As at Aug 29, Digital Realty’s share price is up 11.1% this year, and 14.7% over a one-year period. In contrast, Digital Core REIT (DC REIT) is down 7.0% this year, but up 12.2% over a one-year period.
The divergence in share price between DC REIT and its sponsor, Digital Realty, this year suggests that DC REIT’s strengths have yet to be fully reflected in its price performance as both REITs are experiencing rising demand outpacing supply, according to John Stewart, CEO of DC REIT’s manager.
“I don’t believe the strength of the underlying business has been reflected in the Singapore REIT’s valuations,” says Stewart. “Our portfolio is a subset of Digital Realty’s. We are pretty similar in geography, in the US, in Europe and Asia Pacific (APAC). They are globally diverse. We are smaller and less diversified. But still, there shouldn’t be a 250 basis-point divergence in the performance.”
The difference between sponsor Digital Realty and DC REIT is Digital Realty’s ability to build, operate and own data centres, enabling it to reap higher returns, but for higher risk. As an internalised US REIT, Digital Realty can have a more flexible strategy than an S-REIT. Under Singapore’s external manager structure, DC REIT owns a diversified portfolio of stabilised properties and collects rent income, which, after costs, is distributed to unitholders. While Singapore-listed REITs can take on some development risk, this is usually limited to around 10% of the REIT’s deposited properties.
Strengthening portfolio with strategic positioning
DC REIT owns 10 data centres, of which eight are in North America, carved out of Digital Realty’s portfolio at the outset of DC REIT’s IPO in 2021. The data centres are stabilised assets in top-tier core markets, providing quality and stable cash flows. Notably, Northern Virginia — the world’s largest and most densely utilised data centre market— hosts three of these facilities, contributing 39% of the portfolio’s value and 30% of its rental income.
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Since its IPO, DC REIT has expanded its footprint with two key acquisitions in Frankfurt and Osaka, further diversifying its portfolio.
DC REIT acquired an initial 25% of the Frankfurt data centre from Digital Realty in December 2022, and a further 24.9% in April this year, taking its stake to 49.9%. Similarly, in Osaka, the REIT’s stake doubled from 10% in November 2023 to 20% in April this year.
The Frankfurt and Osaka date centres were developed by Digital Realty within the last five years. “They’re absolutely state of the art. They’re almost brand new; they’re very certainly first generation and very recently completed,” Stewart says.
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Proactive lease management boosts accretion
When acquiring the Frankfurt data centre, in 2022, the accretion to distributions per unit (DPU) was 2%. That has since improved. “In Frankfurt, we signed several new leases during the second quarter, generating 630 basis points of positive net absorption, and leasing up substantially all the remaining vacancy on the Frankfurt campus,” Stewart says in prepared remarks during the REIT’s 1HFY2024 results briefing.
In DC REIT’s 1HFY2024 results, Stewart also said that two anchor customers in Frankfurt had renewed lease agreements for five years of additional term at a positive 2% cash rental reversion. A third customer terminated its lease due to bankruptcy proceedings.
However, Stewart says the REIT has managed to retain all the end-user customers, “significantly outperforming our underwriting”. As a result of the REIT manager’s pro-active lease management, both the Osaka and Frankfurt facilities have higher occupancies than when DC REIT took initial stakes in them. “I think the level of accretion that we’re able to deliver was pretty attractive,” Stewart says of the facilities’ performance.
Building on the achievements in Frankfurt, Stewart is optimistic about replicating this success in Los Angeles, where the REIT is “in the process of taking over operations from the former co-location provider” to direct agreements with the end-user customers.
“In Los Angeles, we won’t take over operations until Oct 1. We are actively signing direct agreements with the end-user customers in both LA properties and enjoying solid momentum to date,” he says, adding: “We still have some wood to chop.”
Data centre hotspots: Northern Virginia and Singapore
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Northern Virginia, DC REIT’s largest market, holds the title of the world’s largest data centre market, and one of the tightest in terms of capacity utilisation. Vacant capacity is around 0.6%, placing its utilisation rate at more than 99%. DC REIT’s facilities are fully occupied in Northern Virginia.
Interestingly, Singapore, despite being an expensive market to build and own data centres, has a vacancy rate of around 1%, indicating almost no spare capacity. Digital Realty owns three data centres here.
Notably, connectivity stands out as a magnet for data centre users in both places.
Singapore is strategically important due to its status as Asia’s premier financial hub and its geographical location as a connectivity hub linking Southeast Asia to the global network through 26 subsea cables and three landing sites.
In Northern Virginia, the proximity to Washington, DC, is significant as the latter is home to the US government, the Federal Reserve, the US Treasury, the FBI and the US Navy where the internet started.
“The legacy infrastructure for the internet is in Northern Virginia, and that’s important in terms of customer demand. Customers like to be close to each other so that they can exchange traffic securely. The closer you are, the less you need to go to a public internet,” Stewart explains.
Factors that make a location attractive to data centre providers include ease of doing business, reasonable entitlement approval processes, respect for property rights and the rule of law, accommodative local utility providers, low natural disaster prone areas, and a well-regulated tax regime.
Other important factors are access to fibre, broadband penetration, proximity to airports and a location for subsea cable landings. These attributes make DC REIT’s newest market, Osaka, attractive as it is situated at the opposite end of the Pacific Ocean to the US West Coast.
“A data centre user wants to get data to the end-user, so [the data centre] needs to be fast, and secure, in a geopolitically stable location, where the redundancy of the network is minimal,” Stewart says. He adds that cost is also a major consideration. Taxes including sales tax are also important considerations.
“In data centres, those [graphics processing units] cost tens of millions of dollars. If you have a sales tax, it’s a significant cost to the user. Some of the most attractive markets have a business-friendly environment with a low risk of natural disasters and a stable utility grid,” Stewart says.
Following customers to drive accretive growth
“Japan is a large developed economy, with a stable government. Our philosophy is basically that we follow our customers, why they find a particular data centre market attractive, and once there’s a critical mass of customer demand in a given market, we are a fast follower,” Stewart says.
Stewart notes that Japan’s low interest rates and lower local cost of debt compared to the US, Europe, and Singapore have enabled DC REIT to generate attractive accretion there.
Similarly, the European Central Bank has started an easing cycle for its interest rates. “Our initial investments post-IPO had been outside the US, where we were able to generate attractive DPU accretion, in addition to the utilisation rate in Frankfurt of 91% initially,” Stewart says. The Frankfurt facility’s utilisation rate is 98.5% as at June 30. “It’s done much better than when we acquired it because we have been able to lease out that vacant capacity,” Stewart says.
The main trigger for investment interest in DC REIT to revive is in the hands of the Federal Reserve, which economists believe is on the cusp of a rate-easing cycle. Interest rates impact REITs in the three main ways: the trading price because of the yield spread relative to the risk-free rate and cost of capital; interest expense which affects DPU directly; and capital values which are indirectly affected by policy rates.
“When interest rates begin to come down, I’m hopeful that the Singapore REIT will become more attractive. Lower interest rates lower cost of capital and make investments more accretive,” Stewart says, referring to tighter DPU yields and lower cost of debt.
DC REIT would also be well-positioned to capitalise on inorganic growth opportunities once its unit price rises and DPU yield narrows.
“The market hasn’t really afforded us an opportunity to capitalise on our sponsor’s US$15 billion [$19.5 billion] pipeline. We are optimistic that once the tightening cycle is over, and we see more of a rotation into REITs, we would land in a virtuous cycle where we are able to issue equity for an acquisition that would fund external growth,” Stewart says.
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