To The Moon

Data Centre REIT

[Written by Edmund Chan: CIO of Tiger Fund Management]

DCREIT's current distress valuation of 0.61x P/B ratio could be an investment opportunity.

The company is trading at low valuation due to the bankruptcy announcement from its second-largest tenant. This could be an opportunity given that concern appears to be overblown.

Here are some insights:

• Freehold data centre REIT

• Tenant Bankruptcy

• Mitigating Worst-Case Scenarios

• Distress valuation

Freehold data centre REIT

DCREIT is a freehold data centre S-REIT with a portfolio of 11 data centres in the US, Canada and Germany.

They are valued at US$1.4b across 1.2m net rentable square feet. The portfolio occupancy is at 96.9%, with 76% of clients possessing investment grade credit quality.

Its properties are strategically located in:

• 66% - Northern Virginia and Northern California - #1 and #2 largest data centre markets in North America

• 13% - Toronto, Canada’s primary data centre hub

• 14% - Frankfurt, second largest and one of the fastest growing data centre markets in Europe.

• 7% - Los Angeles, North America’s data centre gateway to international hubs and a key beneficiary of the U.S. entertainment industry

DCREIT’s sponsor, Digital Realty, is the largest global provider of data center, colocation and interconnection solutions. The Portfolio is fully integrated into Sponsor’s global data centre platform, PlatformDIGITAL®

Tenant Bankruptcy

DCREIT has announced that its second-largest customer, global colocation and interconnection provider, has filed for chapter 11 bankruptcy protection on 4 June 2023.

The customer, responsible for a significant 22.4% of DCREIT's annualized rental revenue, had been occupying three shell & core facilities in Silicon Valley, two similar facilities in Los Angeles, and a notable 4% of a fully-fitted facility in Frankfurt.

However, there may be glimmers of hope amid the turmoil.

Until May, the customer had dutifully met its rental obligations, and even after the filing, they have taken proactive steps to secure up to $200 million of debtor-in-possession financing. These will be used to pay vendors and suppliers in full for services rendered post-filing.

It appears that market sentiment has been somewhat reassured by these developments. Since the bankruptcy announcement, DCREIT's share price has experienced an impressive 25% surge, signaling that initial concerns could be overblown.

Mitigating Worst-Case Scenario

Looking at the worst-case scenario where there is a 100% elimination of annual revenue from the bankrupt tenant, it is estimated that:

• DPU would be reduced to $0.02 from US$0.192;

• NAV would be reduced to $0.74 from $0.81

• Aggregate leverage would increase to 36.5% from 34.4%

So, the impact is still manageable.

Furthermore, such worst case scenario is unlikely.

Let me explain.

The customer has a 120-day window to determine which leases to assume or reject.

DCREIT can retain the existing end-users and continue operating as a colocation facility. This approach is possible due to sponsor's colocation expertise.

Moreover, with rental arrangements set below-market levels and prime locations boasting low vacancies, there is a strong possibility of retaining these valuable leases.

Alternatively, should leases be rejected, DCREIT has the opportunity to re-lease the vacated spaces. This allows the REIT to explore new partnerships and potentially offsetting any losses incurred.

Distress valuation

DCREIT’s aggregate leverage is at 34.4%, with average cost of debt at 4.1%. With a global ROFR pipeline from its sponsor, there is still scope for DCREIT togrow.

The company is also engaging in share buyback. This indicates their confidence in its asset and tenant quality.

Currently, DCREIT is trading at 0.61x P/B and 19.0x EV/EBITDA.

Its dividend yield is 7.3%, much higher than its Asian listed peers such as 4.7% and 5.1% for Keppel DC REIT and SUNeVision respectively.