Digital Realty Trust: Downside Risk Remains (NYSE:DLR)
The valuation of most REITs has declined over the past year due to the rise in interest rates. As borrowing costs grow, some REITs will likely see cash flows strained. Further, the fair value of most REITs has been depressed as investors can find higher risk-adjusted returns in the bond market. This shift has significantly impacted high-value REITs, particularly the rare growth-oriented digital REITs like Digital Realty Trust (NYSE:DLR). DLR has lost considerable value over the past year and now pays dividends above many other REITs. See below:
DLR’s dividend yield of ~4.5% aligns with the REIT sector median overall, while its “P/FFO” valuation is around 15% higher. Of course, DLR is a larger REIT, and most large-cap REITs have lower dividend yields, closer to that of the ETFs (XLRE) or (VNQ), which are heavily weighted toward large REITs. Due to this, DLR may appear to be a discount opportunity, particularly considering the growth potential of its operating segment. That said, crashing gross margins may imply competitive pressures that could spur further losses for DLR.
What is Data Really Worth?
Digital Realty Trust pays a solid dividend yield, but does trade at a valuation premium to most REITs. From a price-to-FFO standpoint, its premium is around 15%; however, it is significantly higher from a “P/E” standpoint since the firm’s FFO is around 3X above its income. The REIT’s price-to-cash flow is also around 50% above the sector median, while its price-to-book is 28% higher. Digital Realty has grown its FFO per share at a relatively steady pace, encouraging its valuation premium, but it is exposed to unique risks not seen in other REIT segments.
Data center REITs are a new class, so investors and analysts may not fully understand the risks they face. Until recently, most were particularly bullish on the sector due to its growth and the high demand for data. Traditional REITs’ primary assets are buildings and land. Data center REITs own these two assets but also more machines and technical equipment. Computers and related items physically depreciate faster and are at greater risk of technological obsolescence. Over time, DLR will need to upgrade and renew its equipment to maintain a competitive edge. While its customers usually pay these costs, competitive pressures could cause a greater need for capital expenses and renovations (see 10-K “risk factors“).
Notorious short-seller, Jim Chanos, believes investors may underappreciate this risk factor, particularly given DLR’s customers are generally cloud-oriented companies like Google (GOOG) (GOOGL), Facebook (META), and others. Most likely, many of its customers are indirect competitors, since they have their own data centers. Third-party data centers like Digital Realty are a “backup” source, and many of DLR’s customers eventually expand their own computing assets to increase margins through vertical integration.
Fundamentally, most REITs benefit from their location, which provides a stable “moat.” No physical property is in the same location, mitigating direct competition between properties and encouraging profits for landlords. As is said in real estate, “location location location.” Unfortunately, data center REITs have relatively few location benefits. Most of DLR’s properties are in ultra-high-demand areas, benefiting its data-speed potential; however, it does not carry nearly the same “location moat” as most traditional REITs, exposing it to high competitive pressures. This trend is evident in DLR’s and Equinix’s (EQIX) falling operating margins and low ROIC. See below:
These data center REITs have seen substantial revenue per share and cash-flow growth, but their operating and net incomes have not risen as stable. In general, both have seen sharp declines in profit margins that include depreciation, although margins that exclude depreciation (such as EBTIDA and CFO) have generally been stable. This implies that Digital Realty is becoming more dependent on depreciation.
While it is true that depreciation does not directly hamper cash flow for most REITs, I believe depreciation is “more real” for data center REITs since their technical nature implies the significant need for ongoing investment. That issue is evident in DLR’s and EQIX’s low return on invested capital, usually around 2-4%. This means data centers are investing a substantial amount for slight growth in real income. Indeed, they would almost be better off investing in Treasury bonds, given their higher yields today. I believe this also implies growing competitive and business model pressures straining DLR’s ability to grow its income organically.
The Bottom Line
For DLR to be fairly valued today, we must assume that the company will manage to grow its income without debt or dilution at a higher rate than most REITs. While it is true that Digital Realty has expanded its cash flow per share considerably over recent years, it appears unlikely to continue to do so over the coming years. Headwinds facing the firm include growing competition from peers, potential loss of customers through vertical integration, and the risk of high cash-flow impairment in the future due to growth in “maintenance” capital costs.
In my view, DLR should not trade at a premium compared to peers, given these headwinds. While its valuation premium varies greatly depending on the measure (from 15% based on “P/FFO” to 200%+ on “P/E”), it appears to be at least around 25%. DLR has risen by over 20% since its October lows, though most REITs are up at least 10% since then as interest rate fears have subsided. While risks to “real interest rates” seem lower, there are some reasons to believe long-term interest rates have not peaked yet. Thus, DLR carries an elevated risk due to roughly 20%-30% overvaluation to the REIT sector and the REIT sector’s potential overvaluation due to macroeconomic headwinds.
Given the variety of headwinds facing DLR, and its recent rally (which has slowed dramatically), I am bearish on the REIT and believe it has much downside risk this year. That said, if my view facing DLR’s competitive pressure does not pan out, allowing DLR’s FFO per share to grow further, and REITs hold their ground, then the REIT could be fairly valued today. Thus, while I am bearish on DLR, I would not bet against the REIT since it is still far cheaper than it was one year ago.