Crush the Shorts with This Contrarian Play

06/19/2013 6:30 am EST

Focus: REITS

Brad Thomas

Editor, Forbes Real Estate Investor

The shorts are dead wrong when it comes to one data REIT, writes Brad Thomas of Intelligent REIT Investor.

The recent dividend sell-off has created some good entry points for real estate investment trust investors, but true bargains—with a wide margin of safety—are harder to find.

Still there's one blue chip that is becoming noticeably undervalued, and the tailwinds are being driven by more than the whispers of Uncle Ben (Bernanke).

Digital Realty (DLR)—a dominating global data-storage REIT with 123 properties and over 23.1 million square feet—has been the target of a Highfields Capital Management short squeeze. Since May 8, Digital has been under the microscope, as the hedge fund contends that Digital's shares are worth only around $20, much less than the $59.89 pricing today.

The short thesis is essentially centered around a silly argument that Digital's earnings (or FFO in REIT-dom) aren't sustainable, and that the San Francisco-based REIT is not accounting for certain cap ex-related expenses.

It's not common for a blue-chip REIT to become the subject of a short play, and I find Highfields' arguments to be extraordinarily stupid. Why?

Digital's growing revenue stream consists of over 2,000 leases with over 600 tenants. The diverse revenue includes many recognizable names, such as CenturyLink (CTL), Equinix (EQIX), Facebook (FB), AT&T (T), Amazon (AMZN), Yahoo! (YHOO), and Morgan Stanley (MS).

As a pioneer of data storage, Digital was effectively able to build a wide moat first, ahead of the competition. That enabled the company to scale and create a fortress brand that is now over three times the size of all other competitors: CoreSite (COR), DuPont Fabros (DFT), and CyrusOne (CONE).

Digital's dividend policy of increasing its dividends paid by over 17%, from 2005 through 2012, is amazingly sound. And given the more recent drop in price ($59.89), I find Digital's dividend yield of 5.24% to be incredibly enticing.

In addition, a REIT with similar dividend characteristics would be trading at a much higher multiple, and I find the data center king's valuation of 12.5 times earnings (P/FFO) to be a real deal. The short squeezer (Highfields) has made an openly stupid pitch that has created a buyer's dream.

In addition, as Equinix (another leading data provider) debates its value proposition for becoming a REIT with the Internal Revenue Service (mainly arguing over the interconnection fees that EQIX generates and whether these fees are considered income or real estate), the market uncertainty has created more good news for Digital share prices to move into Ben Graham's bargain box.

Now is a good time to consider Digital Realty as an unusual outlier, wherein the current price has created an opportunity where all of the stars are lined up. Minimizing risk and maximizing returns are essentially the cushion (or margin of safety) that Ben Graham taught.

On rare occasions, there are bargains in which you will be able to "buy a wonderful business at a moderate price." That's what I call "sleeping well at night."

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