Last month, we kicked off this new series about dividend growth stocks. Last month’s featured stock was AT&T (T). I said in that article that we would be looking at different genres of dividend growth stocks.
This month’s pick is a totally different type of stock from AT&T. The latter is a slow-growth, high-yield telecom stock.
This month’s pick is a different beast entirely. It is a real estate investment trust that specializes in real estate related to technology. So Digital Realty Trust (DLR) is about as different from AT&T as you can get. Yet they are both dividend growth stocks.
A Primer on REITs
Before we get into the merits of DLR individually, let’s talk a bit about REITs.
A Real Estate Investment Trust, or REIT, is a company that specializes in real estate development. REITs were authorized by Congress in 1960.
A REIT is a fundamentally different corporate structure from C-corporations in the view of dividend growth investors, because REITs pay out most of their earnings as dividends.
REITs come in several flavors: Some own real estate outright; others own mortgages or securities backed by real estate; and a few hybrids do both.
Real estate companies do not have to be REITs.
They choose the REIT structure in order to avoid taxation at the corporate level. A corporation must meet several requirements in order to qualify as a REIT, but two of the most important are:
- They must hold more than 75 percent of their assets in real estate assets.
- They must distribute at least 90 percent of their taxable profit to shareholders annually.
When a corporation elects REIT status, it is permitted to deduct dividends paid to its shareholders from its federal tax liabilities. The responsibility for taxes is passed along to shareholders. Thus, REITs are known as “pass-through” entities. The distributions are not qualified for favorable tax treatment under the tax code.
Most REITs own and manage real estate, and they generate income by collecting rents. Many REITs specialize in certain types of properties: healthcare facilities, apartments, offices, hotels, malls, or timberland. Some owe money on their properties; others own them free and clear. Some operate what they own; others outsource operations. Some REITs sell their real estate developments once they have been completed; others continue to own and operate them.
U.S. REITs collectively own nearly $2 trillion of real estate assets. REITs are the only practical way for most individuals to invest in large commercial developments. Real estate is considered to be a distinct asset class beyond the “big three” of stocks, bonds, and cash. Therefore, REITs offer investors benefits of diversification.
As with other types of equities, REITs are subject to market risk, because their shares are traded. Therefore, the stock market determines their prices. On the other hand, as with other dividend growth stocks, the market does not determine their dividend policies, their dividend payouts, or their dividend growth decisions. The companies control those.
For more information about REITs in general, the NAREIT trade association site has a wealth of helpful material.
Digital Realty Trust’s Dividend Characteristics
What jumps out at you?
• At 4.6%, DLR has a very good yield. I don’t call it “Excellent,” because I usually reserve that for stocks with yields of 5% or more. But DLR is close. Its current yield has been sliding back recently, because the stock’s price has been rising. When DLR announces its expected increase in March, its yield will hop up a bit.
• With a dividend increase streak of 10 years, DLR is in the middle class of dividend raisers shown on David Fish’ Dividend Champions, Contenders, and Challengers. It is a Contender. That 10-year streak takes it back before the Great Recession, which is excellent for a real-estate company, considering that the recession was in large part caused by real estate. The Contenders have an average yield of 2.7%, so DLR’s yield is quite a bit higher than its category.
• DLR’s most recent increase of 6.4% (last year) is pretty high for a stock yielding as much as DLR . You may recall that last month, AT&T offered a tradeoff between high yield and slow growth. DLR does not force such a choice.
• On the other hand, DLR’s dividend growth rate has been declining. It would be unrealistic to expect a company to maintain a dividend growth rate of 20% per year (its 5-year average). The most recent increase for all Dividend Contenders was 8.4%. At 6.4%, DLR is below that average, but I consider that in the context of its high yield. That’s why I called its 2014 increase “Good” rather than “Fair.”
I would expect that as DLR matures, it will settle into a growth rate range around 5% per year. I would consider that more than decent for an investment with a 4%+ yield.
The company has stated that it is committed to a growing dividend.
Is Digital Realty Trust a high-quality company?
Let’s look at some fundamental information about DLR.
As we discussed last month, ROE is a measure of efficiency. It is a standard metric used in judging stocks. It tells you how effectively the company uses shareholders’ capital to generate profits.
Thinking that perhaps ROE may not be a good metric for measuring REITs, given their intense use of capital, I examined all 35 REITs that are Dividend Champions, Contenders, and Challengers. Their average ROE is 14%. (The average for all 637 CCC companies is 18%.) DLR’s ROE is definitely below its own industry’s average. So it does not get a free pass on its low ROE performance.
I called DLR’s Investor Relations department about its ROE, and they explained that they use another measure of efficiency, called ROIC, which stands for Return on Invested Capital. They are focused on getting this metric into and keeping it in the 10%-12% range. They pointed me to the following slide.
The green line at the top is ROIC. As you can see from the bold-faced bullet point at the bottom right of the slide, improving ROIC has been identified as DLR’s top strategic priority. They intend to do this by improving the leased percentage in existing facilities, selling off non-core assets, and transitioning to a “just-in-time” building philosophy wherein they know returns with more certainty before building new facilities.
This sounds to me like intelligent strategic intent. The question going forward, of course, is whether they will execute it well. The fact that they have not been doing it all along strikes me as the weakest part of their story.
DLR’s estimated earnings growth going forward of 5% is OK. I am not concerned about DLR’s Debt/Equity ratio of 1.6 (160%). By their nature, REITs are high-debt enterprises, as they always need financing to acquire and build properties. It is a natural part of their business model.
S&P IQ says this about debt for REITs:
Interest Coverage Ratio: This ratio is one indicator of a REIT’s ability to meet its debt obligations. A high ratio indicates the REIT is easily able to meet its debt obligations and has the flexibility to issue more debt in order to acquire properties and grow. A ratio below 2.0 may be cause for some concern.
DLR’s interest coverage ratio is 2.0, which is adequate. That supports the OK rating on debt.
S&P Capital IQ considers DLR to be in the “Office REITs” subcategory of REITs. DLR is the only REIT in that group that S&P awards a quality ranking of A. All of the others have ratings two notches (or more) below A, or they are not rated at all.
S&P gives DLR a credit rating of BBB. Under S&P’s system, that is one notch below “investment grade.” I usually invest only in investment grade stocks, but I would make an exception here based on other factors, including S&P’s own quality ranking of A.
DLR’s Story: How Does It Make Money?
Digital Realty Trust builds and leases data centers. It is one of the 20 largest publicly traded REITs, with 130 properties rented to more than 600 firms across North America, Europe, Asia and Australia. Examples of customers include CenturyLink (its largest customer), IBM, AT&T, and a variety of large banks.
Data centers are facilities designed to house servers, store data and network equipment. They provide a highly reliable, secure environment with redundant mechanical cooling systems, electrical power systems, and network communication connections.
As you can see, this is a highly specialized form of real estate. The categorization of DLR as an “office REIT” does not begin to describe what they really do.
As you might guess, with this much complexity to even build a data center, making sure that these facitlities are leased is an important part of the business model. For that reason, I approve of DLR’s strategic emphasis on getting existing facilities leased and being conservative in deciding whether and when to build new ones.
They identify this as an “opportunity,” and obviously if they are successful, the return on their investments will improve. By their own reckoning, 100% occupancy will lead to the 10%-12% ROIC that they seek. Right now, the company has excess non-fully-rented facilities, and their ROIC only clocks in at around 6%. They also have legacy non-data-center assets, which they intend to relinquish.
DLR’s growth will come from contractual rent bumps, more fully leasing existing facilities, and careful development and acquisition of new facitlites.
I give DLR’s Story a slightly above-average grade. They are clearly in the middle of a megatrend, with cloud computing and corporate networking needs creating a tremendous demand for what DLR can provide. Their financials have great potential to improve. Their strategy seems correctly focused, while questions exist about how well they will execute it.
On my usual point scale of 15, I would give DLR a 9. I add a point in recognition that they increased their dividend each year during the real-estate recession. That is an impressive demonstration of their strong niche.
I described how I value stocks in Dividend Growth Investing Lesson 11: Valuation. The idea is to interpret how a stock’s actual price compares to what it “ought” to be based on its current financials and growth outlook.
In my valuation process, I look at two FASTGraph valuations. The first is the default valuation, which usually uses a P/E (price-to-earnings) ratio of 15. That is the historical long-term P/E ratio of the market as a whole.
With REITs, traditional earnings are not the metric that anyone uses, because of the capital-intensive nature of the business model. Every year, they are taking depreciation on facilities long since built, and that lowers their “official” earnings. Depreciation is not really a current cash cost like most expenses. Rather it is a bookkeeping entry designed to write off investments already made.
So with REITs, the usual measure of profits are not traditional earnings, but something called FFO: Funds from Operations. That is what we will use to examine DLR’s valuation.
In this first graph, which uses a standard price-to-FFO ratio of 15, DLR looks exactly fairly valued. Its price is on the orange fair-value line.
The second FASTGraphs valuation looks at “fair value” being defined by the stock’s long-term average P/FFO ratio. It turns out that DLR historically has traded at a valuation of more than 15, specifically 16.1.
This chart depicts the fair value line (now dark blue) as shifted upward to coincide with DLR’s historical P/FFO ratio. The stock now looks a little undervalued, but since it is only slightly so, I would still rate it as fairly valued by this method.
I normally use Morningstar’s star ratings as another method of reckoning valuations, but DLR is not covered by Morningstar’s analysts. It has no rating.
Finally, I like to look at a stock’s yield to see how it stands to its historical yield. You usually don’t want to purchase a stock when its yield is historically low, because that suggests that its price is relatively high. If the stock’s current yield is near its historical average, that suggests that the price is currently fair.
This chart shows that DLR’s yield is a little above its historical range. That would make its valuation fair to slightly better than fair.
Here is a summary of DLR’s valuation.
There are a couple of factors that I like to look at that do not fall neatly into any of the earlier categories.
Beta measures a stock’s price volatility relative to the market as a whole. Most dividend growth investors like to own stocks with low price volatility, because then you are less likely to become emotional about the stock. Emotionalism often leads to bad decisions, such as panic-selling.
Academic studies have also shown that low-beta stocks tend to have better total returns over long periods of time.
DLR’s beta is 0.54, which means that it is 54% as volatile as the market. That is an excellent lack of volatility relative to the market.
Analysts’ recommendations take into account each analyst’s business evaluation, earnings estimates, valuation assessments, and other things that we have already covered. Most analysts are too focused on price changes, which as dividend growth investors we are less concerned about. Few analysts pay much attention to dividend growth, which is our main focus.
Nevertheless, I like to see what the consensus ratings are, if for no other reason then to see if there are red flags that I somehow overlooked. As you can see, 18 analysts cover DLR, and overall they consider it OK right now.
I think that Digital Realty Trust is a good dividend growth investment. It is fairly valued. The company is in an excellent niche for potential growth opportunities. It is impressive that even in the real-estate recession, it continued to raise its dividend each year. The company has opportunities to increase its profitability by making better use of facilities that it has already built and focusing on its core business.
That is why I started a new position in DLR in January. That purchase, which was part of a portfolio rebalancing, was described in this article.
— Dave Van Knapp
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