Crunching the Data on Digital Realty

03/31/2014 10:00 am EST

Focus: REITS

Roger Conrad

Founder and Chief Editor, Capitalist Times

In Capitalist Times, income expert Roger Conrad looks at a favorite investment in a lesser-known sector of the REIT market—the data centers.

Steve Halpern: Joining us today is Roger Conrad, income and utility sector expert and editor of both Capitalist Times and Conrad’s Utility Investor. How are you doing today, Roger?

Roger Conrad: Great, Steve. How are you?

Steve Halpern: Very good. When most investors think about real estate investment trusts, they think of property management, office buildings, malls, and the like. But in Capitalist Times, you recently highlighted a less followed area of the REIT market called data centers. Before we look at a specific investment opportunity, could you explain what data centers are?

Roger Conrad: Well, basically, as we’ve seen with the growth of the Internet and the need for broadband capacity and data storage, we’ve seen the rise of data centers that, basically, are, to avoid getting too technical, facilities where companies can store, or individuals can store, their data.

They are physical facilities. The companies that run them provide a range of other services that comes along with them, but, in some ways, they’re similar to the real estate investment trust that we’re used to talking about, such as the ones that own apartments, or industrial facilities, and so forth.

In other ways, it’s kind of a new area because, again, the growth of the Internet and the need for more infrastructure. They make their money off of rents, primarily, for companies that use the capacity, that use their services.

Then, using the tax code, they are able to pass the income, bulk of the income on directly to investors just as they are, or as a REIT owner of an apartment building would.

Steve Halpern: Now, within this market, you like one REIT, in particular, called Digital Realty Trust (DLR). What’s the attraction with this company?

Roger Conrad: Well, as you pointed out, this is kind of an under-followed area. It’s also, and one reason for that is because it’s pretty much a new area. I mean, we really didn’t have the need for these facilities up until fairly recently.

There is a limited history on these things. This is the one, though, that’s been around the longest and we’ve seen it make it through several major crises, such as 2008, they actually were able to continue raising their distribution over that time.

The only other company around in this area at the time, actually, had to make some pretty major cuts. They actually suspended the dividend over that period. Data Realty, however, made it through some difficult periods of time and have proven that they’ve been able to do things in a conservative way.

We just had a distribution increase occur last month, so that’s, of course, always a pretty good sign that things are moving ahead. They surprised some people with the most recent earnings on the upside.

So, you know, this is the one with, I guess, the pedigree in a group that’s fairly new and I like to see that, particularly, you know, with a business model like this, which is a little bit different from the other REITs. You like to see it being able to—a company being able to—manage it through very tough times.

Steve Halpern: Now a more traditional REIT such as you mentioned, one that would operate in say a shopping center area, it doesn’t have to concern itself with changing technology. How big of an issue is the technology side for these data center REITs?

Roger Conrad: Well, I think it’s pretty huge. I mean, I think you do have maintenance capital costs even with apartments and so forth with upkeep needed and so forth; but you do have a little bit of a higher percentage of these companies’ cash flows going to those types of, what would be called, maintenance capital.

There, I think one thing that kind of sets this one apart, Digital Realty apart, is that they do have such great contacts with some many different companies that are major in this data area such as Comcast, such as Netflix and so forth.

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By doing so, I think they’re constantly talking to, they’re having to constantly talk to the customer and get what the customer wants out of it. IBM just became the second largest customer, and they’re 5.5% of revenue. When you’re doing business with companies like that you have to be on top of your game.

Again, you’re absolutely right to bring up the fact that this is a little bit of a point of uncertainty for these data center REITs, so we’re certainly not recommending people mortgage the farm and buy these things.

Again, this one has proven its ability to make it over an extended period of time. It has, pretty much, a blue-chip customer list and, again, they’ve just recently surprised on the upside. They’ve also been one of the few that’s, well they’re the only one in the US that’s been able to take its act overseas.

Again, this doesn’t guarantee that they’re always going to be top of the technology, but it does mean that they are competing in markets where they have to be on top of the technology. I think you have to watch the earnings every quarter.

Of course, I do that with everything that we recommend, and be mindful of the fact that there are some different, these aren’t just an apartment, or a commercial property, or shopping mall. Again, this is a company that’s been proving itself, pretty much quarter after quarter.

Steve Halpern: Now you note your latest research report on this company that short interest is high which means that investors are betting against it. Is that typical within the REIT sector or is that high short interest specific to this company?

Roger Conrad: Well, I mean there is fairly high short interest no matter how you slice it. I think REITs, in general have been pretty heavily targeted at least since last May when the Federal Reserve started talking about tapering off of bond buying and people started talking about higher interest rates.

REITs are perhaps more than any other dividend paying vehicle considered to be interest rate sensitive. I’ve done some research on this and, in fact, even last year when you saw benchmark interest rates rising about 70%, the REITs in general were actually up overall.

I think you can pretty much debunk some of that, but that’s definitely having an impact and it’s making people feel a lot more comfortable about shorting these things.

I think this one in particular there’s a particular hedge fund that is taking the position that, and in fact you raised the question earlier about their ability to keep their systems and keep their data centers up to date technology, and so that’s the bet that they’ve been making. Yeah, short interest is fairly high on these things.

Another thing investors might want to just have a little bit of their ear to ground on is the fact that we’re seeing some movement in Congress to restrict these future conversions—at any rate, from corporations to REITs and that potentially affects one of Digital Realty’s competitors.

But this is, again, something that any kind of tax deferred investment, even master limited partnerships investors need to be aware of what’s going on the federal level. I don’t see this as being a threat, but again I think it’s another reason perhaps why we do see such large short interest.

The other side about the short interest is, of course, if a stock starts going up and shorts start getting squeezed out you really have a potential for a big up move, so a windfall gain for people on the long side, as short sellers which are often leveraged see the price rising and cash out to cut further losses thereby affecting what amounts to a buy, so the price of the stocks go up.

I look at it kind of in two ways. I think there’s definitely a lot of dumb money on the short side as well, and particularly when you see large amounts of short interest often that’s a pretty good sign that you have a potential squeeze that people have really imputed a lot of too much bad news in and, perhaps, in almost any kind of positive is going to squeeze people out. Definitely a double-edged sword.

Steve Halpern: Well, it will be a very interesting situation to follow. We thank you for taking your time today.

Roger Conrad: Thanks, Steve.

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