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Low-Yielding REITs Leave Little Margin for Error

By Motley Fool Staff - Oct 1, 2017 at 6:30AM

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When REITs pay low yields, you have to be really confident about what the future will hold for them.

Data-center REITs enjoy some of the highest multiples on the market and thus offer yields of 3% and sometimes even less when other high-quality REITs in other sectors trade at higher yields. To achieve a good return from a low-yielding REIT, a lot has to go your way -- lease rates have to go up, interest rates have to stay put, and so on -- for you to eke out a solid rate of return.

In this episode of Industry Focus: Financials, join Michael Douglass and Jordan Wathen as they discuss why data-center REITs offer little margin of safety and aren't exactly immune from disruption themselves.

A full transcript follows the video.

This video was recorded on Sept. 25, 2017.

Michael Douglass: Jordan, the key question for us is, what do you think of data-center REITs as an investment? Listen, obviously they're going to be around. These folks are probably not going to be going out of business anytime soon. They've got big sector trends that benefit them. On the flip side, they invest in an asset that may not be as attractive as the actual tech companies. So as an investor, how do you think about this sector as a whole?

Jordan Wathen: As the sector as a whole, it's kind of disinteresting to me. Data centers, there's going to be more data in the future, as you said. I have a hard time understanding who's going to win and who's going to lose. So when Equinix says, "We have the most pristine asset in Miami, Fla. It's the only way or the best way to connect the United States to Latin America," I hear that but I don't really know what that means, and I don't understand what that will mean 10 years from now. So whether or not I want to invest in a stock at a 3% yield based on something I don't really know that well, it's hard for me to wrap my head around. When you're paying a high multiple of earnings, you have to have a lot of certainty. Otherwise that investment doesn't make sense. I can't get comfortable with a margin of safety with the price where it is. I can't get comfortable with how much I can be wrong about it and still make money.

Douglass: Yeah, I think that's a fair concern. For me, one of my big concerns is that someone will figure out how to disrupt this area. When I'm thinking about industries that are adjacent to tech, a lot of times, they get disrupted as tech folks, some Silicon Valley entrepreneur, or somebody thinks of a different and better way to do things. And I worry that someone will figure out how to store and call up this data in a cheaper fashion, and that will then require these REITs not to go out of business, but to retool. And the cost of that will be so substantial that it'll hamper growth. Plus, frankly, I'm concerned about interest rates growing. REITs as a whole tend to benefit enormously in a low-interest-rate environment. They tend to suffer in higher-interest-rate environments. And we're looking at a higher-interest-rate environment long-term. To be honest, there are sectors I tend to invest in in real estate. I tend to like healthcare for real estate, in part because its multiples are lower and the dividend yields are a lot higher. So I do tend to think there's a little bit more margin for safety there. And also because healthcare, the actual delivery of care isn't being disrupted nearly as much as things like data storage really have that potential to be. So I tend to think of that as a safer place, where there won't be a potentially enormous, life-changing thing that requires everyone to retool and shut off growth for a couple of years.

Wathen: That's actually a really good point. If we think about capacity as far as data-center REITs are concerned, it's based on the amount of electricity you can pump into the building, the amount of computing you can do with a certain amount of electricity. And over time, that goes down -- you can do more computing with less electricity, whereas if you think within the confines of a traditional REIT, say an apartment REIT, for example, people aren't going to want to live in 100-square-foot units. There's a certain minimum.

Douglass: Maybe it's not 100, but it's something.

Wathen: Yeah. It's something. I've seen studios recently being built that are tiny. But there's a limit to the minimum. I don't really understand where that is with tech. And I think you're right, I think there's a lot of potential disruption risk there, because you're building long-lived assets. Was this data boom a big thing 20 years ago? No. But these buildings are going to be standing 20 years from now. So it's hard for me to wrap my head around.

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