Data centre Singapore REITs (S-REITs) are under pressure from recent headwinds, as concerns on one technology tenant’s financial health made headlines for its supposed impact on several names here.
That said, DBS Group Research analyst Dale Lai thinks investors can turn challenges into opportunities. He highlights Keppel DC REIT’s “diversified exposure”, which offers “longer-term growth”.
“The past year has been tough for data centre S-REITs [such as] Mapletree Industrial Trust (MINT) ME8U , Keppel DC REIT (KDCREIT) AJBU and Digital Core REIT (DCREIT) DCRU , where repeated news of potential vacancy risks has weighed on share prices,” writes Lai in an April 10 note. “The financial health of Cyxtera Technologies, a tenant across the three S-REITs, has weighed heavily on the sector.”
Lai has “buy” calls out for all three names, with the highest upside potentially coming from DCREIT, with a target price of 90 cents against a price of 45.5 cents on April 6. “We see a trading opportunity for DCREIT at 0.57x price-to-book (P/B), or 0.65x P/B after a 50% asset write-off for Cyxtera-leased facilities. We believe the market has substantially priced in the risk of nil income from Cyxtera with DCREIT offering more than 5.4% yield, the highest compared to peers.”
Meanwhile, KDCREIT is a “preferred long-term pick”, says Lai. “KDCREIT’s well-diversified portfolio and the full-year contribution of Guangdong DC 2 and 3 [the REIT’s first acquisitions in China] will drive a 4% growth in distribution per unit (DPU) in FY2024, and offers the most resilience.”
Spotlight on tenants
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News of tenants cutting back on space and their deteriorating financial health have raised concerns of leasing risks for data centre S-REITs, once thought to be in a structurally sound space, says Lai.
“As a result, the share prices of data centre-focused S-REITs have corrected by between 10% and 60% since the start of 2022. This has brought average FY2023F yields up to between 5% and 8%,” he adds.
In the first quarter of 2022, KDCREIT reported that the REIT will be suing its tenant, IT services and consulting company DXC, in Singapore over defaulted payments.
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This is due to a dispute in the provision of colocation services provided in one of its data centres in Singapore, which remains unresolved and has hit KDCREIT’s revenues.
For MINT, DBS understands that AT&T, which accounts for 6% of its revenues, may look to return space at its data centres in the US when the lease expires but a short-term extension was signed to spread out the expiries over the period from end-2023 and 2024. Rental payment has been prompt, adds Lai.
Sungard Availability Services posed another problem when it filed for Chapter 11 bankruptcy in April 2022. “We understand that the major contributing factors were a spike in energy cost and inability to pass these on to end customers. In addition to issues with its capital structure, Sungard’s woes were further dragged down by its loss-making workplace recovery facilities segment that was impacted by Covid-19 and high energy costs.,” writes Lai.
In August and October 2022, Sungard entered into asset purchase agreements with 11.11 Systems and 365 Data Centers for its North American businesses.
For the impacted REITs, DCREIT (7.0% of revenues) and MINT (1.1% of revenues), Lai says rentals were prompt during Sungard’s chapter 11 process. “To offer support to DCREIT, its sponsor also stepped in to guarantee any payments due to DCREIT from Sungard and replacement tenants have since been found for part of the space at its Toronto data centre. In the case of MINT, it has also renewed [its] leases, which closes the chapter for this tenant..”
What next?
Is Cyxtera Technologies the next leg to fall? The spotlight has now shifted to Cyxtera Technologies, which Lai says has leased several data centre facilities across a number of S-REITs.
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“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 Lai.
Cyxtera is a global colocation and interconnection data centre provider with 61 data centres in 29 markets. It currently operates in the US, Canada, Netherlands, Germany, the UK, India, Singapore and Japan. “In the past few years, Cyxtera has been growing its footprint rapidly to serve enterprise and service provider customers. In addition to working with data centre developers to build new facilities, Cyxtera has also committed capital to add capacity at existing facilities,” writes Lai.
Cyxtera was in a positive adjusted ebitda position in FY2021/2022 but financial metrics are stretched, says Lai. “Based on our understanding, Cyxtera’s capital-intensive expansion strategy to grow its business has probably put a strain on Cyxtera’s balance sheet, which prompted the company to enter discussions with its lenders to extend and modify certain loan terms. We did a quick comparison with two of the market leaders in the data centre space (Digital Realty and Equinix), and it is evident that Cyxtera’s capital structure is vastly different.”
Lai remains upbeat for a number of reasons. Firstly, DCREIT’s data centre facilities leased to Cyxtera are “under-rented”. The properties are in Silicon Valley and Los Angeles, where rents have been increasing strongly over the past two years and occupancy rates have remained high.
Compared to the passing rents at DCREIT’s properties, market rents are currently higher by as much as some 15% in LA, and some 40% in Silicon Valley. “Although this provides an immediate uplift in revenues for DCREIT, we also recognise that in the event of Cyxtera vacating the properties, there will be some downtime required to backfill the space. Moreover, there may be some undisclosed capex on the assets before releasing to new tenants.”
If the worst-case scenario unfolds, DCREIT’s earnings would have the largest impact as Cyxtera accounts for 23% of its revenue (compared to 2% for MINT and KDCREIT). “In our scenario analysis, while a total loss of revenues will set DPUs back by -3% to -31%, backfilling 50%-70% of the vacated space and at higher rents of between 10%- 20% will negate the impact to -1% to -7%.”
In addition, gearing levels remain below 40% even if Cyxtera-leased data centres are written down by 70%, says Lai. “Assuming a devaluation loss of 50%-70%, all three REITs will still be able to maintain a relatively healthy gearing level of between 37%-41%, way below the 45% limit.”
Overall, Lai recognises that concerns on the impact to DCREIT’s earnings are valid. “However, we maintain our confidence on DCREIT’s ability to recover from the worst-case scenario. Thus, we believe the large impact on DPUs will be temporary, and we would see a gradual earnings recovery within six to 12 months.”
Specifically, Lai believes that DCREIT is currently trading at such a deep discount that even in the event of the worst-case scenario unfolding, its current valuations have mostly priced in these negatives.
Units in DCREIT closed 1 US cent lower, or 2.08% down, at 47 US cents on April 11; while units in MINT closed 1 cent higher, or 0.42% up, at $2.39; and units in KDCREIT closed 1 cent lower, or 0.48% down, at $2.06 that same day.
