The stock markets have been volatile since late last year, with a slight respite in recent days.
Among the various stocks / Reits in my portfolio, many are still holding up.
Having said that, for my dividend income portfolio, my main focus will always be on the sustainability of the dividend income and not the short-term price movement.
However, among the counters in my portfolio, one that caught my attention due to the recent share price drop is Digital Core Reit.
Digital Core Reit only recently IPO-ed on the Singapore market on 6 Dec 2021. The Reit closed some 14.8 per cent higher than its initial public offering (IPO) price of US$0.88 at US$1.01 on Monday (Dec 6), as it made its trading debut on the mainboard of the Singapore Exchange (SGX).
Things were looking rosy until Jan 2022. In a short span of time (around 6 months), its share price has crashed some 37% lower.
Personally, for me, I always deem Reit holdings as long-term holdings. One needs to hold it long-term, for the incremental dividend payout to work its wonders (of slowly building up one’s passive income). Moreover, the fluctuations of many of the bigger cap Reits aren’t really that volatile (relatively speaking esp. compared to smaller cap growth stocks).
Typically with such a big price swing, I would start to question what triggered it, and should I continue to hold on to my position, buy more or sell (at a loss).
Brian from 3foreverfinancialfreedom (3Fs) Financial Independence and Alvin Chow from Drwealth both wrote good articles explaining the potential reasons that could have caused the price decline.
Digital Core REIT (SGX: DCRU) Has Crashed 33% Since Hitting The Peak Just Months Ago. Is It Time To Accumulate or Run? (Read here)
Why are data centre REITs falling? (Read here)
I shall not go into the details here, and I feel that the points are very clear in their articles.
In addition, from the media, we can clearly see two opposing views.
On one end, we have the group led by Investment manager Jim Chano who believes that data centres in REITs and, that are not owned by Alphabet, Microsoft and Amazon are going to be behind the curve so to speak.
Jim Chanos’ latest big short: data centre REITs (read here)
While on the other end, we have the bank analysts (led by DBS Group Research analysts Dale Lai and Derek Tan, UOB Kay Hian’s Jonathan Koh), who remain positive on Digital Core Reit (and data centre Reits in general).
DBS says it remains buyers of Digital Core REIT after further downside in price (read here)
UOBKH disagrees with Chamos’s ‘big short’ on data centers, maintains ‘buy’ on DCR and MINT (read here)
Digital Core REIT has upside, analysts say (read here)
“Citi has initiated coverage on Digital Core REIT with a buy recommendation and a target of US$1. Citi says Digital Core REIT’s portfolio of US$1.4 billion is valued at a historical capitalisation rate of 4.25% compared to a capitalisation rate of 4.7% based on NPI forecasts for FY2022.”
In May 2022, BofA did a presentation for Digital Core Reit at the 2022 APAC Financial, Real Estate Equity and Credit Conference.
I particularly find the research reports by DBS insightful (read here and here).
By the way, DBS is a issue manager, global coordinator, bookrunner and underwriter as stated in Digital Core Reit IPO Prospectus. Likewise for Citigroup and BofA. UOB is a co-manager.
These pieces of information are readily available online, and if you are like me, curious about the insights into the price decline, the above links are good sources. Nevertheless, with this current information, these are all views through the ‘rear view” mirror. Perhaps what is more important to me is what’s ahead.
Perhaps Howard Marks said it best in his memo titled “Something of value”, see below extract.
In gist, instead of readily available quantitative information, a good investor needs to be good at knowing qualitative factors and have a good grasp of how events will unfold the future.
I guess my opinions are biased in the sense that I am currently vested in Digital Core Reit. However, personally, I am not concerned about some of the points put forth by Jim Chanos.
1) Rising interest rates: On April 21, the manager announced that it had established a minimum target of 50% fixed rate debt, and entered into a US$175 million interest rate swap to mitigate interest rate risk. The REIT has some US$500 million of debt, of which US$350 million has been drawn down, and the remaining US$200 million is undrawn. The amount that is on fixed rates is just US$175 million. Cost of debt is 2.1%.
2) Google Cloud, Microsoft Azure and Amazon Web Services, the so-called trio of “hyperscalers” prefer to build data centres to their own design rather than moving into existing ones. When they do outsource, they typically offer low returns to their development partners.
These are known quantitative facts, even prior to the IPO.
Perhaps Andy Power — President and Chief Financial Officer said it best in response to this question: “So we’ve heard some very large deals in the first quarter. What’s changed in the market that would lead to these massive deals? “
Andy Power — President and Chief Financial Officer:
While Digital Core has only 50% fixed rate debt, in Digital Realty’s case, a little over three-quarters of their debt is non-U.S. dollar-denominated, reflecting the growth of their global platform while also acting as a natural FX hedge for investments outside the U.S. Over 90% of their debt is fixed-rate, guarding against a fixed a rising rate environment, and 99% of their debt is unsecured, providing the greatest flexibility for capital recycling.
“I assume you’re seeing large leases, large multiple megawatt leases. I mean — I think the theme — the growth in the sizing of customer requirements on the hyperscale front has been building for some time, not necessarily a completely overnight phenomenon. And I think you witnessed in the first quarter this year or the fourth quarter of last year, other quarters of last year and the year prior.
I think you guys are seeing this continued cloud adoption broadly, continued opening of new regions, opening an offering of new services. And you’re seeing this digital transformation wave in the cloud customers despite the volatility and the uncertainty of an economic backdrop or the war and the like leaning in and securing infrastructure to future-proof their runway for their end customers. So it doesn’t feel like the — one record quarter after another is a little bit of an unusual outcome. But it doesn’t feel like the pace of demand is really slowing on the hyperscale front.
And I think what’s also helped in that backdrop of this continuing steady demand, it’s just become more challenging to be a provider. You have the inflationary pressures, you have supply chain challenges, you have labor challenges and you even have moratoriums in certain parts of the world see some demand. And I think going to the part of how do you get ahead of this is that you’d be in this business for the long run, with Digital Realty been in this business for almost 20 years. You build a scale and capital sources to support our customers through good times and bad.
You make sure you have the runway to future-proof their growth. That’s the acres and acres of often contiguous expansion capacity. You secure your supply chains so that you’re on time and under budget, wherever possible and be that trusted infrastructure partner. I think those are the key ingredients to our recipe.“
Digital Realty CEO refutes Chanos short claims, says data center “demand has never been stronger” (read here)
Perhaps we are surprised by the sudden rise in inflation and the 75 basis point rise in interest rates by the Federal Reserve recently, however, from a long-term perspective and the rising demand for data centres, these can be overcome.
What does one expect anyway? Near-zero interest rates for the next decade (after the past 15 years of low-interest rate environment)? At some point, interest rates will rise (which acts as gravity to stock and Reit prices).
Or perhaps it is the sudden bankruptcy of Digital Core REIT’s fifth largest customer – a privately held IT service provider occupying 2.7 MW of the capacity in Toronto also revealed that perhaps the Reit does not have the “high quality and growing data centre customer base” as touted in its prospectus.
Digital Core Reit is a relatively small and young data centre Reit in the Singapore market. In terms of the total market value of the data centres in its portfolio, Digital Core Reit is still behind Keppel DC Reit and Mapletree Industrial Trust.
However, it has the added advantage of tapping into the expertise of its big brother Digital Realty. Both Keppel DC Reit and Digital Core Reit have a relatively low percentage of Shell and Core data centres.
Although shell & core data centres may seem the most attractive as it requires minimal management and does not carry any operational risks, landlords of colocation and fully fitted facilities could potentially generate higher profits from the individual smaller tenants with the right operational experience.
And from what we can see from the example of the bankruptcy of its fifth-largest customer, its financial muscle as well.
Digital Realty Demonstrates Commitment to Digital Core REIT (read here), To quote:
“In keeping with Digital Realty’s continued commitment to the success of Digital Core REIT, it has reached an agreement in principle to guarantee the rental income stream to Digital Core REIT in the event of a near-term cash flow shortfall due to the customer bankruptcy. Given the current customer stance as well as the strength of the Toronto market and the cash flow guarantee, the customer bankruptcy is not expected to have a material impact on Digital Core REIT’s distribution per unit, or DPU.
“Digital Core REIT is a strategic capital partner, and we are pleased to demonstrate our commitment to their success,” said Digital Realty Chief Executive Officer A. William Stein. “This support is a direct reflection of the strength of Digital Realty’s global platform as well as the depth and breadth of our large and growing installed customer base.”
Digital Realty Trust (DLR) Q1 2022 Earnings Call Transcript
As mentioned by Howard Marks, perhaps the key to successful investing is via the good judgement of the qualitative factors and future events. So what are these qualitative factors? One is the management team.
As stated in Digital Core Reit’s prospectus:
Management team and board of directors comprised of longstanding Sponsor team members with extensive data centre experience, along with real estate and finance industry veterans serving as independent directors.
Digital Core Reit just IPO, hence the next best thing I could get a sensing from was via Digital Realty April 22 earnings call transcript.
I was trying to gauge the competency of the management team via reading the transcript, and in the process found some information about Digital Core Reit and the bankruptcy of its fifth-largest customer.
Digital Realty Trust share price itself has also been on a downtrend. About 29% decline from end 2021.
Digital Realty conducted its earning call on 28 April 2022. You can read the transcript here.
During the earnings call, there were mentions about Digital Core Reit and the bankruptcy of its fifth-largest customer.
This same customer is also Digital Realty’s 23rd largest customer and leases approximately 10.5 megawatts directly from Digital Realty across six facilities in four markets, totalling approximately $22 million of annualized revenue, or 0.7% of Digital Realty’s total revenue.
While Digital Core has only 50% fixed rate debt, in Digital Realty’s case, over 90% of their debt is fixed-rate, guarding against a fixed a rising rate environment, and 99% of their debt is unsecured, providing the greatest flexibility for capital recycling. A little over three-quarters of their debt is non-U.S. dollar-denominated, reflecting the growth of their global platform while also acting as a natural FX hedge for investments outside the U.S.
1) Question about why the customer became bankrupt:
Andy Power — President and Chief Financial Officer:
“I think what’s more relevant is that customer obviously got, call it, sideswiped by two particular issues. One, obviously, a part of their business what’s not common in our customer base was disaster recovery for office, which has obviously got impacted by the Zoom-ification during the pandemic; and then secondly, the elevated power prices, especially in Europe at incremental liquidity constraints. I don’t see that as a really recurring theme in our customer base, especially the first piece of what I described.
And this customer is going to obviously work through with this bankruptcy process. And I think we’ve been taking active steps not just related to this customer but in general, to continue to streamline and focus our portfolio on core assets that we have — we see robust and long-term demand, multicustomer facilities, less single stand-alone facilities. And quite frankly, why we entered the colocation interconnection business several years ago was not only was the growth to our business but also to be prepared in the event that some of our colocation resellers ran into financial times and we had to step in and support their end customers only in the event that leases are rejected, obviously.”
2) Question about core FFO per share growth
Ques: I think you outlined core FFO per share growth on a normalized sort of constant currency basis this year would be north of 7%. I know, Andy, I think in the past, you’ve talked about mid- to high single core FFO per share growth on a forward basis. Just wondering, all else equal, as we start thinking about 2023, without giving specific guidance, is that sort of 7-ish percent rate that’s on the Slide 22, a good sort of framework or start point to think about as we think beyond this year? Thanks.
Andy Power — President and Chief Financial Officer:
“And then, Matt, on your second question, I mean we just reported the first one quarter of 2022. So obviously, not prepared to put 2023 guidance out just yet. But obviously — but you can see on a constant currency basis, we’re now north of 7% on the bottom line core FFO per share that extraordinary FX headwinds this year, if you look back the last several years, you had, call it, currency fluctuations in the, call it, two to five or so percent. And this year, the year, call it, soon to be like 9% delta.
The headwinds — or could be a tailwind, usually we’re in the 50 to 75 basis points range. And now we’re, call it, north of 200 basis points of headwinds. I think — look, the goal from the beginning of the year, as well as last year is to continue to accelerate bottom line’s earnings growth. Last year, we came out of the gate with guidance of 4%.
We ended up with 5%. This year, we came out with guidance of 5%, which we are affirming in this call, despite these FX headwinds as well despite a customer bankruptcy. And our goal is to kind of again keep consistently putting up mid- to high single digits bottom line growth.”
3) Question how the bankruptcy affects the FFO outlook
Ques: And maybe I missed it, but the bankruptcy, is that in the FFO outlook? And what’s the impact from that, if it is?
Andy Power — President and Chief Financial Officer:
“Bankruptcy, aside from a, call it, noncore straight-line right add back that’s not in core FFO, we basically already absorbed about almost $4 million of a hit for the first quarter due to, call it, pre-petition receivables, which I mentioned earlier on the call. And then we’ve made an assumption as to additional, call it, $6 million of headwind for the remainder of the year because quite honestly, we’re kind of just handicapping the outcome of events because the customer is obviously going to go through the court process and either accept or reject leases. The last time this go around, I think almost all of the leases were accepted. I’m not sure or that will be the case this go around.
And then there’s the scenarios as to if a lease is rejected and their end customers could be essentially absorbed by Digital Realty. So $6 million of incremental and on top of the $4 million, taken in the first quarter is our essentially hit or adjustment due to the bankruptcy for the year.”
My thoughts
There are a number of questions in my mind pertaining to the initial fears which probably triggered the price decline for Digital Core Reit.
1) The rising interest rate and Digital Core Reit low percentage of fixed-rate debt.
As stated by Brian: While the REIT might be lowly geared at only 26%, the debt profile is based on 50% fixed and the other 50% on floating rate. Given that the entire debt is in USD and interest rate is increasing, the cost of debt might increase from here onwards, although we would argue that this is likely the case for most of the REIT with gearing not on fixed rate.
If one is to compare among the Reits listed in the Singapore market, Digital Core Reit does indeed have a really low fixed rate debt percentage.
Extract from post from Reit-tirement below:
Fixed debt % ≤ 50%:
1) BHG Retail REIT
2) Dasin Retail Trust
3) Digital Core REIT
4) Lippo Malls Indonesia Retail Trust
Now the interesting part is that the Reit was IPO-ed in Dec 2021, However, only in April 2022, the manager announced that it had established a minimum target of 50% fixed-rate debt, and entered into a US$175 million interest rate swap to mitigate interest rate risk.
The Reit has some US$500 million of debt, of which US$350 million has been drawn down, and the remaining US$200 million is undrawn. The amount that is on fixed rates is just US$175 million. Cost of debt is 2.1%.
Keep in mind that Digital Realty Trust (Digital Core Reit Sponsor) has 90% fixed debt ratio. They are keenly aware of the importance of this ratio (after touting this in their April 2022 earnings call).
Now, can Digitial Core Reit manager change this fixed debt percentage?
I am sure there will be implications. For instance, floating rates interest will be lower than fixed rates interest, and by doing so will incur more interest payment, thereby reducing the distribution income (and reducing DPU/dividend payouts).
Would that be an option to explore to address the achilles heel of this Reit? Given how fast events unfold, I would not be surprised.
Nevertheless, with the reduction in DPU… it would bring us to the 2nd point below… would it contradict the growth mandate (aren’t DPU supposed to rise by 5.26% in PY 2023)?
2) Lowered price and rising yield, and a mandate for growth
From a typical owner’s perspective, he may or may not be that disturbed by fluctuations or even drops in stock prices, as they typically do not fundamentally affect the day-to-day runnings of the business.
However, in the case of Reits. It is not that simple.
To qualify as securities, REITs must payout at least 90% of their net earnings to shareholders as dividends, leaving very little left (for expansion). And more so for a newly IPO Reit with key strategies plainly listed out in the prospectus (see below).
Digital Core Reit IPOed with an offering Price of US$0.88 per Unit. The yield expected for forecast year 2022 is 4.75%, with a distribution per unit of 4.18 cents.
With the current share price US$0.76, the yield (assuming DPU is still 4.18 cents) is now a high of 5.5%. Assuming the share price stagnant (unlikely), and with the DPU expected to go up in FY 2023 to 4.4 cents, the yield will jump to approx. 5.8%. If share price tank further, yield will even go higher into to 6% to 7% range.
Given that DigiCore Reit was listed as a perpetual long-term vehicle for Digital Realty to divest and recycle its assets, I would be really interested in how Digital Core Reit can acquire accretive assets given its increasing yield.
In this 2021 Savills article, it states: “In the USA, the most liquid market, prime yields range from 4% to 12%; a wide range which very much depends on size, tenure and various locations across the country.
In Japan, prime data centre yields range between 4% and 5%, in Western Europe between 5% and 7%, in Singapore between 6% and 7%, in Malaysia between 7% and 7.5% and in China between 8% and 12%.”
In this Feb 2021 PGIM Investment Research article, it states: “The U.S. data center market is the most transparent compared with Europe and Asia Pacific, given the relative maturity of the market and availability of data on leasing fundamentals and pricing. Data center yields, currently at 5.8% according to Green StreetAdvisors, have been compressing over the past two years while maintaining an attractive spread over major commercial real estate sectors except retail (exhibit AM4). Listed data center REITs have performed well relative to other real estate sectors throughout the COVID-19 pandemic market volatility, suggesting market confidence in longer-term structural drivers that the data center sector offers.”
Would Digital Core Reit honour its commitment to acquire Quality income-producing properties to achieve a 5.26% increase in DPU amidst the falling share price? A drastic sharp fall in share price does not make things easier.
In simple terms, from the Reit manager’s perspective, it would not make sense to acquire a data centre yielding lesser than the Reit’s own dividend yield. Investors would be unhappy with this move (them being the potential source of funding for the acquisition). And if Digital Core Reit dividend yield rise to 6% to 7% or more…it just further reduces (or eliminates) the options available and the job harder. The Reit manager would be caught between a rock and a hard place.
In addition, the customer which went bankrupt is also Digital Realty’s 23rd largest customer and leases approximately 10.5 megawatts directly from Digital Realty across six facilities in four markets, totaling approximately $22 million of annualized revenue, or 0.7% of Digital Realty’s total revenue.
So likewise, Digital Realty (Digital Core Reit’s sponsor) is also impacted.
However, Andy Power (President and Chief Financial Officer) has affirmed Digital Realty’s core FFO per share growth to be 5% despite these FX headwinds as well despite a customer bankruptcy.
Note: Digital Realty Trust increased its core funds from operations (FFO) by 5% to $6.53 per share in 2021.
Nevertheless, it is worth noting (as stated in Digital Core Reit prospectus):
Close to 100.0% of existing leases by Base Rental Income for the month of June 2021 and NRSF as at 30 June 2021 have built-in annual rental escalations. The annual rental escalations generally range from 1.0% to 3.0%, with a weighted average of 2%.
Approximately 85.2% and 62.2% of existing leases are triple-net leases, based on NRSF as at 30 June 2021 and Base Rental Income for the month of June 2021, respectively, which shields Digital Core REIT from increases in real estate taxes and property expenses, which are absorbed by or passed on to customers.
And the prospectus has stated a number of risks:
Closing thoughts
As mentioned earlier, I do not deem this counter as a short-term play, and I do intend to hold on to this counter for the time being and to judge further on how events unfold.
The bankruptcy of a key tenant is an unfortunate but possible event. More so for a newly listed Reit with a concentrated portfolio (10 assets concentrated in top-tier data center markets across the U.S. and Canada valued at $1.4 billion).
What is important is how it was managed.
Although the management team for the newly listed Digital Core Reit is newly formed, the management team and board of directors are comprised of longstanding Sponsor’s team members with extensive data centre experience, as well as real estate and finance industry veterans serving as independent directors.
However, looking at the previous appointments of the executive officers, many previously worked for BofA, Citigroup, DBS – aren’t these banks the syndicate that forming the issue managers, global coordinators, book-runners and underwriters of the Digital COre Reit IPO?
Ultimately Digital Core Reit and Digital Realty are tied at the hips. With the former being considered as Digital Realty’s highly strategic capital partner. (Key word being ‘capital’; especially during this period when liquity is sucked from the markets).
From reading the transcript of Digital Realty earnings call, I have no doubt about the expertise and professionalism of the management team (of Digital Realty) eg. CEO Bill Stein and President and CFO Andy Power. Chief Investment Officer Greg Wright, Chief Technology Officer Chris Sharp, and Chief Revenue Officer Corey Dyer. They were forthcoming, candid and good in their area of expertise. They also tend to finish each other’s sentences and tackle questions related to their scope well.
However, they did come off from the high of the Covid induced strong growth phase and they did acknowledge that but seem to be prepared for the future. Nevertheless, probably more need to be done for Digital Core to succeed in the Singapore market, with yield-hungry Singapore investors being spoilt for choice.
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