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

Good afternoon, everyone. I'm Eric Luebchow, senior analyst at Wells Fargo. We're really pleased to be joined today by Greg Wright, Chief Investment Officer at Digital Realty Trust. So Greg, thanks for joining us.

Thanks for having us today, Eric. We really appreciate it.

Absolutely. So Greg, I just wanted to dive in. I wanted to first ask about demand. So you have put up two consecutive record bookings quarters. And it seems like there have been really strong bookings across the whole industry, particularly with hyperscale the last couple of quarters. So maybe you could -- how would you characterize the demand environment today based on what you see in the pipeline? Are there any particular geographies or verticals to call out that are seeing strength?

Yes. Thanks, Eric. I think you've summarized it right. We've seen strong demand after two consecutive record quarters of leasing when one was $167 million, I think the other was $156 million. I think when we look at this, our view is this is not a demand pull forward, and we say that because our funnel remains healthy right now. When you look at first quarter bookings, I said they're like 1/3 higher than the average of the four prior quarters, each of which was strong in its own way. So I'd say Q1 level is well above the trend and I would say would be difficult to maintain. With that said, demand has been strong globally, and we've seen it across product mix over the last year. So you see it when you look at our greater than 1 meg and less than 1 meg. In terms of one region, I'd say at this point, we're probably particularly bullish on EMEA, which is our largest -- where we have the largest amount of current development in our pipeline, together with our pending acquisition of Teraco.

Great. That's helpful. So on the hyperscale side, Greg, we've heard anecdotally that they may be tilting more this year towards leasing versus self-building facilities. What would you attribute that to? Do you agree with that statement? And do you think that trend is sustainable? Or do you think that certain hyperscalers will revert back to more self-building if the current supply chain environment -- some of the constraints out there used?

Yes. Look, Eric, I think to start, right, everyone who's building data centers are experiencing supply chain challenges globally. But I think it's more than just supply chain. So it's hard to say whether they're going to be more outsourced or more self-build facilities, but I think it goes beyond just supply chain. I think when you look across these major markets, I think we're seeing things like power shortages, right? I mean you look at places like Singapore, where there's a development mode for it. You look at places like Ireland where there's power restrictions and the like. So again, I think it's more than just supply chain. I think some of it is as you look at some of these critical markets and you look at strategically located land with power, and it's harder to come by in many markets. You see the same thing in markets even looked like Ashburn, right, where there were supply issues not too long ago. Now we've seen that market shore up. So look, I think you're right, trend as we have seen more towards leasing than self-build right now. I don't want to -- it's hard to handicap whether that continues or not. But I would say there's more things than just supply chain that's driving some of that, I believe. And I think if you look at markets, I would say probably less mature markets. There's -- we've seen a trend of more outsourcing in those.

Yes. That makes sense. And then maybe on the enterprise side, obviously, we're in kind of a challenging macro environment today with perhaps some rest of falling into a recession. Do you think that has changed at all the enterprise funnel or is it remaining pretty steady, especially in that...

Well, I think when we look at that bucket, as you can look back and look at our supplement and see the trends, that bucket has paid -- has remained strong for us. So look, it's not to say that certain enterprises don't have challenges, but sure they do. But when we look at it, we still see the demand from that enterprise wanting to be in our facilities remain strong. But we obviously continue to monitor that. But I think, look, you're seeing strong, I think, enterprise demand for the cloud service providers as well as for data center providers like ourselves. So look, I would say the enterprise to date is, in general, is remaining pretty resilient.

Good to hear. So you touched just on Northern Virginia, and it's an interesting market because as you mentioned, supply is tightening in part due to not as much available plan, longer lead times for power. And you have a pretty large land position there near the Dulles Airport. Maybe you could talk about how you think that 420-plus acres of land kind of positions you in that market longer term? And when you'll start to see more capacity on that new site?

Yes. Look, I would say you're right in that the Northern Virginia market is tightened. As we complete our existing campus out there, we're beginning to move on to digital Dulles, where we can continue to develop. It's really over a gig of additional capacity, and we've already started clearing the first site and we have a substation built for that. So that's clearly the next leg of our [ art ] ramp in that market, if you will. Look, we think it's a real competitive advantage to have a site that to support a gig plus as our customers as we look to future -- as we look to supply proof these markets for our customers. No one else has that size -- that piece of land strategically located like that in Loudoun County. So as we look at that longer term, we express -- we used at NAREIT somebody has had a great reference. They said it was like liquid gold. I would agree with that. We're very fortunate to have it.

And as you look at some of your other markets outside of Northern Virginia, are there certain areas where you would like to add to your land parcels so you have future runway?

Well, we have been. I mean it's not -- I mean, look, we continue to try to -- we always, as part of our regular ongoing business, look to where we can secure land to ultimately build. The good news about land acquisition and building news, right, you get what you want, where you want it. We said to somebody used the expression, it's 3 yards in the cloud, a dust because it takes a while, but it's a great strategy. But yes, I mean, we've been supply proofing markets around the globe, right, whether it's Frankfurt, whether it's Paris, whether it's Osaka, whether it's Tokyo, right, Singapore, you name it across the globe. We've been looking at our strategically important markets to continue to procure land that we think is strategically significant to our customers. So yes, that will continue.

Okay. Good to hear. So I wanted to touch on the topic of inflation and the impact on your business. You've said publicly you're largely insulated due to your VMI program where you're prepurchasing a lot of inventory you have contracts with suppliers. Maybe you could talk about how those work, how far out you prepurchase -- your prepurchase contracts run? And at what point do you expect to see build costs start to creep higher across your footprint? And are there any design efficiencies you can extract to kind of help offset some of that pressure?

Yes. I would say we've locked in our development input costs, if you will, for existing projects, which generally run into 2023, early 2023. For projects beyond those, we expect that our costs will be more reflective of the market at that time. We've been exploring -- really expanding our VMI program to further assist customers. But look, I mean, I think when you get down to it, this is an area where our scale really helps sustain efficiencies, including sourcing these king inputs, whether it's land, power and the like. And I would say our existing land holdings in combination with these VMI programs and having these purchasing efficiencies really provide us with a competitive advantage, particularly on the cost side, and look, I mean, we're optimistic. But with that said, we will totally be immune to this whole inflation situation beyond a certain point but at least we've locked in the near term under construction pipeline, if you will.

And I guess when you look at into the future in the areas that might be escalating in price once those contracts renew, I mean, what are the biggest inflationary impacts to your business? Is it labor cost for new construction? Is it new equipment, land prices? Maybe any color you can provide on that.

I mean, I think it's a combination, right? I think it's labor. I think it's commodities like copper and the like. We're just saying cost across the Board for data halls, those are continuing to increase, right? Now they're being magnified some I think now with some of the supply chain issues you talked about. But look, I would say like most areas of the world right now, I would say inflation has been pretty broad. So we're seeing the same.

And I guess related to that, you mentioned on the call, you're starting to see pricing lift. I think Bill said 6% like-for-like improvements in new lease pricing in Northern Virginia. So do you think that we're starting to see across all of your markets, pricing more broadly reflects some of these inflationary costs in that? This will be a tailwind for years to come.

I'm going to turn my screen off, so I think I'm getting bad reception. Can you hear me okay, Eric?

I can hear you great.

Look, yes, I think -- look, I think when you look at it, I think it's a combination of things. I think you have inflationary pressures, which are obviously making us reassess what we do in terms of our rental escalations and the like to keep up with inflation. I mean that obviously doesn't hit right away. But where we can, we try to work in CPI adjustments with hopefully some floor. Customers may come back and ask for some ceiling as well. But we're trying to work that through to make sure that we're keeping up with inflation on the cash flow side because we are seeing inflation on the cost side. And look, I think we're seeing that across the globe. But look, we're working hard to make sure that we do provide the right escalators to combat that inflation. And look, I think -- and I think there's other elements though that are also helping pricing. We talked about some of them in certain of these markets, there's less supply. And it's not just Northern Virginia. And we're seeing it in other markets. Eric, can you hear me?

Yes, I can hear you. We lost you for a second.

Sorry, is that better?

Yes, I can hear you now. So you were talking about less supply in certain markets that's having an impact on pricing as well.

Yes. I was saying less supply in certain markets, which are being driven by things so the power challenges and finding strategically located land, those things are becoming more scarce in many markets now. And again, that touched on the power markets, whether it's Singapore, whether it's Ireland, we've seen some of that in Amsterdam as well. But the combination of inflation and these other barriers to entry, if you will, are helping on the pricing front.

Yes. That's good to hear. So as CIO, Greg, I obviously have to ask you about the M&A environment. There's obviously been a tremendous amount of consolidation take privates in the past year. Do you think we're entering a period where industry M&A will naturally slow in the near term just based on fewer companies coming up for sale? And then on the pricing side, do you think private market pricing, which has remained very high despite all the disruption in the public markets, do you think that will start to converge back down to the public market in the coming quarters? Or do you think that will remain sticky high?

Yes. Look, I think clearly, there are fewer providers available in the public markets, right? With that said, there's still a lot of private companies out there. Look, I think from -- like I think that is true. I think we have seen the private market stay sticky high. I think what's driving that is I think investors have gotten to better understand the asset class and they're trying to get exposure to the asset class. So I think you see a lot of these infrastructure funds and the like that are continuing to buy platforms. There clearly is a disparity right now between private market pricing and public market pricing. And I think the most recent example of that is probably the Switch deal, right, that was priced. So look, I think pricing does remain robust. I think we don't -- who knows when that stops, so it'd be interested to see if some of this back up in the debt markets of it, but we haven't seen that yet. But look, from our perspective, once tariff goes closed, we're really going to focus more on organic growth. As I said, buying land, building on it maybe smaller things like Altus IT in Croatia, Lamda Hellix in Greece, smaller things like that, were really we're buying it, they may have an asset or two or three and you're getting a theme. But I think you'll see us look to do more tuck-in type things like that rather than anything broad and larger.

Okay. That's helpful. And I guess, on the other hand, the private market stickiness could certainly help you in disposing of assets. And related to that, I wanted to talk about your relationship with Digital Core REIT. So you have a $15 billion [ ROFR ] with them for future asset sales. So maybe you can talk about how you assess future comp contributions to the [ S3 ] versus accessing other forms of capital like [indiscernible]?

Sure. But I think when I look -- when you think about Digital Core REIT, it's really a perpetual capital partner for us. And the assets that we're putting into that vehicle are strategic to digital to keep for the long term. And so you'll see assets that are going in there. They may be stabilized assets. They may have a slower growth profile, but they're still strategically important to us and to our customer base. So those are the kind of assets that you're going to continue to see going into the Digital Core REIT. Look, I think in terms of markets, Digital Core REIT has a global mandate. So the assets -- although the assets that have gone in to date have just been North American assets, you'll see that be more global over time. But those are the core assets we'll see going in there. As we look at assets that aren't part of the connected campus that may be in a geography that's not strategic as strategically important to us, those kinds of assets are the ones you'll see will do outright dispositions and what you've seen us do that in the past, right, whether it was with a Maple Tree, whether it was a capital land in Europe and the like. You can just see some of that -- some of that activity, too. So I mean, look, we look at these things, all of our -- if you look at our capital sources, almost as a capital source toolbox, right? And what we try to do is to provide as many pockets capital sources as we tend to drive our business and maximize shareholder value. So whether that's the Digital Core REIT, whether that's forming JVs with select partners, whether that's selling assets or recycling out right, right, whether it's doing an equity forward like the team did last year, whether it's preferred market, whether it's the debt market. Again, we view it as our job to have as many pockets of capital, as you will. And look, I mean, markets move. So our job is to try to have as many of those pockets of capital is -- at any point in time, use whichever ones are most advantageous to our business and creating value for our shareholders.

Okay. That's a helpful overview. So as you look at new geographies for Digital Realty, you've obviously moved into quite a few in the last couple of years -- a couple of years. You have a pretty broad reach today. Maybe you could talk about some geographic areas where you'd like to establish a presence and whether partnerships or M&A might make the most sense to enter those markets?

Yes. Look, I think when you go around the globe, look, I think when you look at our footprint in North America, that's -- it's -- we're pretty happy with our footprint there, same with South America. And then throughout EMEA, right? When you look at APAC, that's clearly our smallest region. We'd love to grow there. But look, we're -- I would say we're mostly using JVs and partnerships, if you will, to supplement organic growth. It's not as much -- it's about having a partner in the market who knows that market and can be strategic to us in that way. We talked about we clearly have a pending acquisition for our 55% interest in Teraco, which is South Africa. Again, that's a perfect example where Berkshire, Premier, Grand Bend Rona's family, they're staying in up to 35% of the equity. I think you saw -- which will be more characteristic of how we're going to grow. We announced expansion in Israel on Monday by our JV with Mid-May, which is one of Israel's leading real estate companies. They own a building in Tel Aviv and they're called [indiscernible], which is one of the most highly connected areas in that area. They have existing data center provider in a suite for -- it has, call it, 1,500 KW, give or take. And then they own the immediately adjacent parcel, which will be a great ramp way for growth, which will support north of 20 megs. So that's the kind of thing, right? So it will be more development and the like. As you see, our Indian JV with Brookfield REIT, we were recently acquired land in Chennai, and we also recently acquired land on balance sheet in Barcelona. So look, I would say we continue to invest to meet our customer demand in these existing markets. And those are the ways we're going to try to do it. I think, again, as I said, it's probably going to be more organic in JVs and it's going to be large strategic M&A.

Got it. That is helpful. So touching on the Teraco acquisition, which I know is supposed to close here in the next few months. Maybe you could walk through your underwriting on that deal in terms of your targeted returns on that asset acquisition. And I think investors were naturally a little skeptical because the going in price or multiple seems pretty elevated. But maybe you can talk about some of the opportunity in Africa to cost efficiently expand the footprint that they have and use that as kind of a beachhead for maybe further expansion into Africa?

Yes, I think it's important to note, right -- Teraco, when you look and see what's in place, under construction or immediately adjacent future development has 187 megawatts. When you look at the 75 megawatts that are in place today, those are not fully leased yet. Now there's folks still moving in and there's lease up there. So that's not stabilized. Then we have 20 megs of development, if you will, which has pre-leasing. But again, that's fairly not stabilized. And then the 112, again, these are not just sites randomly located in different markets, these are right on the existing campuses immediately adjacent. So when you look at that, you got to look at it almost as a development project, right? And you don't go in with a higher yield on development project. But what over time, we think we will get those returns. And so when we look at these returns, we take a look and say, what kind of return when you look at currency risk, country risk, the fact that we're not in that country today. And you take a look and see where the risk-free rate is in South Africa and we're going to do double-digit percentages over and above that. So that's going to put our IRRs in the high teens to low 20s. When we look at that, we think that is -- we think we're being compensated for the risk we're taking, given the assets that we're getting here. I mean just to remind folks, Teraco has some of the most densely connected assets in the world with over 22,000 interconnections along with subsea cables assets -- cables landing in the data centers with another three expected to land over the next several years. So I mean, look, we think this is a great asset. And look, we're going to have to develop it to get the returns. But I think given our expertise in that area, we feel comfortable that we're going to get the right risk-adjusted return.

And do you see that naturally as a complement to the interaction acquisition because some of those subsea cables are going back into EMEA or into Europe, for instance, at locations like Marseille, just wondering how that ties in to your footprint in Europe and your footprint in Asia?

Well, look, we clearly like the fact that Africa -- like Africa is going to become critically important over time to tie into APAC, Europe, right, and even North America. So yes, when you look at our -- if you look at our European footprint, we think that's going to really provide a great service for the customers in Africa and then obviously, going back the other way into Europe. So yes, we're excited about that. But most importantly, we think it's going to provide customers with what they're looking for. And we think it will be well received. So look, we're excited about that.

Okay. Great. So a topic that's been pretty interesting to talk to investors about recently is the convergence between tower and data center assets. And American Tower made a big splash last year when they acquired CoreSite. So what are your thoughts on the convergence of tower and data center infrastructure? Is there actually a business case there? And then are there -- would there be any opportunities to partner with our operators going forward, the mobile edge develops further?

Yes. Look, from our perspective, we think there's a solid rationale for the commercial relationships among the various digital infrastructure food groups, if you will, with towers, fiber, small cell data centers. But in our opinion, we don't see the need for common ownership. In other words, they don't need to be under the same vertical to make -- to drive industrial logic, if you will. Look, I still think folks are trying to figure out how that's going to come together, whether these -- you got this customer base of the MNOs and the customer base of the CSPs. How is that all going to come together exactly? I don't think folks know yet. But look, as I said, we understand the rationale. We don't see the need for it to be under common ownership. And yes, we would -- look, if that makes sense, we think we have great data centers to provide folks on the tower side, and they would have great towers to provide us. And look, if it makes sense, as we do in any business line, we would look to partner with folks where have made strategic sense.

That's helpful. And another topic which we talk about all the time, it is defined differently depending on who you ask, is the Edge. And we often hear that the next evolution of Edge will go from Tier 1 to Tier 2 and Tier 3 markets to more broadly distributed compute outside of the core availability down. And so I think at some point, digital would be interested in entering some of these smaller markets that might see the next evolution of the edge? Or is it still too early to say?

Look, here's how I would say. I say we continue to monitor developments related to the Edge, but it's still very early days and the business models are still developing. We have investments in partnerships with Edge providers such as our investment in AtlasEdge, which is being run by one of our former colleagues, Giuliano Di Vitantonio. Look, I mean I would say our global platform and connected campuses are key as the Edge developed provide a core-to-edge solution that enable Edge workloads to move seamlessly between the Edge of the core and the cloud. So look, I mean you never say never, but I think that gives you a little more insight to how worth it.

Sure. And one other business line that we've seen your peer Equinix move into what was going up the stack, they acquired packet, now they're offering bare metal as a service. And you -- would digital ever have any interest and exposure to more of a managed services type area? Or do you think those needs can really be fulfilled by your large hyperscale customers?

No, look, I think when you think of digital, we view ourselves more in an open platform, and we don't believe we need to own a great step, if you will. I mean we have partnerships with other experts to enable additional products. We're announcing service fabric this week at our major customer event in New York MarketplaceLIVE. This is an alternative to existing choices in the market. We think it's a differentiated offering with an open platform as opposed to a walled garden. But no, we would -- we look to partner with folks for these other products such as bare metal. And I don't think you're going to see us going up the stack, if you will.

Got it. That's helpful. And as you look out -- kind of tying it all together, obviously, pricing you mentioned is starting to go up. You probably will see some costs go up as well in the coming years. I mean do you -- is digital still underwriting to pretty steady returns in the development business? Do you think there'll be any changes in returns for hyperscale or enterprise in the next couple of years? Or do you think they should be relatively stable where pricing lifts kind of offset higher development costs and you can still underwrite to those kind of, call it, 9% to 12% type of returns?

I'd say given -- it wouldn't be prudent to -- for one bit that you're going to gain greater inflation movement on the rent side than you do on the capital expenditure side. With that said, we do think you'll see pricing that keeps pace, if you will, with the CapEx development, and we think we'll be able to maintain those yields that Jordan, Jim and Andy and the team have public have gone out and told the market. So we do feel comfortable in those return levels that we've already highlighted to the market. But I would say we're not at a point where we're willing to make a bet on whether rates are going to increase faster than the cost of CapEx, if you will. So I'm saying we're not willing to make a bet on that. But we do feel as though rates will keep up and that our business will be a good inflation hedge as we go here.

Sure. And I also wanted to get perhaps your opinion on some of the private capital we're seeing. I mean just wondering if you have any sense for how much leverage some of these private platforms are putting on new data center acquisitions. And if you think given some of the disruption in the debt markets, we might see that pull off some of the multiples we've seen paid for private assets. Or is there essentially a quantum of private capital out there looking to get into data so that it won't have much of an impact?

Well, I mean, again, most of the debt markets that those folks traffic in, isn't the investment grade debt market that we traffic in. So -- but look, we hear things in the market. And we've heard that there has been some backup in the securitized market. I don't -- I'm not sure it's true. It's just we're hearing it. In other words, we're not out barring in those markets. So it's harder for me to say. But look, I think all else equal, if debt costs are going up, folks should overtime pay less, unless for some reason, they're getting more aggressive with their underwriting assumptions.

Yes. I would generally agree. Okay. Well, with that, we'll wrap it there, Greg. So I appreciate your time today and your participation in the conference.