Digital Core REIT - Not US, but EU.
Concerns on rising interest rates.
- With interest rates beginning its upward trend since the start of FY22F, concerns were raised on its impact to Digital Core REIT (SGX:DCRU)’s earnings, especially as the REIT’s entire loan book was on floating rates. Digital Core REIT subsequently worked on hedging 50% of its loan book and reported a doubling of its all-in financing cost to 2.1% in 1Q22.
- During the quarter, we also understand that some of the increase in financing costs were mitigated from savings in certain trust expenses and lower profit attributable to non-controlling interests. These savings were estimated to be ~US$1.5m, or half the impact of the increase in financing costs.
- With interest rates expected to rise further, this will continue to pose a risk to Digital Core REIT's earnings. We have taken this into account in our revised projections and assumed higher all-in borrowing costs going forward.
First acquisition expected to be in Europe rather than the US.
- Despite taking longer than anticipated to embark on its first acquisition, we remain confident that Digital Core REIT will deliver an acquisition within 3Q22. With higher financing costs eroding margins and cap rate spreads (spread between cap rates and interest rates) turning negative in several markets, we think that there is an even more pressing need for an acquisition to happen sooner rather than later. Within the markets where Digital Core REIT’s sponsor pipeline is concentrated, we see acquisitions in Europe and Japan as the most likely in the near term.
- Digital Core REIT has previously highlighted its intentions to expand in the US, but with cap rate spreads now in the negative territory, we believe that any acquisitions will be unlikely or will have to be bundled into a portfolio with assets outside of the US, which still provides a positive spread.
- In our revised estimates, we continue to maintain our assumptions of US$250m in acquisitions in FY22F. Looking further ahead, we believe that acquisitions beyond the next six months could be more uncertain as interest rates continue to inch up, while cap rates for data centres continue to remain at record low levels. As such, we decided to adopt a prudent approach in our growth expectations for Digital Core REIT and removed all acquisition assumptions beyond FY22.
- In our revised estimates, we have also rolled back our assumption for the acquisitions to only contribute one quarter of earnings. For this US$250m in acquisitions in FY22F, we will still be maintaining the assumption that it will be a fully debt-funded acquisition, given Digital Core REIT’s ample debt headroom. We will also be maintaining our assumed NPI yield of 4.5% for acquisitions this year.
Sensitivity of acquisition yield on DPU accretion.
- Although we have maintained our assumed NPI yield for acquisitions this year to be 4.5%, there could be a possibility of slightly higher yields for acquisitions carried out in Europe. Conversely, we also considered the possibility of lower NPI yields in our sensitivity study. In general, we believe debt-funded acquisitions in FY22 would be accretive, as there are still positive cap rate spreads for data centres in several markets, specifically in Europe. Accretion to DPU in FY22F will be muted as we have only assumed the acquisitions to contribute only one quarter, and the full-year accretion to DPU will only be reflected in FY23F and beyond.
- Another possibility to fund the assumed US$250m in acquisitions in FY22F could be through a mix of debt and equity. In this exercise, we have assumed that Digital Core REIT relies on a debt and equity mix of 60:40. Based on our worst-case scenario assumptions of an EFR (equity fund raising) at US$0.70 and an acquisition yield of 4.0%, acquisitions done in FY22F would still be ~0.4% accretive to DPU. However, we see this as highly unlikely for its maiden acquisition, especially given the current Digital Core REIT's share price is at more than 16% discount to NAV. We believe that Digital Core REIT would not want to risk destroying investor confidence by raising equity at a significant discount to NAV, even though it may still prove to be accretive to DPU.
Correction overdone, opportunity to load up at yields that are close to 5.4%
- Based on the currenet Digital Core REIT's share price, the REIT is expected to generate forward yields of close to 5.4% in FY22 and 5.7% in FY23. We believe that its yields will compress quickly once its maiden acquisition is announced and Digital Core REIT reignites our confidence in its growth story.
- Although concerns of higher financing costs are valid and will pose a major risk to Digital Core REIT’s earnings, we believe that it has been overdone, as our estimates show that even with a higher all-in cost of borrowing, forward yields are very attractive at the current levels.
Maintain BUY rating on Digital Core REIT with revised target price of US$1.15.
- As mentioned, we have lowered our projections for Digital Core REIT, as we conservatively factored in higher financing costs in FY22F and FY23F.
- As the acquisition is slower-than-anticipated, we revised our expectation that the acquisition will contribute only one quarter in FY22 earnings. Our projections assume that Digital Core REIT will likely miss its IPO forecasts due to the unforeseen surge in interest rate environment, but it is within the 10% threshold.
- Higher-than-expected savings, an acquisition yield of more than 4.5%, and lower average financing cost could all lead to an upside to our estimates.
Above is the excerpt from report by DBS Group Research.
Clients of DBS may access the full report in PDF @ https://www.dbs.com/insightsdirect/.
Dale LAI DBS Group Research | Derek TAN DBS Research | https://www.dbs.com/insightsdirect/ 2022-07-22 2022-07-22
Previous report by DBS Research:
2022-04-22 Digital Core REIT - Sense Of Urgency For Accretive Acquisitions
Digital Core REIT Analyst Report,
Digital Core REIT Target Price,
Digital Core REIT Share Price History,
Digital Core REIT Announcements,
Digital Core REIT Dividends/ Corp Actions,
Digital Core REIT News Articles