Digital Realty’s Key Risks
We generally avoid investing in technology companies because industry trends can unexpectedly and quickly take a turn for the worse. In Digital Realty’s case, we think the biggest risk is that data centers are overbuilt in anticipation of strong data usage trends.
After all, Digital Realty Trust, Inc. (NYSE:DLR) cannot control the capital allocation of its competitors. As long as cheap financing is widely available and industry margins are high, more supply will enter the market. If an excess supply of data centers occurs, Digital Realty could experience unfavorable lease renewal rates (13% of its square footage under lease expires through 2017), weaker profitability, and lower growth.
As seen below, new construction is set to double data center supply in some of the cities Digital Realty operates in. Time will tell if this new capacity loosens the market’s favorable fundamentals, but it’s important to remember that Digital Realty is somewhat protected due to its scale, reputation, cost-efficiency performance, and financial stability.
Source: Digital Realty Fact Sheet
As technology evolves, it’s also possible that companies learn to store and manage data much more efficiently. This could reduce demand for physical data center space. However, there would have to be major advancements to offset the 20%+ annual growth in data usage across Digital Realty’s major markets.
Beyond risks unique to the data center market, Digital Realty faces risk from the health of capital markets. REITs are required to pay out 90% of their taxable income as a dividend to keep their REIT classification and the favorable tax treatment it comes with.
Since REITs pay out such a high amount of their earnings, they have less capital on hand to grow their businesses. As a result, they typically issue shares and debt. As seen below, Digital Realty’s capital structure was over 50% debt last year, and the company’s diluted shares outstanding have risen from 24 million shares in 2005 to a whopping 139 million shares last year.
Source: Simply Safe Dividends
Source: Simply Safe Dividends
REITs can run into trouble if credit markets tighten up and/or their share prices sink, raising their cost of capital and potentially causing a liquidity squeeze.
Digital Realty currently maintains investment grade credit ratings from the major agencies, although it sits at the bottom tier of what is considered “investment grade.” The company has just $75 million in cash on hand compared to $5.9 billion of debt, but it has a relatively conservative debt maturity schedule with nothing major coming due until 2020 (see below).
