Digital Realty Trust: Crown Jewel for Your Dividend Portfolio

In the technology sector, big data and digital security are of paramount concern for many technology companies. This is an era of heightened security risk, as a steadily increasing amount of information gets digitalized. Cloud storage and data centers are significant areas of growth for the technology industry. Companies that service this demand are poised for many years of growth. Digital Realty is situated well to capitalize on these high-growth areas.

Digital Realty stock has performed well this year, as investors and analysts become more optimistic about the company’s growth trajectory. Digital Realty yields 4.7%, more than twice the dividend yield of the S&P 500.

Digital Realty is a real estate investment trust, commonly referred to as a REIT. It owns and operates technology-related real estate properties, such as data centers, in both turn-key and collocation arrangements. As a REIT, Digital Realty is not subject to corporate income tax. In exchange, Digital Realty is required to distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends. This results in very high dividend yields and is why many income investors are drawn to REITs.

Due to this requirement and its strong earnings growth, Digital Realty has raised its dividend for 10 consecutive years, despite already being a high-yield stock. This year, Digital Realty raised its dividend by 2%. The company maintains a high rate of dividend growth looking back further—according to Digital Realty investor relations materials, it has increased its dividend by 13% per year since its initial public offering.

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 (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 multiple and is below its long-term average multiple.

There are two key risks to consider when evaluating Digital Realty’s future earnings and dividend growth: 1) the likelihood of higher interest rates in 2016 and 2) the prospect of technology companies building their own data centers. These are significant headwinds to Digital Realty’s specific business model and have weighed on its valuation multiple over the past year. The U.S. Federal Reserve is likely to increase interest rates for the first time since 2006 soon, perhaps as early as December. This would put a strain on balance sheets across the REIT asset class—as 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. As interest rates rise, it will become more costly to refinance its balance sheet, thus causing higher interest expense and lower growth of FFO.

Separately, analysts have recently become concerned that some of the world’s biggest technology companies, such as Amazon, are building their own data centers instead of contracting with external firms. That is a significant risk, but Digital Realty has not experienced a deterioration or slowdown at all over the past year. As this risk alleviates, Digital Realty could earn a higher valuation multiple of FFO in 2016.

As a result, there are more tailwinds than headwinds for Digital Realty going forward. While rising interest rates are a concern, Digital Realty maintains a sound financial position and is highly profitable. Demand for data centers and technology real estate is set to grow for many years. This should lead investors to believe that the stock can experience modest multiple expansion into next year. We believe Digital Realty can earn a multiple of FFO of 15-17 times, which is closer in-line with its historical averages. At that valuation level, the stock would trade between $77 per share and $87 per share.

Digital Realty stock recently closed at $72 per share. This price target represents 6%-20% upside potential from its current levels and implies the stock is modestly undervalued at its current price. But when incorporating Digital Realty’s 4.7% dividend, and the likelihood of 3%-5% annual dividend growth, investors should reasonably expect double-digit annual returns over the next several years.