The last time we covered digital real estate (New York stock market :DLR.PK), we told you why it was such a dangerous stock. This logic moved away from the usual cheerleaders and focused on why the risks were so much higher than they actually appeared. We left with that.
On the equities side, things are heavily oversold. A rebound is of course likely and we simply cannot issue a “sell” rating here. We stick to a “hold/neutral”. However, if we get a bounce towards the 200-day moving average, which sits near $140, we might consider going short.
Source: Jim Chanos Will Be Right, Stick to Preferred Stock
The decision not to buy can be as important as the decision where you enter. In this case, avoid the 15% drop and huge underperformance against the S&P 500 (TO SPY) was fantastic.
Of course, the entire REIT sector is hit hard and in such cases, it becomes difficult to decipher the signal and the noise. The most recent earnings, however, helped to elucidate the picture. We give you our three main takeaways.
There is no growth
The DLR lowered its forecast for the year. It was clearly evident that whether you looked quarter over quarter, year over year for Q3-2022 or year over year for the first 9 months, growth was nowhere to be found. . Adjusted funds from operations (AFFO) were down across all time horizons.
Yes, there were currency headwinds.
But it works both ways. If DLR is accessing very low-cost debt in Europe, which it is, it really can’t blame the Forex headwinds that blow at it from time to time. The main driver of this weak growth was not the strength of the US dollar, but rather extremely low relocation spreads.
Margins are extremely low
The comparison of the same store portfolio shows that revenues fell by 1.6% in a strongly inflationary environment while expenses were up.
Net operating profit decreased by 6.2%, leading to a net operating profit margin of 55.9%. You get this number by dividing $486,957 by $869,966. Some might find it bizarre to call a 55.9% NOI margin low, but REITs tend to have very high margins. Even looking at the history of the DLR, it turns out to be extraordinarily weak. Q3-2021, for example also shown above, had an NOI margin of 58.6%. Let’s go back a little further.
Q3-2020 had an NOI margin of 62.2%. Q3-2019 was at 62.9%. How about going back even further?
Q2-2018 was at 66.6% and Q2-2017 at 65.1%.
The trend is therefore very obvious to us and does not bode well for the REIT. Of course, as to the “why”, it’s pretty obvious. As we have repeatedly pointed out, it is difficult to seriously say that there is an insane demand for data centers when the occupancy rate has generally been declining in a straight line for the past 7 years. The stabilized occupancy rate is currently 83.4% and was 94.3% in June 2015.
Capex is always monumental
We are not growth hunters. Sometimes the best thing a business can do is not try to grow. So the steady state AFFO or FFO numbers wouldn’t bother us if the other fundamentals were good. What worries us in the case of DLR is the capital expenditure that keeps the AFFO flat. DLR plans to spend $2.45 billion in 2022.
Keep in mind that DLR’s total AFFO is about 30% less than this capital expenditure number. DLR also sends around 80% of its AFFOs to shareholders as dividends. So spending $2 billion above cash flow seems like a very dangerous proposition. Of course, some will come through equity and that reduces risk. But debt to EBITDA is high for a REIT with less than 85% occupancy and very little pricing power.
We stand by our assertion that while DLR has been unable to produce FFO growth over the past 12 months, while issuing equities at 25X multiples and when interest rates were at rock bottom, it will not do so for the next 12 months. The results were very weak but our main concerns come from capex and future refinancing. In a recession, we could easily see a debt to EBITDA ratio of more than 7x, which could lead to credit downgrades. The risks are too high in our opinion. If readers disagree, they can present 3 REITs that have lower occupancy than DLR and plan to spend 130% of their current AFFO on capital expenditures.
Those seduced by DLR’s dividend yield should realize that they have other alternatives.
Digital Realty Trust, Inc. 5,850 PFD SR K (DLR.PK) is a question we would consider.
With a current yield of 6.7%, it gives you a higher seat in the capital structure and the potential for capital appreciation should interest rates decline. We don’t own this one yet, because we think the risks are still too high, even for preferred stocks, but if we were to own either of the two, we’d go for preferred stocks.
Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.