Digital Realty Trust is one of the world’s largest data centre owners and operators. In the US, Digital Realty is an operator and developer of data centres with a DPU yield of around 3%. But Digital Realty is also sponsor to the Singapore Exchange’s latest IPO, Digital Core REIT. Isn’t it unusual for a REIT to sponsor another REIT?
That’s not quite how it appears. According to Daniel Tith, CFO of Digital Core REIT’s manager, Digital Realty is structured as a REIT for tax efficiency.
“The investment proposition for both REITs are actually quite different. I know we use the REITs for both companies. But when you think about the sponsor, they’ve got a material developed pipeline. The dividend yield for the sponsors is 3% whereas for Digital Core REIT, the yield is 4.75%,” Tith explains, adding that Digital Realty is an owner operator and not an asset manager.
Investors in Singapore may find it strange for Digital Core REIT to list in this way. But, according to investment bankers, we should think of Digital Realty as a developer, no different from CapitaLand Investment or Frasers Property. In the US, REITs do not have a development limit but developers are structured as a REIT to achieve tax efficiency. For instance, Equinix, another data centre owner and operator, is also structured as a REIT.
“We’re offering different investment merits to investors. The sponsor is looking at more capital appreciation driven from the fact that they are developing data centres and taking that risk. For Digital Core REIT, we appreciate the fact that the investor base here is looking for a stable and growing dividend yield. That means minimal interruption, little to no development at all,” Tith continues. “We’re looking to grow through accretive acquisitions. The term REIT doesn’t make them analogous in terms of their propositions to investors.”
For instance, investors in Digital Realty are among cornerstone investors in Digital Core REIT because the S-REIT offers yield while the NYSE-listed REIT offers more growth. The average S-REIT yield for REITs with US portfolios is around 8% (See Table 1 in main story).
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The portfolio
Digital Core REIT is listing with 10 properties comprising 1.2 million sq ft. Of this, 414,000 sq ft valued at US$479 million ($653 million) is in Silicon Valley. According to John Stewart, CEO of Digital Core REIT’s manager, Silicon Valley has limited land available for development. “It’s a very supply constrained market, there’s just not a lot of land available. And so it’s a market where we tend to have the best pricing power,” Stewart says.
The largest part of the portfolio is in Northern Virginia, with 494,00 sq ft valued at US$629 million. Northern Virginia is the world’s largest data centre market by far and 70% of the world’s internet traffic runs through Northern Virginia, Stewart proudly points out.
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On the other hand, Stewart acknowledges that supply is higher and there are more players in Northern Virginia. “Northern Virginia is definitely much less supply constrained than Silicon Valley. That is a market that has within the recent past probably been over-supplied,” Stewart acknowledges.
However with increased demand during Covid, the market has stabilised. “Not only did you have kind of an acceleration in demand but at the same time you had a lot of certainty; the brakes were tapped in terms of any new entrants to that market. It’s been harder to bring on new supply for the past couple of years.”
Stewart admits that Northern Virginia is the most competitive data centre market out of the four that Digital Core REIT has a presence. In addition to Silicon Valley and Northern Virginia, Digital Core REIT has a smaller presence in Los Angeles and Toronto. Los Angeles is more of an “enterprise” market, Stewart says, referring to smaller start-ups versus the big tech companies which are tenants in Silicon Valley and Northern Virginia.
Older buildings, large pipeline
An observation of the data centres in the US, including those in Digital Core REIT, is that the buildings are mature, with some built during the 1970s and 1980s. “In Silicon Valley, land is scarce there. So you’re gonna see a lot of existing buildings retrofitted to be data centres. So that’s kind of what’s influencing the age to some extent, I think a second point to highlight is that six out of our 10 data centres are also what we call powered shells. What that means is actually, the [cost and upgrade of] mechanical electrical equipment and the generators, are actually borne by the customers,” Stewart explains.
The landlord of a data centre provides the four walls, the roof, and the parking lot. What about cutting-edge technologies? “A lot of technologies such as generators, and UPS systems (uninterrupted power supply) have not really undergone massive technological changes or innovations. What we’re thinking of is like the servers, and that’s completely borne by the customer themselves. In addition to the six of the 10 buildings (in the IPO portfolio), where the mechanical electrical is actually borne by the customers, the servers themselves are actually invested and put in by the customers, so we don’t bear the costs, or that investment from our end,” Stewart elaborates. “We’re just providing infrastructure. So we’re not a software or a technology company.”
In terms of lease expiry, Digital Core REIT’s first expiries are in 2024. Stewart reckons customers have no reason not to renew. “We see no reason to expect that these customers will not continue to renew. These are mission critical business applications and they are very healthy customers with actively deployed workloads.” In other words it is very expensive for the customer to shift.
According to Tith, the portfolio’s in-place rents are similar to market rents. “Where we stand today, the current rents in this portfolio and leases represent very much what we’re seeing in the market.”
Digital Core REIT is coming to market with a gearing of 27%, giving it a headroom of US$424 million if it were to reach a gearing of 45%. “The sponsor has granted us a global right of first refusal (ROFR). So to the extent that there is an asset that meets the criteria for the REIT, we will have the exclusive right to or at least the first right to bid on that under the global ROFR,” Stewart says.
He points out that the REIT will acquire stabilised assets. “The two numbers to remember are defined as data centres that are north of 90% leased, and do not require any material capital expenditures within the next two years. And so when we apply that filter to the sponsor’s portfolio, we have an acquisition pipeline north of US$15 billion,” Stewart says.
