Over the past couple of years, interest in data centers has skyrocketed, resulting in an acquisition spree by asset management firms that have been taking data center REITs private. Do you remember CyrusOne, CoreSite Realty, and QTS Realty Trust? Well, between 2021 and 2022, they were taken private by KKR (NYSE: KKR), American Tower (NYSE: AMT), and affiliates of Blackstone (NYSE: BX), respectively. Currently, only two data center REITs remain publicly listed – Equinix, Inc. (NASDAQ: EQIX) and Digital Realty (NYSE: DLR). There’s also DigitalBridge (NYSE: DBRG), but due to its small size, I’ve left it aside. Out of EQIX and DLR, the latter looks like the better pick, and I’ll discuss why in this piece.
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Could Equinix and Digital Realty be taken private as well? I don’t think so. With market caps of $60.6 billion and $29.4 billion, respectively, they are likely too large for anybody to take them private in the current illiquid market environment. Nevertheless, the lofty interest in their (now privately-held) competitors by asset management firms should affirm that data center REITs remain highly-attractive assets.
Why are EQIX and DLR High-Quality Investments?
Growing Dependence on Data Centers
Data Center REITs have become increasingly attractive due to the rising dependence on data and the internet for a broad range of activities. These catalysts are driving demand for data centers, which are critical for storing, processing, and managing large amounts of data.
This trend is likely to continue in the future as cloud computing and other technology solutions that require data storage and processing become increasingly needed. Further, due to their role in the operation of many other critical infrastructure systems, such as transportation, energy, healthcare, and telecommunications, REITs in the space face limited risks in terms of experiencing lower occupancy rates during unfavorable economic periods. A company is more likely to shut its headquarters office first before considering dumping its access to its data centers, where all of its critical data is stored.
Stable Cash Flows
Data center REITs know how essential their properties are to their customers, which provides them with enough leverage to negotiate long-term tenancy contracts. For context, Equinix features a weighted-average remaining lease term of 14 years, while Digital Realty’s equivalent metric stands at five years.
Through such long-term contracts with their customers, data center REITs enjoy a stable source of cash flows. This makes data centers much more attractive assets than retail, commercial, or residential properties, in that regard. Predictable cash flows also help to mitigate the impact of economic downturns, which should ensure data center REITs remain resilient during a potential recession, even if their growth rates slow down.
Diversified Cash Flows, High Scalability
Data center REITs generate cash flows from several sources, such as colocation, managed hosting, and cloud services. Simultaneously, each data center can host multiple tenants. For instance, Digital Realty’s multi-tenant data center capacity features more than 170,000 cross-connects in critical locations despite owning just over 300 data centers. Diversification through multiple services and customers means that risk is reduced and scalability improves.
Another noteworthy point regarding the scalability of data centers is that most are designed in a modular fashion, meaning that they can be easily extended by adding extra components. For instance, a data center REIT could add new servers or storage systems to its properties to meet the requirements of its customers with little incremental effort.
Is EQIX Stock a Buy, According to Analysts?
Regarding Wall Street’s view on Equinix, the stock has a Moderate Buy consensus rating based on 13 Buys and five Holds assigned in the past three months. At $746.61, the average Equinix stock price target suggests 14% upside potential.
Is DLR Stock a Buy, According to Analysts?
Analysts forecast even stronger upside potential on Digital Realty, with the stock having a Moderate Buy consensus rating based on six Buys, five Holds, and one Sell assigned in the past three months. At $119.25, the average Digital Realty stock price target implies 18.9% upside potential.
Takeaway – DLR Stock is Likely the Better Pick
With uncertainty likely to persist in the markets in 2023, investors can benefit from the inherent qualities we just discussed that come attached to EQIX stock and DLR stock. Not only are they set to keep producing robust cash flows in the face of increased uncertainty, but being REITs, investors should also continue enjoying robust dividends. That said, I believe that DLR stock offers a more compelling investment case.
The stock yields a substantial 4.9% and trades at a reasonable forward price/FFO ratio of about 15x based on forecasts for Fiscal 2022 (FFO = funds from operations, an earnings metric used by REITs). This should translate into a solid margin of safety if valuations were to be compressed further through the year. The same cannot be said for EQIX stock, which trades at a price/FFO ratio of 32x and yields just 1.9%.
Why is the market willing to pay double the price for EQIX stock? I believe this is because the company’s enormous scale is likely to allow for multiple synergies across data centers in the coming years, which is likely to lead to better FFO/share growth. Additionally, EQIX leases are significantly longer than those of DLR.
Nevertheless, paying this much these days, especially with interest rates on the rise, which can have a major impact on REITs, is too risky, in my view. DLR’s higher tangible returns and fairer valuation are likely to outperform EQIX if tension among REITs persists.
