Digital Realty Trust: A Different Kind of Tech Stock

When you think "tech stocks," you generally don't think about real estate investment trusts, or REITs, but Digital Realty Trust (DLR -0.44%) certainly fits into both categories. The data center REIT's growth story could just be getting started if we continue to become more and more connected as a society.

In this segment from Industry Focus: Financials, host Michael Douglass and Motley Fool contributor Matthew Frankel discuss the prospects for this unusual tech stock.

A full transcript follows the video.

This video was recorded on June 4, 2018.

Michael Douglass: Our next company, Digital Realty Trust, ticker symbol DLR. This is really a play on data.

Matt Frankel: In articles, I refer to Digital Realty as the tech stock that no one thinks of as a tech stock. It's a REIT. They own data centers, which, if you're not familiar, these are big buildings that house servers and other networking equipment. The idea is that high-tech companies -- think IBM, Facebook, things like that -- need secure and reliable places to store all the data that's flowing through them. That's where Digital Realty and the whole concept of data centers come in.

Digital Realty is one of the biggest players. They're actually the seventh-largest REIT in the market. They own about 200 data centers all over the world. Most of their revenue still comes from the U.S., but they do have a pretty good presence in Europe and Asia. This is a pretty interesting growth story with what's projected to go on in the tech space over the next couple of decades.

Douglass: Yeah. DLR is really interesting. Frankly, from an income perspective, it still looks pretty good. It's a 3.8% dividend yield. Again, well-covered, no issues there. Now, one thing that I have to note about Digital Realty, and it's something to be aware of with most REITs, is the difference between GAAP and cash basis rent. Here's the background.

Digital Realty has issued guidance, and they've said that, on a cash basis rent, they're expecting their rent to be down a little bit this year. Then, on a GAAP basis, they're expecting it to be up. The reason for that is that, GAAP, or generally accepted accounting practices, requires that you do essentially what's a straight line on your rent. As an example, if you have a lease that, this year, is $10 per year per square foot, and for the next five years, $10 per square foot, and then for the five years after that, it jumps up, doubles, to $20 per square foot -- think of it as $150 per square foot over ten years -- you have to report, on a cash basis, that this year's rent is $10 per square foot. On a GAAP basis, you're reporting it as $15 per square foot, because they require you to straight-line it across the entire term of the lease.

What that basically means is, they're getting people in on some relatively cheap rent today, but they're planning to raise the rent pretty significantly on them over a longer time period, and that's a good sign for the business' growth.

Frankel: Yeah, definitely. Speaking of growth, there's a bunch of reasons to believe in the data center story. Digital Realty, first of all, has been very aggressive in acquiring competing data center REITs over the past couple of years. They've grown by leaps and bounds, and I actually think they'll continue to do so. That's why I own the stock. They're basically a play on the fact that the need for data storage and data transmission will continue to increase over time. A lot of people think that the data market's getting kind of saturated, devices are streaming as much data as they're going to, but that's really not the case.

The big catalyst I like for this is the whole Internet of Things market. The number of connected devices is soaring. When you think of just how many of your devices are internet-connected compared to a few years ago -- my doorbell is internet-connected right now. That would have seemed crazy five years ago. My vacuum cleaner has an internet connection. [laughs] Things like that. That's growing at a 34% annualized rate right now. And that's going to fuel the need for, like I said, secure and reliable transmission and storage of data.

So, although this market's big, Digital Realty is a very, very big player in the space, we could just be scratching the surface of the need for data centers in the world.

Douglass: Yeah. And at the end of the day, tech companies tend to -- now, this isn't true for all tech companies, necessarily -- want to operate on a pretty asset-light model. They don't want to necessarily be controlling a bunch of data centers and paying for all that real estate upkeep. It's much easier to just pay somebody else to do it, so you don't have that stuff on your balance sheet, so you can focus on reinvesting your cash in anything else, in development, in research, in new ideas, in innovations, in new apps. It's a really attractive business for a lot of reasons.

And frankly, it's growing pretty quickly. Rental revenues were up 31% year over year. Of course, funds from operations were only up a few percentage points, about 7%, because of both operating expenses and share issuance, which, again, is one of the ways that these companies grow. There are a lot of puts and takes there. But, it's an attractive company that really functions a little bit like one of those growth-plus-dividend stocks. And for my money, that can be pretty darn attractive.

Frankel: 7% is actually a pretty high rate for real estate. Most REITs aim for 2-3% for share rental growth. This seems to be more of the norm. One other thing I'd like to point out about Digital Realty is that they have a very diverse tenant base, and they have a ton of great companies that rent from them. Their top ten include Facebook, I mentioned, IBM, Verizon, AT&T, JPMorgan Chase is a big tenant of theirs. And they have 2,300 customers, so they're not very dependent on any single one. Getting back to what we were talking about Rayonier, where they're dependent on just one thing -- not that it's going to happen, but Facebook could go bankrupt tomorrow, and Digital Realty would be just fine. That's great diversity to have.

Douglass: So, that's our two cents on Digital Realty Trust, ticker symbol DLR.