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Subject: COR: Selling Picks to Miners Date: 8/17/2014 6:47 PM
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Not too many posts on REIT commons these days, so I will copy and paste a blog post on it that I did for SNL Financial a couple of weeks ago. Those who like yield (perhaps most of you) will note that the yield on COR is an above-average 4.2%, and has good growth prospects.

Ralph


DATA CENTERS REITS:
SELLING PICKS TO MINERS?

The vast majority of the scribbling I do for Block Party relates to large and squishy issues involving REITs and REIT investing generally. However, at times I try to get closer to the ground (without crashing and burning) to look at specific REIT sectors, and even individual REITs.

Data center REITs are fairly new to REITville, the first one (Digital Realty Trust – DLR) arriving on the scene about 10 years ago. There are now five of them, including CoreSite Realty (COR), CyrusOne (CONE), Digital Realty, DuPont Fabros Technology (DFT), and QTS Realty Trust (QTS). These REITs own and operate large buildings that provide the infrastructure needed for data storage and Internet usage, including access to huge amounts of power and communications fiber – and essential redundancy in case of power outages. (For many of the observations that follow I am indebted to Green Street Advisors for, among other things, their excellent coverage of this interesting sector – but any errors here are mine, of course).

The prospects for the growth of this industry appear favorable; my 96-year-old mom may not be Twittering with her friends and relatives, but the Millennials are demanding more bandwith and connectivity almost every hour, and even the Boomers are being dragged into the Internet age. It seems that we can no longer even pay our bills or apply for a driver’s license renewal without Internet access. The business is, in a sense, like supplying jeans and picks to miners – but one hopes that, unlike the gold rush, the Internet never gets played out.

One fairly recent concern for data center owners and investors has been a wave of new supply and greater competition, especially in certain commodity-like segments such as “enterprise” data centers that cater to the needs of corporate IT departments and users of the “public cloud.” But these pressures seem to be easing of late, and spreads between new rents and expiring rents are growing again (albeit modestly).

There are sub-specialties within the industry, with some REITs providing more commodity-like space and others building and owning more specialized centers. “Network-dense” data centers has been likened by Green Street to highly-productive urban in-fill shopping malls, as they are hard to replicate and require great care in creating the right tenant mix; they act as key hubs for the Internet and related connectivity. And, like the best mall properties in great markets, they tend to provide their owners with greater pricing power.

CoreSites is my personal favorite among these REITs; unlike most of its peers, it has a favorable balance between enterprise and network-dense centers, which should insulate it, to some extent, from greater competition. COR became public in 2010, and – although its public company track record is thus somewhat short – appears to have a very good management team. Its equity market cap is approximately $700MM, and its properties are concentrated in the San Francisco Bay Area, Los Angeles, Northern Virginia and Boston. Like most of its peers, COR engages in new property development to drive external growth; its pipeline appears to be manageable, with 50,000 square feet of data center space under construction at a second facility in northern Virginia at the end of Q2, at a cost of $73.9 million. Another $94.7MM in developments has been completed, is in the process of stabilization and is one-third leased (including three large developments completed since February 2014).

It is my belief that REIT stocks, on the whole, are now reasonably valued; accordingly, finding terrific bargains may be almost as difficult as locating a mean Golden Retriever. But COR may be one of those bargains when risk, growth potential and valuation are dumped into the cauldron.

COR’s growth potential is significant and will be driven by ever-greater demand for Internet use and related connectivity, coupled with its expertise in network-dense centers which, as previously noted, are less commodity-like and may provide pretty good pricing power. Intelligent development of new centers will also drive cash flow growth. In Q2, per-share FFO (excluding a two cent software write-off charge and an eight cent gain from the “true-up” of accrued real estate tax liabilities) increased by 13.3% year-over-year. Green Street Advisors has estimated that per-share AFFO will grow by over 15% next year and an additional 10% in 2016 and, for those who still care about dividend yields, COR provides a current return of 4.2% on Monday’s closing stock price of $33.49.

Risk is difficult to quantify for these data center REIT stocks. Like all real estate owners, new competing supply will always be something that needs watching, as well as greater competition from Amazon and other public cloud providers. However, COR is somewhat protected from this via its heavy exposure to network-dense centers. COR also has reduced investors’ risk by maintaining a very low-levered balance sheet. Debt leverage, including an issue of preferred stock, amounts to just 16% of estimated asset value (using a property cap rate of 7.7%). At the end of Q2, long-term debt amounted to $391.8 million, just 2.9x COR’s Q2 annualized adjusted EBITDA. Growth without debt leverage – how refreshing!

Valuation also appears to be attractive. At $33.49, COR stock trades at just slightly above SNL’s consensus NAV estimate of $32.52, and at a significant discount to a recent (and higher) Green Street NAV estimate. Its AFFO yield, at approximately 5% (on 2015 AFFO estimates) seems reasonable and in line with the REIT industry average.

Can anything go wrong? Do Republicans dislike Nancy Pelosi? An increasing supply of competing data centers could exceed the growing demand for them, and new technologies could produce economic obsolescence for some centers. And, certainly, COR’s new development projects could be slow to fill, and at lower-than-projected rents. But I believe that these risks are more than offset by its growth potential and a very unlevered balance sheet. I own COR stock, but will be careful not to pig out on it.
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