Digital Core Reit bullish on tight supply, strong demand for data centres

RENTAL rates are rising for data centres across the United States and Europe, as supply falls on concerns over optimal land use and the stress that data centres place on electricity grids.

There is also strong demand from companies digitalising and adopting artificial intelligence, which Digital Core Reit (DC Reit) believes should be a net positive for its data centre-focused portfolio.

“We’re only doing more digitally, and at the same time, you’ve got very constrained supply in the markets that matter to us,” said John Stewart, chief executive of the manager of the real estate investment trust (Reit). “What that means is you are experiencing significant increases in pricing.”

However, he noted that limits are increasingly being set on data centre growth in a number of cities.

For instance, Frankfurt, Germany, has released plans restricting “company-independent data centres”, or cloud and co-location facilities, to certain neighbourhoods, over concerns about the city’s land use and power consumption.

California is also taking legislative action to prioritise residential developments over data-centre developments, to improve housing affordability, Stewart said.

A CBRE report said power constraints continue to affect major primary markets such as Northern Virginia and the Silicon Valley, where DC Reit has assets.

“In Northern Virginia, operators expect Dominion Energy to provide significantly less power for development until 2026. In Silicon Valley, transmission substation sites can’t be energised until 2028-2029,” CBRE said.

Unit price underperformance

But the market dynamics of rising rentals and tightening supply of sites for DC facilities are doing little for DC Reit’s unit price.

The counter has tumbled by more than half since its debut in December 2021, as the US Federal Reserve aggressively raised interest rates to curb inflation.

It closed Friday (May 5) at US$0.425, down 58.7 per cent over the last 12 months and 22.7 per cent in the year to date. That gives the Reit a market capitalisation of US$482.9 million and a historical yield of 9.25 per cent.

Stewart admitted DC Reit could have done better by converting more of its debt to fixed rates earlier.

It has been doing so as interest rates have been raised. The proportion of Digital Core Reit’s debt that was fixed rose to 74 per cent in Q1 this year, from 50 per cent in Q1 last year.

Of course, it hasn’t helped that one of DC Reit’s tenants, a data centre services provider called Cyxtera Technologies, is having trouble repaying its debts. Cyxtera is Digital Core Reit’s second-largest tenant by rental, noted analysts.

In DC Reit’s business update for Q1 FY2023, Cyxtera, listed as a “global co-location and interconnection provider”, accounted for 22.4 per cent of annualised rent as at Mar 31. The largest tenant, a “Fortune 50 software company”, accounted for 38.1 per cent.

But Stewart suggested that DC Reit is not in any danger, given that it has received a cash flow support agreement from its sponsor, Digital Realty.

The agreement guarantees 100 per cent of rental payments until December this year from any potential cash flow shortfall due to customer bankruptcy.

DBS analysts said in a March report that although Cyxtera Technologies was downgraded by Moody’s because of concerns over the company’s ability to service debt obligations, the company has remained current on all its rentals.

They noted also that the Reit’s sponsor had been prompt in supporting the Reit in a similar situation in the past.

The Reit’s manager announced in April last year that SunGard, its fifth-largest tenant accounting for 7 per cent of its rental income, had filed for Chapter 11 bankruptcy protection in the US, Canada and the United Kingdom.

“Moreover, Digital Core Reit has already successfully backfilled almost half of the space that was vacated by SunGard, as demand for data-centre space remains robust,” the analysts said. They maintained their “buy” recommendation with a target price of US$0.90.

Stewart noted that there could also be opportunities for positive rental reversion rates even amid customer bankruptcies.

“As far as what the backfilling strategy would be … we own good real estate (and) the in-place rents are dramatically below market (rate),” he said, adding that it usually takes about 12 months to backfill the space vacated by a tenant.

Between 2021 and 2022, wholesale rental rose from US$105 to US$180 in Northern Virginia, and from US$130 to US$200 in Northern California, on a per kilowatt per month basis.

The Reit’s weighted average lease expiry stood at 4.2 years as at Mar 31, 2023. In 2024 and 2025, respectively, 16 per cent and 45 per cent of leases will expire.

Acquisition opportunities

As for inorganic growth, Stewart concedes that the current macroeconomic environment is not conducive for equity fundraising.

The Reit had to settle for acquiring a smaller 25-per-cent interest in a freehold data centre in Frankfurt last December, in a debt-funded transaction.

DC Reit’s managers had also floated a plan to take a majority stake in both the Frankfurt facility and another facility in Texas, to be funded by a combination of external bank borrowings and an equity fundraising. But the managers decided later to withdraw this plan.

“I think…the size of the pipeline hasn’t changed. We’ve got a tremendous runway, and I think we need to be patient. I think over time, the tightening cycle will come to an end and the US won’t always be out of favour,” said Stewart.

“I expect that we will have an opportunity to rerate as we continue to deliver value for unit holders.”