Home prices are climbing and so are mortgage rates, but one area of the real estate sector is thriving. No surprise: it’s AI-related.
The two largest data center REITs, Equinix (EQIX) and Digital Realty (DLR), have been outperforming the benchmark Standard & Poor’s 500 index. Year to date, DLR grew 18% and EQIX gained 33%, solidifying their outperformance compared to the S&P 500’s 12% growth.
These REITs have sparked a question within the real estate sector that is permeating every area of the market: is this stock overvalued as a result of AI hype? So far, the performance of DLR and EQIX suggest that while investors can be drawn to the companies due to market enthusiasm, there’s some reason to believe the gains are earned.
“Mostly it’s driven by people trying to figure out how to benefit from AI,” said Kim Forrest, chief investment officer of Bokeh Capital Partners. “I do think that the financial benefits of being a digital realty trust that focuses on data centers will benefit them, especially over warehouses and regular old housing.”
These financial benefits come from the fact that data center REITs can charge higher premiums for rent because they provide a niche service. The companies buy plots of land, then turn them into technological centers equipped with advanced cooling systems, security and the ability to connect with other networks. The company is then able to charge rent and utilities.
Unlike most AI companies, the business model is profitable.
Equinix reported a $2.63 billion second quarter revenue, up 16% from last year, and a $479 million profit, up 30%. Digital Realty saw a 56% percent decline in profits due to an unusually high income last year, when a one time gain inflated profits. But this year the company still made $458 million after expenses, posting revenue of $1.9 billion, up 29%. Both second quarter earnings reports nod to a financial strength that suggests the company’s stock price isn’t founded solely on AI speculation.
“It’s mostly fundamental outperformance: actual development gains, occupancy growth, and rental rate growth,” said Dane Bowler, chief investment officer at 2nd Market Capital Advisory Corporation.
Data centers may seem flashy and new due to AI, but these companies have actually had decades to fine-tune their finances. Andy Schroepfer was a senior analyst at Goldman Sachs when Equinix had its IPO in 2000. Now the bank owns almost 2% of the company.
The ability to build so much technology on a small plot of land and deliver a profit has become a science, according to Schroepfer. While he thinks Equinix is the leader in its field, he says the smartest investments will be made by watching all the Data Center REITs.
“You want to always own something in the stack, be willing to switch out from who’s had outperformance recently, because they’ll probably have a pause when someone else picks up the pace,” said Schroepfer. “But as a category, that stack is going to move up and to the right.”
The former Goldman analyst said he continues to own these stocks.
But for some, the age of the company is part of their hesitation. Jim Chanos, who predicted Enron’s collapse, is shorting both the companies. He thinks these real estate businesses are profiting off of AI when a lot of their facilities aren’t the kind of data centers that accommodate the cutting edge technology. This sentiment is catching on among some retail investors.
“After hearing what Jim Chanos had to say about the data center business, I decided to stay away,”said mdn845, an anonymous redditor.
The industry is also facing another hurdle in the form of public controversy.
“The angry villagers with pitchforks and firebrands are going to slow down or maybe even stop the buildout of these places now,” said Forrest. But she also points out that this also comes with a benefit: “Might that not make the existing data centers more valuable?”
Mizuho’s recent report shares this perspective. The bank found that 20 states have passed bills restricting data centers, nine other states have similar legislation pending, and New York has instated a total moratorium. But despite this, their analysts still believe the REITs will outperform mostly because existing data centers will likely be exempt from new legislation.
The Fed also raised borrowing costs, which will compound strains on construction. Both Equinix and DLR added debt last year, and higher borrowing costs will make it harder for these trusts to invest in new properties.
Still, with their depth of real estate portfolio, Equinix and DLR may be able to benefit from the undersupply.
“Existing properties will be able to raise rent, have higher occupancy, etc,” said Bowler.