Digital Core REIT undergoes a ‘realty check’

Goola Warden and Lim Hui Jie
Goola Warden and Lim Hui Jie8/3/2022 08:02 PM GMT+08  • 11 min read
Digital Core REIT undergoes a ‘realty check’
SIN12 is multi-tenanted and customers comprise a mixture of CSPs (cloud service providers), media companies and financial institutions
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SIN12, one of Digital Realty’s two data centres in Loyang and the newest of Digital Realty’s three data centres locally, is probably one of the safest places in Singapore. During our visit to SIN12, security was tight. In addition to the usual layers of security at the main entrance and the building entrance, there is a capsule visitors have to walk through before entering the data centre proper.

Digital Realty is the sponsor of Digital Core REIT (DCREIT). The latter was listed on the Singapore Exchange in December with 10 data centres.

William Heng, who oversees SIN12, and is in charge of the local sales and engineering team, points out that SIN12 is blast-proof, a requirement by the Monetary Authority of Singapore as stipulated in its technology risk management guidelines. These guidelines stipulate a framework for financial institutions (FI) to manage their system development life cycle (SDLC).

This security-by-design approach refers to building security in every phase of the SDLC to minimise system vulnerabilities and reduce the attack surface. That is why numerous physical security processes for visitors and staff are in place. According to the SDLC, security requirements should minimally cover key control areas such as access control, authentication, authorisation, data integrity and confidentiality, system activity logging, security event tracking and exception handling.

SIN12 has a capacity of 50MW and is multi-tenanted with a mixture of CSPs (cloud service providers), media companies and FIs. Barriers are high when it comes to FIs — especially banks — because data centres serving banks have to comply with a host of regulations.

“The key is security-by-design to make sure all the recommendations from external third parties on security threats are incorporated. For instance, we need a building that is blastproof because the columns of FIs must be of a certain thickness,” Heng describes. “This building allows us to onboard FIs and as it meets the requirements for all the threats to FIs.”

See also: Resilient DPU, stable valuations, faltering ICR

All three of Digital Realty’s data centres in Singapore are on the approved list of the Association of Banks in Singapore’s (ABS) OSPAR’s audited outsourced service provider. OSPAR stands for outsourced service providers’ audit report.

More than that, Digital Realty introduced PlatformDIGITAL recently. This is where Digital Realty’s data centres act as a place for companies and data to come together.

Not quite what Chanos had in mind

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“What you see in this building is similar to what we’ve built around the globe. The layout is the same whether in Singapore, London or Sydney. Global customers have that comfort of not going to a new provider in a new building,” says John Stewart, CEO of Digital Core REIT’s manager. This means that a global US bank can make use of Digital Realty’s services, platform and data centres in any part of the world. “Our customers are with us in 50 locations and that is part of the value proposition. They get the same experience whether in Singapore, San Francisco or Sao Paolo.”

In June, US hedge fund manager Jim Chanos was quoted by The Financial Times as saying that data centres in REITs and those that are not owned by Alphabet, Microsoft and Amazon are going to be behind the curve because the web service arms of the trio have their cloud services housed in their own leading-edge data centres.

Chanos is quoted as saying that although the cloud is growing, the cloud is the REITs’ enemy, not their business. This is because “value is accruing to the cloud companies, not the bricks-and-mortar legacy data centres”.

Stewart acknowledges that the web service arms of these giants have indeed built their own leading-edge data centres in the US. In Europe and Asia, the situation isn’t quite the same.

“Returns on development [of data centres] remain very healthy, in the high single digits to low double digits. The counterpoint of this would be these cloud providers are putting up 40% growth on multibillion-dollar businesses. Therefore, the notion that they would pivot from a very capital-light model to invest in high single-digit to low double-digit returns in physical infrastructure doesn’t jive with what we’re seeing in the real world,” Stewart says.

Moreover, Digital Realty follows its customers, including banks and FIs which are heavily regulated, serving them globally, whether in the US, Europe or Asia Pacific. In Europe which has privacy regulations, data centres in different countries have to comply with different regulatory frameworks. As such, it is more efficient for the likes of Digital Realty to service MNCs including CSPs in different jurisdictions.

Digital Realty’s bookings and new business have grown in tandem with cloud revenue but this is far from the only driver, Stewart says. “Digital Realty serves more than 4,000 customers across a broad cross-section of industry and geographic regions on its global platform.” The cloud is highly symbiotic with Digital Realty’s business, Stewart continues.

For more stories about where money flows, click here for Capital Section

“We see the world evolving to a hybrid cloud architecture. Data centres play a critical role in the digital economy. And third-party data centre landlords provide the physical infrastructure that enables a vibrant open community of enterprise customers exchanging traffic with other business partners on a global platform that offers access to a dense network of carriers and cloud providers,” he elaborates.

Ready for acquisitions

Despite a volatile six months since its IPO where inflation and interest rates have risen dramatically, DCREIT’s DPU in 1HFY2022 ended June 30 of 2.06 US cents (2.84 cents) came within 2% of its forecast DPU. In addition, unitholders will be paid a “stub” of 0.31 US cents for Dec 6–31, 2021.

DCREIT was listed on Dec 6, 2021. During a results briefing on July 28, CEO Stewart announced DCREIT’s expansion plans. DCREIT is ready to acquire data centres in Frankfurt in Germany, as well as Dallas and Chicago in the US.

Each of these assets was purpose-built as a data centre by Digital Realty from the ground up within the past five years. The properties are predominantly leased to leading global cloud providers and publicly traded IP service providers. According to Stewart, in Europe, where 60% of the acquisition portfolio is situated, the assets are primarily powered by renewable energy.

Based on data by data centre data provider datacenterHawk, absorption in the top five markets in Europe, led by Frankfurt in 1H2022, has already surpassed the total absorption for each of the past three years.

The Chicago asset is situated on the sponsor’s campus in Franklin Park and tethered to the sponsor’s dominant carrier hotel by a dark fibre. The Dallas asset is on the sponsor’s digital Dallas campus in the Richardson telecom corridor and is likewise tethered to the sponsor’s interconnection hub in Dallas.

“These assets would significantly enhance portfolio diversification and reduce customer as well as geographic concentration by introducing new customers to our roster and establishing a presence in new markets,” Stewart says. “We expect any transaction we undertake will be DPU accretive, and we expect to be in a position to sign the purchase and sale agreement and schedule the EGM during the third quarter.”

Turning conservative on capital management

During the July 28 briefing, Stewart pointedout that data centre demand is not directly linked to job growth or global GDP growth. This may reassure the investing community that DCREIT’s fortunes are not correlated to the recent selloff in tech stocks. Instead, data centre demand is tied to secular trends.

As an example, Stewart uses sponsor Digital Realty. “Digital Realty has generated positive y-o-y growth and dividends per share each and every year dating back to its IPO in 2004,” he says. During the Global Financial Crisis (GFC) and the global pandemic, Digital Realty performed favourably compared to the US REIT Index.

“During the capital constrained environment and the GFC, it was corporate IT outsourcing, along with a prudently managed balance sheet, that was responsible for Digital Realty’s performance. In the world of remote everything during the global pandemic, we experienced several years with a digital transformation in a matter of months.”

Stewart has also explained that the bankruptcy protection filing in April of Digital Core REIT’s fifth largest customer is unlikely to impact the rental income of a Toronto data centre.

“We have formally executed an agreement with our sponsor to make us whole for any cashflow shortfall through the end of 2023. Toronto is a very healthy market, and we have already received unsolicited customer interest for their entire footprint. We are bullish on the prospects of backfilling this capacity in the event the customer does reject its lease. But the bottom line from our perspective is that particularly with the cash flow support agreement with the sponsor in hand, this event is not expected to affect DPU,” Stewart explains.

Although yields on the 10-year US treasuries have fallen to nearer 2.5% as at Aug 2, from as high as 3.2% in mid-June, the US Federal Funds Rate which impacts policy rates in the US such as the Sofr (secured overnight financing rate) has moved up from around 50 bps in December 2021 to 2.25%–2.5% as at July.

“We will continue to face higher interest rates in the second half of the year, and all else equal, every 100 basis point move in Sofr will represent approximately a US$900,000 impact to distributable income in the second half of the year. However, we will continue to work diligently to mitigate the impact of higher interest rates through a combination of proactively managing controllable costs and creative investment activity,” Stewart says.

Based on the presentation of the results, the quantum for acquisition ranges from US$150 million to US$600 million. Stewart says the management team will remain flexible. “If the equity markets remain in hospital, we will execute the smaller transaction funded entirely with debt. If the equity capital markets continue to improve, we will look to take down a larger stake in the portfolio partially funded with equity,” he says.

Whatever the financing structure, Stewart articulates that he has “no intention of issuing equity at a deep discount to NAV”. On the contrary, if DCREIT, which had retreated to as low as 77 US cents in July and has rebounded to 86 US cents, trades at a large discount to NAV, the manager is likely to implement a unit buyback programme.

Steward outlines three prerequisites for a unit buyback programme from which the manager already has board approval. “First, we must have ample liquidity to fund the business. In other words, we won’t put the balance sheet at risk with buyback units. Second, all material information must be out in the market. And finally, our units must be trading at a meaningful discount to unlevered asset value. When these three conditions are met, we believe we have an opportunity to create value for unit holders by buying our assets for less than they’re worth,” he says.

In a results update, UOB Kay Hian set a target price of 98 US cents for DCREIT: “DCREIT provides a distribution yield of 4.9% for 2022 (versus Keppel DC REIT at 5.1% and Mapletree Industrial Trust at 5.1%). It deserves to trade at a premium as it is a pure play on data centres with acquisition-led growth supported by Digital Realty.” Furthermore, Digital Core REIT’s current portfolio of 10 data centres is less than five years’ old which makes them more energy efficient.

In the pipeline SIN12 complies with IMDA’s latest standards for newly-built data centres or newbuilds. For instance, it has a power usage effectiveness (PUE) of 1.3 or less. PUE or power usage effectiveness is the ratio of the total amount of energy used by a computer data centre facility to the energy delivered to computing equipment.

Singapore will require that new data centres have a PUE of 1.3 or lower. A typical data centre has a PUE of around 1.5– 1.7 while the newest data centres in Australia and South Korea, for example, have target PUEs of 1.2–1.4, according to Savills.

In addition, SIN12 will have green features. These include an energy-saving generator — just in case of power failure although this is a rarity in Singapore. The expansive roof terrace will be fitted with solar panels with an energy output sufficient to run utilities for common areas.

In the short term, according to IMDA guidelines, the maximum power available for new data centres is around 60MW. Hence, the number of new data centres will be very limited, with a maximum of three approvals in a new post-mortarium pilot phase, which begins in the second quarter of this year and which will last 12–18 months. The new data centres will also have a cap on their power use — all must be between 10MW and 30MW.

With these supply curbs, SIN12, along with its greener features and modern facilities, is most likely the largest major data centre that was approved before the Covid-19 pandemic.

While SIN12 is not in DCREIT’s portfolio, Stewart says it is “well suited” for the REIT. DCREIT’s mandate, he explains, are properties that are “stabilised and income producing”. As SIN12 was just completed, Stewart explains that it will have to be at least two years after delivery, should it be included. “But I think there’s a very good chance that this will be a DCREIT asset.”

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