Digital Realty Trust (DLR 2.68%) is a rare growth-stock Real Estate Investment Trust (REIT). REITs are required to pay out most of their net income as dividends, so they are rarely fast growers. Digital Realty's presence in the technology arena has helped it keep growing while also churning out a nice dividend for investors.
We asked a couple of our contributors to make a bull and bear case to give investors a picture of both Digital Realty's growth prospects and risks.
Expanding the digital world further into underserved markets is the key to long-term success
Kristi Waterworth(Bull Case): As we lead increasingly digital lives, companies like Digital Realty Trust, which primarily make their income off of renting out space on servers in data centers, are going to become even more important. Everything is online now, but where is online data stored? In a data center, maybe even one controlled by Digital Realty Trust.
With data center REITs being both a present- and future-tech type of company, it's no surprise that Digital Realty Trust continues to find ways to expand its reach. It has data centers on every continent save Antarctica; there's no place where this REIT isn't found. That's part of the reason I'm convinced it has long-term staying power. It already has data centers in Africa but is pushing to be even more present in this emerging market with a recent acquisition in South Africa, adding to holdings in Kenya, Mozambique, and Nigeria.
Globally, new leases for the 12 months ended June 30, 2022, totaled $504,985,000 annually with a weighted average lease term of 7.7 years. Of course, that's a drop in the bucket compared to the existing leases that were renewed (with a retention ratio of 76.6% and weighted term of 4.4 years, excluding renewal options) that are worth a total annualized rent of $3,104,380,000.
Digital Realty Trust's top 20 leaseholders account for $1,721,156,00 of total revenue, or 49.4%, with the largest tenant worth 10% of revenues and the second contributing 3.9%. The weighted average lease remaining for these top 20 companies is 6.1 years, not including renewal options.
These stable, long-term tenants make it far less of a gamble for Digital Realty Trust to penetrate new markets, like Africa and the Middle East, where there's significantly lower competition for data center contracts. It's true that the company is spending considerable money right now between acquisitions and new construction, but it seems to be managing this burden well.
The company's total assets as of June 30, 2022 were $35,956,057,000 and its liabilities were $18,284,791,000. Having debts of roughly 50.85% of its assets is fairly normal among REITs. While that's just outside where I prefer to see debt burdens, it's still well within the safety zone when you consider the sheer amount of pre-leasing that's taking place as companies wait for new hardware to come online.
For these and so many other reasons, I see a long and plentiful future for Digital Realty Trust and its bold penetration of markets in both tech-heavy regions and areas that are trying to reach saturation.
Inflation-related issues could derail the REIT's growth
Mike Price (Bear Case): The best business to own in a time of high inflation is one that made all of its capital expenditures in the past and can now reap organic revenue growth as prices rise across the board. Every year its returns on capital will increase. Many REITs fall into that category: Net lease REITs, ground lease REITs, and even many retail or healthcare REITs. Digital Realty does not.
Digital Realty spent $1.4 billion on improvements to investments in real estate in 2019. That number jumped to $2 billion in 2020 and $2.5 billion in 2021. The REIT's revenue grew by about $700 million from 2019 to 2020 and about $500 million from 2020 to 2021.
Digital Realty stated in its 2021 10-K, "The locations of and improvements to our data centers, the network density, interconnection infrastructure and connectivity-centric customers in certain of our facilities, and our comprehensive product offerings are critical to our customers' businesses, which we believe results in high occupancy levels, longer average lease terms and customer relationships, as well as lower turnover."
Its business depends on the REIT spending to make its data centers the perfect fit for its customers and to load them up with the latest technology. As prices continue to go up, will it be able to pass along those increased costs? Will it have enough cash to keep making these investments when it has to pay out 90% of net income as dividends and debt becomes increasingly expensive? And that's not the only inflation-related issue.
Increases in interest rates in the U.S. strengthened the dollar in 2022. Six months ago, $1 bought less than 0.90 Euros. Today, it buys more than one. An increase in interest rates in a geographical area causes an increase in demand for the currency, and the value of the currency goes up. That sounds like a good thing, so what's the problem for Digital Realty?
Digital Realty is diversified around the globe, so much of its revenue is earned outside of the U.S. and has to be converted to dollars to be paid out to shareholders. Management reported in its conference call that the dollar's strength this year led to a 4% to 4.5% drag on growth in the second quarter.
Management also mentioned that the majority of its development pipeline would come from countries that use the Euro as currency. Inflation in the U.S. is still over 8%, and there's no sign that rates will stop increasing anytime soon, much less fall back to where they were when the Euro was the stronger currency.
Digital Realty could fall prey to a double whammy of inflation problems. It will cost more for it to keep up its record of improvement investing, and even if it can pass along those costs to customers, there may continue to be a drag on those earnings from currency conversion costs.
Will inflation just be a speed bump?
We've described the case for Digital Realty's long-term growth prospects and the problems that inflation may bring to the business over the medium term. It's up to you to decide whether the growth case is strong enough to make up for inflationary pressures.
