Benefits and risks of investing in data center REITs
Data center REITs have benefited from the explosive growth in data usage over the years. This secular trend has allowed these REITs to expand their portfolios, driving fast-paced revenue, earnings, and dividend growth. Those upward trends aren't showing any signs of stopping, given the current projections for data growth in the coming years.
Benefits of investing in data center REITs include:
- Tapping into the growth in data usage. With the rise of artificial intelligence (AI) and the immense computing power it requires, the need for server farms and large facilities capable of significant data processing will continue to grow. That should drive the need for additional infrastructure to transmit and store data, including more data center capacity.
- Recession-proofing your portfolio. Most tenants sign long-term contracts for data center space, allowing data center REITs to generate recurring revenue.
- Investing in AI without investing in AI. If you've wanted to get into an AI investment but don't feel like you know enough about it, a data center REIT might be the answer. After all, they benefit if AI thrives. The more data that's used, the more data centers will grow.
Data center REITs are less risky than many other real estate investments and technology stocks. However, they aren't without risk. Here's a look at some of the factors that can affect these REITs.
- Interest rate risk: Rising interest rates increase borrowing costs, which affects all REITs because they tend to borrow heavily to expand. Rising rates make lower-risk, yield-focused investments, such as bonds, more attractive. That often pressures REITs to raise their dividend yields to compensate investors for their greater risk.
- Oversupply risk: Data center operators often build new capacity on speculation. If they build too many data centers, the surplus can affect occupancy levels and rental rates. This is currently a significant risk to monitor, as everyone and their uncle is building a new data center to try to stay ahead of AI demand.
- Environmental risks: Data centers consume significant amounts of energy and water to keep servers and networking equipment running and cooled. They face environmental risks from climate change, storms, and droughts that can affect their ability to deliver 100% uptime.
Methodology: How these stocks were chosen
Although The Motley Fool strives to only give you the best stock suggestions, in this particular case, only three pure-play data center REITs are currently publicly traded. We included all three for completeness.
As with any REIT investment, it's important to understand the company you're buying, what it does, and how it makes money in its industry. Just because there are only a few data center REITs doesn't mean you have to choose one if something feels off about their fundamentals.
Generally speaking, you want a company with healthy income, geographical diversification, and markets that can still be tapped. If its dividend continues to grow, this is also a great sign that its actual revenue is increasing, beyond just on paper.
Data center REITs vs. data center ETFs
Data center REITs are companies that own and lease space on large servers within a data center, along with the bandwidth that's required for users to access those sites.
Data center ETFs, on the other hand, may include data center REITs but can also include other companies related to data centers, such as those that service, build, or are otherwise less directly involved in the day-to-day running of a data center. ETFs are generally managed and adjusted as needed by the fund's manager, so stocks can move in and out of the ETF over time.
The bottom line
The future of any particular data center REIT depends on its business model and how well it manages debt and customer demand, but overall, the future of data center REITs is bright.
With the rise of AI and the growing demand for computing power that doesn't yet exist, data center REITs have significant room to grow and capture future market share. As the AI boom continues, the need for data centers will only continue to grow.
The flip side of that, of course, is that when or if the AI bubble pops and some demand disappears, data center REITs that haven't been managing their businesses well may suffer or even fail. Even just the plateauing of demand for computing power will leave some data center REITs naturally behind.
