This article originally appeared on January 24, 2017. It has not been updated.
This ad has generated quite a few questions from Gumshoe readers, and I’ll agree that it sounds pretty enticing (of course, almost all ads do — that’s why they work so well!)… here’s part of the Jim Pearce email that gets the juices flowing:
“You’ve probably never heard of this company – but the world’s best-known CEOs are very familiar with it. Facebook, AT&T, JPMorgan Chase, and others pay them more than $180 million a month for the right to keep their websites online.
“The best part? 90% of the money coming in goes directly to shareholders. That’ll put an extra check in your pocket every three months.
“This company is taking over the world. They just gained a foothold in my neighborhood… and they may be coming to yours next.”
The spiel is an ad for Personal Finance, which is one of the venerable old generalist investing newsletters that predates the wave of internet and email newsletters — Personal Finance helped to launch some fairly well-known names in investing punditry, like Stephen Leeb, and led the Hulbert charts a few times in the past, though I don’t know what the record has been like in recent years. (The Hulbert Financial Digest was closed by Marketwatch last year, FYI, Mark Hulbert has restarted it on his own but seems to track a very tiny portfolio of newsletters now).
Personal Finance has been through quite a few analysts and editors in the past decade (and a name change or two for the publisher, which is now the generic-sounding “Investing Daily”). The ads for Personal Finance have lately been coming from Jim Pearce, who is now the “chief investment strategist” for the newsletter.
And, as you’ve already guessed, they’re hinting at a fantastical investment… and they’ll send you the name and info just as soon as they get your subscription bucks ($40/year) and your credit card number.
So what’s that investment? The spiel is that “ordinary Americans just like you are pocketing an extra $8.47 every second in ‘Digital Rent Checks’,” and Pearce opens up the story by talking about the valuable “dirt” in that headline — which is really just a reference to the fact that he got caught in a traffic jam near his home in Northern Virginia because this secret collector of “Digital Rent Checks” was moving some dirt around as they build a new facility.
Here’s a bit from one of the FAQ’s after the presentation:
“Will I really get a ‘digital rent”’ check in a matter of weeks?
“Yes! Your ‘digital rent’ checks are subject to PL 86-779, a government document that mandates that 90% of REIT income be paid out to shareholders. So, if you take my recommendation and buy the data center REIT I recommend, they MUST send you “rent checks” on a regular schedule. It’s the LAW.
“The Internet landlord you’ll read about in your Data Center Profits report collects rent every second of every day. For convenience, it cuts checks on a quarterly schedule. Depending when you take advantage of this opportunity and the processing time, your first check will arrive between three and twelve weeks from today.”
So yes, Personal Finance is recommending the shares of a Data Center REIT — of which there are about a half dozen that are publicly traded. So which one?
Well, if you’re unfamiliar with Data Center REITs we should quickly explain what they are. They are Real Estate Investment Trusts, but instead of owning shopping centers or office buildings or apartments or what have you, they own data centers. Data centers are the brain of the internet, massive buildings with sophisticated connections to all the telecom providers, huge, sophisticated and complex power supplies and cooling systems, and racks and racks of computer servers that house the websites, movies, emails and everything else that we think of as being in “the cloud.”
You can see how the “cloud” terminology took off, because “in the cloud” sounds much more modern and ethereal than “in the dystopian, windowless, high security warehouse.”
But anyway, these providers are selling much more than just real estate — they do effectively lease out space, usually described in terms of square footage, and most of them are either renting out wholesale (supplying a “powered shell” for a large customer, like perhaps Facebook, though the major companies tend to also own some of their own data centers) or providing colocation services (renting out individual racks or small areas of racks, fenced off from other customers, within a powered and telecom-connected space), but much of what they provide is the security of the power supply and the interconnectedness with major networks. There are various tiers of data centers, but the higher end (tier 3 and tier 4), where uptime guarantees are huge and there’s required redundancy of network connections and power, can be difficult to place and build — partly because they need to be near major network hubs and also need incredible amounts of electricity.
For example, Digital Realty Trust (DLR) is the oldest of the Data Center REITs, and they own the huge Lakeside Technology Center in Chicago, which is in a million-square-foot building that used to house the printing presses for the Sears Catalog. That’s been calculated as the tenth largest single-building data center in the world, and I read recently that it is the second largest consumer of electricity in the Chicago area, second only to Ohare Airport. There are quite a few larger facilities now, often located in areas closer to cheap electricity (particularly hydroelectric dams), though the prime city locations are also important because of the high value of proximity — getting that shorter fiber connection to millions of homes and, at least as importantly, to key financial facilities like the CBOE and the NYSE just a few milliseconds faster.
So the value is in location, in the connections these data centers have to major telecom pipes and to power, in the ability to host network hubs that let data flow between the major telecom operators’ networks more quickly, and in the price and reliability of electricity… as well, of course, as in the amount of space these data centers have available and their ability to expand that space for future demand. Many modern data centers are built in campuses, like the one near Jim Pearce’s commute, so when the buildings fill up they can expand with another new center that has the same connections and access… though that expansion potential is much more difficult to find in downtown Chicago or Manhattan or Los Angeles than it is industrial or rural or, as in the case of Northern Virginia, suburban areas.
And yes, Real Estate Investment Trusts (REITS) are required to pay out at least 90% of their income to shareholders in the form of dividends — which means they are usually high-dividend stocks, and also that they are sometimes challenged to compound shareholder value because they can’t retain and reinvest income because it has to be paid out to shareholders (so when they need capital to expand, they either have to borrow or issue new shares or, more typically, both).
So… which data center REIT is he pitching here? Some clues for you:
“This landlord serves every major tech firm in Silicon Valley, plus some of Wall Street’s biggest names, too.
“Their tenants are companies you’ve heard of – IBM, Facebook, LinkedIn, Adobe, AT&T, JP Morgan Chase.
“Plus 1,968 more you probably haven’t heard of… including the “next big thing” IPOs that will eventually replace them.
“And a full 70% of all this Internet traffic was running through one cluster of unmarked buildings in Loudon County, Virginia.
“In other words:
“No Matter Who Wins Or Loses In Silicon Valley… Investors In This One Stock Get Paid No Matter What.”
It is widely reported that ~70% of internet traffic goes through Loudoun County, Virginia — I don’t know if that’s really true or not, but Northern Virginia is indeed a major hub area for the internet and most of the major data center owners have facilities there. I don’t know that this means that 70% of the internet goes through one particular facility, but we’ll keep that in the back of our minds as perhaps a bit of exaggeration.
More clues about specifically which REIT he likes? Here you go:
“156 locations this group operates across North America, Europe, Asia and Australia….
“THE ONE COMPANY with a chokehold on the Internet all around the planet….
“… in the third quarter of 2016, they acquired an additional parcel of land next to their existing (and fully rented) buildings in Loudoun County, Virginia….
“Over the last year, the stock has gone up 29.56%….
“Barron’s Says This Company Will ‘Outperform’ Other Income Investments.”
So… enough clues? Yes, the Thinkolator says that this is, coincidentally enough, the data center REIT I mentioned as an example above: Digital Realty Trust (DLR)
Digital Realty is not the biggest data center REIT anymore — they were surpassed when Equinix converted to become a REIT a year or two ago — but it is the first one that comes to mind for most investors, and it is a big player, with a market cap of about $17 billion and a huge global footprint.
I have tended to prefer the smaller data center REIT players, and have had a substantial position in Coresite (COR) for several years (and it’s probably the most successful pick I’ve ever suggested to the Irregulars, up more than 500% since 2010 not including dividends), but there are also several other players that are on the smaller side — QTS Realty (QTS), Dupont Fabros Technology (DFT), and Cyrus One (CONE).
And they’ve all done well of late, this is the total return chart for the ones that have been around for at least three years (DLR, EQIX, COR, DFT and CONE):
The data center REITs have current trailing yields that range from about 2% to 4%, and it is generally the large and slower-growth big players that have the highest current yields (and the lowest dividend growth rates) — so Digital Realty has a current trailing yield of about 3.3%, which is above average and larger than all the others except for Dupont Fabros… but it has also grown the dividend much, much more slowly than the smaller players. DLR has annual dividend growth of about 3.5% per year over the past five years, while COR has increased the dividend each year by an average of 25-30% and DFT has usually also boosted the dividend by double digits.
That’s what has soured me on the large data center REITs in years past, really — they are solid companies with valuable assets, but they are not growing their dividends very rapidly and they’re so big that adding or expanding a couple new data centers doesn’t have a huge impact on their revenue or earnings (or funds from operations (FFO), which is the term most REITs use and most analysts forecast that’s akin “cash earnings” after removing depreciation, etc.). Some of that outperformance in terms of dividend growth by COR and DFT has come because both of those firms have levered up their balance sheets a bit in the past five years — but even so, they have not become substantially more levered than Equinix or Digital Realty, they really have just “caught up” with the debt ratios of those bigger firms.
So you can see where my biases lie — I added more to my position in Coresite last month because of a strange anomaly in the market: They announced a huge and dramatic 50% increase in the quarterly dividend… yet the stock fell. Whether that’s because investors begun to be worried about the sustainability of that dividend growth (it had risen by 25-35% each year for four or five years before that), or just because of fears of rising interest rates, I don’t know, but that’s the kind of opportunity that looks compelling.
Today, not so compelling. Coresite is now trading at a much fuller valuation and looks pretty expensive, within just a few percent of the all-time highs it hit early last Summer… so the dividend yield still looks very good, it’s expected to be 3.7% going forward, at least until next December when it will likely increase the payout again, but it’s hard to buy stocks that have risen so dramatically, especially when they’re in a class (REITs) that are supposed to be somewhat sleepy and interest rate-sensitive.
On the other hand, data center REITs in general still have ample room to increase their dividends — not because they’re paying out less than their earnings, that is not the case (they’re all paying out much more than their earnings), but because they’re paying out only about half of their funds from operations (FFO). These are technology-dependent companies who need to consistently reinvest in their data centers, to be sure, but they tend not to need to invest as much as depreciation calls for in any given year, particularly if they’re increasing their occupancy rates and raising lease costs, so there’s more cash that they can send to shareholders.
Digital Realty and Coresite both trade at essentially the same trailing P/FFO valuation — both are trading for about 15X trailing Funds from Operations. QTS is at about 21X, EQIX 30X, CONE 20X, and DFT 9X. Dupont Fabros is the one that stands out there, with the lowest current valuation and a relatively high dividend growth rate, though each company also has company-specific drivers and challenges that you’d want to consider if you’re digging through to try to choose your favorite.
In general, I’m comfortable with the high-dividend-growth data center REITs even in an era when REITs may be worrisome because of the potential of sharp rises in interest rates… mostly because I think a 3-4% yield that’s growing at 10X the rate of inflation will always be valuable, even if inflation speeds up a bit. The REITs I’d worry about are those that don’t have the capacity to increase dividends at at least 5-10% a year, which makes me a little bit concerned about the larger, lumbering EQIX and DLR… but I’d still choose either of them over most shopping center or office REITs given the ongoing increases in demand for their services, and the likelihood that data center demand will continue to grow. DLR and EQIX also, unlike the smaller ones, have meaningful global operations and probably more exposure to more rapidly growing areas of the developing world — but, as we’ve seen, there’s still plenty of growth in Internet traffic and data here in the US as well.
So that’s what I think… but it’s your money, so what matters is what you think. Do you want a piece of a data center REIT? Do you think that a 3-4% yield will change your life with those “internet landlord rent checks?” Have a preference among the half-dozen or so choices in that sub-sector? Let us know with a comment below.