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