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How to Analyze Data Center REITs

Dec 28, 2019 by Matthew DiLallo
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Most commercial real estate investments are relatively straightforward. A tenant signs a lease for physical space in a building, such as an apartment, office suite, or storefront, and pays rent to the property's owner. Because of that, Real Estate Investment Trusts (REITs) that focus on these segments of the market tend to be relatively easy for investors to analyze.

Data center REITs, on the other hand, are a bit trickier to understand because they not only earn rental income from leasing physical space to tenants but also make money by providing additional services. Here's what investors need to know about investing in the real estate that securely stores the data that's vital to our economy in the information age.

Data centers 101

Data centers are facilities that play a vital role in the storage and transmission of data. While many large technology companies own and operate data centers to store raw information for themselves and their clients, others outsource this activity to third parties, including data center REITs.

A data center REIT will typically own:

  • The physical data center, which includes the building core and shell
  • The power and cooling equipment
  • Exchanges and cross-connects, which are the physical sites and cables used by companies to exchange data between their networks.

Within these data centers, clients own:

  • The servers
  • Storage
  • Networking equipment

In addition to providing rentable space to house their clients' equipment, data centers deliver three essential services:

  1. High levels of security: This includes physical security at the site as well as ultra-secure network features.
  2. Reliable power: Data centers operate 24/7. Because of that, and their importance to their clients' operations, they must always be online. As such, data centers need both reliable power sources as well as backup generation that immediately kicks in should the primary power source fail.
  3. A regulated temperature: Servers produce lots of heat. Because of that, data centers need to provide a cool environment to keep this equipment from overheating.

How data center REITs make money

Most data center REITs get paid a recurring fee (i.e., rent) for space at their locations. Some, known as colocation (colo) data centers, rent space at a site to a multitude of clients, while others rent a facility to one customer.

The industry has three main classifications for third-party data centers based upon the amount of space a customer leases: hyperscale, scale, and retail.

Hyperscale data centers typically house one primary customer, which often leases the physical shell of the building under a long-term contract, usually 10 or more years, with multiple renewal options. These customers typically pay lower rent and don't usually require additional services, such as interconnection (which we'll discuss shortly). As such, REITs focused on operating hyperscale data centers tend to generate very predictable revenue.

Scale data centers, meanwhile, provide colo services to more than one large customer that rents big blocks of space under five- to 10-year contracts. REITs that operate scale facilities typically charge customers rent as well as fees to cover power and cooling costs, while their customers are responsible for everything else in their leased space.

Retail data centers also provide colo services, but for a much larger number of customers. These clients pay for rent on the space they use as well as power, installation fees, and cross-connects. The lease terms, meanwhile, tend to be much shorter at three to four years.

In addition, many retail-focused data centers provide their colo clients with other recurring and nonrecurring services. One of the most important is interconnection, which is a private data exchange between businesses. These interconnection fees enable data center REITs to make more money as they meet the needs of their customers.

What differentiates data center REITs?

The most important factor investors need to analyze when looking at different data center REITs is the type of facilities they focus on owning. That's because facility type can have a notable impact on their financial results.

While most data center REITs will own a diversified portfolio of facilities, some focus on specific types. CoreSite (NYSE: COR), for example, mainly operates retail data centers. This strategy has both benefits and drawbacks. On the plus side, its data centers can generate more revenue because they provide colo services to several customers as well as other services such as interconnection. On the downside, retail leases tend to be shorter in duration. Because of that, a site's revenue might not be as stable since customers could switch to a lower-cost provider. As such, a retail-focused data center REIT like CoreSite is a higher risk, higher reward opportunity.

Digital Realty (NASDAQ: DLR), on the other hand, focuses a bit more on the hyperscale and scale side of the data center sector, including leasing space at 21 of its locations to fellow data center REIT Equinix (NYSE: EQIX). Because of that, it has more revenue stability since its weighted average remaining lease term was 5.3 years at the end of September 2019. Those longer duration leases help reduce risk.

The key to analyzing data center REITs

Data centers are growing increasingly important to our digital world. Because of that, data center REITs have significant growth potential as the demand for data storage space increases.

Real estate investors, however, need to be mindful of what type of data center a REIT focuses on owning since that could have a notable impact on its returns. A retail-focused data center will likely be much more volatile than a company focused on scale and hyperscale since it will need to address a larger volume of lease expirations each year. If competition intensifies, rental rates could slide, potentially impacting its results.

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Matthew DiLallo owns shares of Equinix. The Motley Fool owns shares of and recommends Equinix. The Motley Fool has a disclosure policy.