Image Source: Digital Realty Trust Inc – IR Presentation
By Callum Turcan
One of our favorite holdings in the Dividend Growth Newsletter is Digital Realty Trust (DLR), a data center REIT whose shares yield 3.4% as of this writing. Digital Realty expects to generate $6.60-$6.70 per share in core FFO this year, up 5% at the midpoint when excluding a new lease accounting standard and foreign currency headwinds. Please note that due to those two factors and pressure from rental renewals (DLR had a lot of leases expire in 2019 and some of the new leases were signed at modestly lower rates), Digital Realty’s reported core FFO ($6.65/share at the midpoint of guidance) in 2019 will only grow marginally from $6.60/share in 2018. While slower than in recent years, Digital Realty is optimistic that growth in hyperscale data centers will continue in the medium-term.
Digital Realty reported second quarter 2019 earnings on July 30, and shares of DLR have been on an upward climb since then as you can see in the upcoming graphic. Management reiterated full year core FFO guidance during the update, which investors apparently liked and more broadly, the prospects of a lower interest rate environment is drumming up excitement in higher yielding equities (we’ll cover that in a moment).
Image Shown: Shares of Dividend Growth Newsletter holding Digital Realty are on a nice upward trend since reporting second quarter 2019 earnings at the end of July with room to move higher.
Management made some interesting comments during Digital Realty’s second quarter 2019 conference call (emphasis added):
“The data center sector is maturing as an asset class and we have seen an uptick in fresh capital targeting the sector. This has had the natural effect of compressing returns, particularly in the U.S. This trend is somewhat of a double-edge sword. On the one hand, it has very positive implications for the value of our existing portfolio. On the other hand, it also makes it harder for us to achieve external growth through acquisitions.”
Here it’s worth mentioning that CyrusOne Inc (CONE) reportedly is considering selling itself according to Bloomberg, which sent shares of CONE sharply higher since the news broke in mid-August. There’s a lot of interest in the data center REIT space and we think that’s partially due to the “Tina effect” (there is no alternative) as investors seeking yield must turn to riskier equities instead of low yielding bonds in order to generate a meaningful return.
To capitalize on this dynamic, investors need to be selective when considering income generating ideas as low-quality companies can hide behind price agnostic trading. Some yields out there may look enticing at first but are in fact lurking value traps that will be revealed through future payout cuts (a product of weak dividend coverage). Avoiding payout cuts and the probable subsequent capital depreciation represents a key way investors can enhance the long-term return on their investment portfolio(s).
REITs are capital market dependent meaning they require the ability to issue equity and debt to fund their growth trajectories while covering their dividend commitments. Digital Realty retains investment grade credit ratings (BBB/Baa2/BBB) and its strong share price makes taping equity markets, as needed, an easier task (less dilution of the existing shareholder base is required to raise the same amount of funds). We give the firm a nice 2.9x adjusted Dividend Cushion ratio to take into consideration the REIT’s ability to tap capital markets. Pro forma for its forward equity offering, Digital Realty ended the second quarter of 2019 with a net debt to adjusted EBITDA ratio of 5.5x (total debt outstanding was a bit over $10.8 billion at the end of June 2019).
During the first six months of 2019, Digital Realty generated $3.04 in AFFO and paid $2.16 in dividends, providing for an AFFO payout ratio of 71%. Ratios below 80% are ideal in the REIT world. Here’s another key quote from Digital Realty’s management team during the aforementioned conference call (emphasis added):
“We believe our global platform represents a competitive advantage in terms of capital allocation as well as access to capital. We have a unique ability to allocate capital, where we see the most attractive risk-adjusted returns around the world while also tapping the broadest, lowest cost pools of capital in the countries where we operate.
In addition, we are adapting to the growing demand within the data center investment sales market by seeking to harvest capital from mature assets in the U.S. and redeploy the proceeds into higher growth opportunities elsewhere. We believe, we have a unique ability to allocate capital, where we see the most favorable risk adjusted returns on a global basis and we believe our current investment activity is creating meaningful value for shareholders.”
Last year, Digital Realty completed its acquisition of Brazilian data center provider Ascenty through a $1.8 billion transaction. Please note, after the deal closed, Digital Realty entered a joint-venture with Brookfield Infrastructure Partners L.P. (BIP), an affiliate of Brookfield Asset Management Inc (BAM), through a transaction that was completed in April 2019. In the second quarter of 2019, Digital Realty acquired land in Tokyo, Paris, and metropolitan Northern Virginia to set the stage for its future growth trajectory.
Concluding Thoughts
Digital Realty is trading right above the top end of our fair value estimate range as of this writing, but we are keeping this holding in our Dividend Growth Newsletter portfolio given its strong technical performance. We think excitement over the prospect of the Federal Reserve cutting interest rates will continue to drive shares of higher yielding names higher, which includes high-quality data center REITs like Digital Realty.
Retail REIT Industry – CONE DLR FRT O REG SPG WPC
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Callum Turcan does not own shares in any of the securities mentioned above. Realty Income Corporation (O) and Digital Realty Trust Inc (DLR) are both included in Valuentum’s simulated Dividend Growth Newsletter portfolio. Digital Realty Trust is also included in Valuentum’s simulated High Yield Dividend Newsletter portfolio. Some of the other companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.