There was good news and not so good news in the business update provided by Digital Core REIT (DC REIT) for 1QFY2023 ended March.
Distributable income was 13.7% below forecast and 10% lower y-o-y, largely due to a surge in interest expense. All-in cost of debt was at 4.1% in 1Q2023.
Dan Tith, CFO of DC REIT’s manager, indicated that any new debt is likely to cost around 4.5%–5%. As 75% of DC REIT’s debt is on fixed rates, the growth in interest expense is set to subside.
The higher cost of new debt means that DC REIT is unlikely to move its aggregate leverage much beyond 1Q2023’s 34.4%. Tith says: “Previously, the target leverage ranged from 35% to 40%. We’re not going to get close to the 40% range.”
The higher cost of debt may also moderate AUM growth expectations, which may be a good thing. “Last year, we did a [transaction] in Frankfurt, and the interest cost was 3%–3.5%. When we came out with the announcement [of the transaction], accretion to DPU was 2% but now it’s looking like 2.5%,” Tith adds. DC REIT acquired a 25% stake in sponsor Digital Realty’s facility in Frankfurt.
Acquisitions are a tall order. Cost of debt in the US is 4.5%–5%. Equity is unlikely to be used as DC REIT’s unit price is trading at 0.55x its net asset value of 80 US cents ($1.07). And capitalisation rates of 5%–5.5% will not leave much accretion for investors.
Tith says there are some markets outside the US where the REIT can pursue growth. The Frankfurt facility was one of them. However, the unfettered growth promoted by investment bankers for DC REIT at the time of its IPO is unlikely. And that may be a positive development given the way AUM growth has actually weakened some REITs.
DC REIT’s manager can focus on organic boosts to DPU. The Toronto facility is a case in point. Its 93,877 sq ft Toronto data centre at 371 Gough Road was previously rented to one tenant, Sungard, which filed for bankruptcy.
“We have now replaced two-thirds of the previous customer’s 2023 rental obligation. We are working closely with the sponsor’s sales and portfolio management teams to backfill the remaining vacancy,” says John Stewart, CEO of DC REIT’s manager.
See also: Changes in ICR, leverage to come into effect immediately, with additional disclosures in March
Stewart is confident of backfilling the vacancy with no impact on DPU because of the strength of the Toronto data centre market. “We had leased out [the facility] to a single use at more of a wholesale rate and we’re [now] selling colocation capacity at retail rates, which are much higher.” He declines to give a number but hints that it is not a low single-digit percentage but much higher.
“I think the Toronto situation is an excellent case study for the way that this could play out, particularly when you have a colocation reseller, as a customer,” Stewart adds, when asked repeatedly about plans for the space rented to Cyxtera Technologies, the REIT’s second-largest tenant.
According to Stewart, rents in Northern California for DC REIT’s properties are dramatically below market, and utilisation rates are very high. According to consultants, demand is greater than supply. Meantime, the local utility provider in Northern California has indicated that incremental power allocations for data centre development will be on hold through to 2028.
“Northern California market rents are up 40% to 60% over the past 24 months and we estimate that our in-place rents are 15% to 40% below current market rents,” Stewart says, adding that DC REIT’s in-place rents in Southern California are 5% to 15% below market.
While Cyxtera’s rent remains current, its balance sheet is stressed with over US$800 million of loan maturities due in April and May 2024. In the event it vacates its space, DC REIT could have the opportunity to actually raise rents.
“When your in-place rents are dramatically below market, you have got an opportunity to recapture that upside much sooner than otherwise would be the case with over 10 years of remaining lease term on those assets. That will absolutely be the strategy and we are quite confident in our ability to manage through that,” Stewart says.
