It wasn't that long ago when investors basically left Digital Realty Trust (NYSE: DLR) for dead. High-profile short-seller Jim Chanos called the major data center real estate investment trusts (REITs) his "big short" idea in 2022 -- but he didn't anticipate the coming artificial intelligence (AI) explosion.
What a difference a couple of years make. Digital Realty is one of the best-performing real estate investment trusts in recent history. So far in 2024, the REIT has delivered a 20% total return, not only outperforming the S&P 500, but also crushing the overall real estate sector. (The Vanguard Real Estate ETF produced a total return of just 1% in the same period.) And Digital Realty could just be getting started.
Data centers and the AI boom
In simple terms, generative AI technology requires vast amounts of computing power. While there are some tech businesses that are clearly winners of the boom in AI investment -- such as chipmakers -- data centers are, as well. If you aren't familiar, data centers are facilities designed to house servers and other networking equipment in a secure and reliable environment.
While chipmakers like Nvidia are selling far more of their purpose-built chips for AI applications, AI chips are largely built for and are housed in data centers like those Digital Realty owns. In Nvidia's latest earnings report, the chipmaking giant reported a staggering 262% year-over-year revenue growth.
But when it comes to the company's four main business segments, the numbers boil down to "data centers, and a little bit of everything else." In fact, Nvidia's data center segment grew more than 5x over the past year alone and now makes up 87% of the company's total revenue.
Digital Realty's data center properties are well-positioned to adapt to increasing power demands and advanced cooling solutions that AI requires.
Digital Realty's progress has been impressive
Digital Realty Trust is one of the largest REITs of any kind in the world. It operates more than 300 data centers worldwide and has more than 5,000 customers.
Recent business results are encouraging. Rental rates are growing rapidly due to rising demand. The base rental rates per Kilowatt on large bookings have grown from $115 in the first quarter of 2023 to $169 in the same period in 2024. Rental renewal spreads throughout the portfolio (the change in cash rent when tenants renew expiring leases) is about 12%.
There also could be a ton of embedded rent growth in the portfolio. The bulk of Digital Realty's leases were initiated well before the AI boom, and the average lease has 4.5 years left.
Not only that, but Digital Realty reported a record backlog of leases yet to commence. And even with continued balance-sheet deleveraging, Digital Realty is expecting core funds from operations (FFO) to grow from current levels by the end of 2024. Plus, Digital Realty is doing a great job of finding outside-the-box ways to grow, such as its partnership with net-lease REIT Realty Income to build two new data centers in Northern Virginia.
Digital Realty's debt has been a bit of a concern in recent years, as the company made a string of acquisitions over the past decade. However, management has done a solid job of improving the balance sheet. Since the first quarter of 2023, the company's net debt to adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio has fallen from 7.1x to 5.4x, and the percentage of variable rate debt has gone from 26% to 4% since 2018.
Plus, there could still be plenty of room to grow. The company estimates that there's room to more than double global data center capacity over time.
Still an attractive buy now
Digital Realty trades for about 24x expected FFO in 2024, but this is somewhat misleading due to the large amount of embedded rent growth that won't be apparent in the numbers until leases expire. With the boom in AI investment still in its early days, Digital Realty can be a great way to get AI exposure in your portfolio, plus a dividend yield of more than 3% while you let the thesis play out.
Matt Frankel has positions in Digital Realty Trust, Realty Income, and Vanguard Real Estate ETF. The Motley Fool has positions in and recommends Digital Realty Trust, Nvidia, Realty Income, and Vanguard Real Estate ETF. The Motley Fool has a disclosure policy .
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