nable to avoid the broader 'Tech Wreck' weakness, Data Center REITs are among the worst-performing real estate sectors this year with declines of nearly 30% - their steepest drawdown on record. But similar selloffs in 2014 and 2018 amid rising rate concerns ultimately proved to be rewarding buying opportunities for data center REITs.

Cloud computing demand remains insatiable and has historically been unaffected by uncertain economic conditions, but this "steadiness" has been a burden amid a sharp 'growth-to-value' rotation within the REIT sector.

While cloud spending continues to boom, it is increasingly concentrated in a smaller number of providers. The companies synonymous with cloud computing - Amazon ($AMZN), Microsoft ($MSFT), Google ($GOOGL), Alibaba ($BABA), Oracle ($ORCL), Salesforce ($CRM), and Snowflake ($SNOW) - are among the largest and most critical tenants of these data center operators, and have become even more critical tenants in recent years as a growing share of leasing activity has accrued to these "hyperscale" tenants which have increasingly dictated the terms of leasing agreements and pricing.

Valuations now appear quite attractive for these performance leaders given the red-hot M&A environment and earnings results showing record levels of leasing demand and renewed pricing power. These factors will fuel the estimated data center market expansion to $519B by 2025.

After three REITs were acquired last year by DigitalBridge ($DBRG), they recently acquired Switch, leveraging their own private equity platform to fuel a buying spree that has rapidly established the REIT into a legitimate player, although it plans to exit its REIT structure to focus on more diversified investments.

global data center market projections (2021-2025)
source: technavio

Meanwhile Digital Realty ($DLR) recently closed on a modestly-sized deal to acquire a 55% stake in Teraco, Africa's leading data center provider for roughly $2B in a deal that is expected to be 1% dilutive to Digital Realty's FFO in 2022, breakeven in 2023, and accretive beginning in 2024. DLR was also busy last year working on the public listing of Digital Core REIT as a standalone publicly traded vehicle listed on the Singapore Stock Exchange.

Digital Realty recorded its second-straight quarter of record leasing volume and, perhaps even more importantly, pricing power appeared to strengthen with cash renewal spreads rising by the most since Q3 2019. Digital Realty significantly expanded its interconnection and colocation business through its Interxion acquisition but remains a mostly wholesale-focused entity.

The value of each data center is largely a function of its position along the internet backbone, the physical fiber-optic network that links every connected-device across the world.

Equinix ($EQIX)
has the highest "quality" portfolio of network-dense assets. Equinix also reported strong results and raised its full-year (adjusted funds from operations) AFFO growth outlook to 7.2%, up 20 basis points from its prior outlook driven by "the best net booking performance in our history, fueled by strong demand across all three regions, robust net pricing actions, and near-record low churn."

top data center markets, market inventory, and rental rates per kW/month
source: nareit

But some analysts are betting against data centers, making them a battleground in the REIT space. Earlier this year, short-selling firm Chanos & Company launched a $200MM fund with a particular focus on data centers. Chanos' described the position as the firm's "big short" based on the thesis that "value is accruing to cloud companies, not the bricks and mortar legacy data centers.‚ÄĚ The short thesis has received pushback from data center REITs and the majority of the data center industry's sell-side analysts, who point out that while Chanos accurately characterizes the overall competitive dynamics over the past five years, the degree to which the cloud is a "zero-sum" game is overstated. In fact, the pricing power of these REITs has strengthened in recent quarters as strong absorption and moderating supply growth have sent vacancy rates towards record lows, and has started tilting the negotiating leverage back towards the landlords for the first time since before the pandemic.

‚ÄćA recent CBRE report noted that "demand for capacity more than tripled year-over-year in 1H22 as companies continued to shift toward hybrid cloud environments... but developers can barely keep up with demand. Among primary markets, almost 75% of under-construction capacity in 1H22 is already pre-leased. Vacancy rates fell from a year ago in all seven primary markets in 1H22 while the unprecedented demand is pushing up lease rates in the few areas where there is vacant space."

Sep 7, 2022
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