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UOB Kay Hian keeps 'overweight' rating on data centre REITs as it sees backfilling supported by tight vacancies

UOBKH maintains "overweight” rating on the data centre S-REITs after seeing first year of positive growth since 2017

UOB Kay Hian’s (UOBKH) analyst Jonathan Koh maintains his “overweight” rating on the data centre Singapore REIT (S-REIT) subsector as he sees the sub-sector seeing its first year of positive growth in rents since 2017.

“According to CBRE Group (CBRE), asking rents across primary wholesale colocation markets increased 14.5% to US$137.90 ($184.33)/kW/month in 2022,” Koh writes.

A shortage of power and land in Northern Virginia and Silicon Valley has resulted in a recorded net absorption of 436.9MW and 62.4MW respectively, bringing vacancies to a low of 0.98% and 2.3%, he adds.

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In Northern Virginia, problems with transmission of electricity via overhead power lines will cause delays in delivery and reduced allocation of electricity until 2026.

In Silicon Valley, coal-fired power plants and nuclear generators are being retired more quickly than they can be replaced by renewable energy and battery shortages. Natural disasters like wildfires and drought are also causing less emphasis on new businesses and capacity expansion over the next five years.

Combined with a nationwide vacancy rate for primary markets hitting a record low of 3.2%, rents are expected to maintain an upward trend in the first half of 2023.

“CBRE expects demand from hyperscalers to outpace supply, which creates a rent premium for available space,” says Koh.

Koh highlights that the demand for cloud computing continues to grow, as internet traffic doubles every four years.

“Amazon Web Services grew revenue by 20% y-o-y and generated operating profit of US$5.2 billion in 4QFY2022. Similarly, Microsoft’s cloud business grew revenue by 22% y-o-y with an attractive gross margin of 72%,” he says.

With the world’s big technology companies like Microsoft, Google, and Baidu racing for AI development, Koh predicts that the demand for data centre spaces will continue to grow.

Koh mentions examples like Microsoft’s OpenAI technology build called Co-pilot, and Baidu’s AI-powered chatbot Ernie Bot.

DCREIT preferred, followed by MINT

In his report, dated March 22, Koh has indicated his preference for Digital Core REIT (DCREIT) DCRU and Mapletree Industrial Trust (MINT) ME8U among the data centre REITs under his coverage.

Both DCREIT and MINT have “buy” calls with target prices of 78 US cents and $2.79 respectively, saying that rising rents and tightening vacancies augur well for the two S-REITS’s efforts to backfill potential vacant data centre spaces.

Despite the positive catalysts globally, the analyst sees potential negative impact for DCREIT should its second-largest tenant, Cyxtera, file for chapter 11 bankruptcy protection.

Cyxtera, which accounts for 22.6% of the REIT’s annualised rent, was downgraded by Moody’s from B3 to Caa2 on February 17. The exposure to Cyxtera is straddled across six data centres.

In the event that Cyxtera files for bankruptcy, Koh’s sensitivity analysis shows that DCREIT’s FY2025 distribution per unit (DPU) and target price could drop by up to 29% and 27% respectively.

“Our base case scenario, which assumes DCREIT backfills half of the vacant data centre space, provides FY2025 DPU forecast of 3.5 US cents and target price of 67 US cents,” he says.

Cyxtera has entered an agreement with all of its revolving lenders to extend the maturity of its US$120 million revolving credit facility from Nov 1, 2023 to April 2, 2024. It is also working to address long-term debt that matures in May 2024.

However, as non-investment grade tenants account for 32% of DCREIT’s annualised rents (Cyxtera Technologies: 24.1% and Sungard Availability Services: 7.3%) as of June 2022, Koh notes that DCREIT would have the opportunity to rebalance its tenant base toward investment grade tenants in the event that Cyxtera files for bankruptcy.

With MINT, Koh notes that the REIT could face the risk of non-renewals for four of its data centres. MINT’s tenants AT&T and Atos could vacate from MINT’s four US data centres, which account for 15.3% of the REIT’s total data centre net lettable area (NLA).

Two of the data centres at Brentwood, Tennessee and San Diego, California, would both expire in November 2023 and December 2024 respectively are “fairly large”.

“Our sensitivity analysis indicates that FY2026 DPU and our target price could drop by up to 8.9% and 8.6% respectively. Our base case scenario, which assumes MINT backfills half of the vacant data centre space, provides FY2026 DPU forecast of 14.0 cents and target price of $2.79,” he says.

However, Singapore’s portfolio for MINT continues to outperform, says Koh.

The REIT’s occupancy edged higher by 0.1 percentage points (ppt) q-o-q to 96.9% in 3QFY2023, driven by flatted factories in Singapore (+1.3 ppt q-o-q to 98.0%).  Gross rental rate for the Singapore portfolio edged slightly higher by 0.9% y-o-y to $2.15 psf/month in 3QFY2023. Retention rate was high at 92.2%.

MINT has also secured Biotronik as its anchor tenant for its seven-storey built-to-suit facility at 165 Kallang Way, which are expected to be completed in the first half of this year.

“In total, 39% of 161, 163 and 165 Kallang Way (previously known as Kolam Ayer 2 Cluster) is pre-committed. MINT has achieved attractive signing rents at high-$3psf/month,” says Koh.

Despite slow progress in securing replacement tenants for vacant data centre spaces, Koh maintains his positive outlook on DCREIT and MINT, with rising rents and demand for data centre spaces.

As at 12.25pm, DCREIT was down 2.30% to trade at 42 US cents; MINT traded flat at $2.33.

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