Recently I interviewed John Stewart, Senor Vice President of Investor Relations at Digital Realty (DLR). In this 28 minute interview we discussed a variety of topics, further validating our current Buy recommendation.
I hope you will take the time to watch the entire interview!
Have a great weekend and all the best.
Hi everyone, this is Brad Thomas with the Ground Up and I’m back again with another C-suite interview. And of course today we don’t have the CO here, but we have something really equally as good, is John Stewart here.
John is the senior vice president of investor relations with Digital Realty (DLR). And John knows everything there is to know… I won’t say better than the CO, because I don’t want to offend the current CO, who I think is doing a fantastic job, I might add.
But John, thank you for joining us today.
Brad, thanks. Thanks for having me. Yeah, definitely a lot of history with Digital Realty, so I’m pleased to have the opportunity to be here with you today.
Great. Well, John, I know physically, you are in San Francisco, and there was some recent news that the company was relocating a part of the business to Austin, Texas.
So can you tell us a little bit about how that decision came about?
Sure. It’s been a while in the works, I would say Brad. But at the end of the day, it’s a couple of things.
Certainly, obviously Texas is a very central location. So in terms of servicing customers around North America, it really, ease of access to both coasts, and we have a fairly distributed leadership team. Our CFO, Andy Power and I are actually… We’ll remain based here in the Bay area.
Our CEO has relocated to Austin, to Texas, and then too, as we’ve grown as a global organization, some of the centers of excellence supporting the business, so functions like accounting and HR, from a cost perspective, it makes more sense to be located in in a lower cost jurisdiction like Texas.
And so, between a combination of supporting the growth of our asset base… We’ve got 30 data centers in Texas so we have a sizable investment in the state, and a pretty sizable employee base. And so, we’re going to continue to grow there.
I see. Well, of course Digital is a global enterprise. And so, I’ve been covering the company now for almost a decade, probably.
So can you talk a little bit about, for the viewers who aren’t as familiar with Digital’s, I guess, far-reaching portfolio. Can you talk a little bit about where your portfolio is today?
Sure. I mean, we are truly global, as you say, Brad. So we are in almost 50 metropolitan areas, in 24 countries, on six continents around the world.
So, we cover most of the major NFL cities here in North America. We’re also in South America with… We acquired a platform called Vicente a couple of years ago with a leading provider in Brazil, and branched out from Brazil, into Chile and Mexico.
And in Europe, we acquired a business called Interaction, which was a publicly traded data center provider. Very well-regarded, very high quality portfolio. They were really the number two provider in Europe. And we were a distant number three. So obviously combined the number two and number three player in Europe, and that significantly enhanced our platform.
So, really strong presence on the continent in Europe, including Frankfurt. A very sizable presence in Frankfurt, Paris, London, Amsterdam, and a really key asset in Marseilles, which really serves as the gateway for interconnection between Europe and Africa.
And then in Asia Pacific, we have a presence in Japan, in Tokyo and Osaka, and in Singapore is our regional headquarters in the region. We’re also in Hong Kong, in Sydney and Melbourne, down in Australia and entering South Korea.
So that’s kind of the global footprint in a nutshell.
I mean, that’s a lot of real estate. What are the pockets, I mean, as you were talking, I was trying to go, where we’re haven’t you gone? What are some pockets that are out there?
Sure. There’s a couple. I would say we feel really good about our presence in North America and in Europe. Again, especially following that recent transaction we did with the Interaction business.
So I’d say Asia Pacific is probably where we have the most room for growth. I would tell you, we’re not in mainland China today. And I don’t know that that’s on the near term horizon, that’s obviously a trickier market to navigate from a geopolitical and investment perspective, both including ownership of real estate, as well as repatriating capital. That’s a trickier proposition, so China’s not on the front burner.
India is a major growth market that we are studying closely. We announced that we have entered into a memorandum of understanding to try and executed a joint venture in India. That particular deal did not come to fruition, but we have been carefully studying the Indian market. I think that’s a country, where over time, it will definitely make sense to have a presence.
And, there’s maybe a few others besides, and in addition, we just have a lot more room for growth in the existing markets where we do have a presence in Asia Pacific.
Like I said, we’re kind of number one or number two in US and Europe, but we’ve got a lot more room for growth in Asia Pacific.
Yeah. I’ve got a book coming out in May and, and I’ve got the… The first book we had in China, and now I’m trying to expand. So you need to get into China. All those other countries where you have a presence, I need to get my book over there as well.
translated into many languages.
Yeah. Teach them what a read is. So I guess the other thing I want to touch on, just in terms of switching from the… I guess your scale advantage, because arguably, I’ve written about this extensively, Digital Realty as a very tremendous scale advantage over their peers, but moving over to cost of capital.
And I’m curious, John, we cover a lot on REITs, like WPK even has a global footprint and now Realty Income, which is now in Europe and growing there, but I’m interested to see how those companies have been able to use European capital at a lower cost of capital.
So can you talk a little bit about… Because I’ve seen a lot of interest in deals and a lot of, really, creativity in terms of your capital formation and the debt that you’ve raised internationally. So can you touch on that a little bit, please?
Sure. Well, I’d say it goes back to our now CEO Bill Stein, who you mention at the outset. He was previously CFO of the organization and did a great job establishing investment-grade ratings for Digital Realty back in 2000. So, that obviously is, what, 12 years ago, and as a result, we’re certainly a well-known seasoned issuer, with a long track record of issuing corporate bonds.
And then, Andy Power, who took over from Bill as CFO after he left, has certainly done a fantastic job managing the balance sheet, very proactively, including, we’re certainly the first data center REIT and one of the first REITs to issue a green bond. So we issued a US dollar green bond in 2015.
And to your point, Brad, especially after we acquired that business in Europe, the Interaction business, [inaudible 00:08:39] nine billion dollar transaction, and our philosophy is to not enter derivative contracts to hedge our currency exposure, but to match the denomination of the assets with the liabilities.
And so, because we have Euro-denominated assets, that nine billion transaction, we have been issuing Euro-denominated debt to match the assets and liabilities.
And as you point out, the benchmark rates in Europe are quite a bit lower, especially as the treasury is running up here. And so, we’ve been able to raise capital very cost-effectively.
In January, we issued a billion Euro green bond, and that was at a 10 and a half year bond. So long duration bond, and the total coupon was 0.625%. So 10 and a half your money at 5/8, so very attractive.
What’s the back of the napkin weighted average cost of capital on that? Back of the napkin, that’s got to put you in a weighted average cost of capital, like zero what, 60%… 60/40 right? Roughly? You got some preferreds, I knew you got some preferreds.
Yeah. More like more like 70/30.
Yeah, I think that’s probably a little bit… Well, the weighted average cost of debt across the entire portfolio is a little bit below 3%. But I think just obviously we were very pleased with that particular transaction, but I think it’s a little bit misleading, I guess, to peg the entire weighted average at that one point in time.
But yeah, no, certainly we’ve done a good job again, of managing the balance sheet extending… And by the way, like I said, it was 10 and a half year money. That’s not short-term money, so we are extending the duration while we’re also ratcheting down the cost of capital.
And again, hats off to Bill and Andy, I think they’ve done an excellent job managing the balance sheet.
Yeah, I agree. And, and can you talk a little bit about… I’m actually writing an article on the subject of how REITs are going to be impacted by inflation. And so, obviously, I mentioned that lease REITs again, and that’s kind of this myth that the net lease REITS don’t have any growth, which you know they do have rental growth, not as great as you see.
So can you talk about it in terms of Digital’s model, in terms of how you are prepared for inflation? And again, you just mentioned you match-funded your longer-term debt. You’ve already kind of answered part of that question, but what about growth? Rental growth and how you can drive growth internally?
Sure. Well, I’d say the first line of defense against inflation, if you will, it’ll affect you in a couple of different ways.
First of all, we do have built in contractual rental rate increases in our leases. So, that obviously helps you… Every year, the rent steps up. So that will obviously help hedge against inflation. Now, those built-in rent increases, they range from 2% to 4% depending on the type of the customer and contract. So, you should be pretty well… And historically, I think that has outpaced inflation for the past couple of decades, for sure.
If we have rampant inflation here with… If you’re spending quite a bit more than you’re taking in and inflation really begins to run away, then you could potentially be exposed to the extent that it exceeds 2% to 4% and then we would have an opportunity to reset those leases to market once they expire, and the weighted average lease maturity across our portfolio is about five years. So as those leases expired, then you’d have an opportunity to reset the market.
The other exposure that we have, especially as a developer is you could very well see an increase in the input costs to your development projects, the price of lumber, the price of steel. And by the way, already I think you’re seeing an impact of higher fuel costs, which translates to transportation is a big part of the total cost of your inputs. So, there, we would need to see higher rents, higher market rents, to justify the higher development costs.
I think that we haven’t seen that yet. I think you’re just kind of potentially on the cusp, and we’ll see how that plays out, but certainly from our perspective, to be able to maintain your returns in a rising inflation environment, then knock on wood, if everything is healthy, we should be able to pass that along in the form of higher rents.
Right. I want to touch on as well, Digital’s had a very predictable history of earnings growth, really best in class, in terms of your profile. And of course, along with that comes dividend growth, a very repeatable model of dividend growth going forward.
So, now this year, and of course, Digital has sold often… In fact, your peers of all the host data center sold off moderately here today, but specifically Digital has in 2021 where we’re based on Amla assessments, we’re seeing a more modest growth profile of around 4%, based on our analyst’s scorecard here, which typically you’ve been in the higher, you know, 8, 9, 10, you know, 8, 9, or 10 or so per year.
So can you reflect on that more modest growth this year going [inaudible 00:14:43] and kind of what you’re seeing out there?
Sure. I’d say there’s a couple of aspects to that, Brad. I mean, one is certainly you’ve got the law of large numbers, right? We’re a much bigger organization today than we used to be, over $50 billion of enterprise value. And so as the, you know, it gets harder to move the needle, the bigger, the bigger the base becomes. So I think that is a factor.
In addition, we have also been selling some assets. And in fact, we announced earlier this week that we sold a portfolio in Europe. And obviously when you do sell assets in the REIT model, as you know, on day one, you lose the cash flow from those in-place rents on those assets that you just sold. So that’s dilutive in the near term and we have been recycling capital for the past couple of years.
That’s definitely been a headwind or contributed to slower growth. And then, you know, finally I’d say we do have a history of under-promising and over-delivering. And we certainly hope to continue to repeat that. So knock on wood, hopefully do a little better than 4% by the time it’s all said and done.
And yeah, I mean, I would also say that I don’t think we are happy with 4% growth. We certainly aspire to re-accelerate our growth again. I do think quite frankly, Brad, that some of the faster growth that you saw earlier in our evolution is probably… I don’t think we’re likely to return to those heady days that we saw earlier on, when the base was a lot smaller, and we frankly had a lot less competition. I think the times have changed.
But we definitely, we are planning and investing to re-accelerate our growth and continue to deliver a safe well-covered and growing dividend for shareholders.
Right. And I got to ask you this. I know, you know, Digital has maintained a fortress balance sheet, and we appreciate that. I think that’s been a big part of the success of the company in terms of its pretty good predictability of the earnings stream and the dividend stream that we’ve seen over the last decade or so.
But I’ve got to ask you how important is it to have that plus on that credit ready? Right now, your S&P got a triple B, how important is it for the plus? And then I want to ask you one last question on that is, do you think it’s ever possible for Digital to get that A-rating?
Great question. That is a great, but tough question, Brad. How important is it? Well, I would say, look quite frankly, and again, I think you can judge this as evidenced by that specific bond transaction that we just talked about in January, right? That while in coupon of 5/8’s, That would tell you that the market, I think, is pricing our bonds tighter than where the agencies seem to have us pegged.
And, quite frankly, Brad, our ratings have not moved since 2009 when Bill Stein first took us to agencies and obtained those investment-grade ratings. And in those ensuing 12 years, we’ve grown dramatically. And, you know, I mean just one key point at that time, our largest customer was represented a… So we had greater concentration with a single customer and that customer was at junk credit.
Today, our largest customer is 7% of revenue and it’s a triple A credit. So, and we’ve grown dramatically, and data centers as an asset class are much more mainstream today than they were back then. So we have grown dramatically, significantly enhanced many credit metrics. And I think the agencies have been a little bit slow to, to recognize that, quite frankly. [inaudible 00:18:39] , I’m not sure that again, I think that the bond market is probably ahead of the agencies, in terms of where they are pricing our debt.
So we would love, we are definitely biased towards higher ratings, not lower. We are not going to lever up the balance sheet to try and squeeze out a little bit more earnings growth, right. I mean, we certainly view that you have a bond with the bond holders as well, right?
And so we’re not going to put the balance sheet at risk and we have a bias towards higher ratings, but I don’t know, it’s again, the agencies have been a little bit slow on the draw. And I don’t think that we’re going to manage the business for what we think is best, where we see the best overall weighted average cost of capital, not just for a rating, so I hope that helps.
No, that is helpful. And of course, you know, we’ve been covering, you know, we watch for a lot, just go from the, A-rating. You know, I think 18 months later we saw a Realty income jump from the, from the triple-B up to the A-minus. So we’re kind of watching this to see.
And you know, I’ve always felt in the back of my mind, watching Digital, you know, move forward, getting closer to that, A-rating that is, we’ve got our own proprietary scoring model, John, where we actually automate… We call it our IQ system, which stands for Intelligent Quality, IQ. And we do give a lot of credit for those A-ratings, just like, you should, and it’s pricing power for sure.
So I guess last question I want to talk about is the dividend, but I want to say… One thing that ties into that indirectly is, I get this all the time, and I’m sure you do too, with these hyperscalers and the competition you have with Amazon and Google, who’re going to start owning the real estate.
And I know this is like a broken record for you. I hear it all the time, but can you touch on that? As far as what are you seeing out there? And then of course, dividend safety, how safe is this dividend in your opinion today based on your payout ratio and your target payout ratios?
Sure. On the first point, the hyperscalers and the propensity to do it yourself, I would say, I mean, they, they do. And they always have, quite frankly. And in fact, what you actually see from in the third party market is really just the tip of the iceberg. They have huge campuses for their own account, but some of where we can really add value, and what we capture from them is really, number one, it tends to be location.
So where you’ll see the hyperscalers have their own huge campuses. It tends to be in really tertiary or secondary locations where they can negotiate single-handedly with the municipality and say, “Hey, listen, we’re going to bring a bunch of jobs to your very isolated, rural community here. And we’ll pay some tax dollars and in exchange, we’ll, we’ll put a huge campus here.”
And, and if you look at where those hyperscalers tend to have their own campuses, it tends to be rural locations for applications, IT applications that don’t have the low latency requirements. They’re not as close to the population basis.
In contrast where the third party providers, like us, where we can add value is we own some really strategic landholdings in those major metropolitan areas, and we’re also able to… Look, this is our core competency, Brad. It’s what we do day in, day out. We build these things and we’re able to have them at the right time and the right locations for these hyperscale customers. And so they have a combination, they built some for their own account and they take some, quite a bit from us.
And we’re also fortunate that we’re not really… It’s not a one-trick pony. There are many, many, many customers who are demanding third-party data center capacity in the major metropolitan areas where we have a presence. And so I think that the do-it-yourself component is going to remain a very viable option for those leading hyperscale customers. But they’re also going to take a certain amount from us in select markets around the world. So, hopefully that makes sense.
In terms of the safety of the dividend, I would say that our first measure is to pay out a 100% of taxable income, which we do obviously, as a REIT, you avoid double taxation, if you pay 100% of your taxable income. And then our secondary measure is we target an AFFO payout ratio of below 80%. And we’re at about 77% today, again, based on those consensus numbers that you mentioned earlier. So a payout ratio below 80% means that you’ve got kind of 20% cushion right before your cashflow doesn’t cover.
So, from my perspective, I think it’s certainly healthy, well covered. And, and we feel very good about our ability to continue to grow those cashflows and grow the dividends that we pay to shareholders each and every year, as we have done every year, since we came public back in 2004.
Right. And I guess the last question I want to touch on again, I know we’ve had that sell-off, but, historically, your price to funds from operation has been… Again, I would go back even over the last five, four years have been in the 18 range. You’re trading about 21 times now, but you hit about a 25 multiple, back in the middle of COVID in July of last year.
Yeah, I’m just trying to get an idea again, in terms of valuation, we’ve just gone through really what I call the quality metrics for Digital Realty, which are the scale advantage, the cost of capital advantage, being able to deliver strong earnings and dividends, but in terms of valuation, it’s just hard to get arms around that your sector, you’ve got a three and a half percent yield right now, which is actually fairly attractive to us.
So if we ever buy officially own Digital today, but what do you feel about that 21-multiple, compared to where you’ve been in the past?
Sure. Well, I’d say, first and foremost, Brad, valuations are like family. It’s all relative, right? So it depends on, you know, you look at how one house in a neighborhood is valued compared to the other houses in the neighborhood.
Now, certainly where REITs are concerned. Part one of those relatives, if you will, is the 10-year treasury, right? Because REITs are kind of somewhat of a yield alternative. And of course the treasury, really, the risk-free rate affects the discount rate that you use to value assets kind of across the board.
So as the treasury ticks up, then generally REITs kind of move inversely to the treasury. So that’s a factor I think that needs to be considered. However, look, I think the fact pattern you just laid out is quite telling, right? You said that we reached our peak of 25 times at the height of the COVID crisis. And so why is that, or what does that tell you?
From my perspective, that tells you that the sector performed remarkably well through another pandemic, a financial crisis, just like we did through the global financial crisis. And so, in my opinion, part of the reason the sector has been re-rated has been because we have really demonstrated durability of this business model, the resiliency.
And by the way, not to take anything away from our brethren in other property types, but if you look at the long-term effects of COVID, right, we we may be using less office space as we work from home a little bit more, like you and I are doing on a Friday, right?
And maybe we do a little more of that going forward. And, maybe you don’t, maybe you do a little bit more shopping online, rather than in person. And now when you do that, when we’re using Zoom, for instance, where do you think Zoom runs, right? It runs right through a data center. The video conferencing platforms are significant customers.
And so my point being the pandemic has really accelerated digital transformation. It’s been positive for our demand profile for the health of our business. So I believe that we are a structural beneficiary of some of the changes that we’ve seen over the last couple of months.
So in my opinion, I would argue first of all, the sector has really proven, demonstrated it’s mettle, right? I think we’ve, again, really shown the durability and resiliency. And I think that we have benefited from some of those long-term structural shifts. And so talking my book obviously, but I think that we are attractively valued today.
Yeah. Yeah. Well, we agree. And, you know, I think we agreed a lot of that conversation, but John, I really appreciate your time. And thanks for jumping in here on this call. I’m sure my viewers would also agree, been very helpful here, so wish you the best. And we’ll circle back again, I guess, real soon we’ve got Nate Reid, coming up among other things, so I’m sure we’ll be back in touch soon.
Good to see you as always Brad, thanks a lot for having me on. Best of luck with the launch of your book in May and hope you have a great weekend. Take care.
Thank you. Thanks again. Bye-bye.
Brad Thomas is Senior Research Analyst at iREIT and CEO of Wide Moat Research LLC. With over 30 years of real estate experience, he is also long-time Editor of Forbes Real Estate Investor, a monthly subscription-based newsletter that dives deep into the vast world of profitable properties, and since 2021, he has served as an adjunct professor at New York University.
Thomas has also been featured on or in Forbes magazine, Kiplinger's, U.S. News and World Report, Money, NPR, Institutional Investor, GlobeStreet, CNN, Newsmax, and Fox. And he was the #1 contributing analyst on Seeking Alpha in 2014, 2015, 2016, 2017, 2018, 2019, 2020 and 2021 based on both page views and number of followers.
Thomas is the recently-published author of The Intelligent REIT Investor Guide (2021), co-author of The Intelligent REIT Investor (2016), and he wrote The Trump Factor: Unlocking The Secrets Behind The Trump Empire (2016) - all available on Amazon.
Thomas received a bachelor of science in business/economics from Presbyterian College and is married with five wonderful kids.