After Lackluster Quarter, Digital Realty Pushes Back On Prominent Short Seller
Digital Realty, a $28B real estate investment trust that is one of the world's largest owners of data centers, is pushing back on the dire predictions of an influential investor after its declining performance in the first quarter raised eyebrows.
After three years of unprecedented growth, data center REIT Digital Realty is showing signs of trouble. The company’s new bookings numbers declined precipitously last quarter to their lowest level since the start of the pandemic. At the same time, the company’s debt exposure has shot up.
Analysts have raised doubts about the feasibility of Digital Realty’s plans to fund new development by selling existing assets.
Digital Realty — and the data center industry in general — have been the target of high-profile short sellers over the past year, and some investors have pointed to this latest earnings report as evidence of impending disaster for one of the world’s largest data center providers. But Digital Realty’s leadership has pushed back on that notion, insisting that last quarter’s numbers are a short-term aberration and that the fundamentals of the business are strong.
“Since our IPO in 2004, concerns have been periodically raised about various potential risks to data centers, including technology, customers, demand, supply and obsolescence — this seems somewhat par for the course for a relatively nascent and growing asset class,” Digital Realty CEO Andy Power said on the company's quarterly earnings call last week.
“We have not witnessed a meaningful and sustained pullback in demand in the nearly 20 years that we’ve been in business, and we are not seeing a pullback today," Power added. "We are optimistic that our business will remain resilient in 2023 and for years to come.”
While Wall Street analysts expected tempered performance from the data center sector amidst global economic volatility, Digital Realty’s quarterly numbers raised red flags that were absent for rival firms like Equinix and American Tower subsidiary CoreSite.
Digital Realty's new bookings were way down, dropping to $83.3M from over $150M a year ago. It was the company’s worst quarterly performance on new leases since the first quarter of 2020.
The decline was entirely in leases of larger than 1 megawatt, a segment of the business most focused on big tech hyperscalers — cloud and social media giants like Amazon Web Services, Google, Microsoft and Meta — that have driven the bulk of the company’s growth in the past.
As new bookings dropped, the company’s debt skyrocketed. Digital Realty added more than $1B of debt in the first quarter alone, much of it in the form of a $740M, two-year term loan the company secured in January. The firm’s leadership has acknowledged that its 7:1 leverage ratio is now well above the company’s own target of six and north of what many investors are comfortable with. By comparison, rival REIT Equinix’s leverage ratio at the end of the first quarter was 3:4.
Compounding the concern around Digital Realty’s rising debt, macroeconomic conditions have made the company's plans to raise capital for new development significantly more challenging. Since late last year, company leadership has touted its plan for capital recycling to fund growth — selling stabilized, fully leased data centers or monetizing shares of these facilities through joint ventures.
But, as Bisnow has reported previously, executing these deals has become more difficult. Overall data center deal volume declined significantly toward the end of 2022 as changing interest rates and volatile debt markets created uncertainty around valuations. Many sellers have held back, concerned they will have to settle for lower valuations in the current environment. Selling assets to fund development could mean getting bad value.
These challenges for Digital Realty come as welcome news for Jim Chanos, the influential short seller who has made no secret of his big bet against the data center sector in general and Digital Realty in particular.
The dip in new bookings larger than a megawatt dovetails with a central tenet of his thesis: that REITs like Digital Realty will see demand from hyperscalers decline as tech giants increasingly develop their own data center campuses.
However, it was Digital Realty’s escalating debt that Chanos seized on publicly following the company’s quarterly call with analysts.
“Don’t look now, but [Digital Realty’s] net debt was up almost $1.3B … in the quarter,” Chanos tweeted. “This is not a sustainable business model.”
Of course, Chanos has no shortage of motivation to push the idea that Digital Realty is in trouble. And even before he took to Twitter, his rhetoric — and the potential damage it could inflict — seemed to be top of mind for Digital Realty’s leadership on the company’s quarterly earnings call.
Power delivered an explicit rebuttal to Chanos’ narrative around the company on the call, calling the short seller’s public stance “the latest misinformation campaign cast upon the data center sector by those interested in seeing the price of our stock goes down.”
Power framed the quarter’s meager bookings numbers as a temporary dip, not the start of a long-term trend or indicator of tapering demand. He suggested that the quarterly figures were largely a matter of timing, with a significant volume of large signings occurring late in 2022 or being finalized in the months ahead. Indeed, Digital Realty did see record new leasing volume in 2022.
Executives at Digital Realty have also pointed to power constraints in Northern Virginia — Digital Realty’s largest market — as contributing to a temporary reduction in new leasing. Unexpected power shortages in parts of Loudoun County due to insufficient transmission infrastructure has delayed much of the firm’s planned development in Ashburn until at least 2026. It’s a reality that is starting to be reflected in the bookings numbers.
According to Chief Financial Officer Matt Mercier, Digital Realty signed around $20M in new leases in Northern Virginia each quarter for the past three years, but this past quarter that number was just $2.5M.
Digital Realty’s leadership also argues there’s no evidence to suggest that the quarter’s low booking numbers are a sign that hyperscale demand is tailing off, whether due to hyperscalers building their own data centers, competition from private equity funded developers or any other reason. The demand forecast, they say, remains strong.
“Nothing’s fundamentally really changed our relationship or our position with these hyperscalers in the greater than 1 megawatt category,” Chief Revenue Officer Corey Dyer said. “One quarter doesn’t make a trend … We’re in a really good position with them from a pipeline perspective and demand.”
The leadership team is also projecting confidence in its ability to raise funds for growth and development and drive down the company’s debt through capital recycling. While economic conditions may make transactions tough, Power told analysts the company is engaged on multiple deals it expects to execute in the coming months and is on track to net around $2B through asset dispositions and joint ventures.
As to whether completing these deals will mean settling for lower valuations, Power suggests that valuations for certain facilities are beginning to come back in line with previous years. He points to a first quarter deal to sell 10% of a Loudoun County data center as evidence that the huge amount of capital looking to invest in the data center sector, combined with few facilities hitting the market, will continue to make deals possible.
“This asset was sold at a valuation of nearly $17M per megawatt, which represents a substantial premium to our development cost today for new data centers in this market and significant value creation,” Power said. “Given the ongoing process that we are undertaking to bolster our capital sources and increase the efficiency of our balance sheet, we remain confident in the institutional appetite to invest in data centers.”
Successfully raising $2B though capital recycling will significantly lower Digital Realty’s debt ratio and bring it in line with the company’s own guidelines, Power said. Whether these arguments land with investors, and help stem the steady slide of Digital Realty’s stock price that has declined more than 30% over the past year, remains to be seen.
Unsurprisingly, Chanos isn't convinced.
“[Digital Realty] management is bad at math,” he Tweeted last week. “Digital Realty better hope that the ratings agencies are as innumerate as they are.”
