Data center REIT shares have rewarded patient investors with gaudy price appreciation. The question now is whether all the good news has already been baked into the share prices.
Publicly traded data center providers continue delivering incredible returns year-to-date, with a sector-average return of about 40 percent. How long can this trend continue?
It’s impossible to predict future prices for publicly traded companies. However, looking at factors driving the outperformance, calculating a few valuation metrics, and considering some recent calls by an influential sell-side analyst, may shed some light on share price sustainability going forward.
Tale of the Tape
As we pointed out in August, poor performance of the data center REIT sector at the end of 2018 has exacerbated shareholder returns this year.
The Vanguard Real Estate ETF (VNQ) is the largest real estate-sector exchange-traded fund and a good proxy for the broader REIT sector performance. Clearly, owning the five data center REITs in an equal-weight portfolio would have significantly outperformed VNQ so far this year.
A Sell-Side Factor?
On Friday, Morgan Stanley analyst Simon Flannery published a research note with an overall theme of technology REITs, including wireless towers and data centers, now trading at premium multiples.
Flannery downgraded Digital Realty Trust to Equal Weight from Over-Weight, raising the price target to $122 from $118 per share (still -3 percent from the previous close). Conversely, Morgan Stanley upgraded QTS Realty to Over-Weight from Equal Weight, raising the price target to $56 from $48 per share, representing a 16 percent upside from the prior close.
He maintained Equinix at an Equal Weight rating, raising the price target to $510 from $435 per share. Frankly, this appears more like a "Sell" rating, since $510 was -9 percent from the prior close, and is now -12 percent from the Equinix closing price on Monday (EQIX shares hitting yet another 52-week high at $582.14 per share). Notably, the analyst consensus price objective for Equinix shares is $566 per share.
Factors Driving Data Center Outperformance
A confluence of factors is likely behind the recent run-up in the data center REIT sector. Here are a few to consider:
Secular tailwinds: The relentless growth of data and cloud computing, machine learning, Software-as-a-Service, content distribution, social media, ecommerce, and cloud-first or hybrid IT architecture for enterprise applications, combined with migration of applications from legacy corporate data centers. This attracts shareholders looking to participate in the long-term growth by owning digital infrastructure REITs like towers, fiber, and data centers.
Interest rates: The US Federal Reserve has morphed from a hawkish consensus in Q4 2018, when a rate hike spooked equity markets, to a more dovish stance, with two 25 basis point rate cuts so far this year. In the short term, falling interest rates tend to become a tailwind for the entire REIT sector. Real estate investment trusts by law must distribute at least 90 percent of taxable income as distributions to shareholders. So, income investors hungry for yield bid up the price of REIT shares when bond yields fall.
Recession concerns: A slowdown in business capital expenditures due to the uncertainty caused by the US-China trade war, the potential for a no-deal Brexit negatively impacting economies UK and EU economies, and tensions in the Persian Gulf impacting the price of oil. Meanwhile, China's manufacturing has slowed to its lowest level in 17 years, creating a headwind for global GDP growth.
Why IT Spending Will Continue
If consumer confidence were to sour due to a combination of these factors, it could lead to flat to negative growth for the US economy.
However, the digital transformation and hybrid IT solutions being deployed by traditional Fortune 1000 enterprise will likely continue unabated. Performance-sensitive applications, SaaS, and digital content distribution usually require a geographically distributed IT architecture to provide a good user experience for both business and consumer clients.
Enterprises and small businesses need to access multiple public cloud providers, which often means collocating servers and network gear in third-party data centers– especially those offering secure cloud nodes, IT service providers, and multiple network options – adjacent to adequate fiber to handle evolving bandwidth requirements.
Additionally, elastic software-defined network (SDN) options, such as those provided by Megaport, PacketFabric, and Epsilon, can provide on-demand connectivity options for colocation customers. In addition to flexibility, these types of service offerings can make third-party data centers an attractive option due to the ability to expand in place, and in some cases provide a more cost-effective solution.
The main question vexing investors right now is how high can data center REIT prices go?
It’s worth looking at current valuation multiples based upon analyst consensus AFFO (Adjusted Funds from Operations) per share. AFFO is the best measure of REIT sector free cash flow, as it reflects cash spent on maintenance Capex in addition to adding back depreciation, amortizations, and other non-cash adjustments.
It appears that QTS is trading close to its "normal" multiple of 19.6x 2019e AFFO, and Digital Realty is trading close to its "normal" 19.2x 2019e AFFO per share multiple.
On the other hand, there are three data center REITs that have been bid up to higher multiples than historical averages.
Equinix is trading at 25.7x 2019e AFFO versus its "normal" 20.9x AFFO per share multiple, and 23.5x 2020e AFFO per share. So, is this the beginning of a new normal for Equinix, or will there be a reversion toward the historical average?
CyrusOne shares appear to have had a boost from Bloomberg reports that several private equity groups and at least one data center REIT peer – Digital Realty – may be considering the company as an acquisition target. CyrusOne is currently trading at 22.2x 2019e AFFO per share multiple versus its "normal" 17.1x 2019e AFFO per share, and 20.1x 2020e AFFO per share.
CoreSite Realty is trading at 23.5x 2019e AFFO versus its "normal" 20.9x AFFO per share multiple, and 22.6x 2020e AFFO per share. In 2020, CoreSite will be bringing online significant expansions is key markets in Silicon Valley, Chicago, Los Angeles, and Northern Virginia.
Data center REIT shareholders now have a "happy problem," deciding between taking profits by trimming or selling one or more positions or holding for the long term and "lettting your winners run."