Digital Core REIT (DC REIT) has had a tough two years following its IPO in December 2021.
As early as April 2022, its fifth-largest tenant filed for bankruptcy and last year, its second-largest tenant filed for bankruptcy. In addition, most of its debt was at floating rates during its IPO. Since then, more than 70% of its debt is fixed. The resolution of the bankruptcy of its second-largest tenant ended with DC REIT divesting two properties at book value in January. And the REIT’s manager is working hard to fill the space vacated by its fifth-largest tenant.
By Feb 7, DC REIT's manager was sufficiently confident to announce a placement. The REIT raised US$120 million from a placement of 192 million new units at 62.5 US cents apiece, raising units in issue to 1,316.7 million.
John Stewart, the affable CEO of DC REIT’s manager, was realistic about the challenges and opportunities faced by the REIT.
By the time he caught up with The Edge Singapore, DC REIT’s sponsor, Digital Realty had announced a joint venture with Blackstone in December 2023 for data centre development in Northern Virginia, Frankfurt and Paris while two properties had been sold at book value.
Northern Virginia is the largest data centre market in the world as it supports the functions of nearby urban centres including Washington DC with headquarters of the US government, US Treasury, World Bank and a myriad of other government agencies including the CIA, FBI, Pentagon, and the US military.
“Last year, before the customer bankruptcy resolution, we weren’t really in a position to be transacting. So, unfortunately, we’ve had to pass on several billion dollars worth of assets that we could have transacted on,” Stewart says, referring to the bankruptcy proceedings of its second largest customer which leased 22% of space based on gross rental income.
In November 2023, Cyxtera Technologies, DC REIT’s second-largest customer, announced Brookfield would acquire all of Cyxtera’s assets for US$775 million ($1.04 billion) including seven of Cyxtera’s data centres from “several landlords”, In the agreement between Brookfield, Digital Realty and DC REIT, Brookfield paid the book value of US$160 million for DC REIT’s 90% stake in two Silicon Valley facilities, translating into a capitalisation rate of 4.4% and only 11% lower than the IPO valuation at end 2021, despite the interest rate hike cycle.
Brookfield will take over the existing lease of a third Silicon Valley property with no change in the lease terms but the lease terms of two more properties in Los Angeles in El Segundo and Burbank will be shortened to end in September this year instead of the 2030s.
See also: Changes in ICR, leverage to come into effect immediately, with additional disclosures in March
“Digital Realty in its status as an owner-operator is an existing (and exclusive) partner with Brookfield in Brazil and India. The existing relationship with Brookfield as the buyer of the customer out of bankruptcy allowed us to collaborate with Brookfield to reach a very favourable outcome from DC REIT’s perspective,” Stewart points out.
Additionally, divesting two assets at book value validates its portfolio valuation. In the two years since DC REIT’s IPO, the Federal funds rate (FFR) has risen by 525 bps, the most accelerated rise in history. Such a move inevitably impacts valuations. Interestingly, the capitalisation rate on its portfolio only rose 40 bps y-o-y, because the rental outlook continues to look robust. In FY2023, DC REIT’s book value fell by 9% y-o-y.
“We note that terminal cap rates of 5.25%–7% were used in FY2023, compared to 4.75%–5% in FY2022, while FY2022 direct cap rates were 4.25%–4.75%), which resulted in a y-o-y decline in AUM of 8.4% (led by Toronto/Los Angeles/Northern Virginia/Frankfurt/Silicon Valley),” states a Citi report following DC REIT’s FY2023 results announcement.
DC REIT’s markets
One of the reasons the outlook of rents at DC REIT’s properties remains resilient is attributed to tight supply and low vacancies.
Vacancies in DC REIT’s markets in places such as Northern Virginia are below 1%. New capacity in Silicon Valley is at a standstill because of the lack of power infrastructure.
“The issue in Northern Virginia is that the utility is not able to build transmission lines that carry the power to data centres so it is acting as an artificial constraint limiting new capacity,” Stewart notes.
To stay ahead of Singapore and the region’s corporate and economic trends, click here for Latest Section
Supply constraints in Silicon Valley are similar to Northern Virginia. Utility company Pacific Gas and Electric had a US$13 billion settlement following wildfires in California caused by one of their wires. As a result, they are “undergrounding” their infrastructure. “All their capex is earmarked for safety. And there are no new data centres till 2028,” Stewart points out.
Frankfurt, where DC REIT acquired a 25% stake in a data centre from Digital Realty with the latter holding the remaining 75% share, is in a similar situation to Singapore, where the government has been restricting supply.
Toronto has no supply constraints. Sungard, which filed for bankruptcy in 2022, was a tenant in DC REIT’s data centre in Toronto. However, Digital Realty provided cash flow support to make up for any cash flow shortfall from the Sungard vacancy up to Dec 31, 2023.
“It’s slow to lease out. We have one lease up for signature. That means we’ve reached terms. But we will face a bit of a tough comp in 2024, due to the expiration of the Toronto cash flow support agreement on Dec 31, 2023, and the expiration of the amended leases for the two L.A. properties on Sept 30, 2024,” Stewart admits.
In November last year, DC REIT acquired a 10% interest in a data centre in Osaka from Mitsubishi for JPY7.725 billion or approximately US$51.5 million. “Japan is fully leased and it’s the landing point of cable systems,” Stewart says.
Cable systems such as the Southeast Asia Japan Cable system, the Japan-Washington State Trans-Pacific Cable System and other cable systems all run to and through Japan to other parts of Asia and the US.
The best locations for data centres are places with important cable systems, a source of renewable energy, a strong rule of law, sources of tenants, users, operators and “eyeballs” or people who make use of the data. Although Singapore does not have ample renewable energy, it is one of the top destinations to own data centres, especially with the city-state’s supply constraints. Digital Realty owns and operates three data centres in Singapore, one of which is state-of-the-art and the most energy-efficient.
DC REIT’s portfolio comprises mainly fully-fitted data centres (78%) by AUM (assets under management), with the remaining 22% as shell and core. This is in contrast with Mapletree Industrial Trust ME8U ’s (MINT) portfolio where 78% of the portfolio by gross rental income comprises triple net leases. By GRI (gross rental income), 56.9% of MINT’s portfolio comprises powered shell data centres, 25.2% are fitted and 17.9% are fitted hyperscale data centres.
Shell and core data centres generally command lower cap rates because the customer puts in its own capital for the infrastructure. “It makes sense to have a diversified portfolio. The key is you want to be in core markets, and you don’t want to be beholden to just one customer. For data centres, you want to be in a market where you’ve got repeat demand and not just a single customer,” Stewart says.
In addition to Singapore, Digital Realty owns and operates data centres in Australia, Japan, Korea, Hong Kong and India. “Of those, Japan is where we transacted. Australia has tax complications. Singapore’s cap rate is very tight and borrowing costs are higher,” Stewart says. “We expect we will be in Singapore over time.”
Asset sale lowers aggregate leverage
DC REIT’s aggregate leverage as at Dec 31, 2023, stood at 40.5%. However, with the sale of the two properties to Brookfield for US$160 million, its aggregate leverage falls to 33.5%. That gives the REIT the debt headroom of a couple of hundred million before leverage heads to 40%, which is what Stewart and his team are relatively comfortable with.
“Setting aside the wrong decision, we philosophically think about 80% of debt should be fixed. It’s not our job to bet on interest rates. And it should be staggered. I would say today, we’re maybe a little bit more inclined to not necessarily lock in a long duration,” Stewart elaborates. The wrong decision refers to a couple of months after the IPO when debt was floating. Its current cost of debt is around 4.7%,
FY2024’s DPU isn’t likely to be much above the 3.7 US cents declared in FY2023. The DPU is also 15.9% below DC REIT’s IPO prospectus forecast DPU of 4.4 US cents.
“Data centres are a little bit of a unique asset class. There aren’t that many data centres that are available for sale. They are also a fairly sought-after asset class because everything we’re doing, including on AI, goes through data centres,” Stewart says.
Digital Realty has provided DC REIT with a pipeline of some US$15 billion of data centres. However, DC REIT can only acquire what investors are willing to bear as they may ultimately be the ones that may be called to finance the acquisitions.
Citi sees the pipeline as a positive. “DC REIT (–1%) has outperformed S-REITs (–6%) year to date but we maintain “buy” in view of its direct proxy to the strong US data centre market and sizeable Sponsor pipeline of US$15 billion, giving it ample inorganic growth impetus,” the Citi report says. — with additional reporting by Felicia Tan.
