Image Shown: We are big fans of Digital Realty Trust Inc’s global footprint. Image Source: Digital Realty Trust Inc – Fourth Quarter of 2021 IR Earnings Presentation
By Callum Turcan
On February 17, Digital Realty Trust Inc (DLR) reported fourth quarter 2021 earnings that beat both consensus top- and bottom-line estimates, though its near term guidance came in a tad softer than expected. The data center real estate investment trust (‘REIT’) is facing headwinds from vintage leases rolling off and concerns about surging power costs around the world. On the plus side, Digital Realty is experiencing decent growth at the part of its business where re-leasing terms have been more favorable, and its contracts generally include provisions that allow the REIT to pass on electricity expenses to its tenants. We include Digital Realty as an idea in both the Dividend Growth Newsletter and High Yield Dividend Newsletter portfolios.
Re-leasing Commentary
Before getting into the headwinds facing Digital Realty’s re-leasing efforts, please note that differentiating between the REIT’s colocation operations and its hyperscale operations is key. Its colocation operations cater to customers with modest computing and power consumption (0-1 MW) needs. These assets are developed with standardized designs and offer contracts that typically last 2-5 years. Pivoting to its hyperscale operations, this business primarily caters to tech giants with massive computing and power consumption (> 1 MW) needs. To meet the specific needs of its major tenants, Digital Realty develops customized data center operations and offers contracts that typically last 5-10+ years.
Image Shown: An overview of Digital Realty’s different data center products. Image Source: Digital Realty – 10-K SEC filing covering 2020
What makes this differentiation important is that its colocation business has seen stronger re-leasing rental rates of late while its hyperscale business is facing major headwinds from contracts signed years ago rolling off. These vintage contracts were signed at advantageous rates at a time when the backdrop for the data center industry was much different. In the upcoming graphic down below, Digital Realty provides an overview of the diverging performance of these two parts of its business.
Image Shown: Digital Realty is facing headwinds from vintage contracts signed primarily with hyperscale customers getting renewed at lower rental rates, though its colocation business has been putting up decent performance of late. Image Source: Digital Realty – Fourth Quarter of 2021 IR Earnings Presentation
As you can see in the upcoming graphic down below, Digital Realty secured $42 million in bookings for its colocation (0-1 MW) business in the final quarter of 2021 along with $97 million in bookings for its hyperscale (> 1 MW) business and $18 billion in bookings for its interconnection and other businesses combined (total bookings of $157 million were secured last quarter). Please note that its bookings metric refers to the expected annualized GAAP revenues these deals should generate during the life of the relevant lease.
Image Shown: Digital Realty’s bookings continue to trend in the right direction. Image Source: Digital Realty – Fourth Quarter of 2021 IR Earnings Presentation
During Digital Realty’s fourth quarter of 2021 earnings call, management alluded to the notion that these headwinds would fade going forward (emphasis added):
“Given the tightened supply environment, we expect flat cash renewal rates in 2022, up from slightly negative in 2021. And we expect overall portfolio occupancy to remain within the current range despite the significant new capacity scheduled to come online during the year in addition to the embedded lease-up potential within the Teraco portfolio.” — Andy Power, CFO of Digital Realty
We are keeping on eye on this situation.
Power Cost Considerations
Data centers are voracious consumers of power and rising electricity costs are a major concern globally, though Digital Realty is well-positioned on this front. Within its 2020 10-K SEC filing, Digital Realty notes that “we control our costs by negotiating expense pass-through provisions in customer agreements for operating expenses, including power costs and certain capital expenditure.” During Digital Realty’s third quarter 2021 earnings call, management noted that (emphasis added):
“While on the topic of energy, I’m pleased to report that Digital Realty experienced only a small negative impact from the substantial rise in energy costs during the third quarter.
In Europe, where concerns of an energy crisis were most acute, we typically contract for energy supplies a year or more in advance, providing price feasibility and certainty for our customers. Elsewhere around the world, energy costs are typically passed through to customers, minimizing our direct exposure.
We continue to keep a close eye on energy prices, but given the resiliency of our business model, we do not expect rising energy costs to impact our reported results by more than a few pennies.” — William (Bill) Stein, CEO of Digital Realty
The REIT has been steadily securing access to renewable energy through retail supply agreements, power purchase agreements (‘PSA’) and other factors. Over the long haul, that should (in theory) reduce its exposure to volatile raw energy resources pricing. According to its website, Digital Realty’s collocation and European operations are now completely powered by renewable energy sources. There is ample room for Digital Realty to grow its access to renewable energy in North America and the Asia-Pacific (‘APAC’) region.
Earnings and Guidance Update
Virtually all REITs highlight the industry-specific non-GAAP funds from operations (‘FFO’) metric as a measure of their cash flow performance. While the metric is flawed, it provides investors with a snapshot of how well a REIT’s underlying business is performing. In 2021, Digital Realty posted $6.53 in core FFO per share, up 5% year-over-year. Expanding its European data center presence by acquiring Interxion through a $8.4 billion deal by enterprise value that closed in March 2020 played a role here.
In 2022, Digital Realty forecasts that it will generate $6.80-$6.90 in core FFO per share, which would represent 5% annual growth at the midpoint. We appreciate that Digital Realty’s business is expected to keep recovering this year after taking a hit in 2020 due to headwinds created by the coronavirus (‘COVID-19’) pandemic. Digital Realty’s core FFO per share fell from $6.65 in 2019 down to $6.22 in 2020. Management expects the REIT will make up all of its lost ground and then some in 2022 after its business staged a nice rebound last year. The REIT is guiding to generate $4.7-$4.8 billion in revenue in 2022, up from $4.4 billion in GAAP revenues in 2021.
Asset Portfolio Update
Digital Realty is constantly optimizing its asset base and capital structure. For instance, Digital Realty listed Digital Core REIT (which is sponsored and externally managed by Digital Realty) on the Singapore Stock Exchange in December 2021 after contributing a 90% interest in ten fully-leased assets in the US and Canada to the new entity. This transaction raised $1.0 billion net for Digital Realty and after taking the exercise of the overallotment option into account, Digital Realty has an approximately 35% equity interest in Digital Core REIT. Also, Digital Realty made a strategic investment in AtlasEdge Data Centres, a European data center operator, during the final quarter of 2021.
Digital Realty started 2022 off running. The REIT announced in January 2022 that it had opened its first data center in South Korea and that it was acquiring a majority stake in the equity of African data center operator Teraco from a consortium of investors. This deal values Teraco at ~$3.5 billion and is expected to close during the first half of this year. Here is what the press release had to say (emphasis added):
After closing, Digital Realty will own approximately 55% of the total equity interests in Teraco, while the remaining 45% will be held by a consortium of existing investors, including management, Berkshire Partners LLC, Permira, van Rooyen Group, Columbia Capital, Stepstone Ventures and the Teraco Connect Trust. The rolling equity investors in Teraco will have the opportunity to put their interests to Digital Realty between 3.5-5.5 years after closing, while Digital Realty will have the right to call those equity interests between 5.5-6.5 years after closing.
The transaction is expected to be approximately 1% dilutive to Digital Realty’s core FFO per share in 2022, breakeven in 2023, and accretive to financial metrics and the growth trajectory of the combined organization thereafter. The Teraco investment will be financed through a combination of proceeds from Digital Realty’s private capital and capital recycling initiatives, committed funding under the existing forward equity commitment and other potential future financings.
Expanding its global presence is the right call, in our view. On the issue of Digital Realty’s guidance, it is important to stress here that its Teraco investment is expected to weigh on its near term core FFO per share performance though this deal should become a tailwind for its financial performance by 2024. Digital Realty noted that a large chunk of Teraco’s asset base was developed within the past couple of years, and it takes time for data center operations to become fully-leased. Teraco plans to continue developing new data centers assets going forward, particularly in South Africa. Additionally, there is room for potential synergies here as Digital Realty has operations in Nigeria and Kenya that could be integrated with Teraco’s growing asset base.
Financial Strength Update
At the end of December 2021, Digital Realty had $13.4 billion in total debt (inclusive of short-term debt) which was only marginally offset by $0.1 billion in cash and cash equivalents on hand. The REIT’s net debt load is sizable. Digital Realty had around $0.7 billion in debt coming due this year at the end of December 2021. In our view, the REIT should be able to tap debt and equity markets at attractive rates going forward to refinance maturing debt and for other purposes, such as making good on its dividend obligations and funding its growth ambitions.
Image Shown: Digital Realty’s debt maturity schedule was well-staggered at the end of December 2021, which makes future refinancing activities a more manageable task. Image Source: Digital Realty – Fourth Quarter of 2021 IR Earnings Presentation
The ’Big Three’ rating agencies all give Digital Realty an investment grade rating (Baa2/BBB/BBB) with either stable or positive outlooks. In November 2021, Digital Realty announced its global revolving credit facility had been extended by three years and upsized to $3.0 billion (from $2.35 billion previously). Now the REIT’s global revolving credit facility matures in January 2027 assuming the two six-month extension options are exercised. Additionally, there is now a sustainability component to the credit facility, with the press release noting that:
The global revolving credit facilities now feature a sustainability-linked pricing component, with pricing subject to adjustment based on annual performance targets, further demonstrating the company’s continued leadership and commitment to sustainable business practices.
Beyond its global revolving credit facility, Digital Realty also announced in November 2021 that its Japanese yen-denominated credit facility had been amended and extended. Both credit facilities include upsize components as it concerns increasing their respective borrowing bases.
The REIT announced in January 2022 that it was issuing approximately EUR€0.75 billion in 1.375% Guaranteed Notes due 2032 (these are senior unsecured obligations) at 99.056% of par, highlighting its ability to tap debt markets at relatively low rates. That same month, Digital Realty announced it was exercising its option to redeem roughly USD$0.45 billion in 4.750% Notes due 2025.
We appreciate that Digital Realty is staying on top of the ball as it concerns managing its debt maturity schedule and making sure it has ample access to liquidity. Historically, the REIT has also used a combination (I, II) of secondary equity offerings, forward share sales, and at-the-market (‘ATM’) equity issuance programs to tap equity markets for funds and we expect that will continue to be the case going forward.
Please note that our adjusted Dividend Cushion ratio for Digital Realty, which sits above parity at 1.1, takes its ability to tap capital markets into account. We view Digital Realty’s dividend strength favorably and expect the REIT to steadily grow its per share payout over time. Historically, Digital Realty has increased its quarterly dividend during the first quarter of the year. Shares of DLR yield ~3.4% as of this writing.
During the REIT’s fourth quarter 2021 earnings call, management noted that “given the continued growth in our cash flows and taxable income, we would expect to see continued growth in the per share dividend” which we appreciate. Using the midpoint of its 2022 guidance, Digital Realty would post a dividend payout ratio (expected dividends per share divided by forecasted core FFO per share) of ~68% this year at its current payout. As a rule of thumb, a dividend payout ratio less than 80% is ideal and indicates there is room for the REIT in question (in this case, Digital Realty) to keep growing its dividend.
Management recently noted that the REIT expects to raise $0.5-$1.0 billion from capital recycling in 2022 (divestment activity). Selling assets to Digital Core REIT is a way Digital Realty can raise funds while retaining a direct interest in those assets (and indirect, due to Digital Realty’s equity interest in Digital Core REIT). A December 2021 press release noted that “Digital Realty expects to retain a 10% direct ownership stake in each of Digital Core REIT’s assets” when announcing the successful listing of Digital Core REIT.
Concluding Thoughts
As with all REITs, Digital Realty will face headwinds from the rising interest rate environment seen in recent quarters. We expect that Digital Realty will be able to manage a reasonable increase in interest rates as the Fed and other monetary authorities work to tame inflation.
Digital Realty is emerging from the worst of the COVID-19 pandemic with its cash flow and dividend growth trajectory intact. Its business is facing headwinds from vintage contracts rolling off, though its longer term outlook remains bright. Digital Realty’s core North American business is putting up decent performance though what we are