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Why Data-Center REITs Are Promising And Risky

Jeff Brown

Investors who have taken a step outside the mainstream may have dabbled in real estate investments trusts -- funds that own malls, apartments and even mortgage securities.

But those choices are so 20th century. For the 21st there is the data-center REIT, which owns server farms for internet and other data-hungry needs. Computers aren't going anywhere and the mammoth volumes of data created every day need to be stored and accessible, making data-center REITs an enticing growth story.

"Data-center REITs had a remarkable performance in the past five years with an average 25 percent total annual return," says Milena Petrova, associate professor of finance at Syracuse University's Whitman School of Management. "Their return in the past three years has been less impressive -- about 17percent -- but still higher than the returns on the stock market and significantly higher than for the REITs' returns on average."

[See: 10 of the Best Stocks to Buy for 2019.]

But although a ballooning industry looks like a slam dunk, this one also offers plenty of risk. Competition is mushrooming, though some experts think a price drop among these funds last year makes them a good buy today.

So, does a data-center REIT belong in the ordinary investor's portfolio? Dividend yields can be alluring, but some experts say these funds are more suitable for young investors who can ride out slumps than for the typical income-oriented retiree who prizes safety.

"Data-center REITs offer the dividend trifecta for investors: reliability, growth, and yield," says Robert Baillieul, head of investment research for IncomeInvestors.com, a website for income-oriented investors.

"Distribution yields have approached 4 percent," he says, referring to REIT income streams. "The industry as a whole trades at 18 times adjusted fund flows from operations, a common measure of profitability in the real estate business, compared to 20 times for REITs as a whole. That's attractive, given the group provides above-average growth prospects over the next five years or so."

NAREIT, the industry trade group, says there are five data-center REITs with total assets of about $65.5 billion at the end of January. As a group, those REITs lost 14.11 percent in 2018, but roared back with a 7.42 percent gain in January.

The five data-center REITs are CoreSite Realty Corp. (ticker: COR), Digital Realty Trust ( DLR), Equinix ( EQIX), CyrusOne ( CONE) and QTS Realty Trust ( QTS).

That slump in 2018 is part of the appeal today, as some experts expect a recovery that would add capital gains to dividend earnings.

"I believe that investment in data-center REITs is a good alternative to technology investments as it can be seen as a technology play, with a real estate component," Petrova says. "It is also a safer play than investing in technology stocks. The attractiveness of data REITs is in their high dividend yield, in contrast to most firms in the tech sector."

Todd Smith, chief technology officer at Transwestern, a commercial real estate firm based in Houston, argues that last year's selloff makes these REITs a good buy today even though they still have high price-earnings ratios compared to ordinary stocks.

"They have the look of tech growth organizations," he says, noting that high debt can be worrisome. "I don't view any of them as necessarily low risk, but I do think that the sector has plenty of growth potential and that it is likely for these stocks to net solid returns in addition to the dividends."

Long-term trends for data services are good, Baillieul says.

"The industry's business model has held up well during recessions," he says. "Consumers aren't going to stop checking their social media feeds just because the economy takes a downturn. Renters (of data storage) also face high switching costs once they install their servers in any given facility. This allows data-center REITs to keep boosting rents without the fear of losing tenants."

[See: How to Invest in Real Estate Without Buying Property.]

But Baillieul, too, acknowledges risks. "The biggest threat: Higher interest rates. Because data center cash flows resemble bond coupons, they compete directly with bonds for capital. If interest rates rise, money will likely flow out of these REITs for safer returns elsewhere."

While growing competition is a danger, Dee Nguyen, senior analyst for real estate securities at CenterSquare Investment Management in Plymouth Meeting, Pennsylvania, says it's a tough industry for newcomers.

"Data center management is a complex business and data center developments require significant capital commitments," she says. New competitors can have trouble luring customers if they are not big enough and well known, she says. That gives current players an edge.

Smith notes that big-name competitors like Amazon.com ( AMZN), Apple ( AAPL) and Microsoft Corp. ( MSFT) could hurt the REITs that specialize in third-party services.

With these hazards, he does not recommend data-center REITs for risk-averse investors.

"I would view them as dividend-paying stocks that may have high upside along with the rising tide of technology," Smith says. "The tech sector has had major busts, while major data center organizations have downside protection with long-term contracts."

"Younger investors with a long investment horizon and higher volatility tolerance would be the ideal investors," says Patrick Wilson, CenterSquare's assistant portfolio manager for real estate. "Despite the strong underlying fundamentals, the stocks can experience higher volatility as they are often viewed as high growth technology companies."

Performance can be choppy due to the relentless need to land big customers, he adds.

[See: 10 Long-Term Investing Strategies That Work.]

So it could be a wild ride but potentially rewarding.

"Data-center REITs are selling picks and shovels in today's technology gold rush, " Baillieul says. "Nobody can predict which gadget will dominate the marketplace in 10 years. That makes these trusts the safer, and surprisingly profitable, way to invest in the industry."

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