There's a big trend in the technology space that has huge implications for real estate investment trusts (REITs). No, it's not online shopping, at least not directly. It's the much broader shift to the cloud, where computing power is centralized in giant facilities and accessed remotely by companies and their customers. Digital Realty (DLR -1.12%) is at the heart of this transition.
Here are five things to consider before you jump in on this long-term real estate trend. How you feel about them could help determine if Digital Realty stock is a buy.
1. The cloud is for "realz"
Amazon's cloud business had revenue of $12.7 billion in the fourth quarter of 2020, making it one of the biggest names in the space. That number, however, was up a huge 28% year over year. Alphabet, another giant in the space, saw its cloud business grow 47% year over year. But Alphabet lost money in the space because it is continuing to invest heavily in the sector's growth. Its results clearly show it is achieving its growth ambitions.
There should be little doubt about how real the shift toward cloud computing is. Even stodgy International Business Machines is betting its future on the cloud, having bought Red Hat to facilitate hybrid cloud adoption -- essentially a mix of in-house technology and cloud systems offered by others, which is in high demand since some companies don't want to trust all of their information to third parties.
So it's clear that the cloud is a very real opportunity for real estate investment trusts that own properties that house cloud computing assets.
2. A giant business opportunity
Digital Realty was one of the first REITs to focus on this niche. Today it owns nearly 300 digital properties the world over, providing key digital infrastructure in around 50 major global markets. Its facilities support more than 4,000 customers. Occupancy at these facilities in the third quarter of 2020 was around 86%, leaving ample room for additional customers.
That said, core funds from operations (FFO) per share fell 8% year over year in the third quarter. But that's not as bad as it looks, because the drop was largely related to new shares, with total core FFO actually higher by 18%. That dichotomy speaks to the growth opportunity here.
3. Spending in the cloud REIT space has been big
Cloud computing is a growth business right now, requiring a lot of cash outlay before revenue starts to come in the door. Digital Realty estimated the lag between a new lease and revenue generation to be around seven months in the third quarter. So it has to raise money for building long before it starts to see rental income, which is a notable factor to keep in mind.
That said, the REIT has a robust pipeline, with $2 billion worth of development projects in the works. Those projects are backed by leases for nearly 60% of the space, so there's ample reason to put boots on the ground, and it's ample reason to expect good things for the REIT's future as it fills up the rest of the space.
However, the growth-focused nature of Digital Realty's business is something that will probably turn off more conservative income investors. This is not a slow and steady tortoise, it is a hare. It has to be that if it wants to keep up with competition and growth in the sector.
4. Its dividend is lagging the REIT sector
That brings up Digital Realty's dividend. On the plus side, the REIT has increased its dividend annually for 16 consecutive years; the annualized dividend growth rate over the past decade was an impressive 8.5% or so. So dividend growth investors will like what they see. However, the yield is only around 3% today, below the REIT sector average of roughly 3.9%, using Vanguard Real Estate Index ETF as a proxy. Anyone looking to maximize the income they generate from REITs will want to look elsewhere.
5. How much for Digital Realty stock?
This takes us to the real pinch point: valuation. Since Digital Realty is focused on growth and new shares are complicating the math on FFO per share, it can be hard to really pin down the price tag here. However, using dividend yield as a rough guide for valuation can help. Although not shocking, the picture isn't great. Digital Realty's yield is near the lowest levels in its history, meaning that the stock looks pretty expensive right now. Thus, value investors will probably want to watch from the sidelines, too, right now.
The final call
Having looked at the big picture here, it looks like Digital Realty would be a bad fit for conservative income investors and those with a value bias. However, growth-minded income investors will probably still be attracted to the REIT. The key is to go in knowing that you are paying up for growth here. If that's OK with you, and you are willing to keep a close eye on the REIT's execution, it could be a solid choice -- just not a cheap one or one that's going to reward you with a fat yield today.