The year’s top-performing S-Reit looks to repeat its act in 2024

CHRISTMAS may have come early for investors in Digital Core Reit .

Units of the real estate investment trust (Reit) have been rallying over the past month-and-a-half, after the manager announced it had entered into agreements that would resolve the bankruptcy of its second-largest customer.

It is the best-performing S-Reit for the year to date as at Dec 22, with its units gaining 15.5 per cent so far this year.

The counter beat out other Reits such as Mapletree Industrial Trust and Frasers Hospitality Trust; which were up 10.8 per cent and 9 per cent, respectively. By contrast, over half the S-Reits are in the red this year.

Digital Core’s outperformance came after it said on Nov 1 that it would sell several Silicon Valley facilities for US$160 million to Brookfield Infrastructure Partners, under a series of agreements to resolve the bankruptcy of Cyxtera Technologies.

The counter has rallied 27 per cent since the announcement, as investors grew more optimistic about the Reit’s prospects.

And, the counter could become more interesting for investors next year, as the manager charts plans for diversification and growing the Reit.

Resolving issues

Digital Core Reit had faced volatile performance before the announcement.

Apart from sector headwinds of high interest rates, the counter had also been weighed down by the bankruptcy of Cyxtera, a global colocation and interconnection provider.

The manager warned in June its distribution per unit could be halved after its second-largest tenant – which accounted for almost a quarter of the Reit’s annualised rental revenue – went bust.

The customer had occupied three facilities in Silicon Valley, two in Los Angeles, and 4 per cent of a fully fitted facility in Frankfurt.

John Stewart, chief executive of the manager, told The Business Times: “The problem was that we had such a big concentration on this customer. And so, by reaching this resolution, we’re able to significantly improve overall credit quality.”

As part of the deal, Digital Core Reit would sell two of the three Silicon Valley facilities to Brookfield and its institutional partners. The customer has also agreed to assume and assign to Brookfield its existing lease agreement for the third Silicon Valley facility, with no change to the terms, conditions or rental rate of the existing lease agreement.

Digital Core also reached an agreement to amend the lease agreements for the two Los Angeles facilities, to bring forward the expiry of these leases to Sep 30, 2024, from February 2033 and January 2035 previously. When these leases expire, Digital Core expects to enter into direct agreements with the end-user co-location customers now occupying the facilities.

Beyond improving credit quality, Stewart added that the Reit is now able to pivot and go on the offence.

“We’re able to redeploy those proceeds to achieve diversification, which is obviously a key strategic priority for us,” Stewart said, adding that the diversification would span both markets and customers.

Eyeing expansion

The manager sees “tremendous opportunity for growth in the Asia-Pacific region”, with Japan as one of its priorities.

Stewart noted that interest rates have shifted dramatically in the United States, but Japan is “relatively unique” as investors can still earn a positive spread.

“We’re acquiring our asset at a 5 per cent cap rate, and the local borrowing cost is, obviously, well inside of that – so we’re able to structure an accretive transaction in Japan,” he said.

The Reit had announced in November that it is entering into the Japan market – acquiring a 10 per cent interest in an Osaka data centre from Mitsubishi Corp for 7.7 billion yen (S$71.8 million).

Stewart sees more opportunities in Osaka, as Digital Core has acquired only 10 per cent of one asset. There are three other assets in that campus, which provides a runway for growth.

After Japan, Singapore would be another market the Reit is keen on.

“Singapore is absolutely a core data centre market, with very favourable fundamentals,” he said. “The challenge in Singapore right now is that (investors) don’t have that same positive spread today, between financing costs and yields or cap rates in Singapore. So it’d be very difficult to structure an accretive transaction today.”

But the opportunity could present itself if interest rates or valuations drop.

In the longer term, Stewart expects that a majority of the Reit’s assets – around 50 per cent – would be in North America, with the remainder split between Europe and Asia.

To drive diversification in the portfolio, Digital Core would also need to get bigger.

“Part of the reason that we’re concentrated is because we’re kind of too small, right? So we would like to grow,” Stewart said.

He noted that the Reit has a US$15 billion acquisition pipeline from its sponsor that it can transact, and the assets in Osaka would already account for a couple of billion.

The Reit has additional debt headroom, given its current aggregate leverage of around 34 per cent. But Digital Core could also consider raising equity at some point in its bid to scale.

At its closing price of US$0.635 on Dec 14, the Reit currently trades at around a 20 per cent discount to book value.

“If we’re able to see some improvement in the overall macro environment, some continued improvement in our unit price – closing the gap to net asset value – then we would certainly look to issue equity,” added Stewart. “We would like to grow; we’d like to achieve scale and diversification.”

The manager has also been carrying out regular buybacks amid the current discount to book values. Since its buyback mandate commenced in April this year, the Reit has bought back around 6.5 million units from the market.

Analysts are also mostly positive on the stock. The five research houses that have issued recent reports all have “buy” calls on Digital Core, with an average target price of US$0.70 – representing a 10.6 per cent upside to the Dec 22 close.

Even so, some remain watchful on portfolio valuations at the year-end. Stewart noted that the two assets in Los Angeles that have been affected by the customer bankruptcy could have some impact on value, even though he expects more stable values elsewhere in the portfolio.

As macroeconomic conditions improve, and with its plans for diversification and growth, Digital Core could be well positioned to maintain its momentum in 2024.

The counter is the most recent Reit listing on the Singapore Exchange – making its debut in December 2021, just before interest rate hikes began.

“It’s been a little bit of a bumpy road since then,” Stewart acknowledged. “But I’m quite optimistic that the customer bankruptcy resolution that we’ve reached, and hopefully reaching the end of the tightening cycle, puts us in a position where the road ahead will be much brighter.”