So Keppel DC REIT released its 1H FY2024 results recently and boy oh boy was it interesting.
On the surface, the results seemed rather stable based on their results presentation.
We can see that gross revenue, net property income and DPU have all increased as compared to 2H 2023. On a year-on-year comparison, the results aren’t that great due to the rental default of the Guangdong data centres’ tenant.
From an interest rate perspective, finance costs did not increase much as compared to 2H 2023, indicating that Keppel DC REIT’s cost of debt has more or less stabilised. In fact, with the recent acquisition of a data centre in Tokyo, the REIT’s average debt cost would decrease due to cheaper Japanese Yen loans.
With rate cuts expected to come in the not-so-distant future, it would likely provide some upside relief to Keppel DC REIT’s DPU moving forth, adding on the fact that they also do not have any outstanding debt to refinance till FY2025.
So despite this rather rosy scenario of Keppel DC REIT, why am I still slightly concerned with its performance? It’s down to a mixture of figures misrepresentation and my assessment of Keppel DC REIT’s near-term prospects. Let me explain.
The financial figures are worse than illustrated
Investors should be mindful that Keppel DC REIT’s 1H 2024 figures are boosted by a one-off income item and some…interesting accounting practices.
With regards to the $157.2 million gross revenue reported for 1H 2024, it included the settlement sum of $13.3 million regarding the dispute with DXC Technology and about $10.5 million in straight-line rental income from the distressed Guangdong data centre assets (Keppel DC REIT has a funny practice of putting defaulted rental income in gross revenue and accounting for loss allowances in property expenses).
Thus, if we were to exclude these two items, the actual figures for 1H 2024 would be as such:
- Gross Revenue: $133.4 million instead of $157.2 million (-5% y-o-y change & +2.5% as compared to 2H 2023)
- Distributable Income: About $75.3 million instead of $80.9 million (-17.6% y-o-y change & -1.5% as compared to 2H 2023)
- Distribution Per Unit: About 4.369 cents instead of 4.549 cents (-13.5% y-o-y change & +0.9% as compared to 2H 2023)
After stripping away the fluff, we can see that Keppel DC REIT has performed marginally better than 2H 2023. And giving credit where credit is due, it was nice seeing a slight increase in total gross revenue and DPU from 2H 2023.
With the recently completed acquisition of the Tokyo data centre and future coupon contributions from the AU DC note with the divestment of Intellicentre Campus, there should also be further upside to DPU in Q3 and Q4 of 2024.
Nevertheless, more experienced investors might question why there was only tepid growth in gross revenue and DPU when Keppel DC REIT is supposed to benefit greatly from the demand of the AI industry.
In fact, this tepid growth rate is not new and mirrors the low single-digit growth pace of Keppel DC REIT’s gross revenue and net property income since FY2021.
And that is exactly where my main concerns with Keppel DC REIT are, or more specifically, the growth prospects of some of the colocation data centres.
Worries about Keppel DC REIT’s prospects
It is no secret that a significant chunk of Keppel DC REIT’s earnings come from its colocation data centres.
As of 1H 2024, revenue from colocation data centres (including the settlement sum with DXC Technology) accounted for 63.9% of total revenue and 66.3% of net property income.
On a full-year basis, colocation data centres contributed to 59.9% and 61.6% of total revenue in FY2023 and FY2022, while net property income contribution was 59.7% and 58.9% respectively.
Given the significance of the colocation data centre segment, it is quite alarming to see a negative earnings trend in recent years.
While there are a multitude of reasons for the declining trend (negative FX impact, rental dispute with DXC Technology), I speculate that some of it could also be due to the declining attractiveness of Keppel DC REIT’s Singapore colocation data centres.
Will potential tenants ditch Singapore for Johor?
Currently, more than half of Keppel DC REIT’s colocation data centres are located in Singapore.
While Singapore remains an attractive location for data centres, Malaysia, or more specifically the state of Johor, is fast becoming a direct competitor with major companies opting to set up their data centres there.
With Keppel DC REIT passing on a bulk of utility costs in its colocation lease agreements to its tenants, potential or even current tenants might turn to Johor to reduce operating expenses as land, water and electricity costs are significantly cheaper there.
While there might be lesser connectivity (in terms of both business and internet aspects), the future completion of the Johor-Singapore RTS and the establishment of the Johor-Singapore Special Economic Zone would alleviate some of these connectivity pains.
Furthermore, with Singapore expected to grant only around an additional 300MW of capacity in the near term, this may also not be sufficient for cloud and hyperscaler players.
So with these factors, I fear that Keppel DC REIT’s Singapore colocation data centres might become less attractive over time. In fact, if we consider occupancy rates, there might already be some evidence of this slowly panning out.
Declining tenants and shorter lease durations
The occupancy rate for 1H 2024 came in at 97.5% as compared to 98.5% a year ago. While an overall 1% drop might not seem much, Keppel DC REIT is losing tenants at its Singapore colocation data centres.
As seen, the overall number of clients and WALE has declined compared to a year before. This is a double whammy for Keppel DC REIT as it means that not only are there fewer tenants, but current tenants are also on shorter relative leases. Whether this is the start of a prolonged negative trend or not would be heavily dependent on the lease renewals for 2024 and 2025.
Part of the reason for the decline in occupancy rates could be that the available lettable area is too small for the requirements of bigger players, while current market rental rates might be too prohibitive for smaller companies.
Nevertheless, it should be said that the valuations of the Singapore colocation data centre assets have risen over the years. This means that by market standards these properties remain attractive and Keppel DC REIT also has room to negotiate for higher rents during lease renewals.
In 1H 2024, Keppel DC REIT managed to secure a 40% positive rental reversion for one of its major colocation tenants (likely to be Amazon Web Services) and its CEO has also mentioned during the AGM that rental reversions remain on an upward trend. With 38.4% of rental income from colocation leases up for renewal over the next year or so, I sure hope that this positive rental reversion trend continues.
Can Keppel DC REIT return to a pathway of growth?
With Keppel DC REIT experiencing dwindling growth over the past few years, the question to ask is can it return to at least a high single-digit growth annually? Personally, I think it is possible but it will likely take a few years.
With Keppel DC REIT’s aggregate leverage at 39.2% after the acquisition of the Tokyo data centre, it’s already literally at its internal cap of 40%. Thus, for Keppel DC REIT to continue growing, it has to divest older data centre assets (Keppel DC 1 I’m looking at you) and acquire newer ones.
The other way to grow is through doing an equity fundraising. However, given the current market conditions and sentiment, I do not think the management team would pursue this option.
Organic growth could also possibly come from Guangdong DC 1 and 2 as a recovery roadmap is still being worked upon and the possibility of managing it as a colocation asset is also on the cards. Keppel DC REIT also retains the right to terminate the purchase of Guangdong DC 3. Its CEO also added during the recent AGM that if Guangdong DC 3 was divested at current distressed prices, it should still sufficiently cover Keppel DC REIT’s initial deposit of RMB 100 million for the property.
Nonetheless, any positive development out of the Guangdong data centre assets will likely take a few years to materialise. Thus, the best possible avenue of growth for now would still be through asset recycling.
Is it time to replace older Singapore assets?
For 1H 2024, Keppel DC REIT derives about 55.9% of gross revenue from Singapore. This figure was 51.5% and 53.2% for FY2023 and FY2022 respectively.
While there are benefits to a Singapore concentration (strong currency, no FX risk), I think Keppel DC REIT would do well to replace some of the older Singapore assets.
Besides the previous challenges highlighted in the Singapore data centre market, the government have also mandated all new data centres in Singapore to have a Power Usage Effectiveness (PUE) of 1.3 or less. Current data centres are also expected to have a PUE of 1.3 or less within the next 10 years.
While Keppel DC REIT does not disclose the PUE of its data centre assets due to confidentiality reasons, I speculate that Keppel DC 1 and 2 may not meet the PUE threshold as they have been in Keppel DC REIT’s portfolio since its IPO in 2014. Their last major retrofit was also completed in 2013 and 2010 respectively.
Thus, instead of potentially spending expensive Capex on these two older properties, Keppel DC REIT can perhaps divest them instead and acquire newer local or overseas assets. These assets could either be from the pipeline of acquisitions from its sponsor or other opportunities in the markets.
Regardless of the options taken, something has to be done to address the tepid growth rate over the past few years.
My plans for my Keppel DC REIT investment
Last I checked, Keppel DC REIT constitutes around 10% of my investment portfolio. Actually, with its recent run-up in price, the allocation could even be more.
My average cost of each unit is also not the best at $2.25. I blame this high average cost entirely on my inexperience as an investor when I first invested in Keppel DC REIT back in 2021.
Thus, despite my concerns about the REIT, I feel it hasn’t reached the stage where I need to liquidate it at a loss. With a conservative FY2024 DPU estimate of 9 cents, it translates to a yield of 4% based on my average cost per unit. Not the best, but also not the worst either.
Nonetheless, should the price rally to around $2.35, I will be liquidating my entire position. At this price, it is close to the average 5-year price-to-book ratio based on Keppel DC REIT’s current NAV of $1.37.
This liquidation would both be due to my concerns and also a desire to revamp my investment portfolio. What’s the rationale for revamping my investment portfolio you ask? Well, I guess I would save that for a future article.