But investors are right to have doubts. The stocks were already underperforming the US real estate investment trust sector this year before the Financial Times published Chanos’ negative view in June. Morgan Stanley analysts summarized the concerns: the demand and pricing outlook, low returns on capital, competition, cost inflation, higher financing costs and the risk of “obsolescence”.
This fits with Chanos’ reported thinking. The big cloud companies – Amazon.com Inc., Google and Microsoft Corp. by Alphabet Inc. – are the industry’s largest customers, but they also build their own facilities. Chanos says that means they really are competitors. In other words, cloud providers are snapping up future growth at the expense of data centers.
REITs certainly have a future. Many companies will want to maintain their own servers in data centers rather than relying solely on the cloud. Facilities in cities close to end users offer fast connection speeds – which in many cases is essential. Cloud companies will still rent data centers as they enter new markets. Equinix CEO 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 will grow as fast as their stock market valuations suggest.
The harsh reality is that the long-term trend is intense competition, which is putting deflationary pressure on rents. Things may be looking better today, but this could be an outlier. Pandemic disruptions hampered new developments as demand accelerated. Vacancy rates in major US markets have fallen to 4% from 10% in 2019, according to analysts at UBS Group AG. In the second quarter, Digital Realty leased properties 3% above existing rents and Equinix saw record bookings.
It’s hard to be confident that this marks a crucial break with history. In addition, construction, maintenance and energy costs are increasing; higher rental extensions may not compensate for this. Morgan Stanley analysts say cloud giants could slow down investment over the next year as they shift from expansion to “digestion.”
Many investors value these companies at a multiple of funds from operations (FFO, a measure of the cash flow generated by the company in the real estate sector) after deduction of so-called maintenance investments. These investments are expenses that companies believe are necessary to maintain revenue rather than win business (accounting standard setters make no such distinction, making it an opaque metric). The concern is that this fee may need to increase.
Maintenance investments at Equinix have been low relative to sales, providing tailwinds that may not last, according to research from Barclays Plc. According to forecasts by Bloomberg, Equinix’s adjusted FFO is expected to grow about 9% annually from 2021 through 2024. That’s roughly in line with Morgan Stanley’s expectations for the REIT sector as a whole. At Digital Realty, the comparable figure is just 6%.
Meanwhile, the financial environment is deteriorating. REITs pay out most of their taxable income in the form of dividends in order to qualify for tax breaks. To finance expansion, data center companies take on debt and sell equity. Aside from the absurdity of a business model that pays out massive dividends and then demands cash from shareholders, debt and equity are becoming increasingly expensive. This increases the reliance on asset sales to finance growth.
Despite all of these uncertainties, valuations look high. Digital Realty is trading at 16.3 times its expected 2023 FFO per share and Equinix is trading at 27.6 times, versus just under 16 times its peers, Bloomberg data shows. If you look at company values in relation to the expected earnings before interest, taxes, depreciation and amortization next year, the multiples are also still above the REIT average despite the declining shares.
Signs of a slowdown in cloud investment or a cost and investment shock would certainly accelerate the sector’s ongoing downgrade, undermining the narrative that the industry is in a virtuous cycle. The challenge remains: Amid rising cost pressures and intense competition, why do these stocks deserve premium valuations?
More from the Bloomberg Opinion:
• Real estate is the crisis risk to watch now: John Authers
• Microsoft’s roller coaster ride exposes cloud risks: Conor Sen
• Alibaba shows how hard it is to break a habit: Tim Culpan
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Chris Hughes is a Bloomberg Opinion columnist covering deals. He previously worked for Reuters Breakingviews, the Financial Times and the Independent newspaper.
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