Yahoo Finance DBS lowers Digital Core REIT’s TP to $1.30 amid tenant bankruptcy, UOB KH downgrades to 'hold'
The brokerage has retained its “buy” call despite the news.
DBS Group Research’s Dale Lai and Derek Tan have maintained their “buy” call on Digital Core REIT (DCR), despite the news that its 5th largest tenant has filed for Chapter 11 protection in the US.
However, the analysts have lowered their target price to US$1.30 ($1.77) from its previous figure of US$1.40 to account for higher borrowing costs as the REIT has hedged 50% of its outstanding loans.
On the other hand, UOB Kay Hian has downgraded its rating on DCR from a “buy” to “hold”, lowering its target price from $1.32 to $1.10.
On Apr 21, it was announced that DCR’s fifth-largest tenant - Sungard Availability Services - has filed for bankruptcy protection in the US, Canada and the UK.
Sunguard occupies about 40% of the power capacity at DCR’s data centre in Toronto and contributes slightly more than 7% of DCR’s rental income.
UOB KH analyst Jonathan Koh writes that despite the bankruptcy filing of Sunguard, DCR’s portfolio remains resilient, as Sunguard remains current on its rental obligations, and on a broader view, the occupancy rate for all 10 of DCR’ s data centres remains at 100%.
Lai and Tan write that the REIT is confident that the positive fundamentals for data centres in Toronto and the low vacancy rates will allow it to quickly backfill the space if Sungard decides to terminate its lease.
The REIT’s sponsor, Digital Realty, DCR’s sponsor, has also committed to guaranteeing the cash flow to the REIT in the event of any near-term shortfall arising from the tenant bankruptcy.
For the REIT’s borrowing costs, the analysts note that DCR has hedged 50% of its borrowings (US$175 million) to fixed rates to tackle rising interest rate risks.
Lai and Tan write, “although this is a positive development and provides more certainty on earnings, the high margins of 180 basis points on the interest rate swap translates to a doubling of average borrowing costs to about 2.1%.”
Previously, DCR enjoyed a low cost of debt of only about 1%. However, the recent spike in interest rates and expectations of further increases has prompted DCR to hedge 50% of its borrowings to fixed costs.
As such, the doubling of borrowing costs poses a downside risk to DBS’s projections, leading to an estimated US$3 million increase in financing cost per annum.
UOB KH’s Koh also highlights the rising cost of debt, saying that its management estimated that every 50 basis points increase in interest rates will reduce distributable income by US$700,000 per year.
“Assuming that the Fed Funds Rate averages 2.5%, we estimate that DCR’s average cost of debt will increase to 3.2% in 2023,” Koh thinks.
The DBS analysts, however, do note that DCR’s management has in place several plans to mitigate some of the increase in costs.
“DCR expects some savings in certain trust expenses and lower profit attributable to non-controlling interests, as compared to earlier forecasts. In the medium term, the REIT could also see a slight reduction in tax expenses for one of its properties.”
As such, they believe that these initiatives could mitigate approximately half of the increase in borrowing costs, or up to US$1.5 million
After accounting for cost savings mentioned earlier that will partially offset some of the increase in borrowing costs, they project an about 3% cut in FY2022 DPU to 4.35 US cents, vs a 4.5 US cents previously.
On the bright side for DCR, they highlight that its earnings are underpinned by solid fundamentals. The REIT has a portfolio of fully occupied data centres and a long WALE of about 5.5 years, which ensures income stability and visibility.
In addition to the booming data centre industry, annual rental escalations of about 2% for its portfolio provide for organic growth in earnings.
Furthermore, Lai and Tan think that DCR has “a pipeline that could make DCR one of the largest S-REITs”, noting that DCR has been granted a Right of First Refusal (ROFR) to about US$15 billion worth of data centres globally.
“In addition, the sponsor has a further US$5 billion worth of data centre developments that could potentially be made available to DCR when completed,” they note.
As of 4pm, units of DCR are trading at 96.5 US cents, with a FY2022 P/NAV ratio of 0.9x and dividend yield of 5.8%.
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