Hedge Fund Sours on Data Center REITs

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Although the entire real estate investment trust (REIT) sector has come under pressure recently, data center REITs have the added negative of a hedge fund manager questioning the industry's outlook. That may present a buying opportunity for a sector that has years of growth ahead.

Hedgies

Barron's recently reported that hedge fund manager Jonathon Jacobson of Highfields Capital Management is not only questioning the accounting of data center REIT giant Digital Realty (NYSE: DLR), but is also suggesting that the entire sub-sector is facing strong headwinds. The accounting concerns are a specific negative for Digital Realty, which has fallen from the high seventies to the low sixties over the last few months. The broader fear, however, may be overblown.

The Cloud

The data center REIT model is based on the trend toward increased use of the Internet. Since computers can be accessed over vast distances, there's little need for every company to have their own in-house network. Specialists like Digital Realty, DuPont Fabros Technology (NYSE: DFT), and CoreSite Realty (NYSE: COR) can provide a home for such networks, allowing the companies to use the Internet to access their information.

These REITs, however, don't just house boxes, though that is one way to use their services. Data centers also offer multiple locations (redundancy), backups, staff to maintain the computers, and the ability to share expenses to keep costs down. That's a compelling offering for companies looking to pare back their IT budgets.

Big Player Problems

One of the concerns is that larger customers are increasingly building their own data centers. That has, in turn, reduced demand and hurt pricing. While this may be true in the short-term, it doesn't tarnish the longer-term view for the industry. Indeed, the market isn't only made up of big players like Google and Amazon, there are thousands of small- and mid-sized companies that want to use data centers, too.

And, large companies may find that owning their own data centers isn't as desirable as they had hoped because the buildings trap capital that could be used elsewhere. Eventually they may want to sell their data centers to free up capital for other purposes. Data center REITs would be obvious buyers.

The Big Player

Digital Realty is the largest player in the space with over 115 properties. It has a global footprint, with about 80% of rents coming from North America and the rest from Europe, Asia, and Australia. It has some big name customers, including International Businesses Machines and Facebook, that could take their data centers in-house.

However, Digital Realty has over 500 tenants. So, even if it lost some large customers, it has plenty of others to pick up the slack. In fact, the company expects data center demand to increase by at least 20% annually in the regions it serves, so demand shouldn't be an issue.

Digital's dividend has been increased on a regular basis and the sell off has left the shares yielding around 5%. That's compelling, but there are still the accounting issues being brought up. More aggressive investors might want to step in, but others should wait to see what happens on the accounting front.

Growth and Risk

DuPont Fabros has just 10 facilities in four U.S. markets, with a couple of new facilities on the drawing board. With only a fraction of the properties of Digital Realty, DuPont has more growth potential. Adding just the two planned facilities will increase its portfolio by 20%.

That said, at the end of 2012, the company only had 33 tenants and 10 customers accounted for over 80% of the rent roll. Although DuPont's average lease length is around seven years, it is far more exposed to big customers bringing their data centers back in house.

The shares yield around 3%, but have been largely range bound since the start of the decade. Despite the recent pullback, investors would be best served waiting for the stock to dip into the $20 range before starting to consider a purchase.

Small, but Diversified

CoreSite, meanwhile, has around 14 data centers in nine U.S. markets, with a few more under development. It has over 750 customers, however, so it has the growth potential of DuPont without as much customer concentration risk. The shares recently yielded around 3.2% or so after doubling in price since their late 2010 IPO. The recent sell off may be a long-term buying opportunity, but a yield in the 4% to 5% range would probably be a better buying point.

Time to Wait

Right now isn't the time to jump aboard any of these data center REITs, or newcomer CyrusOne. The current REIT sector pullback and the specific issues around data centers, however, does make now a good time to examine the options in this growing niche. Keep in mind, however, that any marks against Digital Realty are likely to be felt across the entire industry. So volatility might be the norm for a little while. That said, at the right price, it might be worth the ride.

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