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Up 19% in 2020, Is Digital Realty Trust Still a Buy?

Jun 22, 2020 by Matthew DiLallo

Digital Realty Trust (NYSE: DLR) has been an outlier in the real estate investment trust (REIT) sector. The data center REIT's stock has enjoyed a double-digit gain despite all the volatility in the stock market.

That outperformance might have some investors wondering if the stock is still a good buy. Here's a look at the case for and against buying Digital Realty's shares right now.

The case for buying Digital Realty

Digital Realty has steadily grown its data center footprint over the years via acquisitions and organic expansion. This growth has paid big dividends for investors as the REIT has expanded its funds from operations (FFO) at an impressive 12% compound annual rate since 2005, powering 15 years of consecutive dividend increases and significant total returns.

The REIT has lots of room to continue expanding, given fast-growing demand for data storage capacity. Digital Realty has made a series of strategic acquisitions over the past several years to enhance its growth platform.

For example, in 2018, it formed a joint venture with Brookfield Infrastructure (NYSE: BIP)(NYSE: BIPC) to acquire Ascenty, which owned eight data centers in Brazil and had six more under development. That partnership has since expanded Ascenty's reach into other South American countries, and they recently agreed to build two new data centers in Mexico. Meanwhile, earlier this year, Digital Realty completed an all-stock, $8.4 billion deal to acquire Interxion, adding 54 assets and a large development pipeline to its portfolio.

Digital Realty complements its exciting growth prospects with a solid financial profile. The REIT has an investment-grade balance sheet and a reasonable 75% payout ratio for its 3.3%-yielding dividend. That gives it the financial flexibility to continue expanding its data center portfolio, FFO, and dividend.

The case against buying Digital Realty

While Digital Realty has a solid financial profile, it's not as conservative as it could be, especially given all the economic uncertainty. For example, its leverage ratio currently stands at 5.9 times debt-to-EBITDA, which is toward the high end for a REIT and well above the 3.9 times of data center peer Equinix (NASDAQ: EQIX). Meanwhile, it also has a higher dividend payout ratio than Equinix (75% to 44%). Because of that, Equinix has more financial flexibility to capture future growth opportunities.

Another potential concern with Digital Realty is valuation. Following its double-digit rally this year, shares recently traded around $136 apiece. With the company on track to generate about $6 per share in FFO this year, the REIT sells for a price-to-FFO ratio of about 23 times. While that's slightly cheaper than Equinix's ratio of 24 times, most REITs trade at a mid-teens multiple of their FFO, though investors typically pay a premium for faster-growing companies.

It's easy to justify that higher valuation given the outlook for data center demand and Digital Realty's growth prospects. However, companies are building new data centers at a rapid pace. That increases the risk that the sector could construct too much capacity, especially if the economy experiences a prolonged downturn.

Meanwhile, Digital Realty has relied heavily on acquisitions to power growth, including recently making a sizable deal for Interxion. Mergers and acquisitions (M&A) can be a risky growth strategy because of potential issues with integration, execution, and financing. If Digital Realty's growth engine sputters, investors won't be willing to pay a premium valuation.

The upside looks enticing

Digital Realty has done a fantastic job creating value for investors over the years because it has steadily grown its data center portfolio, FFO, and dividend. That upward trend appears poised to continue, given its recent development-focused acquisitions. Add in a compelling dividend, solid financial profile, and reasonable valuation, and Digital Realty looks like a good REIT to buy for the long haul.

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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Digital Realty Trust and Equinix. The Motley Fool recommends Brookfield Infrastructure and Brookfield Infrastructure Partners. The Motley Fool has a disclosure policy.