Realty Income (O -0.17%) has done a magnificent job growing its dividend over the years. The real estate investment trust (REIT) has increased its payout 123 times since its public market listing in 1994. The main driver has been its ability to invest in real estate that generates steady and growing rental income.
The REIT primarily invests in retail and industrial properties net leased to high-quality tenants in durable industries. However, it has been expanding into new property verticals over the years. Last year, it made a small, under-the-radar investment in the data center sector. That deal opens the door to a massive growth opportunity that could give it more power to grow its dividend in the future.
An attractive investment opportunity
In November, Realty Income announced that it formed a build-to-suit data center development joint venture (JV) with leading data center REIT Digital Realty (DLR 0.95%). It agreed to invest about $200 million for an 80% equity interest in the JV. That was a small fraction of the record $9.5 billion the REIT invested in real estate last year.
This deal checked a lot of the boxes for Realty Income, including boasting strong economics. Digital Realty had already pre-leased the under-construction facilities to an investment-grade-rated S&P 100 company (one of the country's top 100 publicly traded companies). The 10-year lease has an attractive initial cash yield of 6.9%, with 2% annual rent escalators.
In addition to that growing income stream, the deal featured built-in expansion potential. The tenant has the option to expand the capacity from its initial 16 megawatts (MW) to 48 MW during the lease term. Realty Income could invest up to $640 million if the tenant exercises its full expansion option. Those drivers position this data center investment to provide Realty Income with a growing rental income stream to support its rising dividend.
Opening the door to a massive growth opportunity
Realty Income's initial data center investment could be the first of many. The industry is undergoing a demand boom driven by cloud computing, AI, and other factors. Add in low vacancy levels, and companies will need to invest heavily to build more capacity:
Data source: Realty Income.
As the graph on the slide shows, the data center sector will grow significantly faster than the overall real estate industry over the next few years. According to Grand View Research, the U.S. will need to invest $400 billion into new data center developments through 2027.
That represents a massive opportunity for Realty Income. Many data center developers like Digital Realty have more projects than they can afford to fund. That's leading them to seek out partners to help finance new data center development projects.
The fellow REIT has spent much of the past year securing partners to help fund new developments. For example, it partnered with private equity giant Blackstone on a $7 billion development joint venture. Blackstone will help fund 80% of the cost to develop 500 MW of capacity across four data center campuses in the U.S. and Europe.
Data center operators are also using capital recycling strategies to fund new developments by selling stabilized assets. Digital Realty estimates that existing single-tenant data centers represent another $100 billion investment opportunity. Selling operating assets to a company like Realty Income would provide data center developers with cash to fund new projects. Meanwhile, those deals will supply the REIT with incremental income to grow its dividend.
Adding a potentially significant new growth driver
Realty Income's initial data center investment was small enough that it flew under the radar of most investors. However, it added a new property vertical that could become a meaningful growth driver, given the $500 billion of future investment opportunities in the sector. That large growth runway puts Realty Income in an even stronger position to continue expanding its portfolio and dividend in the future.
