Digital Realty's Dividend Remains Well-Covered, Despite Industry Pressures

The second largest data center REIT, Digital Realty Trust, will likely announce a low-single-digit dividend raise within the next few weeks and reach 18 consecutive years of payout growth.

This increase will come on the back of what proved to be a frustrating year for investors, with Digital Realty's stock trading down about 40% last year compared to a 26% loss for the broader real estate sector. 

But the market's concern for the REIT's outlook may have been overblown.

Digital Realty's 300-plus data centers are used by a diverse base of over 4,000 customers, with around half having investment-grade or equivalent ratings.

Strong tenants and a wide geographical footprint should provide a solid foundation for continued growth fanned by industry tailwinds, given the global expansion of online platforms and connected devices.

Furthermore, a BBB rated balance sheet and consistently well-covered dividend all contribute to our reaffirmation of Digital Realty's Very Safe Dividend Safety Score.

That said, we are mindful of the REIT's near- to medium-term challenges that, if exasperated, could lead us to downgrade Digital Realty's score.

Occupancy has trended lower in recent years to just under 84% after averaging close to 90% before 2019. Management attributes this drift to new buildings coming online with excess capacity.

Ongoing construction projects that will expand Digital Realy's physical footprint by around 25% could keep occupancy on the lower end of its historical range, with just 60% of development space pre-leased.

But analysts predict this growth will push income modestly higher in the year ahead, suggesting that excess capacity will eventually be filled – "if you build it, they will come."

While the long-term tailwinds of data and cloud computing should continue to push the industry forward and sustain demand, fierce competition in building data centers and ever-improving technologies leading tenants to need less space have pushed rent prices lower.

Another contributing factor to declining rent prices is that many data center customers are also competitors.

For Digital Realty, the top 20 customers who comprise half of the REIT's annual rent include multiple hyperscalers like Oracle and Facebook that operate their own data centers in addition to being tenants.

If rent prices get too high, these customers may shift more digital storage in-house by expanding their own data center capacity. Even so, overall supply is beginning to tighten as demand remains strong and the challenges of building new facilities grow.

Persistently high construction costs, a challenging permitting process to build these often ugly nondescript buildings, and the massive amounts of power required to maintain constant temperatures and humidity levels all contribute to a high hurdle when expanding capacity. Not to mention the increased costs of financing these projects as interest rates have spiked.

These pressures have led to rental rates reversing their downward trajectory and growing by about 6% through the first half of 2022, according to the real estate firm CBRE.

This report is welcoming news for Digital Realty, with nearly 50% of leases up for renewal over the next three years that could be renegotiated at lower rates.

While profit margins may be lower in the next few years with many lease renewals on the horizon, Digital Realty's conservative payout ratio looks poised to sustain the dividend through this turbulent period as the industry inches towards equilibrium.

Finally, it's worth noting that Digital Realty's stock was swept up in the tech frenzy brought on by the pandemic. This also explains some of the stock's underperformance last year as higher interest rates and slowing digital spending have tempered investor sentiment.

DLR's price-to-adjusted funds from operations (AFFO) ratio, a measure similar to a P/E ratio for REITs, increased from around 20 to nearly 30 in 2020. The stock's current multiple near 16 appears much more reasonable going forward.

Overall, the critical nature Digital Realty's data centers play in the modern economy should ensure they keep generating reliable cash flow. Even with the challenges noted, we feel confident in the REIT's dividend profile and ability to maintain its prominent role in the industry.

We will keep a watchful eye on Digital Realty and provide updates if any of these trends become problematic to the firm's payout or long-term outlook.