Investing in Big Data with Data Center REITs
Andrew Carnegie once said that 90% of millionaires have achieved their wealth through owning realty. Americans better hope that’s the case, because the lower the income of a homeowning household, the greater the share of its wealth coming from homeownership. According to the historical Survey of Consumer Finances data, that pattern has remained consistent over the past three decades. Here’s a look at how much wealth the average American has tied up in their home by income bracket (results from 2019) courtesy of First American Financial Corporation:
- Lowest-income households: 75%
- Middle of the income distribution: 50-65%
- Highest income households: 34%
For those who don’t want to physically own a home, there are other avenues for getting exposure to residential real estate such as fintech firms like Arrived Homes and of course Real Estate Investment Trusts (REITs).
About Real Estate Investment Trusts (REITs)
In 1960, President Roosevelt signed legislation to create a new vehicle that would allow Joe American to enjoy the benefits of commercial real estate investing with a vehicle that resembled a normal stock. Following America’s lead, 40 countries today offer investment vehicles that resemble the following description of a REIT taken from Nareit:
REITs, or real estate investment trusts, are companies that own or finance income-producing real estate across a range of property sectors. These real estate companies have to meet a number of requirements to qualify as REITs. Most REITs trade on major stock exchanges.Credit: Nareit
The above definition talks about companies having to “meet a number of requirements,” the most notable being the need to pay out “at least 90% of its taxable income in the form of shareholder dividends each year.” So how come some REITs have payout ratios less than 90%? The answer lies in examining principles of accounting that are so dreadfully boring we would lose half our readers in an instant. We’ll simply conclude by saying that REITs are a large asset class that offers growing streams of income across various “sectors” including:
- Commercial Real Estate
- Cell Phone Towers
- Data Centers
It’s that last sector that we’re going to talk about today.
Data Center REITs
Despite what it says on the tin, “the cloud” doesn’t live in the sky. The world’s biggest cloud computing companies house all that data storage in large warehouses with industrial-grade security for limited access, generators for power backup, and cooling equipment to manage heat from all the servers contained within. A typical business model would be for a data center to provide the infrastructure and companies to then lease space to house their server equipment. This is referred to as “colocation.” Another business model is “interconnection” where data is exchanged privately between businesses. Then there’s “wholesale,” (also referred to as hyperscale) which consists of the large cloud providers who seek bulk data center storage capacity.
Data center REITs usually represent a mix of the above three business models. It may not be a traditional real estate model, but data center REITs own roughly 30% of investment-grade data center facilities in the United States and command roughly a fifth of data center capacity globally. That’s according to a firm called Hoya Capital which lists out six total data center REITs for investors to dabble in.
The above list includes two of the top-ten largest REITs in the world – Equinix (EQIX) and Digital Realty (DLR) – which are names of interest since we always look to invest in leaders for whatever domain we invest in.
On the surface, the idea of a data center REIT sounds appealing. Both these companies have a broad customer base with no single customer accounting for more than 3% of revenues. They’re rapidly expanding by building out more data centers and acquiring growth, and Digital Realty is even amassing quite the track record of 18 years consecutive dividend growth. But there are downsides as well.
The business models are exceptionally complicated and difficult to understand with both companies taking on large debt loads. Both firms seem to have an unhealthy obsession with D&I, a divisive practice within organizations that encourages discriminatory hiring practices and forces employees to engage in identity politics. Equinix even has the audacity to say they’re “creating a culture where everyone can confidently say, “I’m safe, I belong, I matter.”
Wrong. Your ass isn’t safe at all. If you don’t perform to expectations, you don’t matter, and you’re getting shown the door. A company’s fiduciary responsibility to shareholders is to create a culture of performance, not a safe space where incompetent people can thrive while rock star performers quickly exit to companies where they’re judged based on merit. When there’s that much fat on the hog to trim, you know that these companies have become lazy and inefficient because the fruit has been hanging low. Once interest rates start rising and those debt loads start to feel the pressure, once companies start to feel the impact of a market where capital starts drying up, all those BIPOC “Days of Understanding” events will be replaced with days spent doing actual work.
Update 6/03/2022: The debt loads both these companies carry are largely fixed interest rate, though there is some unhedged variable rate debt. That said, the combined debt load of about $26 billion will need to be paid back some time or refinanced.
Before we get too far into evaluating the pros and cons of these two data center REITs, we need to determine if this is a safe space we’d want to invest in, to begin with.
The Appeal of REITs
We always emphasize the importance of asset class diversification. Having assets that aren’t correlated to tech stocks – the riskiest asset class we’re holding – ensures that our wealth doesn’t evaporate every time there’s a dot-bomb dilemma. REITs have historically shown to become less correlated with stocks as time passes which is part of their appeal. So is income, which is why we’ve invested in three REITs as part of our dividend growth investing strategy. Here are the three reasons we’re holding REITs.
- To provide a diversification effect since REITs are weakly correlated to the broader stock market
- For exposure to realty as an asset class
- To provide a growing stream of income
Regarding the first bullet point, a downturn in the tech industry won’t do any favors for data center REITs. Even though they advertise a breadth of industry types occupying their data centers, maybe it’s best to think like any CTO would. When it comes time to cut costs, does it make sense to try and negotiate lower terms with a data center provider? Or does it make sense to utilize cloud capacity from a major cloud provider like Amazon that gets the absolute lowest rates based on economies of scale? As capital dries up, companies go out of business, and that will affect data center REITs as well. Amazon, Microsoft, and Google collectively now account for more than 50% of the world’s largest data centers across the globe according to an article by CRN which talks about how these three firms had 600 data centers at the end of 2020.
Regarding our second bullet point, data center REITs don’t provide us exposure to realty which makes the label seem misleading. Sure, there’s some warehouse space being leased or outright owned for the 522 data centers these two large REITs operate, but it’s not real estate we’re getting exposure to here. What we’re exposed to is demand for data center space which could change based on the 500-pound cloud computing gorillas meandering about. For example, Digital Realty drives 60% of their revenues from the large cloud provider types who demand the lowest of prices and have little allegiance to vendors. They’re also exposed to America where 80% of their revenues come from. If we want exposure to realty, we’ll own traditional REITs. If we want exposure to the growth of data centers, we’ll look to NVIDIA (NVDA) – our largest holding – which now drives 45% of total revenues from their data center segment.
Regarding our third bullet point, the last place we’re looking to find income is in growth stocks. The majority of our money is invested in a dividend growth investing strategy we spent the last decade developing which produces a growing stream of income every year. As part of that strategy, we’re holding three REITs which have increased their distributions for an average of 38 years in a row. That’s nearly as long as Amy Schumer has spent failing at standup comedy.
Having additional exposure to the growth of big data is appealing, provided we find a solid pure play company that isn’t behest to the whims of the world’s largest companies. Data center REITs seem to offer the risks of tech stocks with the rewards of boring old REITs. In financial lingo, the Sharpe ratio feels out of whack.
Investing in a data center REIT is taking on too much risk – much of which comes from not being able to understand the businesses because of all the moving parts – without all the promise of meaningful upside. We already have plenty of income coming from our 30-stock dividend growth investing portfolio with the average company having increased their dividend for 44 years in a row.
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Thanks for the well written article. It would be great if we could get a stand-alone informational article on REITs since they have different financial measures to take into account, such as Free Cash Flow (FCF) and whether to use FCF/share to compare different REITs or if Price to Book is more useful. Thanks
You’re quite welcome Spac Jesus. Looking under the hood of REITs can quickly cause a migraine. They seem quite difficult to understand, which is precisely why the article you’re requesting is a great idea. What we might do – since it’s not directly related to tech – is produce a YouTube video on that topic. Stay tuned, and make sure to subscribe to our YouTube channel as the content oftentimes compliments these research pieces. Link to subscribe to our channel below:
Thanks for taking the time to write this article about my suggestion! It helped me in my selection of asset. Great article!
You are welcome Dominic. We will always try to cover companies or themes requested by paying subscribers if they are relevant to the various tech themes we cover.
Many thanks for this great piece of research. I was just looking for investing into one of the big twos. However, after this article I understand more about Digital Reits and will spend my mony otherwise
You are quite welcome. We’re glad you found this piece insightful!