Data centre dilemma: Is Keppel DC REIT a buy or sell?

Keppel DC REIT owns data centres across the Asia-Pacific region and Europe. The REIT owns colocation, full-fitted as well as shell and core data centres. Most of its colocation data centres (with short leases and more potential of rental income growth) that contributed to approximately two-thirds of its rental income in 2022 are in Singapore and Ireland.

The REIT lost 37.5% of its market capitalisation since its post-pandemic peak as its share price fell from S$3.04 in August 2020 to S$1.90 in November 2023. Is this a temporary issue affecting the REIT or is there a permanent change in the fundamentals of the business?

Higher interest rates and finance costs

The higher-for-longer interest rates have triggered the sell-down of REITs in general. The higher cost of financing has affected the performance of some REITs in the market. For instance, Mapletree Industrial Trust owns primarily data centres (56.0% of its assets under management) and industrial assets. Its DPU was down in 2023 because of higher utilities and finance costs.

Keppel DC REIT’s DPU in 9M2023 was down to 7.543 cents, from 7.634 cents in 9M2022 because of higher finance costs. This is despite 72% of its debt at fixed interest rates in 9M2023. If the REIT does not manage to deliver a year-on-year increase in DPU in 2023, it will break its seven-year consecutive DPU growth record since its listing in 2015.

Some dividend investors are also moving to low-risk instruments like Singapore Savings Bonds, Singapore Government Securities Bonds, and Singapore Treasury Bills due to the higher interest rates which exacerbated the sell-down of the REITs like Keppel DC REIT.

Utility costs

Electricity expenses of data centres are largely pass-through in nature. The electricity expenses of colocation data centres are borne by tenants. Tenants of the long-lease data centres (fully-fitted as well as shell and core ones that provide income stability) negotiate the electricity expenses — including any increases due to commodity prices — with electricity providers directly.

Keppel DC REIT is largely shielded from the sharp increase in gas and coal costs. On the other hand, the higher electricity expenses incurred in non-data centre industrial assets are most likely absorbed by the REIT itself — like in the case of Mapletreee Industrial Trust. Data centres in general are more resilient than other industrial assets because of the current supply-demand imbalances in certain countries.

Lease expiry

All of Keppel DC REIT’s assets in Singapore are leasehold and the land leases will expire between 2044 and 2055. The management is not worried about the expiry and mentioned at an analyst briefing that they would approach the government (who is also the ultimate shareholder of the REIT) to negotiate to renew the leases.

Counterparty risk

Neo Telemedia is the sole tenant and master lessee of Keppel DC REIT’s Guangdong Data Centres 1, 2, and 3. The tenant is loss-making and in a net debt position of HK$828.6 million as of 9M2023. The tenant may struggle to pay rent as all its debt will be due in a year’s time. This tenant contributes to about 11% of Keppel DC REIT’s revenue and an analyst estimated that up to 16% of the REIT’s DPU could be impacted. The management has yet to respond to this issue and the REIT is still receiving its rental payments from Neo Telemedia.

The drop in the share price of Keppel DC REIT is largely in line with those of other data centre players. The fourth and the second largest tenants of Mapletree Industrial Trust and Digital Core REIT respectively filed for bankruptcy. Interestingly, infrastructure management asset firm Brookfield Infrastructure Partners came to rescue these tenants and offered to buy over certain assets from these two REITs as well as take over the tenants’ leases. This shows that data centres in good locations are still in good demand.

Industry tailwinds

Data centres in Singapore and Ireland contributed to about two-thirds of the REIT’s gross revenue in 2022. In these countries, the demand outstrips the supply of data centres. Vacancy rates in these countries in 2023 were less than 5% and were among the lowest among the cities surveyed according to commercial real estate and services firm Cushman & Wakefield.

Singapore’s three-year moratorium was lifted in 2022 but there are constraints on power capacity as data centres are electricity and water-intensive. Ireland has been an ideal place for data centres because of its low corporate tax as well as geographically and politically stable environment. Vacancy rates in Frankfurt and Amsterdam where some of the REIT’s data centres are located were also low in 2023.

As our lives are constantly connected and we continue to shop online, stream movies and music, and remotely (and the list goes on as the digital economy expands), the demand for data centres will remain. The demand will even grow further in tandem with the rise of cloud computing and generative artificial intelligence.

The fifth perspective

Keppel DC REIT’s share price was on the high side in 2020 as investors rushed to buy stocks that benefited from and remained largely unaffected by the pandemic. Based on its DPU in FY2022 at 10.21 cents, the stock traded at 5.4% yield in November 2023 which is quite a decent yield to me.

The REIT has been on an active acquisition spree since its listing. The manager has also demonstrated its capability in growing the REIT’s DPU year after year and engaging in DPU-, yield-, and NAV-accretive acquisitions. This stock is worthy of a closer look as the global data centre industry is still growing. The issues that bother investors are temporary.