S-REIT Digital Core REIT (DC REIT) had its baptism of fire following its IPO here on Dec 6, 2021. While its listing was met with much fanfare, all its debt during IPO was on floating rates.

Still, by the end of 1QFY2022 ended March 2022, the manager had ensured that 50% of DC REIT’s debt was fixed and by the end of 4QFY2022, 75% of debt was on fixed rates.

Fortunately, DC REIT’s aggregate leverage (LTV) as at Dec 31, 2022 is a relatively modest 34%, compared to the S-REIT sector, while its interest coverage ratio (ICR) of 5.7x is the highest among the US S-REITs.

DC REIT’s sponsor Digital Realty supported the REIT by stepping up with rental support, although this would eventually have to be paid back.

However, higher-than-expected interest expense — the actual interest expense was US$10.27 million (US$13.67 million) in FY2022 compared to a forecast of US$4.8 million — caused distributions per unit (DPU) to be 4.8% lower than forecast DPU at time of IPO.

Unlike the US office sector, vacancy rates for data centres in Northern Virginia, Northern California and Toronto where DC REIT has properties, is low at 2%–4%. And, with the development of AI and computing moving increasingly to the cloud, demand for the services offered by DC REIT’s tenants should remain steady.

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Since its IPO, two of DC REIT’s major tenants have faced certain challenges. One of them, Sungard Availability Services, which is DC REIT’s fifth-largest customer, filed for bankruptcy protection in April 2022.

However, the space vacated by Sungard has been partially back filled at similar rents to Sungard’s and DC REIT did not really suffer much loss in rental income.

The other major tenant is Cyxtera Technologies, which is a substantial provider of colocation services, has a stressed balance sheet, with a large loan maturity due in April and May 2024. Cyxtera is DC REIT’s second-largest customer and accounted for 22% of gross rental income in FY2022.

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“The spotlight has now shifted to Cyxtera Technologies, which we understand has leased several data centre facilities across a number of data centre S-REITs. There are concerns surrounding its stretched balance sheet. Again, we believe this is due to company specific reasons, while its core underlying business (as a colocation data centre operator) continues to perform well and remain profitable. For Cyxtera, its capital structure rather than its business has been a concern as it had experienced a phase of aggressive growth in prior years,” says DBS Group Research in a recent report.

According to the DBS report, the five properties rented to Cyxtera in Silicon Valley and Los Angeles are under-rented. That is, market rents are higher by around 15% in LA and around 40% in Silicon Valley. Before becoming too bullish, it must be noted that if Cyxtera vacates — and it has not filed for bankruptcy protection or anything of the sort — there will be some downtime and possibly capex before a new tenant moves in.

On the other hand, DBS reckons that gearing levels would remain below 40% if the Cyxtera-leased data centres are written down by 70%.

In our analysis, the revalued assets to total liabilities ratio is at 1.053x, implying that DC REIT’s stressed net asset value is positive.

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