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

Thank you again for being here with us today. Michael Funk, Bank of America. Really happy to have Jordan Sadler from Digital Realty, we were seeing before we walked in that we're going to have Digital Realty, I think, speaking 3 times in the next 1.5 weeks at Bank of America. So thank you again for being here with us this afternoon for the first of the 3 presentations. I don't know if you had any kind of safe harbor that you wanted to read off first or or anything else

No safe harbor per se, but please do visit our website or Investor Relations website. In the event anybody has any questions about some of the numbers or statistics data we put out here today. quarter

Okay. Perfect. I appreciate that. So I wanted to start with the core FFO growth because the commentary of the language, it evolved last quarter, right, the way that you talked about the growth rate. And prior to last quarter, this is partly wrong, you can correct me. But I think the narrative was more like a high single-digit for longer and steady narrative and I'm paraphrasing. And then last quarter, I think you talked about double-digit growth for 2027 and beyond, right? So leaning more into development-based growth and other factors driving higher growth. what was the genesis of that change in language or communication, if I'm framing that right.

Yes. If I may, I'm going to back it up. A couple of years to maybe tell a little bit of the story to how we got to -- just to give a little bit of a context. And thank you again, Michael, for all that you do and your coverage for us and spreading the word and for having us out here today and setting up meetings with folks. So just backing it up to February 24, which was the fourth quarter of '23 earnings conference call, where we gave guidance for '24, which was in the low single digits bottom line growth. which was not a super satisfactory number in the context of what was going on in the world. But you were still coming through negative releasing -- we were coming through -- right, there's plenty of things dragging on us rising rates. Obviously, we're a big impact. we had delevered tremendously 2 turns from virtually 7x at March 31, 2023. And to 5x by the end of the year. So that 2 turns delevering was definitely impactful in dragging out in '24 as well. So that low single-digit growth number we put out there was not too per satisfactory in a contract or a world where video is seeing explosive growth, and AI was ripping and taking hold and on the earnings conference call, you may recall, Matt gave the sheepishly gave the low single-digits growth guide. But when asked about the algorithm, what does growth look like longer term, he said, mid-single digits, right? He walked through a construct where in 2025, he was pointing folks to basically 5% growth. and roll forward through '24 and into early at the outset of 25, we ended up giving guidance for the year. That was a little bit better than you had originally forecast, you said we're probably going to do closer to 6% this year, right? So as a little bit better. Things would come along. Obviously, the environment was helpful. Our leasing go-better -- our leasing spreads got better, to your point. Our development started to come along. Rates certainly weren't helping. But the business was definitely getting better or we were executing, roll forward to the beginning of this year. We ended up delivering 10% bottom line growth versus the 6% we expected last year. And for this year, we were saying, hey, we think we can do really well again today, sorry, this year, things are really strong. We're building a really nice backlog. We've got momentum in all aspects of our business, which I'll get to. And we guided to 8% growth, not the double digits number. What happened in between sort of February of this year and our July conference call, as we signed, we had very, very good progress in both 1Q, 2Q signings, very strong signings in the first half of the year. Year-over-year relative to all of the leasing in 2025, we were ahead and that resulted in a backlog at June 30 of $1.9 billion of signed but not commenced leases, including the lease we signed in July, post quarter end that we reported on, which is a $400 million lease, we were at $2.3 billion. That $2.3 billion equals north of 30% of our in-place data center revenue. So as you look to that signed but not commenced revenue commencing, 31%, 32% on a base of $5 and change billion of data center revenue. You got more than compounded. And that's really where the bulk of this is coming from. And that's what enabled us to sort of reset the course and the cadence for guidance. And we said it to your point, for -- we said this year, we'll deliver double-digit growth. We'll also do it next year and potentially beyond that.

And I wanted to dissect some of the drivers and the change in guidance. But I would characterize Digital Realty management team has been incredibly prudent and thoughtful the way that you approach the business and underwriting risk. It is part of my interpretation, but I'm an equity analyst, so I always try to create my own narrative, right? Is that maybe a year or 2 ago, there was less certainty of Digital Realty and the staying power or longevity of the AI demand cycle or maybe specifically where that cycle was moving for development, okay? It feels to me is that based on what you just said and some of the lease signings and where you are developing a recent site acquisition, that there is greater confidence now at Digital Realty and kind of the duration, sustainability of the AI demand cycle. Is that accurate framing?

It is -- that is absolutely a key piece of the puzzle. We talk about 3 core pillars of growth, right? We talked about the 0 to 1 plus interconnection business, which we've been driving the hyperscale business, which you're speaking to now, right, big leases going into backlog, execution there is imperative and takes that you're signing those, you're derisking future growth. And then the third piece of the business, which is strategic private capital. which has been -- which is relatively nascent. We've been raising private capital through joint ventures for well over a decade, but we really started down the path towards building a funds business, a co-mingled funds business. a couple of years ago. We were really successful last year. We raised $3.25 billion of LP equity for our first close-end fund which is going to support north of $10 billion of investment activity at cost and data centers, right? So what did that do? That gave us a checkbook, right? $10 billion checkbook to fund the hyperscale leasing that we were doing, what we had already done and what we're going to do in the future. We continue down that path on the private capital side. We continue to raise money because we think capital is paramount in a world where there is tremendous demand for capital. So we're 4.7x levered debt-to-EBITDA the mother ship, but we're also using private capital to fund the development of the hyperscale data center capacity. So we think as long as we have capital and we can sign leases, so we have powered land that we can sign into new development. Those are the pieces that are going to derisk the future growth. The signed lease, raise capital and lease raise capital.

And are there specific indicators that Digital Realty Cs, and I had lunch with a private data center company, a few weeks ago, and what they said is that they can see through their own monitoring that today versus a couple of years ago when they deliver capacity to a customer that usage however you want to qualify it goes then to 100% overnight, whereas before, it would scale slowly. So that gives them confidence in the durability of demand. Customers are asking for 100% of contract capacity on day 1 today, where in the past, maybe they would have scaled in that capacity over a number of years. So that company provided a number of examples of what they are seeing internally through their own systems and their contracts that give them confidence. Do you have similar examples on digital realty that have increased confidence?

Similar anecdote along those lines, and this is just pretty consistent, which is we consistently hear from our customers who are building data centers for as we're signing -- before we sign leases, as we sign in leases, we know that time to power is paramount today. And so that happens when we're marketing a piece of a potential property or data center, that would be a development. And that happens when we're underway, we're already developing it. They're looking for us to hand off the rooms or the data halls as fast as we can. Some are even looking for us to accelerate it, right, meaning add resources. We want an extra crew in there. We want to be commissioning at the same time, these folks are fitting out the PDUs, so we double the workers in the room. And we've seen that in our data centers as we've even been touring them as we're doing fit-outs, we see how active the construction is. And so it's just a function of this time to power that we're seeing in this current environment. And a lot of that is obviously AI-oriented.

And I want to talk about the contracts here in a second, but you just mentioned kind of labor and the workers in the room and maybe think back to NAREIT in December, and I think I met with you and Matt and I kind of last question I asked was what's the biggest risk I think concerning you in 2026? And the answer was labor? And at that time, maybe it wasn't as obvious how tight labor was becoming in data center development. Today, I think everyone is very aware of that. What does Digital Realty doing to solve the labor shortage, specifically master electricians and plumbers. How do you address that relative to peers?

So look, I mean there's a couple of different things that we're doing. One, we're building in a lot of our existing markets in certain locations. You've been to digital dollars, for example -- this is a site that's been -- we took down the site in 2018. It's essentially been under construction for 5 or 6 years. . So because it's a gigawatt site with sort of a 10-year build plan, right? So there -- when you pull on to that site, 1 GC's construction office is on the right. The other GCs construction office is sitting on the left, and they have consistent work on that site, these GCs, right, 2 different GCs, so diversity where you're essentially feeding the beast and handing them work somewhat consistently. So keeping those crews active. That's a big piece of it. So part of building the relationship, building the track record. Sort of multiply that by what we're doing across our development life cycle or across our footprint, right? We're doing this in 30, 40 markets globally and have been for some time and that's helpful to the overall sort of being able to bring resources to bear where we need them, when we need them. We get pretty good priority. So that's been helpful. But I think you're also asking what are you actually doing to sort of build up the workforce and to make sure that we have the people we need. And there are lots of things that we're doing from our human resources department from our ops department across sort of all markets and all regions to continue to sort of bring additional people into the data center workforce. So our intern ships are up dramatically. The number of folks that we're bringing in new from colleges into the data center up significantly. Though interns converting into new hires. And we're adding people on to the platform at a pretty rapid pace as well if you look at our job site, right? We've got quite a bit of hiring going on, and this has been going on for as long as I've been here, which is roughly 4.5 years. So we're staffing up pretty significantly.

And there are a lot of parts to that question. I'll come back to it later. There's obviously a labor cost component. There's modular as part of your build process to address it. But I wanted to go back to development yield, which I mentioned a few months ago, because the investable data center universe has expanded tremendously in the past 12 months, which is great, right? Bring more eyeballs to Digital Realty. But I think it also creates greater need for differentiation, right, across the space, at least investors differentiating between the different operators. And in one metric where I do see differentiation is development yield, right? And I think that Digital Realty talks about targeting unlevered development yield is about 8% to 10%, let's say, probably about the right range. You would at talk about the same thing. Some of the more transitional data set providers talk about unlevered yields of low to mid-teens, right? But I think there are differences beneath the surface here as well that I want you to go into maybe why you're targeting a lower development yield. And that is maybe ability to control for risk where maybe some companies are taking on more development risk going back to the cost per megawatt or even the cost of capital might be different or more risk and where it comes in versus projected. So why is Digital Realty able to accept the lower development yield? And I guess in your contracts, how do you control for those risks, right, to have certainty? Yes.

So it's a good -- I appreciate the question. I think the context of it comes relative to maybe some of the smaller or nascent hyperscale developers who are out there, maybe have a little bit of a less -- a smaller portfolio or a track record. Just a little bit of a different story. We have -- we target 10-plus percent development yields. We have $20 billion under construction today and 11.5% expected initial cash yield. . When we talk to our and sort of compare versus our large private peers who alongside us, we tend to dominate the third-party hyperscale data center provider market. I think we're pretty consistent with those folks and maybe even probably get a premium relative to...

I agree with you.

And part of that is because they are leveraged -- they're using significantly more leverage than we are. So their levered returns are higher, but they're using 75% to 95% project level.

It might be levered at 12x to 15x.

Correct. Yes. So that's sort of how we see the landscape. When we see some of these other numbers that are being quoted, I think it's really incumbent upon the investor and analysts like yourself to look at -- to compare apples to that -- make sure you're comparing apples and apples. So are those developments and are those yields on a gap basis? Meaning, are we looking at the average NOI over the life of the lease? Or are you looking at initial stabilized cash, which is the number that we give you. So the number would be 20% higher or so if you were using a GAAP yield. So maybe your 11.5% would be 14, right? Or what's embedded in the underlying cost that Digital Realty provides versus some of these other folks, right? Are they including land? Do their data centers have generators or redundancy? Are they including contingency in their costs and/or losses until stabilization, right? Some of the things that we embed in our cost, we would say we have a fully loaded cost estimate that we're projecting a yield. So I think there are differences. So I think in general, we command a premium, and I'll tell you why in the marketplace. Number one, we have somewhat uniquely low leverage for a hyperscale data center provider. Number two, with that leverage with that balance sheet and with our diverse sources of capital, we have the ability to have patients, right? In many times, we've already procured the capacity, including not only the land but also the power. We've signed an ESA, right, on our own credit or using our own balance sheet. And we don't necessarily need to go out and get financing, right? Most of our financing and most of -- we're capitalizing it at the corporate level. through our revolver, cash on hand or equity, et cetera. So we don't need to take a tenant lease and then go get it financed or then -- or bring it to a power provider to get an ESA side. So I think we're able to have a little bit more patients and for that, we're able to command a premium. But that's -- it depends who you're comparing us to, I think, to some extent.

Sure. And embedded in that question is actually a complement as well that I think you do a better job of controlling for development yield spread as well, right? So you can target the 9% to 10% because you have greater certainty in your cost of development, right? So I'd love to hear more detail in how you do that. I think the devil is in the details now when we're thinking about contracts and specifically how they are written and how data center developers protect themselves, whether it's upside in development cost or other factors just to ensure some certainty around the development spread. So can you -- is that something you can address Jordan?

I think generally, we're controlling cost rate. We're underwriting deals, right? We go into -- we buy land, we try and have a low basis from a procurement perspective, you know well that we have had a vendor-managed inventory program for well over a decade, right? So we've got multiple literation of supply chain issues over the course that we've seen over the last 2 decades, really, right? That experience has brought us to evolve our supply chain team and procurement process to really make sure that we have inventory or capacity available, right, of this equipment that's needed to bring these developments to bear at a good or well negotiated price, right? So we have very good relationships with our largest vendors, and we're buying at scale, right, across the equipment stack -- so that's obviously pretty helpful. Similar to what I was describing on the balance sheet side, that construct taking equipment into inventory is not necessarily something you see on the private side as much. And so that's also beneficial. And then I would say we just have to have line of sight to capital, which I talked about earlier around the strategic private capital side. So we're locking in. We know what our cost of capital is. And at the same time, you have to -- we have a robust global design engineering and construction team who is accustomed to sort of wash rents repeat in terms of standardized design, our process and shopping our developments to our GCs and getting a GMP from these GCs and thereby locking in the cost and locking in the spread.

So I haven't even gotten to leasing yet. I'm surprised taking me so long. You talked earlier about the 0 to 1 and the greater than 1 is normal question, #1 or 2 during these sessions. I want to start the 0 to 1 first, though, because I've also heard in conversations with public and private data center operators that they are seeing not just increased demand from say hyperscalers or AI companies, but enterprise is now deploying AI. And I think Digital Realty spoke about this in recent quarters as well, but there's been a real uptick from what I'm hearing, presumably they'll continue to drive the 0 to 1 activity. So I'd like to hear what Digital Realty seen from enterprise demand? And how much of that is related to AI inference.

So it's a very relevant question. When we speak to our core pillars of growth the first pillar is really the 0 to 1 plus interconnection growth, which is the enterprise and colo.

And that's a sticky -- that's a consistent order after quarter, steady eddy, land-and-expand type of business.

We've set a target of sort of doubling our production a few years ago. Within this business, we were doing 2 years ago, $50 million a quarter of 0 to 1 plus interconnection leasing. This past quarter, which happened to be another record 4 of the last 5 quarters have been records. So we put up $108 million of aggregate leasing in the 0 to 1 plus interconnection leasing. You and I are doing this long enough to remember when $100 million was a total leasing bogey for Digital Realty and probably even before that, when the numbers were even lower. But -- so we did $108 million of 0 to 1 plus interconnection leasing this quarter. So not only was that a record, but we also had a record level of AI-related leasing or workloads embedded within that. So it was north of 21%. So that's generally our enterprise segment, enterprise business, we saw a significant uptick there. So what's notable about that is that's probably double the pace or the percentage of the total. So not only is the leasing is up 28% year-over-year in the second quarter, but the percentage has also almost doubled. So and the really even talked about yet, but it also significantly above expectations coming into the quarter. The releasing but yes, they were on the 0 to 1 side as well as across your overall portfolio. So what's interesting about re-leasing spreads you're right, they were 25% in the quarter, which was almost anomalous type level relative to what we've been doing relative to the sort of the, I don't know, 7% to 8% guide we gave in the year at the outset of the year. Now we're expecting to do 10 for the year. When you split out that leasing, weighted 5.2% on the 0 to 1 side. Historically, right, the [ steadyeddie ] business as you described, historically, that's a 2%, 3%, 4% increase or type business, we did 5.2%. So we're definitely above the high end of the range. And we are seeing upward pressure on that side of the business. And a lot of that is being driven by reduced availability and increased or steady demand. So that's on the 0 to 1 side. We saw a very big number on the greater than 1 megawatt. Re-leasing spreads, and those were 67% and those were driven by a handful of leases in APAC that were up for renewal.

I get this question frequently, and it's going to sound like a knock, but it's not. The question I get is, why isn't growth in the industry, not just Realty. why isn't growth news 3 higher if occupancy is so high or supply is so tight. And that goes back to re-leasing spreads that you're right, this past quarter, I mean, there were tremendous levels. But you've been averaging kind of that high single-digit level and that was the expectation, I think, for the industry. So why shouldn't releasing spreads remain at teens or 20%, if you're 90% occupancy right? Sellers market why accept anything less than 15%, 20% release my have to say like it go somewhere else -- so why shouldn't they remain at that level?

Re-leasing spreads are like FOMC policy they tend to have like long and variable lags. So the increases tend to look like this, right? They're sort of gradually higher as the market has tightened as fundamentals have tightened and demand has increased and outweighed new supply or the ability to bring new supply to bear. We've seen re-leasing spreads march higher, but we've -- this quarter, right, it's higher with upside volatility. So it's been steadily higher. But this quarter was plus 25% on a path towards 10% for the year. So we do expect to see quarters where we're going to have meaningful upside volatility. And that's just along this path of tightening of overall fundamentals. So when we look at -- you didn't necessarily ask this question, but if you look at our renewal schedule...