But investors are right to have doubts. The stocks were already underperforming the real estate investment trust sector in the United States this year before the Financial Times revealed Chanos’ negative opinion in June. Morgan Stanley analysts summarized the concerns: demand and price prospects, low capital returns, competition, cost inflation, rising financial costs and the risk of “obsolescence”.
This corresponds to Chanos’ reported thought. The major cloud computing companies – Amazon.com Inc., Alphabet Inc.’s Google and Microsoft Corp. – are the largest customers in the sector, but they also build their own facilities. Chanos takes this to mean they are truly competitors. In other words, cloud providers will capture future growth at the expense of data centers.
Certainly, REITs have a future. Many businesses will want to maintain their own servers in data centers, rather than relying exclusively on the cloud. Facilities located in cities close to end users offer fast connection speeds, which is essential in many cases. Cloud companies will continue to lease data centers as they enter new markets. Equinix boss Charles Meyers says he’s not in a “zero-sum game” with the cloud majors.
The catch is that none of this guarantees that REITs are destined to grow as fast as their market valuations imply.
The harsh reality is that the long-term trend is intense competition that is putting deflationary pressure on rents. Things may be looking up today, but it could be a blow. Pandemic disruptions hampered new developments as demand accelerated. Vacancy rates in major US markets fell to 4% from 10% in 2019, according to analysts at UBS Group AG. In the second quarter, Digital Realty re-leased sites at 3% above existing rents and Equinix saw record bookings.
It is difficult to be sure that this marks a decisive break with history. In addition, construction, maintenance and energy costs increase; higher rent renewals may not compensate for them. Cloud giants could slow investment next year as they shift from expansion to “digestion”, Morgan Stanley analysts say.
Many investors value these companies on multiples of funds from operations (FFO, a real estate industry measure of cash flow generated by the business) after deducting so-called maintenance capital expenditures. These capital expenditures are, according to companies, necessary to maintain revenue rather than to win business (accounting standard setters make no such distinction, making it an opaque measure). The concern is that this load might need to increase.
Maintenance investment at Equinix has been low as a percentage of revenue, providing a tailwind that may not last, according to research from Barclays Plc. According to forecasts compiled by Bloomberg, Equinix’s adjusted FFO is expected to grow about 9% compounded annually from 2021 to 2024. This is roughly in line with Morgan Stanley’s expectations for the REIT industry as a whole. For Digital Realty, the comparable figure is only 6%.
Meanwhile, the financial environment is deteriorating. REITs pay most of their taxable income in the form of dividends to benefit from tax breaks. To fund expansion, data center companies are going into debt and selling stocks. Even leaving aside the absurdity of a business model that pays out massive dividends and then asks shareholders to provide cash, debt and equity are getting more and more expensive. This increases the reliance on asset sales to fund growth.
Despite all these uncertainties, valuations look high. Digital Realty is trading at 16.3 times expected FFO per share in 2023, and Equinix at 27.6 times, versus just under 16 times its peers, according to Bloomberg data. When it comes to enterprise values versus expected earnings before interest, taxes, depreciation and amortization next year, multiples are also still above the REIT average despite the decline in stocks.
Signs of a slowdown in cloud investment, or a cost and capex shock, would surely accelerate the sector’s ongoing devaluation by undermining the narrative that the industry is in a positive cycle. The challenge remains: why do these stocks deserve higher valuations given increasing cost pressures and intense competition?
More from Bloomberg Opinion:
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• Alibaba shows how hard it is to kick a habit: Tim Culpan
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Chris Hughes is a Bloomberg Opinion columnist covering the deals. Previously, he worked for Reuters Breakingviews, the Financial Times and the Independent newspaper.
More stories like this are available at bloomberg.com/opinion