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Data Center REITs Look to Rebound

After posting negative total returns in 2018, the sector is off to a strong start through the first quarter.

Data center REITs in the U.S. took a pounding in 2018 after riding high for two consecutive years.

Data compiled by trade group Nareit shows the sector—made up of five publicly-traded REITs—tumbled to an overall return of -14.1 percent in 2018. To be fair, data center operators weren’t the only publicly-traded REITs that were dwelling in the cellar last year. Office REITs, for instance, posted an overall return of -14.5 percent in 2018, while the return for lodging REITs stood at -12.8 percent as the year came to a close.

Still, the fall that data center REITs took in 2018 was stunning, especially in light of the sector’s positive returns of 28.4 percent in 2017 and 26.4 percent in 2016, according to Nareit.

The five publicly-traded data center REITs have rebounded mightily thus far in 2019, though. As of April 2, according to Nareit, the year-to-date return for data center REITs totaled 22.5 percent, less than only one other REIT sector—industrial (22.8 percent).

But will the momentum continue?

For its part, Morningstar Credit Ratings LLC believes it will. The credit rating agency says data-gobbling technologies such as the Internet of Things, edge computing, artificial intelligence, self-driving vehicles and 5G expansion ensure growth in the U.S. data center industry “will be high for the foreseeable future.”

For many of the same reasons, commercial real estate services company CBRE also foresees considerable momentum for data centers, at least this year.

From an investment perspective, new capital sources [continue] to fuel interest in the sector as data centers continue offer investment diversity and strong returns,” CBRE says in a recent forecast. “In 2019, we expect positive market fundamentals with demand continuing to outpace supply and elevated interest in data center capital markets.”

CBRE notes that demand from cloud-computing providers led to a record 303 megawatts of absorption in the seven primary U.S. data center markets in 2018. Meanwhile, development pipelines ramped up in primary markets to more than 500 megawatts last year.

In a Q&A with NREI, Chris Wimmer, vice president of REITs at Morningstar Credit Ratings, offers his outlook for the five publicly-traded data center REITs as a whole: CoreSite Realty Corp., CyrusOne Inc., Digital Realty Trust Inc., Equinix Inc. and QTS Realty Trust Inc. Collectively, those REITs boast a market cap of $65.5 billion.

This Q&A has been edited for length, style and clarity.

NREI: What’s your take on the current state of the data center REIT sector?

Chris Wimmer: Data center REITs make up a small though growing and increasingly important subsector of the overall REIT sector. These REITs are building their portfolios to enable their customers to not only connect with each other but also with populations and organizations across the globe.

While the development and maintenance of these facilities tends to be more capital-intensive than most traditional types of commercial real estate, the data center REITs have accessed capital without burdening their balance sheets with secured debt, ensuring the flexibility to access alternative liquidity in the form of their unencumbered assets should the need arise.

NREI: Despite its significant downturn in 2018, the data center sector has been one of the hottest among REITs in recent years. What’s behind that?

Chris Wimmer: Expansion in many areas of technology—including the Internet of Things, edge computing, artificial intelligence, automated vehicles and the buildout of fifth generation, or 5G, mobile platforms—ensure robust demand for data center space will be high for the foreseeable future.

 NREI: How long can the healthy run of data center REITs continue? What might be some of the headwinds that they face?

Chris Wimmer: We believe the fundamental trends driving demand for data center space are strong and secular. There may be some throttling back in growth velocity during a recession, of course, with new and existing tenants rethinking their expansion spending.

It’s also important to note that in a weaker economy, enterprise businesses will look to cut costs, and one of the ways they do this is through outsourcing by moving servers off-site into a data center, as well as other possible savings through cloud or hybrid cloud services.

NREI: There’s recently been some consolidation among data center REITs. What do you see going forward in terms of M&A activity?

Chris Wimmer: The sector seems to be taking a breather at this point after some significant transactions in the last couple of years. If, for whatever reason, the shares of data center REITs trade at meaningful discounts to net asset value in the equity markets, we would expect activity to increase again.

NREI: What’s your outlook for 2019 and 2020 for data center REITs?

Chris Wimmer: Construction of new data center facilities has been elevated in recent years, though demand was at record levels in 2017 and 2018 and easily exceeded supply. We expect strong absorption to continue for 2019 and 2020.

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