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Smart Money Is Investing Here -- Should You?

By Bill Stoller - Oct 14, 2013 at 3:57PM

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Why this recent IPO didn't make it onto your radar screen.

On Oct. 9, 2013, a gutsy little company, QTS Realty Trust ( QTS ), rang the opening bell at the NYSE to celebrate its IPO. It was not front-page news. The shutdown of the federal government by Congress and looming debt ceiling debate certainly overshadowed the event.

However, there was no shortage of tweets regarding Twitter's plans for its upcoming IPO. Individual investors will soon have an opportunity to buy shares in a leading social media company where users co-create pop-culture trends in real time.

Surfing the wave of online memes requires an ocean
There is a bunch of mission-critical infrastructure behind each 140 character tweet.

If you believe in the growth prospects of a company like Twitter, it isn't a giant leap of faith to conclude that companies focused on providing the facilities and infrastructure for wireless communications, information technology, and e-commerce should prosper moving forward.

Wall Street just gave a big thumbs up to this asset class
Just a week prior to QTS Realty becoming a publicly traded data center REIT, a Prudential Financial real estate fund, PREI, invested in 80% of a joint venture created by Digital Realty ( DLR 1.38% ). Digital contributed nine large data centers totaling just over one million square feet of 100% leased data center space. This JV was valued at $366 million, or $346 per square foot. 

This was the first time a highly regarded institutional investor had decided to make data centers part of its core real estate holdings. Smart money is beginning to flow into this REIT sector. PREI senior portfolio manager Cathy Marcus said, "The long lease terms and contractual rental rate increases on these Powered Base Building data centers provide a stable income stream..."

Does size really matter?
In the data center REIT sector, size does matter, but perhaps not in the way you may think. 

Digital Realty operates 127 facilities worldwide, serving over 600 customers totaling 23 million square feet. By comparison, QTS Realty operates 10 data centers supporting more than 850 customers in 3.8 million square feet -- with currently only 714,000 built out as raised floor space.

How has Digital Realty performed compared to its smaller peers?

DLR Total Return Price Chart

As you can see, not so well.

How does QTS stack up to its larger rivals?
If you look at who is incubating the most customers with potential for growth, Digital Realty isn't the leader. Based upon company websites, Digital Realty has over 600 tenants; CoreSite ( COR 0.16% ), who focuses on interconnection, has over 750 customers; and newly minted QTS, as of June 30, 2013 had 870 customers.

One metric to keep an eye on
The number of customers per 1,000 square feet might be an indicator of future growth potential for data center REITs. Let's face it, not all technology companies will thrive over time. 

The large Fortune 500 companies have the resources to build and operate data centers without impacting the bottom line. On the other hand, small to mid-size companies need to reinvest capital into core business initiatives, or they will wither and die.

That is not to say that large companies can't benefit from outsourcing IT, but the sales cycle is likely going to be a long process.

Why a disappointing debut may be an opportunity
When you look at customers per 1,000 square feet of data center space, QTS Realty is the leader, with a 870 customers leasing 714,000 square feet for a ratio of 1.19. CoreSite Realty, which has outperformed the sector, has 750 customers leasing 1.2 million square feet, a ratio of just 0.63. Sector giant Digital Realty has the fewest customers -- 600 -- who lease 23 million square feet of space -- the greatest amount -- yielding a tiny ratio of 0.026. 

Please keep in mind that is a back-of-the-envelope metric, not an industry standard.

Investor takeaway
Based upon SEC filings, QTS had hoped to raise $356 million based upon the projected mid-range IPO pricing of $28.50 per share. They actually sold 12.5 million shares at $21.00 per share, raising only $257 million.

QTS Realty's poor IPO debut may be a blessing in disguise for investors -- if you believe that big data, wireless communications, and e-commerce are growing faster than the economy as a whole. QTS Realty is planning to spend $277 million to add 312,000 square feet of customer space over the next two years.

The QTS Realty IPO is looking attractive from both a growth and a value perspective.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Digital Realty Trust, Inc. Stock Quote
Digital Realty Trust, Inc.
DLR
$167.42 (1.38%) $2.27
CoreSite Realty Corporation Stock Quote
CoreSite Realty Corporation
COR
$170.34 (0.16%) $0.27
QTS Realty Trust Stock Quote
QTS Realty Trust
QTS

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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