It hasn’t gone unnoticed that Keppel DC REIT’s (KDC REIT) unit price is up some 19% this year while Digital Core REIT’s (DC REIT) unit price is unchanged although it is up 34% since its mid-year lows.
While both data centre REITs are listed on the Singapore Exchange (SGX), more than 50% of KDC REIT’s portfolio is in Singapore while most of DC REIT’s portfolio is in the US. This means the risk-free rates which DC REIT is priced off are US rates while KDC REIT is likely to be priced off Singapore’s risk-free rates.
As at Sept 21, Singapore’s risk-free rate is at around 3.39% while US risk-free rates are at more than 4.4%. KDC REIT is trading at a yield of around 4.6% compared to DC REIT’s 6.6%.
Following the IPO of DC REIT on Dec 6, 2021, its unit price moved above the IPO price of US$0.88 to a high of US$1.18. As at Sept 21, DC REIT is hovering around US$0.55 ($0.75). Here’s why.
DC REIT was listed at a forward yield of around 4.77% in 2021, compared to the then US risk-free rate of 1.4%. Following the Federal Open Committee Meeting (FOMC) on Sept 20 where the Federal Reserve left the Fed Funds Rate unchanged at 5.25%–5.5%, yields on 10-year US treasuries remain elevated at 4.4% while yields on two-year US treasuries rose to pre-Global Financial Crisis levels.
Based on DC REIT’s yield of around 6.9%, its current yield spread is lower than its yield spread at IPO. This is probably because most of DC REIT’s negatives have been priced in. With most of its debt hedged and the outlook for demand and rents at its facilities improving, its cash flows should stay resilient.
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DC REIT’s unit price came under pressure following the announcement of Cyxtera Technologies’ FY2022 results ended December 2022 on March 16 when it turned out that Cyxtera would have challenges refinancing its debt in 2024. Cyxtera is one of DC REIT’s largest tenants that filed for Chapter 11 in June as it struggled with some US$1 billion in debt.
On August 7, Cyxtera announced it had filed for a reorganisation with the US Bankruptcy Court for the District of New Jersey that would eliminate more than US$950 million of Cyxtera’s pre-filing debt. On Aug 11, Bloomberg reported that Brookfield and Digital Realty, the sponsor of DC REIT, are looking at Cyxtera’s assets.
Cyxtera says a few parties are looking at acquiring its assets and all interested parties had submitted their bids by Aug 18.
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Underscoring continued demand for modern data centres, John Stewart, CEO of DC REIT’s manager, during a results briefing on July 27 said: “Artificial intelligence has quickly become a buzzword and everyone wants a piece of the action. Data centre absorption reached a new record high in the second quarter, driven in part by several sizeable artificial intelligence requirements. Supply remains constrained across most core global data centre markets while demand has accelerated, driving continued improvement in pricing.”
Higher for longer
According to JP Morgan Asset Management (JPMAM), the refreshed Summary of Economic Projections (SEP) suggests FOMC intends to keep rates higher for longer “given the impressive resilience the US economy” has exhibited under higher rates.
“The upgraded growth and unemployment forecast suggests the committee sees only a short period of modest sub-trend growth next year followed by a more balanced economic environment into 2025 and beyond,” JPMAM says.
ING points out that 4Q2023 y-o-y growth has been revised higher to 2.1% from 1% and FY2024 y-o-y growth has been revised higher to 1.5% from 1.1%. The unemployment rate has also been forecast to fall to 3.8% from 4.1% for the year-end and fall to 4.1% from 4.5% next year.
“We expect bond yields to see further upside in the very near term given the Fed’s hawkish position. However, high interest rates will eventually cool the economy, leading to falling yields. Hence we remain constructive on duration over the next 6–12 months, not only long-tenor government bonds or investment grade corporate debt, but also assets that performed well when yields are falling,” JPMAM says. This includes growth and tech stocks that can leverage more on valuation re-rating, it adds.
“[Fed] officials are firmly of the view that they can generate a soft landing/no recession while guiding inflation towards the 2% target over time. This is a bold call given all the uncertainties out there and makes it appear more likely that the Fed will indeed carry through with another hike even though we don’t think it is necessary,” ING reckons.
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Markets are usually forward-looking and by their action, they are not anticipating an inflexion point in the trend of rising risk-free rates. However, Janus Henderson Investors’ portfolio manager Jason England and global head of fixed income Jim Cielinski note “securitised instruments have priced in more economic softening than have corporate credits and, consequently, may appear attractively priced should a soft landing, or even a shallow recession, materialise”.
That would include REITs such as DC REIT with its US portfolio where underlying demand remains robust.
