Digital Core REIT: Trading up at a discount
- Option to acquire a further 40% stake in the Frankfurt DC at 20% discount to valuation, “too good” an opportunity to miss
- Various options available for DCREIT to act on, accretion could rise to +7.0% if DCREIT uses its debt headroom to fund the acquisition
- Further avenues include a potential asset swap with sponsor, providing a longer runway of attractive total returns, or a fundraising exercise, which can be accretive, based on our estimates
- Maintain BUY with unchanged TP of USD0.75
When Digital Core REIT (DCREIT) increased its stake in the Frankfurt DC by 24.9% back in April 2024, the agreement included an option for DCREIT to further increase its stake by an additional 0.2% to 40%. This effectively allows DCREIT to raise its stake from the current 49.9% to a maximum of 89.9%. DCREIT announced its intention to exercise this option with an announced plan to take its stake up by an additional 10% in the property, which will be fully funded through debt.
DCREIT has up to 90 days to conclude the deal, meaning it must be completed sometime in early December 2024. As this is an interested party transaction, DCREIT will need to hold an EGM to seek unitholders' approval.
Option allows DCREIT to acquire the additional stake at previously agreed price; valuations for the property have increased by c.20%, thus “a discount”. Since December 2023, the occupancy rate of the Frankfurt DC has increased from 92.0% to 98.5%. Additionally, underlying rents have risen significantly after DCREIT terminated the Cyxtera lease (which accounted for c.4% of the property) and replaced it with new leases at substantially higher rental rates.
Based on latest valuation exercises carried out on the property, its valuation has increased by more than 20%, rising from EUR470.0mn (December 2023) to EUR571.5mn (the average of two valuations) as of 7 September 2024. The agreed-upon purchase price for the additional stake implies a NPI yield of c.5.7% at present. Under the terms of the option, DCREIT can acquire the additional stake at the previously agreed valuation of EUR470mn, representing a discount of more than 20% compared to the latest valuation.
Debt capacity to debt-fund the deal as acquisition will be DPU accretive.
Through an acquisition at the agreed price, with the asset already seeing a revaluation uplift, DCREIT’s gearing will be lowered by c.70bps, bringing it down to c.33.8%. This reduction gives DCREIT enough debt headroom to acquire the entire additional 40% stake, which would increase gearing to c.41%, if it chooses to do so. Such a move could potentially lead to a DPU accretion of up to 7.0%, which is yet to be priced in.
However, DCREIT, for now, has indicated that they are more likely to acquire only an additional 10% stake in the Frankfurt DC. This 10% stake is valued at EUR47.0mn (USD51.7mn) and will be fully funded through new EUR debt at an estimated cost of 3.6%. By taking this more conservative approach, DCREIT can maintain a prudent gearing level just below 36%, while still generating a DPU accretion of around 1.7%. In addition, the acquisition will also be accretive to NAV, increase DCREIT’s scale while diversifying its geographical footprint and tenant base, and also create future earnings upside with the rising occupancy and rents at the Frankfurt DC.
Should DCREIT continue to acquire the remaining 30% stake in a high-quality asset that is being sold at a discount?
We believe that DCREIT should act on the optionality to bring its stake up fully to 89.9%. While interest rates are turning more conducive with a turn-down in benchmark rates in recent weeks, there remains a debate over whether DCREIT should remain prudent and acquire only an additional 10%, or fully utilise their debt headroom, raising gearing to 41% to generate higher DPU accretion. There is headroom to take its stake up to 89.9% (or an investment outlay of USD206.8mn), but we believe that the manager is probably retaining some debt capacity for future capital expenditure (CAPEX) that could be incurred in the coming years.
In the near term, we believe CAPEX may be required for the two Los Angeles properties, with master leases expiring at the end of September 2024. Looking further ahead, CAPEX could be necessary for the 8217 Linton Hall Road property in Northern Virginia, particularly if the underlying tenant does not renew their lease and vacates the premises.
What are the other options to consider? Apart from utilising its debt headroom to acquire the asset, we believe that there are other options for f DCREIT to consider to acquire the entire additional 40% stake in the Frankfurt DC without pushing gearing to 41%, two potential options could be considered:
- Asset swap with sponsor: DCREIT could consider and asset swap with their sponsor, allowing the REIT to acquire the additional stake without significantly increasing gearing.
- Equity fundraising: DCREIT could partially fund the acquisition through an equity fundraising exercise, reducing reliance on debt, which, contrary to market expectations, can be accretive.
Option 1: Consider an asset swap with sponsor
With the record-low vacancy rates for DCs in Northern Virginia, currently below 1.0%, DCREIT is confident it can backfill 8217 Linton Hall Road DC quickly with minimal downtime in the event the tenant does not renew their lease beyond June 2025. However, we think that there may be an even more appealing strategy for the asset given its location and amenities, and we understand that there is potential to redevelop the property to capitalise on the unused power load.
Linton Hall DC currently has a power capacity of c.10MW, while the on-site substation already has access to 24MW of power, more than double the current capacity. Furthermore, we understand that DCREIT is in discussions with authorities to potentially increase the power capacity up to 50MW. This can be a potential win for the REIT and presents a strong case for redeveloping the property to increase its power load by up to five times.
An asset swap of a stake in the redevelopment of Linton Hall DC for the 40% stake in the Frankfurt DC with its sponsor looks plausible, in our view, for the following reasons:
- Development limits imposed on S-REITS. (10% of AUM)
- Reduce development risks and immediate income generation
- Eliminate drag on earnings as Linton Hall DC undergoes redevelopment
An asset swap with DCREIT's sponsor could be a viable option, especially given the development limits (up to 10% of AUM) imposed on S-REITs, and large redevelopment projects typically create a drag on earnings during the construction phase. As DCREIT benefits from having a sponsor with proven capabilities and a strong track record in constructing DCs, redeveloping the property with the help of its sponsor.
This potential deal could allow DCREIT to exchange a development project for an income-generating asset while retaining partial participation in the redevelopment project. This would reduce development risks for DCREIT and minimise any negative impact on earnings during the construction phase. With construction costs for DCs averaging USD10mn per MW, the 8217 Linton Hall Road redevelopment could potentially cost c.USD500mn if its power capacity is increased to 50MW.
From a property NPI yield perspective, the asset swap would be accretive for DCREIT, given the current NPI yield of 4.3% for Linton Hall DC versus 5.7% for the Frankfurt DC. Currently, the Linton Hall DC is valued at USD204.4mn, making it possible for DCREIT to make an asset swap for the 40% stake in the Frankfurt DC (c.USD206.8mn) without having to raise additional capital or debt. Moreover, with the potential to increase power capacity at Linton Hall to 50MW, we believe the property's valuation could rise significantly once approvals are obtained. A higher valuation for the Linton Hall DC will allow DCREIT to retain some equity ownership in the Linton Hall DC redevelopment while acquiring the additional 40% stake in the income-producing Frankfurt DC. This also creates the opportunity for DCREIT to enjoy future earnings growth potential from the redevelopment, and the remaining stake held by the sponsor will also be a pipeline asset for DCREIT.
Option 2: Equity fundraising
An alternative option for DCREIT would be to conduct an equity fundraising (EFR) exercise to acquire the additional 40% stake in the Frankfurt DC. We carried out a sensitivity analysis that assumes DCREIT does an EFR to partially fund the acquisition and bring gearing higher, towards a more optimal c.37%. Based on these assumptions, the deal is likely to be accretive for DPUs from share prices from USD0.55/unit onwards.
In line with management’s guidance to avoid dilutive EFR, the best option should only be carried out at NAV (USD0.67), and this also ensures DPU accretion. However, since DCREIT is currently trading at a price-to-book (P/B) multiple of 0.9x (c.USD0.60), the key question to consider is whether management could be looking at a fundraising opportunity to shore up balance sheets to prepare the REIT for its next growth leg.
Our thoughts
We believe that DCREIT has many options bring its stake up to 89.9% and we see a golden opportunity not to be missed in the immediate term. The issuance of new equity at below book value is unlikely to be a major bugbear as the size of raising (if any) is small and less than 8% of the current market cap.
In our view, the asset swap option would be the ideal and could surprise for investors for DCREIT at this stage, as it allows them to increase their stake in an income-producing asset with a yield of c.5.7%, and also participate in a redevelopment project to drive future earnings growth. Moreover, DCREIT does not have the development headroom to carry out the Linton Hall DC redevelopment on their own, and the construction and leasing risks involved would be too high for the REIT at this point.
As highlighted in our earlier views on reliance on “divestments as a currency”, this would be the perfect opportunity for DCREIT to divest a part of a redevelopment project, and immediately recycle proceeds into a DPU-accretive acquisition. More importantly, a fair valuation of the Linton Hall DC that takes into account the potential upside of increasing its power load by up to 50MW will be key for the asset swap option.
As we keep a lookout for more details over the next 90 days, we will maintain our BUY recommendation at this point, with an unchanged TP of USD0.75.
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