When the Federal Reserve hinted that a reduction in its monthly bond-buying program is likely, the move shook assumed interest rate sensitive areas like the real estate investment trust ("REIT") sector especially hard. For example, the iShares DJ US Real Estate ETF, one of the largest in the REIT category, dropped about 15% within the last six months.
As REITs took their lumps, the data center sub-sector showed some attributes that might appeal to the value investor. The industry's fundamentals looked good, its future seemed promising, and valuations appeared attractive. But a nagging question remained, should a data center REIT be considered a short-term play or could the sector be relied on for larger longer-term gains?
The what and why of data centers
Data centers are buildings that house a large number of computer servers and include the key infrastructure needed for their optimal operation. In the past, most companies kept their data center requirements in-house. However, a combination of globalization, bandwidth intensive applications, and cloud computing access, plus tight corporate budgets made the use of data centers increasingly sagacious.
The industry has grown significantly, thanks to favorable conditions. In general, revenue from the sector has more than doubled since 2008 and analysts believe that there's continued growth of around 10% a year for at least the next four years. Since data center REITs are just as profitable as other real estate peers, but with a lower debt profile, this conducive environment looks to offer room for meaningful advancement.
There are some concerns, however. Since high data center utilization is a fairly recent phenomenon, there isn't a lot of evidence on how the sector would handle a tough economic environment longer term. One major worry is the concentrated customer base these REITs seem to have. Digital Realty Trust (NYSE:DLR), a leading global provider, had 20 of its largest tenants generating 47% of annualized rent with the top three tenants generating 17% in 2012. DuPont Fabros Technology (NYSE:DFT), a smaller player, reported that three of its largest renters accounted for 48% of revenue. The risk from a single defecting large client seems very real.
Some notable data center REITs
Digital Realty Trust, having 127 properties with 23.7 million square feet worldwide, is a major data center player. It seems to be doing well with latest quarter revenue up 19.7% and adjusted booked funds from operations or FFO rising 11.2% from last year. FFO is an alternative financial measure used by the real estate industry to measure operating performance. FFO basically represents normally derived net income excluding items like impairment charges, gains and losses on real estate sales, and depreciation/amortization expenses.
An aggressive expansionary firm, Digital Realty shares might look interesting. Using a cash earnings times a capitalization multiplier valuation, fair value is around $63 a share, 22 times earnings, a discount from the REITs' 27 average multiple. Fair value being based on revenue of around $1.5 billion, cash earnings of $370 million, and a cash profit margin of around 24.7%.
DuPont Fabros Technology is a smaller operator. It has 10 data centers located in four major U.S. markets with a total of 2.5 million square feet. For its latest quarter, the company reported FFO jumping 22.7% from 2012 with revenues rising 11%.
While the company is currently focusing on maximizing occupancy, it is also developing a new location. The property, called ACC7, will be the first built using the a new efficient power usage design which should result in reduced energy costs for customers and lower operating costs. DuPont Fabros also has a $80 million stock repurchase plan in place, a rarity in the REIT world.
The company seems to be worth considering with a reasonable business value of around $27 per share at a 22 times multiple. But that's only if it can maintain revenue of around $370 million, cash earnings of $80 million, and a cash profit margin of around 21.6%.
Equinix (NASDAQ:EQIX), which connects more than 4,000 companies inside the world's most networked data centers, is a little different than the REITs previously mentioned. It is not currently a REIT, but is pursuing conversion and plans to make an election for REIT status for the taxable year beginning Jan. 1, 2015.
The company is also more of a hands-on data center operator, offering additional services such as technical support, remote services, and network monitoring more freely than other providers do. Its focus on having a wide-ranging neutral interconnection communication hub for cloud service providers, large financial companies, network service operators, and other large enterprises gives it a key competitive advantage. The company's scope also means that it has a more diverse customer base. No single client accounts for more than 10% of sales.
Equinix's recent growth has been impressive with revenues increasing 15% in its latest quarter, income from continuing operations jumping 10%, and its FFO equivalent gaining 8% from 2012.
Equinix shares look a bit rich with a reasonable fair value of around $158 a share at a modestly discounted 20 times multiple. This calculation is based on revenue of around $2.3 billion, cash earnings of $386 million, and a cash profit margin of around 16.8%.
Data center REITs certainly look intriguing. Their story seems solid and valuations appear mostly inviting, but the sector hasn't been time-tested like conventional REITs. It's not quite clear how data center REITs will fare over the long-term in a less favorable and more competitive environment. Nonetheless, they look an interesting shorter-term consideration.
Bob Chandler has a long position in DuPont Fabros. The Motley Fool recommends Equinix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!