Data centres were hot investments in the past few years as investors bet on the increasing cloud and data demand in the tech era. Very few investors believed that the bet will go wrong simply basing on the premise that ‘this is the future’.
Well. Things went south after the Covid boom for data centre REITs.
Keppel DC REIT (AJBU) share price peaked around the second half of 2020 at a price of $3.04 and it gradually fell to $1.97 in Jul 2022. That’s a 35% decline and the dividend yields weren’t sufficient to cover this drop as they were less than 10% in the past 2 years.
The other pure play data centre REIT listed in Singapore is Digital Core REIT (DCRU). It IPO-ed in end 2021 to much fanfare – share price jumped 15% higher than the IPO price of US$0.88 on the first day of trading.
It peaked at US$1.18 before crashing to US$0.76, a 36% decline in just 7 months of trading.
Here’re reasons for their fall.
If you prefer to watch:
#1 – Rising interest rate
Interest rate has been rising and that hurts REITs because they borrow to fund capital intensive real estate investments. Their financing costs would go up and eat up the margins, thereby reducing dividends for investors.
The damage was larger against the data centre REITs because they were relatively more expensive than the other types of REITs – their dividend yields were lower.
For e.g. Keppel DC REIT average 5-year dividend yield was just 3.38%. And with the 10-year Singapore Government Bonds edging close to 3%, it doesn’t make sense to take on higher risk with the REIT for about the same yield.
Hence, Keppel DC REIT share price has to fall in order for the dividend yield to go up.
Same goes for Digital Core REIT, which is more sensitive to the US rates as the data centres and financing are located in the US.
There may be more room for these data centre REITs to fall considering that the Federal Reserve is planning for more rate hikes for the second half of 2022.
However, it is hard for investors to call the bottom and the forward-looking stock market makes timing even more difficult – stock market may bottom before the inflation data shows that it has peaked. One way is to adopt a dollar-cost average approach to these REITs instead of attempting to time the bottom.
#2 – Tenant went bust
The second reason is more specific to Digital Core REIT. Its fifth largest tenant has filed for bankruptcy. It contributed about 7% of Digital Core REIT’s revenue. This would impact the dividend payout if the rental payment halts.
Although not disclosed, rumour says the tenant is Sungard Availability, an IT company that does data recovery, business continuity, cybersecurity and cloud. It has exposure to four data centres and one of which, the Toronto one, is majority owned by Digital Core REIT. The other three are owned by the parent, Digital Realty.
But the bankruptcy is unlikely to impact Digital Core REIT because of two reasons. First is that the spare capacity could be filled by others as the demand for space is still high. Second, the sponsor has agreed in principle to guarantee the cash flow to the REIT if there is a shortfall.
#3 – Big cloud providers are a threat to data centre REITs
Jim Chanos, a hedge fund manager who became famous for shorting Enron, has openly said he is shorting data centre REITs that have no exposure to major cloud companies.
His argument against these REITs is that the big cloud businesses are going to gobble up the market share as they build their own sophisticated data centres instead of renting from the REITs.
The big cloud providers are Amazon, Microsoft and Alphabet, where they command 64% of the market share at the end of 2021.
Let’s dive into the top customers of Keppel DC REIT:
We can see that majority of the customers are tech, IT and telcos. The top client contributed 35.6% of the rental income. It is worded as “one of the largest tech companies globally”, which we believe is likely one of the cloud providers. So indeed if the big player leave, it would leave a big void to fill.
Next let us look at Digital Core REIT’s top customers:
Similarly, the customer base is mainly from IT and telco sectors. “Fortune 50 Software Company” sounds like Microsoft. If true, Digital Core REIT will also need to fill this hole if Microsoft leaves.
But we don’t envisage a world with only the big cloud providers.
Although the REITs may not offer the most high-end infrastructure, they could continue to serve the other customers who want to rent the space.
Small and mid-sized companies who don’t have the scale to justify for managing their own physical servers are likely to subscribe to cloud services and yield cost savings.
But for bigger companies where they may even rival certain services against the big tech, would prefer to own their servers and have more control. Sometimes privacy and data protection is a key consideration too.
In fact, a16z (a venture capitalist), published a case against cloud when the scale of IT operations get too big. Companies can achieve cost savings when they switch to their own dedicated servers, away from the cloud providers. They used Dropbox as an example,
“When the company embarked on its infrastructure optimization initiative in 2016, they saved nearly $75M over two years by shifting the majority of their workloads from public cloud to “lower cost, custom-built infrastructure in co-location facilities” directly leased and operated by Dropbox. Dropbox gross margins increased from 33% to 67% from 2015 to 2017, which they noted was “primarily due to our Infrastructure Optimization and an… increase in our revenue during the period.”
Hence, data centre REITs are very much relevant in the future as cloud providers are a godsend for startups but not cost effective or safe enough for big corporates. Data centre REITs provide the space needed for housing these dedicated servers.
Are data centre REITs a buy now?
It sounds like the bad news aren’t that bad after all. This means that the falling share prices can be an opportunity to buy the data centre REITs at good prices.
Relatively I would think that Keppel DC REIT is a safer choice considering that majority of the real estate is in Singapore.
The Singapore government has disallowed any new data centres to be built until further notice. So even if the big tech wants to build new ones are not possible.
Singapore is still an important hub in Asia Pacific and will serve as a connectivity node. Hence having servers in Singapore can be non-negotiable in some cases. Given the limited land supply, it is not easy to get the space for more data centres. Hence, Keppel DC REIT is in a good position.
At a dividend yield of 5% and a Price-to-book of 1.4x, Keppel DC REIT is trading at 1 standard deviation from the average 5-year values. This usually indicate a good entry point.
Can price worsen and go to 2 standard deviations? Possible but no one knows where the bottom is.
I often hear people say this, “I will buy if the price comes down”. But when it happens, some still don’t dare to pull the trigger because there’s bad news. It should be clear to you that they come as a package.
The key is to stay objective and determine if the bad news are permanent or temporary. Stay away if it is the former and have the courage to buy if it is the latter. I see the bad news for data centre REITs as temporary.