Digital Realty Trust, Inc. (DLR) Earnings Call Transcript & Summary

Welcome, everybody. We're going to get started. I'm Jon Atkin. I cover the data center sector and, more broadly, the communications infrastructure sector here at RBC. And I'm joined by Matt Mercier, who is the SVP of Finance at Digital Realty; and by John Stewart, who's the Chief Executive Officer of Digital Core REIT. Welcome and appreciate you participating in our event. So I'm going to kick off with a couple of questions for Digital Core REIT. And then -- for John Stewart, obviously, to address. And then we'll pivot over to Digital Realty. And then if there's questions at any point, just raise your hand, and we will try to fold in your topics.

So first of all, for John, given the recent IPO late last year, maybe kind of reacquaint people with the profile of your company and what sorts of financial metrics investors were prioritizing and do prioritize whether it's cap rate or dividend per unit yield, dividend per unit growth, et cetera?

Sure. Thanks, Jon, and thanks for having us. Good to be here. So we took Digital Core REIT public on the Singapore Stock Exchange in December of last year, seeded with a portfolio of 10 assets across North America, core assets in core markets, Northern Virginia, Los Angeles, Silicon Valley and Toronto. In terms of what investors are looking for, I think you hit the nail on the head, John. It is definitely the Singapore REIT market is certainly more yield-oriented. So DPU yield is a key consideration, but so is the growth in that DPU. That said, I would definitely say that Singapore investors are pretty in tune with the data center market, broadly speaking. And so they're certainly -- they care about the -- all the other metrics that U.S. investors would focus on as well. So cap rates, in particular, are going to factor into the potential growth in the DPU from an acquisition. So they're looking for you to invest accretively to be able to grow that DPU.

And then just kind of a current snapshot of ownership and investor base.

Yes, sure. So about 15% is held by retail. Digital Realty is, of course, still the largest shareholder at 35% and then the remainder is held by institutions. And that institutional geographic breakdown; North America represents about 10% of the shareholder base, another 10% directly from Singapore and then the balance is really throughout the APAC region.

Great. And then maybe kind of a quick recap on 1Q '22 trends you're seeing in same-store revenue, same-store NOI growth and then kind of the factors -- the swing factors to think about as we consider 2022 guidance top line and any kind of expense variances that you are -- that are kind of baked into your guidance?

Sure. So of course, at 1 level, we're going to be a reflection of what you're seeing at Digital Realty since we own 10 assets that came directly from Digital Realty. An important nuance to remember is that our mandate or mantra is owning core assets and the IPO portfolio is 100% leased. So really, the organic growth is going to be primarily a reflection of the built-in rental rate escalators, a little bit of timing and then a little bit of burn-off of free rent. So we expect to have a little faster growth in the near term in terms of cash NOI. But as far as fundamentals, I think it's a reflection of exactly what we're seeing, especially in Northern Virginia and Toronto, which Digital Realty talked about on their earnings call.

And then maybe talk about the contract structures. You got modified gross plus E, so pass-through and then you got triple-net. What's kind of the rough mix there?

Roughly 2/3 triple net and the balance is full-service gross plus electric. And in all cases, energy is a pass-through to the customers. So we're not seeing margin impact from rising energy costs.

Who do you consider some of the -- your peers in terms of who you might compete against for acquisition opportunities, particularly if you pursue the path of acquiring outside of the Digital Realty portfolio?

Yes, good point. I was going to make that distinction. First of all, as you probably know, Digital Realty granted us a ROFR. So any asset that Digital Realty wants to bring to market globally, we've got first dibs on that. And obviously, that sets us up very well for a very sizable runway for growth. In terms of third-party acquisitions, I think it's going to depend to some extent on the region. Certainly, we are -- I think the peer set is really the Singapore REITs that do have a data center focused. Obviously, Keppel DC REIT being first and foremost among them. I think you're going to face a lot of the same suspects, although I would say we're still small enough that we can really generate growth through a one-off acquisition, whereas somebody like Digital Realty or Equinix is going to be much more focused on portfolio transactions rather than one-off assets. So we may be able to find some one-off opportunities and I think competition is going to vary by region.

So powered shell, turnkey, even land, what's kind of the profile or property type that falls within your radar?

Sure. So again, our mandate is investing in stabilized income-producing assets, which is, for purposes of the Singapore regime, defined as north of 90% leased. So we're not really in the development business. We're really buying core stabilized assets. So I would -- land is not likely to factor in. I would say that we're certainly open to both shell and fully built out data centers or turnkey facilities. We had a good chunk -- a good mix of both at the IPO. I think going forward, certainly from the Digital Realty pipeline perspective, there's probably fewer power-based building investment opportunities remaining in the portfolio. So I think we're likely a little bit more focused on fully built out data centers over the near to intermediate term.

Got it. So if there are questions for John later, let us know here. And I'll pivot over to Matt to ask a couple of questions about Digital Realty. And I guess, top level, as you think about the 2022 overall outlook and then beyond kind of medium to longer-term FFO per share cadence, talk to us a little bit about tailwinds and headwinds that you're thinking about.

Sure. So starting with tailwinds, which I think we've talked about a decent amount in the first quarter, but I think with where the euro and -- we'll call it, broadly speaking, the strengthening of the dollar. So exchange rates have become -- have become a headwind that we've spoken about, which is also a reason why we've given not only our kind of reported guidance in results, but also on a constant currency basis as the exchange rates are creating about a 200 to slightly over 200 basis point headwind to our growth. So we -- last year, we grew roughly around 5% on core FFO share. We're guiding to roughly the same amount on a reported basis. But on a constant currency basis, we're north of 7%. So that has had an impact. I think some of the other headwinds that have kind of been embedded in guidance, but again, are relatively, I would say, muted just given the way our contracts are structured is around power. Obviously, power has been a big topic of discussion of late. But with the way our contracts are structured, roughly, we're passed through and recover directly almost 90% of our power costs from our customers from the retail, call it, a colocation or 0 to 1 megawatt category that we have. That's also either we have an ability to, in some cases, increase pricing as a result of increase in power costs in certain markets under certain contracts. So we have the ability to pass along some increases through that, too. But largely speaking, we've been insulated from power cost increases that have been happening over the last, call it, now at this point, probably 12-plus months. So feel we're in a pretty good position from that standpoint. And then lastly, we've obviously seen, of late, interest rates are starting to increase. But again, we've -- the majority of our debt is long-term fixed rate, the vast -- where we do have exposure is our revolving credit facility, which is variable, but it's, again, a modest amount drawn now in terms of our overall debt profile. So we are able to manage that, I think, pretty prudently as we term out debt. We accessed the euro market earlier this year in January, issued Swiss bonds as well. And we're also kind of getting ahead in terms of being able to bolster our liquidity where we increased the size of our revolving credit facility by $750 million just a month or so ago. I think from -- so again, relatively muted impact from some of the headwinds we're seeing. I think on the positive side, I mean, demand is as good as I think we've seen in quite some time. We've had 7 out of the last 8 quarters where we've had well over $100 million of signings. Our pricing, I think, has started to turn a corner in terms of being able to have that become more of a pricing power in sort of the provider's favor. That's a little part of why we were able to increase our guidance around our renewal spreads with our last earnings call. And we see a path to, again, being able to support that mid- to high single-digits growth that we've discussed and targeted as part of where we think we can and should be as a company.

So I guess 1 metric we didn't hit on is same-store cash NOI, which has seen some pressure this year, if I recall correctly, from FX and then Loudoun County taxes. And -- but how do you kind of think about the same-store pool? Anything that's going to change in 2023? And then building on that, what's your kind of optimism level about that trajectory improving compared to the last 2 years?

Yes, sure. So our -- we have -- our same-store guidance that we put out was in the negative 2.5% to 3.5% area. If you adjust that for constant currency, again, we get, I think, actually is slightly more than 200 basis point improvement there. So we were, I think, really closer to like a negative 100 basis points. And I think what we're -- that's been an improvement from where -- what our results were last year. I think the tailwinds we're seeing now within the same-store portfolio are: one, improved pricing dynamics that we just talked about in terms of renewal spreads; two, we've had a concerted effort and focused on leasing some of our available capacity. And we've done a considerable amount of our leasing in what we call our move-in ready, which we'll squarely hit and improve our same-store portfolio outlook. Now that will commence over the course of this year. So I think we'll see an improving profile and sort of, call it, run rate trajectory coming out of '22. You mentioned property taxes. Those are there. Those are relatively uncontrollable, but we continue to monitor that. We also push back in certain jurisdictions and seek to minimize the impact from property taxes. But I think between increase in pricing power that I think we're seeing a continued focus on leasing available capacity, which we've had success on, and I think we'll continue to as supply/demand dynamics continue to tighten in various markets. We see an improving outlook going forward in our same-store results going forward. We obviously haven't given guidance yet, but I think we're pretty positive about where the trajectory is given what we're seeing.

And then turning to kind of asset recycling. What are -- remind us what the range is and then kind of how do we think about timing and what would the cadence of that be? What types of assets?

Yes. So our guidance for, call it, dispositions or capital recycling was roughly, call it, $500 million to $1 billion for this year. We've done very little, if any, so far. So the majority of that will be -- we expect to happen going forward. There's 2 components to that capital recycling. One is I think we still have probably less than a handful of what we call noncore assets that we'll look to dispose of. So those were called or in progress or in the works and will happen over the course of the rest of the year. I think the other part of that is our, call it, our partnership with Digital Core REIT and continuing additional assets to that -- to John and his team over the course of the year, which will probably make up the majority of that bucket.

So on the M&A front, you are acquiring Teraco, the major platform in South Africa and the whole African continent from an interconnect standpoint as well as from a scale standpoint and having major CSP customers update us on where that stands.

Yes, yes. So Teraco, I think one of the -- basically the premier portfolio in South Africa and probably across the continent, I think, really gives us a tremendous foothold and advantage across the African continent, which we see as a growth market going forward. Very similar in terms of the makeup and the type of business that Teraco does in terms of it's got a mix of not only cloud and large scale -- large-scale providers that are in the Digital portfolio, but also has a mix of, call it, enterprise retail colocation specific to South Africa and, call it, the broader African continent and quite a bit of runway there in terms of growth, additional land and sites that are under development today and for future expansions. So we're very excited about closing that deal. The deal in terms of the process is still -- is still going through kind of the regulatory review and I think that's probably taking a little bit longer than we had originally anticipated, but I don't see any signs that that's going to be -- cause us anything other than maybe some timing in terms of close. But we expect that -- expect it will close, obviously, sometime this year, probably more towards the third quarter at this point, but still on track.

And thinking ahead to the integration and how you integrated a not dissimilar kind of pan-European asset, namely a reset of assets, Interxion. Any kind of learnings from the Interxion integration earlier, Telx for that matter, and how you would proceed with Teraco and integrating that into the fold?

Yes. I mean there's some differences in terms of the Teraco just given that, that will be -- their existing shareholders are rolling a decent stake within the company still. So it's -- it will be more of a joint venture management, more probably from a -- from an oversight perspective, actually probably more similar to Ascenty and how we manage that business in South America where the existing management team has done a tremendous job, will remain in place. Obviously, we'll -- what we'll look to do is to make sure that we're bringing the best of both businesses together in terms of construction and supply chain management, dealing with customers, being able to cross-pollinate between sales teams, now only in Africa, but from the digital side in North America and Europe, being able to bring business -- import and export business to and from, which I think we've done a tremendous job at with the Interxion business. I think that -- speaking to Interxion, I mean that, I think, has been a tremendous acquisition or combination for us as Digital. You could see that in sort of the results and the leasing that we've done in Europe over the last several years since that combination. So it's a little different in that it's not -- we won't be wholly owned -- we won't wholly own the company, Teraco, but we'll continue to work closely together on making sure that we're bringing sort of the best capabilities across the value-add chains, especially around sourcing deals and getting the most out of our construction and development process.

Audience questions? So the question was the Teraco structure not being wholly owned and what's kind of the background to that?

Yes. I think it's a mix of, one, the existing management. I think -- I don't think we would have had a -- we would have been fine also owning the business outright. I think there's part of the existing management also saw a continued upside in the business. So there's a part of that. And then I think -- but it also, at the same time, similar to what we've done with Ascenty, where it's also, I think, part of a prudent risk management approach, just given profile of the country and the dynamics there and the currency and other risk management factors that, I think, having some partners in that deal is also beneficial from a Digital Realty standpoint, not only from, call it, a risk management perspective, but also from an equity check, if you will, or part of that business. So I think we're doing what we think is the best in terms of managing both sides of the equation there.

Are you getting any customer inbounds based on just the headline news, even though it hasn't closed yet. And then given the Nigeria acquisition and then what you have in Kenya and then Mozambique, anything notable given that you've got global relationships with a lot of customers?

I mean I'll say yes, in terms of -- I mean, again, the majority of the -- especially the large customers in Teraco and even some of the ones in the other Medallion and iColo, and our other vehicles that we have on the, call it, East and West Coast of Africa. I think what people are most excited about is the connectivity play in the platform there, connecting not only around Africa, but also up through to EMEA, through Marseille, which is one of our highly connected assets in France. So we're seeing a lot of interest in where we're deploying in those, call it, very highly connected facilities, expanding through there and bringing that back to not only EMEA but also then looking to APAC and other regions. I think there's also interest coming in from other, call it, other regions into Africa as they see their expected growth plans within that region as well.

So we had a panel earlier this morning and then panel in a lot of companies yesterday as well talking about pricing. So -- for hyperscale essentially. And you yourselves, on your 1Q call, mentioned favorable trends on a like-for-like basis. I think the -- what I took away was NoVA going higher by 6%, and we'll see how that trends going forward. But any other -- is that a trend that you're seeing throughout your portfolio? Or what can you call out within parts of EMEA, within parts of North America and across Asia? I imagine there's some differences, but maybe give us a little bit of color around what's going on with pricing and to what extent it's going higher and by how much and in which markets?

Yes, sure. So yes, we did mention kind of on our call on a like-for-like basis in Northern Virginia, which is, obviously, a global market, has -- probably also one of the most competitive markets in terms of supply, but also -- tremendous amount of supply, but also a tremendous amount of demand. So we have started to see, I think, again, tailwinds in terms of pricing within that market. That was the reference to roughly the 6% on a like-for-like deal. I think we're seeing that across generally the most of our major markets, which I think is a reflection of not only a tightening, broader supply/demand dynamic in various markets. I mean Singapore is one that's called relatively easy to call out. We've had a tremendous amount of business in Singapore over the last, call it, 18 to even 24 months. That one obviously is also a market where it's hard to keep and build supply on a rapid basis. So we've seen a lot of pricing power in that market. I think in several markets within EMEA, we've seen good pricing dynamics, again, as a result of a tightening supply/demand balance, whether that be just because demand is outsized as well as certain elements like power are becoming harder to procure, but we've got a good runway, at least within our portfolio, based on what we're developing. So I think in Germany, in Switzerland, we've seen good pricing dynamics. And I would say, overall, when -- we have a process that we go through where we look at our price book, which is kind of what we look at and monitor as, call it, stated price rates. I think this has been the -- in the last, call it, several months or since the start of the year, I think I've seen more increases in our price book rates than I've seen kind of in several years. So I think we're really seeing, call it, tailwinds again from a pricing dynamic perspective, which again leads back to our views on go-forward growth and results.

So what types of unlevered returns are you aiming for in the multi-megawatt category for new developments?

Yes, sure. I mean so our returns have been, I'd say, relatively steady, and we're hoping, again, as part of the pricing that those -- we'll be able to enhance those over time as that dynamic continues. But I'd say, in general, we've been pretty comfortably within our, call it, 9% to 11% range depending on the market. Some might be -- some deal specific might be even higher than those, but I think -- if you look at our supplemental, where we give ranges on yields across our regions, I think, you'd see a relatively consistent 9% to 11%, again, depending on the region, we've been able to achieve.

So given what's happening with the pricing, but also with costs and so forth, are you -- I asked this on the earnings call as well, but you're aiming to sort of maintain the historical ranges that you just talked about? Or is there an opportunity given the scarcer inventory to maybe be a little bit more ambitious?

I think we'd love to be more ambitious, but there's obviously multiple factors at play. I think we are, though, now seeing a position where on the -- we're seeing pricing turned more favorable from a provider perspective. At the same time, we got to be conscious about where costs are going as well given inflation. I think we talked about earlier, we feel pretty insulated given our development pipeline. We've locked in the majority of our costs there. And again, we feel -- our desire is to enhance or push returns as -- in order to enhance our bottom line. But it's a mix of both supply/demand in various markets and the cost side equation, which we continue to monitor pretty closely.

I think some of what you're seeing, Jon, is an improvement in underlying economics. So customers are, obviously, not oblivious to the inflation pressures throughout the economy. And so they're understanding of the need to pass through rising costs. And I think that you're seeing improving rent bumps, improving lease structures and underlying economics that should lead to enhanced returns over time.

And so rent ups meaning higher fixed or CPI linked? Or is that still kind of being worked out?

Being worked out in real time. I think generally speaking, hyperscale customers are -- they like to have visibility on their cost structure. And so I think there's generally a preference for fixed as opposed to CPI-linked, but I think there's a recognition that those fixed bumps need to be higher in the current environment than they have been for the past several years.

I mean just to add to that, the majority of our -- particularly in the, call it, the 0 to 1 megawatt, especially in EMEA, our CPI-linked, so we've seen inability to be able to ascribe those 2 deals that they renew within the year, especially this last year.

And then for John, just of the medium to longer term, but when can we expect to see kind of the first acquisition of a non-Digital Realty stabilized asset?

Great question. I mean -- we've got such a large pipeline to work through with Digital Realty. I don't think that third party is top priority, but we're certainly open to it. So I don't think that will be a 2022 event.

Is it beyond the realm of possibility or imaginations, I think, that you could acquire an xScale site?

I wouldn't say it's beyond the realm of possibility. We did -- I got to catch up with Krup week before last, and he didn't try to sell me anything. So like I said, probably not a 2022 event, but not out of the realm of possibility for sure.

Questions? So the question was around renewal options and escalator structures.

Yes. I mean our -- historically, we've been -- I would say, our contracts in place now are -- for the larger contracts are generally in the range of 2% to 4%, so with a, call it, a 3% roughly in the area. Given where inflation is, what I can say is we're having -- we're working to have conversations that are pushing that to a higher level. And that's a, call it, a work in progress. Again, on the other side, for the smaller deals, a lot of those are already CPI-linked, so it gives us a path to -- ability to push that through kind of annually. But right now, I think we -- again, the majority of our contracts that are in place, those are signed during the 2% to 4% range. And as we sign new deals, we're working to kind of increase that as much as we can.

That -- we are out of time. That was the last question. You had the last word. Thanks to both of you.