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Is Keppel DC REIT an attractive investment for income?

Tuesday, August 4, 2015

I have been asked on various occasions what do I think of Keppel DC REIT and my usual reply was it was still something very new to me. I didn't know what to make of it but just looking at the prospective distribution yield was surely the wrong way to value the REIT although as income investors it would be the first thing that drew our attention.

In the latest copy of The EDGE, we would find a well written article on page 27 on Keppel DC REIT. The title is attention grabbing as it included the phrase "solid DPU growth". Read the article carefully and we would learn why data centre REITs are so different from other industrial property REITs.

I would draw attention to the following:

"For Keppel DC REIT, depreciable infrastructure accounts for approximately 70% of the development cost, with the building shell accounting for the remaining 30%."

This is an important bit of information, an eye opener, and it is just one line in a full page article. It could be quite easily missed or even dismissed.


Citadel 100. Land lease expiring in 2041.


Even for seasoned income investors in S-REITs, we would think industrial property REITs are just landlords. Buy or develop an industrial property and find a tenant or tenants. The tenants do their business while the REIT manages and maintains the property (if the building does not have a Master Tenant) and, of course, collects rent.

When we think of asset value, we think of the value of the buildings a REIT holds. We think mostly of brick and mortar. In the case of a data centre REIT, the asset value is not just the building but significantly the high tech infrastructure in the building. Of course, what the high tech infrastructure is exactly will remain Greek to me. I only need to know that it has to do with IT and it is very costly.

By now, most of us would have realised why listing the REIT at a premium to NAV was a very good deal for Keppel T&T. IPO price was 93c a unit while NAV was 86.6c a unit.

For those of us who still don't get it, remember why there is a preference for properties which are freehold instead of properties which are leasehold? It has to do with depreciation. Freehold properties (and Keppel DC REIT has 3 of them at IPO), theoretically, do not depreciate.


T25. Land lease expiring in 2021. Option to extend for 30 yrs.


However, if a data centre REIT should own a freehold property, it would also depreciate since "depreciable infrastructure accounts for approximately 70% of the development cost". To be able to sell a depreciating asset at a premium to valuation is a wonderful thing. It is like selling a used family car at a premium to market price.

Understanding Keppel DC REIT better now, we want to remember that as a REIT pays out most of its income to unit holders as dividends, it won't be wrong for us to question if the current income distribution from the REIT, all else remaining equal, is sustainable. After all, the high tech infrastructure has to be maintained regularly or even replaced periodically. Where is the money going to come from?

We could, of course, argue that because Keppel DC REIT's gearing, post latest acquisition, is 29.9% and, so, it has ample debt headroom to borrow more funds to maintain or replace ageing high tech infrastructure. However, if its NAV is formed mostly of depreciable assets, would gearing increase without any additional borrowings, given time? I am not IT savvy but I hear that IT infrastructure suffers from rapid obsolescence.

So, I went online and searched for the cost of maintaining and even replacing the high tech infrastructure in data centres. It seems that the costs are usually less than 10% of the revenue generated but in certain years the costs could spike. For anyone who is investing in Keppel DC REIT, this is something very important to bear in mind.


S25. Land lease expiring in 2025. Option to extend by 30 yrs.


With an estimated DPU of 7c, post latest acquisition, and a closing price of $1.095 a unit, we are looking at a distribution yield of 6.39%. I would argue that, realistically, this is not a sustainable distribution yield, all else remaining equal.

It might sound totally unrelated but it could be useful to bring up the case of HPH Trust which maintained a higher DPU than it should for a while by delaying much needed CAPEX. I believe that was a move to support its unit price and to keep investors happy. The Trust could not delay those CAPEX forever.

When we invest in any business or business trust that requires regular and relatively high CAPEX, we must be ready for it. If these entities should pay out all their income to investors as dividends, we must be realistic enough to understand that something must give.

I would demand a higher distribution yield, free of any financial engineering, before investing in Keppel DC REIT, if ever. How much higher? I have yet to decide.

Related posts:
1. The instant gratification of yield.
2. Overpaid for our investments in biz trusts?

27 comments:

unluckid said...

Hi AK,

Agree fully with you. I got 1 lot during the IPO, will be looking to sell for a profit soon as I think data centres are quite expensive to upkeep. Likely to reenter at a more attractive valuation though.

AK71 said...

Hi unluckid,

That sounds like a plan. :)

Wei Jian said...

Thanks for your analysis. Never thought about it this way but makes a whole lot of sense. Very sharp eyes there to spot that line.

Would teach us to be more aware of depreciation even in the world of reits/trust.

E H said...

My earlier, short take on Keppel DC Reit:
http://callingthetop.blogspot.com/2015/06/data-centres-glut.html

AK71 said...

Hi Wei Jian,

I have a friend who likes to say "Same, same but different." ;p

Industrial property S-REITs have probably the most diverse property types in the S-REIT universe. I am still learning. :)

waileong said...

Freehold building and land does not depreciate. Being a dc reit doesn't change accounting principles. What does depreciate is the assets within the data centers. Which are very expensive computers and network infrastructure.

There's two models for data centers. One is as a host, ie rent out rack space for those who want to house their servers there. The other is to put in their own servers and sell cloud computing solutions.

I believe Keppel is doing the former. Companies just lease data centre space from them.

The good thing about this business model is that it's very painful for clients to move data centers once they are in. Hence client retention is better than (say) for retail tenants.

A certain amount of capex must be spent every year to maintain and upgrade the quality of the data centre, to keep up with changes in technology and client expectations. But that's no different from any maintenance expenses which any landlord has to incur on its properties.

AK71 said...

Hi waileong,

Thanks for weighing in on this which is a very new topic for me. :)

Considering the fact that the CAPEX required for a data centre is a few times more than an industrial building (the shell) of a similar size and that this is due to a majority component that is depreciable, I cannot imagine how it is an apple with apple comparison with other industrial properties (a warehouse building, for example) which have arguably a smaller depreciable component.

In my blog post, I mentioned that 3 of Keppel DC REIT's assets at IPO are freehold. It pays to bear in mind that the remaining 5 are not. One of them has, in fact, a few years left to its lease and although there is an option to renew its lease for another 30 years, in Singapore, that is going to be costly. Another major expense on the horizon? Perhaps.

I am still learning about this class of industrial properties which like I said is very new to me. So, please feel free to correct any misconceptions I may have. :)

LetsGetRichTgt said...

Hi AK,
Well spotted. There was much hype about this REIT but what's stopping me from taking the bite is the industry it is in.
Technology moves quickly, and since I'm not too well verse with data centres as well, I only know that technology can change very quickly.

Who's to say that in the next 10 years data centres are no longer relevant? Heck, the iPhone is only here for 8 years and it changed a lot of things. I'll be likely to stay away from tech since its too fast for my slow brain. hee!

Cheers.

AK71 said...

Hi LGRT,

I am still trying to understand this better but I am facing an uphill battle. I am beginning to feel that my time could be better used doing other stuff. -.-"

So, it makes sense for me to distil the data (pardon the pun) that I have gathered and focus on what an investor without any IT background can understand. ;p

For now, I am still more comfortable investing in warehouses (preferably those with ramps) and business parks. :)

Jared L said...

Agree with waileong. Keppel Dc reit is much like a industrial reit where industrial space, in this case rackspace, is being leased to the tenants.

As for the concerns that IT infrastructure changes rapidly and needs capex frequently, I think these applies more for the server hardwares and less so for the racks, power infrastructure or connection infrastructure. So the replacement/refreshment capex wont be significantly more than an industrial reit.

And depending on the lease/co-location arrangements, some of the facilities management costs are also borne by the tenants. So with the long leases and rent escalation catered in the leases, I think the business model is worth looking at.

I think the main thing going against this reit is the unfamiliarity of this new type of reit versus traditional reit..

AK71 said...

Hi Jared,

I am learning from you guys here. Thumbs up. :D

I read in The EDGE that more than 70% of Keppel DC REIT's leases are co-location or on double net. Less than 30% of the leases are on triple net where the tenant takes full responsibility for the maintenance and replacement (if necessary) of the high tech infrastructure. Could this be a concern?

My research shows that it is normal for about 5% to 6% of revenue to go to the maintenance of the high tech infrastructure and in certain years, it could spike to be much higher. I don't know why though. A non-IT savvy guy and IT journals are not a good fit.

Actually, I don't think we need worry about the lack of familiarity with DC REITs, judging by how Keppel DC REIT's unit price has been rising steadily. ;p

Jared L said...

I think if more investors get familiar with how data centers work and how much of a demand data centers are, the unit price of keppel Dc will be going up much faster :p

AK71 said...

Hi Jared,

Haha... I guess I've got much to learn but this just came in on my FB wall:

Daniel Cheng · Friends with Raymond Ng
There is gonna be a DC Glut very soon! Juz like property.. With oversupply of computing resources & empty racks...waiting for tenants...

Raymond Ng
Expert in IT speaking... must pay attention


Hmmm....

Jared L said...

Definitely there is always going to be lots of money jumping into any sector that is booming.

I am just glad keppel Dc reit has lock in their tenants for the next 7 years haha.

I shall collect dividends for 7 years before jumping to the next boat:p

AK71 said...

Hi Jared,

You sound very optimistic. Haha. :)

Well, let's hope it doesn't cost too much to extend the land lease for one of their properties here in Singapore in 2021 and that the management don't do anything to dilute the DPU in the next few years. Crossing fingers. ;)

PI Trooper said...

Hi AK,

thanks for writing about keppel dc reit. i am currently vested in this counter at 1.02.

Still thinking of collecting the yield and divesting from this counter in 1-2 years time. hopefully, prices continue to soar. :)

AK71 said...

Hi PI,

Divesting 2 years from now? As long as the management do not do anything that would lead to DPU dilution in the next 2 years, I think your investment is pretty safe since their assets were all outfitted in recent years and the shortest land lease is expiring in 2021.

As unit price climbs, it becomes easier or less expensive for the REIT to raise funds for acquisitions. It also becomes easier for the REIT to find yield accretive assets to purchase since yield gets compressed as unit price increases. I suspect that more acquisitions could be on the way.

Wei Jian said...

Not an expert. But some costs I can think of that is different from a normal industrial reit includes rack maintenance (including cooling fans), change in server sizes requiring new racks, additional cooling for the room (vs normal AHUs), fire protection systems, physical security of racks.

Some of which has annual checks as well which eats into operating costs and may not be depreciable assets.

AK71 said...

Hi Wei Jian,

I am totally clueless but do you think these are costly? So, you think these costs are OPEX and not CAPEX? Wouldn't racks, cooling fans, servers, cooling systems, fire protection systems be depreciable? Just wondering. -.-"

Wei Jian said...

I think most are depreciable and some overlaps into OPEX. So yes, they are depreciable CAPEX. As for their cost, i can't judge. I had the impression they are relatively lower costs when compared to building and land. But 70% spike, that, i can't grasp.

AK71 said...

Hi Wei Jian,

Yes, there is much I do not understand about Keppel DC REIT. However, as the high tech infrastructure depreciates, I am concerned that the gearing level could increase, all else remaining constant. This is especially worrisome because a majority of the development cost of the REIT's assets is made up of depreciable infrastructure:

"For Keppel DC REIT, depreciable infrastructure accounts for approximately 70% of the development cost, with the building shell accounting for the remaining 30%."

So, even if the shell (i.e. the building) is freehold, that accounts for only 30% of the development cost, the rest is depreciable infrastructure. That seems to suggest to me that 70% of the NAV will depreciate relatively quickly. How quickly would they depreciate? This is probably a pertinent question. Any idea?

pf said...

I have this at near IPO price. But recently trying to divest some. To get some money to pay for my renovation. Hahaha...

AK71 said...

Hi pf,

Congratulations! Never wrong to take profit or so they say. ;)

SMK said...

it's been a fun ride. will have to bid dc farewell for a while. :)

Siew Mun said...

In based on my experience a DC need to be rebuilt every 15-20 years due to technology changes and obsolescence minus the physical infrastructure. Large established DC players like AWS and Microsoft have deep pockets who build and own hundreds of DC world wide has better economy of scale andexpertise. In the near future, large corporation will host IT applications with such big boys to lower operating expenses with zero cap ex and higher reliability. Local boys like Keppel DC are not in their league.

AK71 said...

Hi Siew Mun,

Always good to hear from industry insiders!

Kamsiah you plenty plenty. :)

SMK said...

"In based on my experience a DC need to be rebuilt every 15-20 years due to technology changes and obsolescence minus the physical infrastructure."

true.

" Large established DC players like AWS and Microsoft have deep pockets who build and own hundreds of DC world wide has better economy of scale andexpertise. "

true.


"In the near future, large corporation will host IT applications with such big boys to lower operating expenses with zero cap ex and higher reliability."

already the reality. it's a growing business with wide moats.

"Local boys like Keppel DC are not in their league."

half true. not specific to keppel dc. geographical location is very important.
edge servers are geographically located to serve cached images faster. especially important for ads.

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