Exuberance over data centre assets, although worrisome, may not be in bubble territory just yet. All of us are using more data, spurred not only by fun stuff like Tik-Tok and Instagram story but also serious stuff such as cloud adoption by businesses, e-commerce, internet of things, autonomous vehicle, AI, 5G roll-out, distributed ledger technology, digital assets, cryptocurrencies, edge computing, FinTech — the list goes on.
According to real asset consultant Turner & Townsend, demand for data centre storage is at an all-time high but there are supply constraints. “Supply chain disruptions due to Covid-19-related delays and pent-up demand have had a severe impact on the data centre sector in Europe. Global steel prices have more than doubled in the past 12 months in Europe, according to the London Metal Exchange. As well as price increases, long lead-in periods are impacting data centre programmes, especially the supply of equipment such as generators and switchgears. It is common at the moment for switchgear to have a 12–16 week lead-in. Similarly, the war for talent continues to impact the data centre sector. Skills shortages persist, and the need to retain and attract talent and diversity into the sector is vital,” says the consultant.
Data centres also require power — lots of it. And although power supply tends to be more reliable in developed markets, they are among the ones which are most environmentally conscious. In addition to power, strong intellectual property laws and other legal and regulatory frameworks all favour developed markets as the first choice for data centres.
Renewable energy is increasingly being used as 75% of the power supplied to data centres in Europe will be through renewable energy or carbon-free energy by 2025, with an aim to reach 100% by 2030, according to the Climate Neutral Data Centre Pact.
Data centre locations such as Stockholm are tapping renewable energy for its new data centres. Singapore is also attempting to switch to renewable energy for its new data centres.
Even then, there are no shortages of funds making a beeline for Chinese data centres. On Nov 30, GLP announced the completion of the first phase of development at GLP Changshu Southeast Data Centre, a brand new data centre campus located in Changshu High-tech Industrial Development Zone in Jiangsu province. Once fully operational, the facility is targeted to provide more than 120 megawatts (MW) of IT capacity.
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In April, CapitaLand announced it was acquiring a hyperscale data centre campus in Shanghai for RMB3.66 billion ($757.7 million). In July, Keppel DC REIT (KDC REIT) also announced its plans to acquire a data centre within a data centre campus in Guangdong province.
However, the world’s largest data centre market is none other than the United States. And New York-listed Digital Realty Trust (NYSE stock code DLR), a provider of cloud and carrier-neutral data centre, colocation and interconnection solutions, is the sixth-largest REIT on the exchange. One of the world’s largest data centre owners, it was overtaken by Blackstone after the latter acquired QTS Realty earlier this year.
Digital Realty and Ascendas REIT
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Soon, Digital Realty will loom large over S-REITs with data centre portfolios. By Dec 6, Digital Realty will be the sponsor to an S-REIT, Digital Core REIT (DCR). DCR will own 10 data centre properties based in Northern Virginia, Silicon Valley and Los Angeles.
The portfolio, valued at US$1.44 billion ($1.97 billion) on a 100% basis, has an expected net property income (NPI) yield of around 4.8% based on the NPI of US$66.86 million for FY2022. DPU in FY2022 is forecast at 4.18 US cents, giving a yield of 4.75% based on the IPO price of 88 US cents. In a recent briefing, John Stewart, CEO of DCR’s manager, emphasised that DCR will be Digital Realty’s only S-REIT although the latter has dealings with other S-REITs.
In March, Digital Realty announced it had completed the sale of a portfolio of 11 data centres in Europe to Ascendas REIT. Four are in the UK, three in the Netherlands, three in France and one in Switzerland for a total ofsome US$680 million. The consideration for the four data centres in the UK was GBP250.25 million ($456.09 million) and the consideration for the seven data centres on the continent was EUR276.85 million ($429.94 million). The portfolio is expected to generate a net operating income of around US$43.5 million this fiscal year, according to a Digital Realty press release.
“These 11 legacy assets are almost fully leased and this portfolio sale enables us to harvest value from stabilised properties and reinvest the proceeds to fund the continued expansion of PlatformDIGITAL in support of our customers’ needs around the world,” Digital Realty’s chief investment officer Greg Wright had said about the transaction.
For his part, William Tay, CEO of Ascendas REIT’s manager, said at the time of the acquisition that the total acquisition cost was $906 million, with an NPI of $55 million. This gives it a yield of 6% before expenses and 5.7% including expenses.
“The standout feature is they are located in tier-1 cities in Europe where the valuation capitalisation rate ranged from 5.6% to 6.7%,” Tay had said when the acquisition was completed. The buildings are mature and Tay has acknowledged that some capital expenditure is needed. However, this is unlikely to shift the needle on return on investment markedly.
The new portfolio comprises 55% powered shell data centres by asset size and 65% powered shell data centres by NPI. Colocation data centres account for 45% of assets and 35% of NPI. The data centres are located in Frankfurt, London, Amsterdam and Paris — the so-called FLAPD cities (the D stands for Dublin).
Amsterdam and Frankfurt have imposed controls on new data centre construction for the time being, placing Ascendas REIT in a plum position. However, its asset size of more than $16 billion implies that its data centre portfolio accounted for just 10% based on assets.
MINT’s higher cap rates than DCR’s
Among the S-REITs, Mapletree Industrial Trust (MINT) has taken the largest steps to increase its exposure to data centres since it acquired a stake in its first data centre portfolio in late 2017. As at Sept 30, data centres accounted for 52.9% of its portfolio. Its total asset size of $8.5 billion implies that MINT’s portfolio is larger than either Keppel DC REIT’s or upcoming DCR’s despite the latter two being pure data centre plays.
In terms of comparables, MINT’s and DCR’s portfolios are in the US, largely freehold and a few of the properties are in the same region. In fact, MINT, along with sponsor Mapletree and Digital Realty, are partners in a hyperscale portfolio.
Capitalisation rates are based on the income a property receives, the outlook for rents and occupancy over a 10-year period, and in-place rents and occupancies.
As at March 31, MINT’s capitalisation rates for its US data centre portfolio ranged from 5.5% to 8%. This includes a $1.6 million revaluation gain. The capitalisation rate of DCR’s portfolio ranges from 4% to 4.75%.
Both MINT’s and DCR’s portfolios are mainly freehold. DCR’s data centres are situated in Northern Virginia, Silicon Valley and Los Angeles. MINT’s largest markets in the US are Northern Virginia and Georgia but also owns assets in Texas, the Carolinas, California and Arizona as well.
In May, MINT acquired a portfolio of 29 data centres in the US for about $1.782 billion from Silas Realty Trust, which has transformed into a pure healthcare REIT play. The NPI yield for the proposed acquisition of 29 data centres in the US is about 5.1%.
With the addition of the Silas Realty Trust data centres, MINT now owns 57 data centres in 20 states in the US and in Canada. The properties are mainly freehold, with a total occupancy of 93.9% and a WALE of 6.5 years by gross rental income. As at Sept 30, the 57 data centres comprise some 8.3 million sq feet of NLA (see Table 2). The valuation of $4.2 billion translates into $505.90 psf.
Although the portfolios are not like-for-like and the tenant rolls are different, DCR’s portfolio comprises 1.2 million sq ft valued at $1.44 billion.
DCR’s valuations are higher on a per square foot basis because the capitalisation rates of DCR’s portfolio are a lot more compressed than those of MINT’s data centre portfolio, with some properties in MINT’s portfolio valued at twice the capitalisation rates in DCR’s portfolio.
In the most elementary manner, the way to look at it is like this: investors or property acquirers usually prefer higher capitalisation rates because this implies lower valuations. Investors into MINT’s assets — ceteris paribus — are on the right side of the equation. Lower cap rates imply higher valuations. Hence for DCR’s portfolio, investors of Digital Realty are on the right side of the equation.
Another difference is at the distributable income level where DCR has a clear advantage. The only tax leakage is from the data centre in Toronto, which accounts for 15% of NPI.
The rest of the portfolio is structured in such a way that it benefits from tax efficiencies based on shareholder loans, a widely held rule, and the portfolio interest exemption rule. This means DCR’s US portfolio does not attract US corporate tax, US withholding tax or Singapore corporate tax.
Leasing challenges
While most of MINT’s portfolio from Silas Realty Trust was fully leased, two properties — one in Atlanta and one in California — had occupancy rates of 63.5% and 63.3% respectively. “The property at 250 Williams Street NW in Atlanta is the largest asset within the New Portfolio, accounting for 30.2% of the New Portfolio by NLA or 22.5% of the New Portfolio by valuation. It is a mixed-use data centre and commercial property with approximately 50% (based on leased area) used for multi-tenanted data centre space and the remaining used for commercial space. As a result of a recent office lease termination, the asset has an occupancy of 63.5% as at June 1,” MINT’s manager announced in May.
In a results briefing in October, Tham Kuo Wei, CEO of MINT’s manager, said: “We are working on leasing out the balance space and doing a more detailed analysis of the market and close to the appointment of external leasing firms to help us reach out to the market. Next year, we are looking to lease out at least a big part of the commercial space, which is an average of 50,000 sq ft to 100,000 sq ft. Hopefully, the commercial market would have recovered by next year. Corporate users, who are in flux, have not firmed up their approach and policies whether they go fully back to work or adopt a hybrid. It’s going to be uncertain in the near term but we are hopeful the market will gradually improve by next year.”
So far, no renewals have materialised for the data centre portfolio. A small portion of the lease expires in FY2023 ending March 31, 2023. A larger portion of the data centre leases expires in FY2024.
“There is some near-term weakness in some of the markets,” Tham acknowledges, referring to the US data centre market.
“Our aim in many of the renewals is to try to keep to the current trajectory. And our target is to push the increase in expiring rents from 2% to 3%. The rent incentives and commission effect will be considered and we are looking at a 5%–6% impact on revenue from lease renewal. So there might be a risk of rent revisions being a little negative.”
On the other hand, since most of the data centre’s NLA is in shell and core data centres, capital and operating expenditure is minimal.
JVs with Mapletree and others
Says Stewart of DCR: “Singapore is also Digital Realty’s regional headquarters for the Asia Pacific region. And we’ve definitely had some exposure to the REIT market as well, by virtue of some of the transactions we’ve done. In fact, a joint venture that we did with Mapletree a couple of years ago really serves as a template for what we’re hoping to accomplish here. And in that transaction, the sponsor contributed three core assets that again, meet the criteria.”
In 2019, Digital Realty announced a joint venture with Mapletree Investments and MINT, for the sale of a portfolio of 10 powered base building data centres and the establishment of a joint venture on three existing turn-key flex hyperscale data centres. The total consideration for both transactions was around US$1.4 billion excluding expenses.
Mapletree Investments and MINT acquired the powered base building portfolio from Digital Realty for US$557 million (excluding expenses). The 10 properties were fully leased at the time of acquisition and acquired at a forward capitalisation rate of 6.6%.
Separately, Mapletree Investments and MINT formed a joint venture to acquire an 80% stake in a portfolio of three fully stabilised hyperscale data centres in Ashburn Virginia while Digital Realty holds the remaining 20% stake. Mapletree and MINT together paid US$811 million for 80% of these three assets, with the NPI of the properties representing a capitalisation rate of 6%. Digital Realty operates and manages these facilities.
MINT has a right of first refusal to Mapletree’s share of the data centre investments in the joint ventures. Digital Realty has partnerships with others in Asia, including Brookstone in India and Mitsubishi Real Estate in Japan. However, Stewart emphasises that DCR will be Digital Realty’s only S-REIT.
“There are no plans to list a REIT in the US or on any other market,” Stewart says. “This portfolio is fully leased. These are large growing customers with numerous deployments and multiple markets across the sponsor’s global platform. The IPO portfolio caters primarily to hyperscale users. They’re large tech companies that are delivering a platform essentially online over the internet. They tend to have excellent credit quality and two-thirds of the customer base is investment grade,” Stewart says.
Growth opportunity
In 2017, MINT pivoted to investing in data centres in developed markets to access the New Economy growth sector and to change the nature of its land tenures. The data centres in the US and Canada are mainly freehold assets compared to its leasehold properties in Singapore.
Tham elaborates: “By composition, we will not want to do allocation by country. Our intent is to look at probably half to two-thirds of the portfolio in data centres. We have crossed the halfway mark for data centre representation and we will continue to look at possibilities globally. The likelihood of us to crystallise transactions in the US is higher because of its size and depth and our presence has been helpful. I do not want to set a limit but we would want to have representation in other markets for a more balanced and diversified portfolio.”
KDC REIT is the other fast-growing data centre REIT. After listing in 2014 with assets of $1 billion, it has now tripled in size to $3.1 billion. More importantly, its units are trading at a premium to net asset value (see Table 1), returns have been phenomenal (see Chart 1) based on the IPO price of 93 cents.
As at June 30, 68.1% of KDC REIT’s portfolio by asset value is in Asia-Pacific, mainly Singapore and Australia. The remaining 31.9% is in Europe. Unlike DCR’s portfolio (see sidestory above), KDC REIT’s portfolio comprises 71.5% colocation data centres by rental lease type, 19.2% fully fitted data centres and only 9.3% shell and core data centres. Among the REITs with data centres, KDC REIT’s is the most geographically diversified, and hence not really comparable to DCR’s US-only portfolio. DCR has a global mandate, so eventually, it may diversify.
Unease about the M1 deal
KDC REIT’s unit price had been under some pressure in recent weeks. Analysts and market watchers had put it down to the impending IPO of DCR. If DCR’s DPU yield had been higher, or if its capitalisation rates and NPI yield had been higher, or its properties priced at lower valuations, investors would have been justified in switching to DCR.
On the other hand, it was KDC REIT’s own pivot that disoriented unitholders. Some investors appeared uncomfortable with KDC REIT’s $89.7 million subscription to bonds and preference shares issued by M1 Network (NetCo). In return, KDC REIT will receive $11 million per annum in distributions for 15 years. NetCo will acquire M1’s network assets with the $89.7 million along with external financing of $493 million. Based on FY2020’s DPU, the investment into these bonds and preference shares is 3.8% accretive.
Anthea Lee, CEO of KDC REIT’s manager, explains the subscription in a virtual dialogue session with unitholders: “We saw this opportunity with a very high yield of 9.17%, a stable cash flow of $11.0 million per annum for 15 years and no operational management risk. We have looked at the merits of this deal and we believe that this is a good investment for our unitholders. And we are not sacrificing data centre deals for this investment. While we are pursuing other data centre opportunities, we came across this and believe that this is in line with our strategy of providing stable and regular cash flows to our unitholders.”
“We also have an internal discipline to having our investment in data centres make up at least 90% of our AUM at any time, even if we see attractive bonds in the market in future,” Lee adds.
Investors still not satisfied with these answers indicated that they invested in KDC REIT for yield as well as growth because of the data centre portfolio.
“All the other deals that we are working on right now are data centre opportunities. We didn’t sacrifice data centre deals for this opportunity,” she emphasised. “Because of its mission-critical nature, it is not about the data centre operator who can offer the cheapest price or highest value. But it is about offering good value and most importantly, being able to maintain the assets well and the trust we built with our clients.”
Will investors who applied for the DCR IPO switch back to KDC REIT now that it is trading above a DPU yield of 4%? There could indeed be room for both pure-play REITs since they have different focuses.
Based on the track record and support of the sponsor, perhaps MINT has the edge in the race to be the default data centre REIT for investors in this time zone.
