Digital Core REIT - UOB Kay Hian 2022-09-23: The Spirit Is Willing But The Market Is Weak


Digital Core REIT - The Spirit Is Willing But The Market Is Weak

  • The timing of Digital Core REIT (SGX:DCRU) announcing its maiden acquisition coincided with the Fed stating that it would be persisting with its hawkish stance. Steep rate hikes are expected to continue till end-22.
  • We see the positive impact of Digital Core REIT acquiring 25% of the Frankfurt facility (scenario A) being neutralised by steep rate hikes on 2 Nov (75bp) and 14 Dec 22 (50bp).
  • Digital Core REIT provides a distribution yield of 4.9% for 2023 (vs Keppel DC REIT: 5.4% and Mapletree Industrial Trust: 5.3%). Maintain BUY.

Digital Core REIT is embarking on maiden acquisition post-IPO.

  • Digital Core REIT announced that it will be acquiring a data centre in Frankfurt, Germany valued at €558m (about US$558m) and a data centre in Dallas, Texas valued at US$199m from sponsor Digital Realty. There are two potential scenarios:
    1. Acquisition of 25.0% of Frankfurt data centre fully funded by debt, which will increase its portfolio size by 10%. Aggregate leverage is expected to increase from 25.7% to 33.0%.
    2. Acquisition of 89.9% of Frankfurt data centre and 90.0% of Dallas data centre, supported by an equity fund raising (EFR) exercise, which will increase portfolio size by 48%. The mix of debt and equity funding is expected to be 60:40. Aggregate leverage is expected to increase from 25.7% to 37.5%.
  • Expansion into two new core data centre markets. Frankfurt is the second largest data centre market in Europe while Dallas is the fifth largest in North America. Both data centres are purpose-built and were completed within the past 5 years (average age: three years). They are fully integrated with sponsor Digital Realty’s global platform and tethered via dark fibre to Digital Realty's interconnection hubs. Both data centres are powered by renewable energy (Frankfurt: hydroelectric power, Dallas: wind power).
  • Creating value by backfilling vacant spaces. Capitalisation rates are 4.5% for the Frankfurt facility and 5.0% for the Dallas data centre. The Frankfurt facility’s occupancy was 91.3% as of Jun 22 (vacancy: 8.7%). Yield is expected to improve from 4.5% to 5.0% when the vacant spaces are leased-up and backfilled. The average in-place contractual rental escalation for the two data centres is 1.6% per year
  • Improving customer diversification. The acquisition will add nine new customers, bringing Digital Core REIT’s total number of customers to 25 post-acquisition. The proportion of its top 5 customers of total annualised rent will be reduced from 97% to 86%.

Potential EFR (equity fund raising) exercise.

  • If conditions in the equity market are conducive, Digital Core REIT intends to embark on an US$277m EFR, comprising a private placement of US$180m (217m new units) and sponsor placement of US$97m (117m new units). Digital Realty would maintain its stake in Digital Core REIT at about 33.4%.

Digital Core REIT expects positive impact.

  • The deal is expected to be accretive to Digital Core REIT's DPU by 2.0% for scenario A and 3.1% for scenario B.
  • The acquisition of the Frankfurt data centre is funded by euro-denominated bank borrowings with weighted average interest cost of 3.5%. The acquisition of the Dallas data centre is funded by the EFR with issue price of placement units assumed to be US$0.83.

Market conditions not conducive for EFR.

  • Digital Core REIT will pursue scenario B if market conditions are conducive for the launch of an EFR exercise. Digital Core REIT's share price is currently trading at US$0.80, which is at a 6% discount to NAV per unit of US$0.85 as of Jun 22.
  • Unfortunately, we believe scenario A is the most probable outcome given the current volatile market conditions for S-REITs and rising government bond yields.
  • The acquisition is subject to approval by unitholders during an upcoming EGM.

Digital Core REIT - Earnings forecast revision and recommendation

Pure play on data centre.

  • Digital Core REIT provides a distribution yield of 4.9% for 2023 (vs Keppel DC REIT: 5.4% and Mapletree Industrial Trust: 5.3%). It deserves to trade at a premium due to its status as a pure play on data centres with acquisition-led growth supported by Digital Realty.
  • P/NAV at huge discount relative to peers. Digital Core REIT's share price trades at P/NAV of 0.94x, which is a discount compared with other data centre REITs that are trading at an average P/NAV of 1.40x (vs Keppel DC REIT: 1.43x and Mapletree Industrial Trust: 1.36x).
  • Catalysts:
    • Organic growth from cash rental escalation of 1-3% (weighted average: 2%).
    • Yield-accretive acquisitions tapping on sponsor’s large and growing data centre pipeline.

Jonathan KOH CFA UOB Kay Hian Research | https://research.uobkayhian.com/ 2022-09-23
SGX Stock Analyst Report BUY MAINTAIN BUY 0.980 SAME 0.980