This past year has been brutal for investors in Digital Realty (DLR 0.37%). The data center REIT's shares have plunged more than 40% for the year. That has underperformed the S&P 500 (down 20%) and tech-heavy Nasdaq Composite (down 33%). 

Here's what caused the company's steep sell-off and whether it can recover in 2023.

Solid results amid growing headwinds

Despite the sell-off, Digital Realty is having a decent year. While the data center REIT is facing headwinds from foreign exchange fluctuations and growing macroeconomic uncertainty, it's on track to produce solid financial results. The company expects its core funds from operations (FFO) to come in between $6.70 and $6.75 per share this year, about 3% higher than last year's total. On a constant currency basis, core FFO would be between $6.95-$7.00 per share, which would have put it in the upper end of its initial guidance range. 

Demand for the company's data center solutions remains robust. CEO Bill Stein stated in the third-quarter earnings release: "Digital Realty again delivered record quarterly bookings in the third quarter, our third record in the past four quarters, reflecting the strong global demand for data center solutions."

That strong demand led the company to continue making investments. It recently closed the acquisition of a majority interest in leading South African data center operator Teraco for $1.7 billion. Meanwhile, it grew its development pipeline, 60% of which it had already pre-leased. The company also acquired more land to support future data center developments. 

The REIT also increased its dividend by 5% earlier this year. That continued the trend of annual dividend increases since its initial public offering in 2004, bringing its streak to 17 consecutive years. Given the stock's slump this year, the dividend now yields an attractive 4.9%. 

Why the sell-off?

The main factor dragging down the stock is the view that demand for data center solutions will cool off. Technology companies have already started to reduce spending because of concerns about an impending economic slowdown. That could hurt contract renewal rates and impact Digital Realty's ability to lease up its remaining development capacity at attractive pricing.

Analysts are also worried about the impact of rising interest rates on the company. For example, Wells Fargo analyst Eric Luebchow recently downgraded the stock and cut the price target. The analyst noted that Digital Realty has about $1.7 billion of funding requirements (capital expenses and debt refinancing) in the upcoming year, which it will likely need to finance at higher interest rates. In addition, it has about $1.5 billion of floating-rate debt that it will have to pay higher interest on in the future. Those higher rates will act as another headwind for FFO growth in the coming quarters. 

Can it recover in 2023?

Digital Realty's headwinds could persist for a while. If there's an economic downturn, tech-related spending could remain muted. Meanwhile, higher interest rates and foreign exchange fluctuations could continue to be a drag on FFO growth.

However, the company has several positive catalysts for 2023 and beyond. As noted, it has a growing pipeline of development projects, with the majority of the capacity already leased, and they'll supply the company with incremental income as they come online. Digital Realty also recently closed the Teraco deal, which should provide a near-term income boost.

Meanwhile, despite growing macroeconomic uncertainty, demand for data center solutions remains robust. CEO Bill Stein stated in the third-quarter conference call: "Our business continues to be levered to powerful long-term secular demand trends, broadly driven by ongoing digital transformation and the growth in IT and data as our record leasing results underscore. We also have an unmatched global operating footprint that is supported by a strong development pipeline that allows us to capture opportunities wherever they may emerge." Companies are increasingly investing in digital transformation to bring more of their business processes online. As a result, they'll need more and more space to store their growing data.

Stein also noted that the company plans to use its scale to its advantage. He stated on the call, "by pressing our newly gained advantage on pricing" it can improve "our internal growth profile and the longer-term durability of our cash flows." He noted that the company is "pushing prices higher to reflect tightening supply and rising costs." That combination of growing demand and pricing should drive FFO growth in the future.

A bump in the road

Digital Realty is facing several headwinds that are slowing its growth. That could continue to impact the company over the next year. 

However, the longer-term outlook remains bright as the company leverages its pricing power and strong demand to grow earnings. The stock should eventually stage a comeback, though that might only happen once there's more certainty on the economic outlook. In the meantime, investors are getting paid well while they wait for the recovery.