Singapore REITs are going up. Except this one.
Source: Singapore Exchange Website
“Willie, what happened?” asked one of my subscribers? “Is it attractive to buy at this price?”
This is one of Singapore’s biggest “pure-play” data centre REITs.
No, I’m not talking Keppel DC REIT.
Digital Core REIT (SGX: DCRU) is a disappointment after its short-run up since it IPO in Dec last year.
So, what happened?
A couple of bad news… I’ll explain.
3 reasons why this Singapore REIT is down
1. One of their big tenants went bust. Earlier in April 2022, Digital Core REIT said its fifth biggest customer filed for bankruptcy protection. This customer is a private IT service provider.
Being a landlord is simple: you need high quality tenants to ensure whether your income is uninterruptible.
Landlord collect revenues from tenants. Tenants don’t pay, REIT’s don’t get income. Shareholders don’t get dividends.
2. Analysts are worried of higher interest rates. One broker recently downgraded Digital Core REIT on “rising cost of debt”.
And Digital Core REIT’s interest payment could go up from 1.2% to 2.1% this year.
It’s not high, but considering the fact that property yield (see cap rates below) on data centres aren’t high.
Source: Digital Core REIT IPO Prospectus
This could reduce the “leveraged yield”.
You see, if Digital Core REIT is going to pay 2% interest cost. And average cap rate on their properties is about 3.3-4.9%, it doesn’t leave a lot of room to get a good “leveraged yield”.
And this could result in in lower distribution income for Digital Core REIT.
Cap rate is property income divided by the market value of the property. It’s a proxy of property yield.
3. Digital Realty, its sponsor was down more than 16%. Digital Realty hasn’t been performing because of lower share price.
Source: ShareInvestor Webpro
This was because of higher interest rates that caused this REIT to be down.
Is it time to sell Digital Core REIT?
It seems like the reasons above are more short-term.
Well, what’s interesting here is if the customer cannot pay Digital Core REIT, its sponsor, Digital Realty has a strong commitment to Digital Core REIT’s tenant.
In fact, Digital Realty “has reached an agreement in principle to guarantee the cash flow to Digital Core REIT in the event of a near-term cash flow shortfall due to the customer bankruptcy”.
In other words, this is not going to affect Digital Core REIT’s distribution per unit (DPU) after all.
This customer in default takes up only 7% of Digital Core REIT’s total income. It’s not huge.
And Digital Realty apparently can easily find new tenants to replace. This is because this tenant is located in Toronto, Canada a place where there’s a short of data centre supply and one where the sponsor can easily fill.
Despite high interest costs, both brokers expect Digital Core REIT to remain “resilient”. DBS analysts think Digital Core REIT’s new acquisitions could “drive a 3-year DPU compound annual growth rate of around 5 per cent over FY2021 to FY2024. This is 4-6 per cent above the real estate investment trust’s (REIT) IPO forecasts”.
it doesn’t seem like it’s all bad news — but this isn’t the real problem.
First, let’s quickly recap who Digital Core REIT is.
Even after shares dropped, Digital Core REIT is still a decently-sized Singapore REIT at US$1.1 billion market cap.
It has 10 data centres all in the U.S., across Silicon Valley, Toronto, Canada and Los Angeles and Northern Virginia. These are freehold assets, fully occupied.
In other words, Digital Core REIT is a “pure-play” U.S.-focused data centre REIT.
Unlike Keppel DC REIT, there’s some difference here.
First, Digital Core REIT pays its dividends in US dollars (don’t worry, there’s no 30% tax on its dividends). Next, and more important, Digital Core REIT’s sponsor — Digital Realty — is a specialist in data centres (but more on its sponsor later).
Since IPO, Digital Core REIT was soaring. The stock market kind of knows about the huge tailwind in data centres — the amount of data that’s going to grow by 2025 is going to grow much bigger than you can imagine…
By 2025, the world is expected to consume 181 zettabytes of data — that’s seven zeroes.
If all the world’s data are stored in a 1 TB thumb drive today, you’ll need 30 billion pieces of thumb drives for all that massive volume of data.
COVID has also accelerated the use of online data — online conferences, e-commerce shopping, digital entertainment. And you need to store all that data somewhere.
This makes data centres a highly lucrative business.
In its recent first quarter results, Digital Core REIT produced US$26.5 million gross revenues. What’s also surprising is Digital Core REIT beat their own expectations.
In its IPO prospectus, this Singapore REIT expected it’s distributable income to hit US$11.9 million. But it produced US$12.1 million of distributable income in its latest 1Q results, slightly more than it expected. Not too bad.
Distributable income is the final amount to be distributed as dividends, after minus all operating costs, interest payments and taxes.
Source: Digital Core REIT 1Q2022 Update
Can this Singapore REIT’s shares/dividends grow higher?
Data centre rental income tends to be sticky.
It’s not easy for tenants to switch to another data centre once they have their installed their specialized equipment.
Digital Core REIT’s leases stretches around six years.
Crucially, all of Digital Core REIT’s leases come with an “in-built” rent escalation clause. The REIT can continue to raise rent between 1-3% (average 2%). That matches inflation.
At the same time, this helps to grow its share/dividends over time.
Most of their leases are on triple-net lease. Even if rent goes up, Digital Core REIT still can control their operating costs.
Triple-net lease means customers pay for property tax, insurance and daily maintenance like site personnel costs, cleaning, security and utilities.
Now, Digital Core REIT is backed by a high-quality sponsor
Here’s the kicker — and why Digital Core REIT’s IPO was oversubscribed by a whopping 19 times!
Unlike Keppel DC REIT, Digital Core REIT is 33% owned by Digital Realty — its sponsor. In fact, Digital Realty is the biggest U.S.-listed data centre REIT at US$44 billion market cap. And the sixth biggest U.S. REIT.
Digital Realty has been listed for 17 years in the U.S. stock exchange. This makes it more than three times bigger than Keppel Corp (Keppel DC REIT’s sponsor).
Today, Digital Realty owns and operates more than 290 data centers across the world. Which means Digital Core REIT has priority and can readily tap into Digital Realty’s big pool of assets to grow the this Singapore REIT’s property portfolio.
Sell Digital Core REIT, buy Keppel DC REIT?
Unlike Keppel Corp/Keppel DC REIT, Digital Realty/Digital Core REIT don’t have to worry competing with other big property players to buy high-quality data centres. Why?
Digital Realty already has its own pool of data centres to tap on.
You see, there are only two ways for Singapore REITs to grow. First, is raising rent. The second, and faster way, is to buy more assets.
And that’s exactly what Digital Core REIT plans to do.
If you ask me, I wouldn’t sell Digital Core REIT because of its recent share fall.
In fact, between two “pure-play” data centre Singaproe REITs, I prefer Digital Core REIT to Keppel DC REIT.
And that’s because of the bigger potential to grow.
Don’t forget this: Digital Core REIT still has a low 27% gearing ratio. That’s far lower than many of Singapore REITs’ gearing ratio (average is around 37%). MAS caps the gearing ratio limit at 50%.
Which means, Digital Core REIT has plenty of firepower to grow their distribution income. Pretty good for shareholders.
Gearing ratio calculates how much leverage a Singapore REIT can take. You calculate it by taking total debt divide by total assets. Higher means more debt.
If this Singapore REIT shares get stuck here, dividends still sustainable?
Digital Core REIT’s dividends is probably more sustainable than many other Singapore REITs because of its strong sponsor.
And don’t forget the main tool of a REIT — Digital Core REIT’s core purpose is to also help Digital Realty recycle its assets:
Digital Realty sells assets to its Digital Core REIT. Digital Realty gets back the capital and reinvests to developer new data centres. The cycle repeats.
So… what’s the real risk here?
I’ll say is currency risk. Like this Singapore REIT, Digital Core REIT pays dividends in USD. At current prices, its dividend yield should be below 5%. If USD continues to weaken against USD, and Digital Core REIT doesn’t grow its dividends, you end up with a much lower dividend yield than expected.
Lowest USD/SGD traded at 1.24 10 years, ago. If USD weakens back to that level, your current dividend yield could drop by 9% against the SGD, your yield could drop to low 4%.
Then, wouldn’t it be better off just buying other Singapore REITs?
Source: CEIC Data
But here’s what I’ll argue. Remember, Digital Core REIT’s data centres have a rent escalation.
And over time, tenants pay more rent every year. This will grow the data centres’ value.
And results in a higher share price over time. So you might get a lower yield from a currency depreciation, but compensated by somewhat growing share prices.
Here’s what people are not paying attention to this Singapore REIT
The more important risk is this. Digital Core REIT actually has another major tenant that has a lousy credit rating, or what industries expert like to call “junk rating” (see below).
Source: Digital Core REIT IPO Prospectus
Companies with junk ratings often struggle to pay their interest and repay debt. If their business weakens, or economy goes into a recession, their probability of default is much higher (not saying it will default).
Just to note: credit ratings that fall below a BBB grade (like a B-/B3) means it’s considered non-investment grade.
So it’s hard to tell.
Even though Digital Core REIT’s data centres are high in demand, losing 24% of your total income at one shot means your dividends could be temporarily disrupted. And Digital Core REIT also needs time to find tenants to fill up the vacant supply.
How will interest rates affect Digital Core REIT?
As mentioned, interest rates could possibly affect Digital Core REIT more than Singapore REITs. And the reason is because of its higher borrowing costs.
If I were management, I try to grow my REIT at a bigger size. Then try to negotiate with bankers for a much lower interest payment. Anyway this takes time.
And you never can control what management does.
In conclusion, what would I do with Digital Core REIT?
If you already have a portfolio of Singapore REITs, Digital Core REIT helps diversify from the popular retail and office REITs.
Hospitality is still recovering from the pandemic over the past two years. And they haven’t yet fully pay out their pre-COVID dividends. I’d think it’s hard to invest in them still because the economy is still opening up.
And industrial REITs have short-term leases. Don’t forget, Singapore industrial properties have 30 year leases. While data centres tend to be freehold. And that makes data centres solid properties to own.
With the huge demand for data storage, it’s going to boost data centre businesses too.
Even if you don’t like to hold Digital Core REIT for the long term, think about it as a REIT to hold since you’re investing in high-quality US data centres with a strong sponsor. Then later on, switch out later for other better opportunities.
Or when industrial REITs trade back to a much reasonable valuations.
I don’t think there’s any big fundamental deterioration in Digital Core REIT.
And I wouldn’t sell Digital Core REIT because of the recent bad news. If you like data centres, in terms of quality, this beats Keppel DC REIT at current valuations.
Sometimes, investing can be simple.
Willie Keng, CFA
Founder, Dividend Titan
1) DC Core Reit 5th largest tenant filed for bankruptcy protection barely 4 months after it’s IPO.
2) Within it’s portfolio is another tenant with a non-investment grade B-/B3 credit quality, as highlighted by you. The risk of this tenant following Sungard’s footsteps is not unlikely.
3) Which make me wonder, did the sponsor knowingly bundle these properties into DC Core Reit’s portfolio to offload the risks to it’s child? Is this why a listed Reit need to list another baby Reit or am I thinking too much? Hmm…..
I mean, it’s hard to guess.
I always give the benefit of the doubt to management. It’s hard to accurately tell if it’s intentional or not. Digital Realty (sponsor) has over 240 properties, and monitoring each and every tenant, then deciding which goes into Digital Core REIT takes a lot of work. If they really did that, I think I’m really unlucky. But again, trying to figure this out is just too painful as a retail investor. And we could say the same for any other listed REITs out there too.
So, to caution, what I’ll do — make sure these REITs are diversified in their tenants. So not one single tenant contribute a huge portion of the income. If they do, I want to make sure the core tenant isn’t a “junk rated” company.
I guess there’s always such a risk that we have to take in investing. That’s why it’s called investing haha.
For Digital Realty to list another REIT is usually to recycle their capital so they can develop and buy new data centres. It’s up to us retail investors to decide whether we want to “piggy-back” on their new list-co. My 2c 🙂