Why Digital Real Estate Returns Are Not Calculated

To manage the explosion of data and cloud computing, hundreds of indescribable buildings are filled with servers, kept at a constant temperature and humidity, and hooked up to huge power lines. For reasons like utility connections and zoning rules, the area south of Washington, DC is now bigger than Silicon Valley as the host of our digital lives. It’s approaching 2 gigawatts of capacity, according to the real estate services company Cushman and Wakefield PLC—enough to power 1.5 million homes.

The biggest creators and processors of all this data are known in the business as hyperscalers—

Alphabet Inc.

GOOG -4.31%

Google,

Amazon.co.uk Inc.

AMZN -3.42%

Amazon Web Services,

Microsoft Body

MSFT -3.19%

Azure,

Oracle Corp.

,

Facebook

owner Meta Platforms Inc. and

Apple Inc.

They spend a lot on their own data centers, but their needs are so huge that they’ve also outsourced tens of billions of dollars in digital real estate investments to niche investors.

“It’s difficult for these companies, no matter how sophisticated, to get the land, to sit on it, to get the electricity and the permits,” says Kristina Metzger, who heads the capital markets of the centers of data for real estate company

CBRE Group Inc.

Mom and dad got in on the action through real estate investment trusts that, in addition to dividend checks in a starved world, held the promise of tech-like growth. Private equity investors jumped just as valuations peaked. KKR & Co. and Global Infrastructure Management LLC paid $15 billion including debt — a 25% premium — for listed REIT CyrusOne Inc., under a deal signed in 2021 and completed this spring. This agreement was concluded only a few weeks after

black stone Inc.

closed its $10 billion deal for data center REIT QTS Realty Trust Inc., at a premium of 21%. There were many small transactions. Synergy Research Group calculates that 209 deals were completed in 2021 alone worth $48 billion.

Now, however, with rising interest rates, data-hungry tech startups are retreating and even stalwarts like Amazon’s Meta, Twitter Inc. and AWS put a brake on cloud investmentsthe remaining data center REITs such as

Digital Real Estate Trust Inc.

and

equinix Inc.

don’t look so attractive. The real story might be that they never really were.

Their return on invested capital is meager, but they’ve also had to raise mountains of cash to keep up with growth while paying dividends. These two weaknesses are normally a feature of REITs, but not a bug. Unlike a normal operating company that might buy machinery or invest money in designing a new product, which depreciate, real estate tends to appreciate in value if maintained. REITs are also pass-through entities that, in exchange for no corporate tax, must distribute 90% of their profits. Capturing the kind of rapid growth that digital owners have experienced therefore requires a lot of new debt and equity. Since early 2012, Digital Realty has grown from 103 million shares outstanding to 287 million, and its net debt has grown from less than $3 billion to nearly $16 billion, excluding operating leases.

But that money was raised during the best times with the rise of technology and yield-hungry investors. Even though many other REITs struggled when Covid-19 hit, a burst of online activity boosted data center shares and creative funding like securitization of leases helped some raise money for new facilities. However, data center REITs have lagged their peers since late 2020, despite all the deal activity. Anyone fueling their growth with new stocks or bonds today needs a lot more yield.

They still aren’t asking for enough, according to short seller Jim Chanos, who make a big bet against them. One criticism is that they overestimate returns by classifying certain maintenance expenses as being for growth – a complicated point that data centers refute. One clearer thing is that, unlike well-maintained apartments, rents have gone down. They have fallen from an average of $145 per kilowatt per month in primary markets to around $120 last year, according to CBRE. That drop has reversed sharply recently in some hot markets as power companies and construction crews struggle to keep pace and inflation hits construction costs. The scarcity could give data center values ​​a break but, in an ominous sign, Digital Realty chief executive A. William Stein was removed from his leadership and board roles this week without explanation.

The other criticism of Mr. Chanos is that the big customers of the data centers, the hyperscalers, are also their competitors. Their ability to “self-construct” makes them different, for example, from an office space rented by a bank. Thomas Dakich, an attorney who has worked on death row cases and is now chief executive and general counsel at data center company Digital Crossroad, was asked during a panel last month about his hyperscale clients. .

“Negotiating with these guys is difficult. They are literally, “What’s mine is mine, what’s yours is mine, but I don’t want you to be responsible, so you take responsibility and I’ll take the asset.”

Normally, in a gold rush, pick and shovel sellers are investors’ best bet. However, digital owners only rent them. If demand for cloud computing continues to slow or prospects like the Metaverse don’t materialize, it will be bad for companies like Meta and Amazon, but it’s the owners of those giant boxes in Virginia who could really be buried.

Write to Spencer Jakab at [email protected]