Investors have become increasingly worried about real estate investment trusts, otherwise known as REITs, because of the likelihood of rising interest rates. Many economists expect the Federal Reserve to finally increase interest rates this month, with the potential for more rate hikes in 2016.
Rising interest rates are indeed detrimental to REITs. Since REITs rely heavily on the debt markets as a source of capital – which they use to acquire and develop new properties – the asset class would suffer significantly higher interest expense in a rising-rate environment.
This has caused share prices across the REIT asset class to decline throughout the year. However, one REIT bucking this trend is Digital Realty Trust (NYSE: DLR).
Focusing on a Growth Niche
Big data is a huge growth industry in technology right now. As companies collect and gather increasing amounts of data from consumers, this data needs to be stored. That’s where Digital Realty comes in.
Digital Realty is a technology REIT. It owns and operates technology-related real estate properties, such as data centers, in both turn-key and collocation arrangements.
The great thing about Digital Realty’s business model is that it has locked in tenants in long-term agreements. It’s also operating in a growth industry, which gives it leverage to regularly raise rents.
One of the strengths of Digital Realty’s business model is its high-quality tenant portfolio. This is what fuels the company’s high dividend yield and dividend growth. Digital Realty enjoys a 93% portfolio occupancy rate, with an 80% client retention rate.
The company is able to pass through 2%-3% annual rent increases, at or above the rate of inflation. Its strong portfolio allows for high margins. Digital Realty carries operating margins in excess of 70%. This provides for steady growth in funds from operations, or FFO, which is a critical valuation metric for REITs.
Digital Realty grew diluted FFO per share by 13% over the first three quarters. Going forward, the company expects $5.15 per share in FFO this year at the midpoint of its forecast. At its recent closing price of $72 per share, Digital Realty trades for 13 times FFO. That is a fairly cheap valuation multiple for a company that is still growing at high rates.
Don’t Panic Over Interest Rates
Some investors may be avoiding REITs indiscriminately because of interest rate concerns. The expected Fed interest rate hike would put a strain on balance sheets across the REIT asset class, since REITs historically utilize debt heavily in their capital structures to finance the purchase of their real estate assets. Indeed, Digital Realty carries $2.8 billion in senior unsecured notes.
But avoiding Digital Realty on these concerns would be a mistake. The company expects to generate more than $700 million in funds from operations this year alone and carries a manageable net-debt-to-EBITDA multiple of 4.7.
Digital Realty’s excellent portfolio and strong business model generate enough cash to sustain higher interest rates and continue to reward its shareholders with a growing dividend.
Fantastic Cash Returns
Digital Realty yields 4.7%, an attractive income level, and the company has raised its dividend by 13% per year since its initial public offering in 2004.
The REIT model itself is an added advantage for income investors. Digital Realty is not subject to income tax at the federal level. In exchange, the company is required to distribute at least 90% of its taxable income to shareholders annually in the form of dividends. As a result, Digital Realty is an attractive dividend stock that should continue to reward investors even if interest rates rise.
DISCLOSURE: Bob Ciura personally owns shares of Digital Realty Trust (NYSE: DLR).
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