Data Center REITs Will Continue to Deliver Outsizes Returns

In the REIT sector, data center REITs are looking more and more like all-star players as customers expand the playing field for cloud computing, e-commerce, connected devices, high-definition video, self-driving cars and other data-dependent innovations.

“We characterize the data center REIT sector as being in the second or third inning, which implies there is significant future runway for growth in the sector—well above any other REIT product type,” says Diane Morefield, CFO at CyrusOne Inc., one of half a dozen publicly-traded data center REITs in the U.S.

To underscore that outlook, Morefield points out that over the past 12 months, the stock price return for data center REITs has been 30 percent, compared with 6 percent for the stock index encompassing all U.S. REITs. CyrusOne’s stock price has more than tripled since the company went public in 2013, she says.

As data center REITs like CyrusOne compete to meet the rising demand for space, they’re growing by way of buying and building.

Most notably, data center REIT Digital Realty Trust Inc. recently wrapped up its $7.8 billion purchase of DuPont Fabros Technology Inc., and data center REIT Equinix Inc. snagged 29 Verizon data centers for $3.6 billion. CyrusOne, for its part, is spending about $300 million a year on acquisitions; to fuel growth, the REIT has boosted its unsecured credit facility to $2 billion, up from over $1.5 billion.

Meanwhile, data center REITs are sinking a pile of money into putting up new structures. At Digital Realty, for instance, CEO Bill Stein has said the REIT’s construction spending is hovering around $1 billion a year.

In addition, data center REITs are laying the groundwork for even more expansion by snatching up land. For example, CyrusOne recently purchased a 48-acre site in central Washington State and a 66-acre site in suburban Dallas-Fort Worth.

A report from commercial real estate services company CBRE notes that investment in U.S. data center real estate soared to a record $18.2 billion in the first half of 2017, more than doubling the amount invested in all of 2016. “At this pace, investment in the data center sector is on track to surpass the total for the three previous years combined,” CBRE researchers write.

In a recent global survey by law firm DLA Piper, commercial real estate executives identified data centers as the third most attractive category for investment, behind the healthcare and industrial sectors.

“I think over time there will be more and more interest [in the data center industry],” says Lukas Hartwich, a research analyst. “And over time that will probably whittle down the returns for the sector overall.”

However, Hartwich, who tracks the data center sector for research firm Green Street Advisors in Newport Beach, Calif., says that shakeout likely wouldn’t happen “for quite a few years.”

For now, the public market for data centers is enjoying above average returns, he says, but the data center business isn’t as attractive as some other sectors, such as multifamily and manufactured homes. However, the data center segment outshines sectors like office, industrial, student housing and triple net lease, Hartwich notes.

Hartwich doesn’t foresee any technological disruptions that would “completely derail” the data center sector for at least the next couple of years. In the near term, the supply-and-demand factors that are fueling the sector’s success “will remain strong.”

Burl East, manager of the Altegris/AACA Opportunistic Real Estate Fund, is among the investors who are betting that the data center sector will remain strong.

Data center REITs make up the largest share—22 percent—of the portfolio for the San Diego-based mutual fund, which has about $200 million in assets under management for high-net-worth and institutional investors. In contrast, 6.4 percent of the overall market is invested in data center REITs, according to East.

“That’s a reflection of our optimism and enthusiasm for the underlying dynamics of the business,” he says.

By comparison, the Altegris/AACA fund has dumped all of the stock it owned in retail real estate within the past year, East notes. Retail real estate had represented about 7 percent of the fund’s allocations, he says, versus 15 percent for the overall market.

“Imagine if I’m wrong, and data centers do really poorly and retail does really well. I’ll be crushed, right?” East says. “So to be right, you need to take the risk that you might be wrong …”

East is willing to take that risk because, in part, it’s difficult for new competitors to break into the data center sector. Also, with only a handful of players, the data center industry is a “tidier business” than, for example, multifamily, which is crowded with thousands of owners of institutional-grade apartments, he says.

The data center business “has a multi-year, aggressive growth profile,” East says.

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