Data center REIT Digital Realty Trust (NYSE:DLR) has performed exceptionally well over the past decade, having more than quintupled investors' money during that time. And although performance like this can be tough to sustain for long periods of time, the trends in the data storage industry tell us that Digital Realty's brightest days may still be ahead of it.
What Digital Realty does
Digital Realty is the largest real estate investment trust that primarily owns and operates data center properties. A data center is a building designed to house servers and networking equipment and to store data in a secure environment.
For example, when you upload photos to your Facebook profile, they have to be stored somewhere. As you can imagine, the photos, videos, and other content uploaded by Facebook's billion users can take up a tremendous amount of storage space. That's why data centers are needed (and why Facebook is one of Digital Realty's biggest tenants).
The company owns 132 properties consisting of 24.2 million rentable square feet. About three-quarters of the portfolio is located in North America, but Digital Realty also has substantial operations in Europe and Asia. The properties are leased to a diverse group of more than 650 different tenants -- many of whom read like a "who's who" of the tech and financial world -- among the top 10 tenants are IBM, Facebook, AT&T, LinkedIn, and Morgan Stanley.
A strong business model
One of my favorite reasons for liking REITs as long-term investments is that they tend to have low-risk, high-reward business models, and Digital Realty is no exception. The company operates at net operating income margins of 73%-75% and doesn't need its properties to be highly occupied to make money. In fact, Digital Realty can produce a 4% return on invested capital (ROIC) with just 50% occupancy, and it would break even with occupancy of about 30%. And because the portfolio occupancy is currently 93.5%, the company is much closer to the 11% ROIC that comes from full occupancy.
Tenants sign long-term leases that generally have rent increases built in every year. Further, data center tenants are more likely to renew their leases upon expiration: The data center industry has an 84% retention rate, compared to a 55% average for other forms of real estate.
Finally, the company has been able to produce incredible performance without using too much debt. Over the past decade, investors have seen an average annual total return of 18.7%, and Digital Realty's funds from operations (FFO -- think of this as the "earnings" of the REIT world) have increased 15% per year. Remarkably, Digital Realty has been able to do this with less debt than most of its peers. In fact, Digital Realty's interest coverage is 4.9-to-one, meaning that the company earns nearly $5 for every $1 it pays its debtholders.
This gives the company lots of room to absorb adverse conditions and also allows it the financial flexibility to pursue attractive development and acquisition opportunities as they come up.
The trends are favorable going forward
It's understandable for investors to be cautious about certain types of real estate. For instance, given the trend toward online shopping and the numerous retail bankruptcies we've seen in recent years, it would make sense to think twice about buying a REIT that invests in say, shopping malls.
However, all signs indicate that Digital Realty's best days could be yet to come. One of the largest suppliers of hardware to data centers, Intel, expects revenue in its data center division to grow at a 15% annualized rate for the next several years.
Even more impressively, Cisco expects global IP traffic to nearly triple between the years 2014 and 2019.
This owes primarily to increasing connectivity across the world. More devices than ever are connected to the Internet, creating more need for data storage and streaming than ever before, and this trend is expected to continue. A study by GE Capital projects that the average person will own and use seven connected devices by 2020, up dramatically from an average of two in 2010.
The same study found that much of this need will be handled by multi-tenant service provider data centers (like the ones Digital Realty owns), as opposed to companies' internal data centers.
To sum it up, the industry trends are extremely favorable for data center development opportunities, and Digital Realty's industry-leading position and its financial flexibility should allow it to capitalize on these opportunities.
What could go wrong?
It's important to mention that no stock that's capable of double-digit returns is without risk, and Digital Realty is no exception.
For example, with its substantial overseas presence, the company is susceptible to foreign exchange markets. In fact, the company's 11.6% core FFO growth rate in the second quarter was cut to 7.4% by unfavorable FX trends.
And there is always the possibility that data needs won't grow as quickly as projected, which could present a problem for Digital Realty when it comes to finding tenants for its newly developed data centers. However, this risk is somewhat mitigated by the low breakeven point I mentioned; the company doesn't need its properties to be full to make money, but this is still a risk investors should be aware of.
Finally, there's always the risk of a recession or a market crash, which could mean Digital Realty would have a tougher time finding new tenants and renewing leases with existing ones. And, if one of the company's largest tenants fell on hard times and had to declare bankruptcy, it could put a serious dent into the company's profits.
I find it unlikely that any of these would occur to such a magnitude as to threaten Digital Realty's profitability, but a slowdown in the growth rate is certainly possible. Still, these risks are all worth taking into account when deciding whether or not to invest.
The bottom line is that Digital Realty has delivered market-beating returns because of the combination of a great business model and favorable trends for its target customer base. While the stock is not risk-free, the proven reward potential of an investment in Digital Realty more than outweighs the risks taken by owning it.
Although nobody can guarantee that Digital Realty's past performance will repeat itself, all signs point to good times ahead, and I wouldn't be surprised to see another decade (and more) of great returns.