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Big Data’s Real Estate Boom

By Ari Charney on April 7, 2017

As Tech billionaires push to make us peasants obsolete, we have to get our few remaining laughs in while we can.

Among the more risible examples of tech triumphalism is when the sector’s CEOs crow about how we’ll create more data this year than in the previous 5,000 years of human history.

Of course, when you consider that most of this data comes from video, a quick scroll through Facebook or YouTube reveals that 99.9% of the data we’re creating is absolute garbage.

Call me old-fashioned, but I’d consider Sumerian grain-storage records written in cuneiform to be of greater cultural value than some Instagram influencer’s latest flatulent emanation.

Nevertheless, one man’s trash is another man’s treasure. And storing, accessing, and exploiting all that data is big business.

With companies increasingly shifting toward centralized data storage, cloud-based data-center traffic is projected to grow 30% annually through 2020. That means more and more server farms will be needed to store and harvest all that data.

The Big Data mega-trend isn’t just for aggressive growth investors. It’s also providing opportunities for income investors.

Over the past year-and-half, investors have piled into data-center REITs (real estate investment trusts), driving gains of more than 50% on average across the seven names that operate in this niche.

That’s not including the reinvestment of distributions, which have grown an average of 25% annually over the past three years, for a current forward yield of 3.7%.

Big Data Centers’ Big Short

Naturally, all that attention has attracted a significant number of skeptics. Short traders have made significant bets that data-center REITs will eventually see their premium valuations revert to the mean.

Since REITs are required by law to distribute more than 90% of their taxable income to unitholders, funds from operations (FFO) is the relevant profit metric for this industry, not earnings per share.

On a forward price-to-FFO basis, data-center REITs trade at a multiple of 19.2 times versus 12.1 times for the average REIT. However, the valuation contrast isn’t nearly as stark when compared to the average office REIT, at 18.4 times.

Although short interest has declined from its highs for most data-center REITs, it still remains quite elevated compared to the broad market. Short interest as a percentage of total float averaged 6.9% across the seven data-center REITs, nearly double that of the broad market.

In particular, Digital Realty Trust Inc. (NYSE: DLR), one of the best-known names in the industry, has been targeted by bears, with 10.2% of its float sold short, equivalent to more than 14 days of average trading volume.

However, DLR has an outstanding record of delivering upside surprises. The REIT has managed to beat analyst forecasts for FFO per unit in all but one of the past 24 quarters.

Though FFO-per-unit growth is expected to decelerate to 4% this year, short sellers may continue to be on the wrong side of the trade.

Even so, as risk-averse income investors, we’d prefer not to hold a stock that’s been targeted by short sellers.

Outside the Crosshairs

Right now, there are two data-center REITs that short sellers are largely ignoring.

Equinix Inc. (NSDQ: EQIX), which has a market capitalization of more than $30 billion, is by far the largest of the data-center REITs. It’s also forecast to have one of the strongest growth trajectories among its peers, with FFO per unit projected to rise 20.4% annually through 2020.

That growth is due, in part, to some major acquisitions, including a pending $3.6 billion deal to acquire 24 data-center sites from Verizon Communications Inc. (NYSE: VZ).

To help fund the transaction, Equinix issued $2.2 billion worth of units in early March. That caused a temporary selloff, but now the REIT is back near its all-time high.

In fact, Equinix trades at a forward price-to-FFO ratio of 27.6 times, giving it an ultra-premium valuation compared to its peers, a fact that has somehow eluded short sellers. That’s especially curious since Equinix has fallen short of analyst forecasts for FFO per unit in all but one quarter since it converted to a REIT at the beginning of 2015.

Equinix’s strong growth trajectory may mean it deserves a premium valuation compared to its peers, but we’d wait for the inevitable correction before establishing a position in this name.

Last year, Equinix suffered a 16.5% correction after hitting an all-time high in July. Given the Federal Reserve’s newfound seriousness about raising rates, we would expect rate-sensitive sectors such as REITs to face selling pressure later this year.

A selloff would also give income investors an opportunity to lock in a better yield than the 2.0% that Equinix’s units currently yield on a forward basis.

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