ scale is becoming more important. Jones Lang LaSalle listed scale first among its top data center trends for 2016. Data center REITs benefit from their presence in multiple markets. Efforts to obtain scale are also fueling industry consolidation and merger and acquisition activity.

Significant spending by public-cloud providers like Apple, Amazon, Facebook, Google, and Microsoft are helping fuel the sector’s growth. Banking, financial services, and insurance firms are other sources of significant demand. New regulations will limit future expansion by one major user, the federal government. The U.S. government’s Data Center Optimization Initiative, adopted in March, means that federal government agencies must prove to the Office of the Federal CIO that new data centers are absolutely necessary before building more space or expanding existing space.

Ideal data center locations are near large population centers, but offer low development, operating, and tax costs, with access to abundant and low-cost energy. Many states offer tax incentives specifically designed for data centers. International demand for data centers also is growing. Markets with the greatest 2015 absorption were northern Virginia, Dallas, Seattle/Portland, San Francisco/Silicon Valley, and Chicago, according to Jones Lang LaSalle.

Equinix converted to a REIT at the beginning of 2015 and is the largest data center REIT by market cap. The company owns 112 data centers in 33 metro areas. It reported better-than-expected fourth-quarter revenues and has provided guidance indicating 13 percent revenue growth in 2016 following the completion of its $3.8 billion acquisition of Telecity in January and Bit-isle in 2015.

Digital Realty Trust ranks second by market cap at $13.0 billion, but it is the largest data center REIT by portfolio size. It owns 130 centers with more than 25 million square feet (2.3 million sq m) of space. In 2015, it completed its $1.9 billion acquisition of Telx. Equinix is now one of its largest tenants.

Four data center REITs with smaller market caps include CyrusOne ($3.0 billion), DuPont Fabros Technology ($3.0 billion), CoreSite Realty Corporation ($2.1 billion), and QTS Realty Trust ($1.9 billion).

Overbuilding is a risk for the sector. The availability of financing, current low interest rates, and strong demand are leading to more new construction. Because REITs must pay out most of their income to shareholders, expansion is largely financed with debt or sales of new shares, leaving REITs especially vulnerable if demand shifts quickly.

Strong appreciation means that many data center REITs are trading at or near all-time highs. Several REITs have taken advantage of high share prices to raise money to fund expansion through secondary share offerings. Questions remain about how much of recently announced growth is already part of share prices, whether stocks are fully valued, and if data center REITs can support further growth in their stock prices.

* TREPP-i Survey Loan Spreads levels are based on a survey of balance sheet lenders. For more information, visit Trepp.com.

** - 10 yr. Treasury Yield as of 4/15/2016.