Should we buy Digital Core REIT with the announced share buyback?

TL;DR

• Digital Core REIT's (DC REIT) 1H22 distribution per unit (DPU) of US$0.0206 was below its IPO projections due to higher interest cost. 
• On a more positive note, Digital Core REIT announced the approval of its share buyback mandate, allowing it to purchase 10% of total units outstanding. 
• Digital Core REIT targets to make its maiden acquisition from its sponsor's portfolio in Europe and US in 3Q22. 
• Digital Core REIT currently offers a dividend yield of 4.8%. This could increase if an accretive acquisition is made in the coming months. 

What happened?

It’s not often that we see companies missing on their IPO projections. After all, management would usually be quite conservative in coming up with these forecasts to make sure that they can be met. 

So it must be quite a disappointment to unitholders of Digital Core REIT (DC REIT) that the REIT reported 1H22 distributions per unit (DPU) of US$0.0206, below its previous projection of US$0.0209.

But it’s exceptional times that we are in now, with inflation going up sharply and interest rates rising significantly. 

The good news is that Digital Core REIT has announced a share buyback with its price as of 28 July falling close to 34% from its peak, and also below its IPO price.

So should we be more positive on Digital Core REIT with the announced share buyback? 

What we learnt from 1H22 results

#1 – Customer bankruptcy did not affect distributions

One of the negative surprises since the IPO of DC REIT is that its fifth-largest customer filed for bankruptcy protection in April. 

This customer is a private company in the IT sector, and accounts for about 7.1% of its revenue.

In the latest update, DC REIT shared that the customer has continued to make its contractual payments through the month of July. 

Regardless, DC REIT has signed a cash flow support agreement with its sponsor, Digital Realty. As part of this agreement, Digital Realty will top up any cash flow shortfall relating to this customer bankruptcy until 31 December 2023. 

This means that the customer bankruptcy is not expected to have an impact on DC REIT’s DPU. 

Encouragingly, DC REIT’s portfolio has a 100% occupancy as of 30 June 2022, reflecting the continued strong demand for data centres.  

#2 – Higher interest rates start to bite

The key reason for the lower than expected distributions is because of higher interest rates incurred by DC REIT. 

The average cost of debt rose to 2.3% in 2Q22 from 1.2% in 1Q22. 

Recall that at the start of the year, all of DC REIT’s borrowings were on floating rates. 

With significant investor concerns as interest rates were hiked aggressively, DC REIT subsequently hedged 50% of its borrowings on fixed rates. 

As of June 2022, the remaining 50% remains unhedged. 

The consolation is that DC REIT has a relatively low gearing of 25.7% as of June 2022. 

Putting these together, a further increase in interest rate of 1.00 percentage point could lead to about 3.8% impact to its DPU.  

#3 – DC REIT targets to make acquisition in 3Q22

The other key disappointment for many investors of DC REIT is its inability to make acquisitions since its IPO.

This is despite its low gearing which provides it with ample debt headroom to buy data centre assets. 

While it is taking awhile to make its maiden acquisition, DC REIT targets to be able to sign a purchase agreement in 3Q22. 

The targeted acquisition size is expected to be about $150 - $ 650 million, and would come through from the sponsor’s portfolio in Europe and US. 

#4 – Starts buyback mandate

Apart from the headroom to make acquisitions, the other benefit of having a low gearing is the ability to purchase its own shares to support the share price. 

The positive surprise from the latest results, is that the board of DC REIT has approved a resolution authorizing its existing unit buyback mandate. 

This allows DC REIT to purchase 10% of its total units outstanding. 

To understand how other REITs performed the last time a share buyback was announced, we can look at Keppel REIT back in 2018. 

At that time, Keppel REIT had announced its intention to start a share buyback, which led to increased optimism in the stock. 

As seen from the chart below, Keppel REIT’s share price saw a slight bounce of about 3.5% after the share buyback was announced. 

What this might suggest is that while a share buyback might help sentiment in the near term, fundamentals are still what would drive the share price in the longer term. 

What would Beansprout do?

Digital Core REIT is a REIT that has attracted a lot of investor interest since its IPO. 

Like Keppel DC REIT, it is one of the most discussed REITs on the Beansprout Telegram community. 

We shared earlier why we’d be avoiding Keppel DC REIT after its 2Q22 results.

The question that most of you would ask is – would we also avoid Digital Core REIT?  

The short answer is that we think there might be more reason to be optimistic on Digital Core REIT. 

#1 – Management appears confident of near-term acquisitions 

From the comments in the results presentation that DC REIT expects to sign a purchase agreement in 3Q22, it would seem like management is fairly confident of securing an acquisition soon.

Of course, there has been no binding agreement signed as yet. There is also no assurance that any of the potential acquisitions may take place. 

But should it be able to complete the acquisition, it would be a relief to investors eagerly waiting for it to use its debt headroom to drive DPU growth. 

#2 – Acquisitions could lead to higher dividend yield

Like Keppel DC REIT, Digital Core REIT’s price has fallen significantly since the start of the year. 

As of 28 July, Digital Core REIT saw a decline of close to 30% year-to-date, compared to Keppel DC REIT’s decline of 17%. 

Based on its share price as of 7 July, Digital Core REIT is expected to provide a dividend yield of 4.8%. This appears to be slightly below Keppel DC REIT’s dividend yield of 5.0%.

However, should it be able to make an accretive acquisition in 3Q22, its distributions could get a boost which could bring its dividend yield to be similar to or above Keppel DC REIT’s yield. 

#3 – Key risk from higher interest rates

What we’ll be looking out for as a key risk, remains Digital Core REIT’s exposure to higher interest rates. 

With only 50% of its borrowing at a fixed rate, its distributions could be impacted if there is an unforeseen surge in interest rates. 

This could offset any potential dividend upside that could come through from its planned acquisitions. 

Do you prefer Keppel DC REIT or Digital Core REIT? Share with us in our Beansprout Telegram community.