DBS Group Research analysts Dale Lai and Derek Tan see data centre REITs and cloud players as more collaborators than competitors.
“In recent years, there has been a rise in the number of hyperscale data centres, mostly developed by the big cloud providers (Google, Amazon Web Services, Microsoft Azure, etc.) for their own use. As these hyperscale data centres come online and these major cloud providers move into their own facilities, it will no doubt put pressure on some of the older data centres as they vacate their space,” the analysts write in their report dated July 1.
In their view, older data centres could see pressure on their occupancy rates in the short term as more hyperscale data centres come online.
But the secular growth of the digital economy and cloud services will “continue to drive positive net absorption and support back-filling fairly quickly”.
In addition, there is nothing to worry about the relevance of the “legacy” data centres as these hyperscale data centres are developed and operated for their own use.
“[They] continue to seek new capacity to keep up with their customer growth,” the analysts write. “We understand that they are still struggling to fulfil their own demand and capacity.”
“Secondly, the big cloud providers are large and sophisticated technology companies that are in the business of driving profits from their core expertise and not as data centre operators,” they add. “Moreover, end users of data centres prefer carrier-neutral infrastructure that provides them with the flexibility to switch between carriers when necessary.”
On the back of this, the analysts currently see “limited risk” of these hyperscale data centres “cannibalising” demand from data centre operators for their end users.
Lai and Tan’s report comes after a June 29 article in the Financial Times that quoted short seller Jim Chanos as saying that “legacy” data centres in REITs not owned by Alphabet, Microsoft and Amazon, are going to be behind the curve.
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Data centre-focused players like Digital Realty, Equinix, Iron Mountain and SGX-listed Digital Core REIT saw declines in their share prices following the article. Digital Realty, which is the largest global data centre provider of cloud- and carrier-neutral data centres and provides colocation and peering services, is the sponsor of Digital Core REIT.
Still seeing positives on Digital Core REIT
Further to their report, the analysts are still positive on Digital Core REIT despite the share price decline, saying they “remain buyers” on the REIT.
They note that Digital Core REIT’s long weighted average lease expiry (WALE) of 5.5 years ensure occupancy and income for the long-term. In addition, the REIT’s sponsor has the ability to operate data centres efficiently and deliver sufficient value to “continuously entice and attract tenants”. According to Lai and Tan, the latter attribute was what helped its sponsor Digital Realty establish itself as one of the world’s largest operators.
“As the data centre sector continues to thrive in this new digital age, and as Digital Core REIT unceasingly works on improving its offering, we believe that demand for its properties will remain robust,” they write.
That said, the analysts have also identified several key risks on the REIT. This includes rising interest rates, which will continue to pose a risk.
“Having already hedged 50% of its borrowings to fixed rates, the borrowings that are still on floating rates remain susceptible to rising interest rates. Based on the current interest rates in the US, we estimate that Digital Core REIT’s all-in cost of borrowings could creep up from 2.1% (in March 2022) to as much as 2.7%,” they say.
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Based on their estimates following a sensitivity analysis, Digital Core REIT’s share price at 77 US cents ($1.07) provides “an opportunity to seek yields”.
“Even if its all-in cost of borrowings rises to 3%, Digital Core REIT is expected to generate forward yields of 5.2% and 5.7% in FY2022 and FY2023, respectively,” the analysts write. “In the unlikely case its all-in borrowing costs spike to 4%, forward yields of 4.8% and 5.2% for FY2022 and FY2023 are still on offer.”
With the rise in funding costs in the US and 10-year US treasury notes, the REIT’s ability to make acquisitions and the sustainability of its asset values have been called into question.
That said, the analysts are not writing the possibility of acquisitions out.
“We believe that while the US market may seem out of reach for now, due to the spike in funding costs, given the sponsor’s global footprint, we think there could be possible avenues in Europe, where the spreads between acquisition yields and funding costs are still wide.”
Finally, the analysts note that the REIT’s capital values should remain “fairly stable” despite the spike in bond yields and funding costs.
“Any potential movements should not result in material impacts from the current levels,” they say. “Based on our estimates, Digital Core REIT now implies a cap rate of 5.0%, which is a 60-basis point (bps) expansion in yields from [its initial yield of 4.4% in the FY2021,” they add.
As at 1.35pm, units in Digital Core REIT are trading 3.5 US cents lower or 4.55% down at 73.5 US cents.
