By Chew Yi Hong and Mak Yuen Teen
On 17 March 2023, before the market opened, Digital Core REIT Management Pte Ltd (DCRM), the manager of Digital Core REIT (DCREIT), issued an announcement on SGX trying to reassure the market. This was after the price of DC REIT had fallen by more than 13% the day before to close at US$0.43.
DCREIT’s price has been largely on a downward trajectory since early April 2022, after a promising start when its unit price increased from its listing price of US$0.88 to US$1.25.
No exposure to banks but….
DCRM’s announcement titled “No Exposure to U.S. Regional Banks” states:
“Digital Core REIT Management Pte. Ltd., as manager of Digital Core REIT, wishes to clarify that Digital Core REIT does not have any customer or banking relationship with Silicon Valley Bank, First Republic Bank or any other U.S. regional bank. None of Digital Core REIT’s customers are financial services firms, technology startup companies or backed by venture capital. Substantially all (>99% of annualized revenue) of Digital Core REIT’s customers are publicly traded companies and the vast majority (75% of annualized revenue) are investment grade or equivalent.”
Neither this announcement nor any prior announcements mentioned the issues raised in the article by Goola Warden on 16 March 2023 in The Edge, titled “Is this why Digital Core REIT’s unit price has been weak?”. Warden’s article mentioned that last month, Cyxtera Technologies, which has been identified as DCREIT’s second largest customer accounting for 22.6% of gross rental income, is attempting to refinance a revolving credit facility that matures in November this year. In addition, as early as mid-February 2023, Bloomberg had already reported that Cyxtera was planning to ask its lenders to push back the maturities on its debt and Moody’s had downgraded Cyxtera’s ratings from B3 to Caa2.
We believe that the REIT manager should have pro-actively updated the market on the troubles with its second largest tenant in a timely and transparent manner. In fact, one could argue that it is required under the listing rules.
Optimistic analyst
The Warden article quoted a report by DBS Research released on 16 March 2023 which states: “Fresh concerns on Cyxtera’s ability to service their debt obligations have surfaced … although [Moody’s] believed in Cyxtera’s underlying business fundamentals, they are concerned with the firm’s ability to service debt obligations in the medium term.”
DBS Research noted that Cyxtera, which they estimate to be DCREIT’s second largest tenant, is current in its rent, and that they “…take comfort from its Sponsor’s commitment to the REIT. Similar to what we saw with SunGard previously, DCREIT’s Sponsor was quick to step in and provide support for the REIT.” DBS Research concluded that: “Although we will take a more cautious approach on DCREIT in the near term, we are confident on the REIT’s ability to navigate such hurdles as previously demonstrated. Until there are further developments on Cyxtera, we will be maintaining our BUY recommendation with TP of US$0.90.”
Concerns we flagged in GIFT 2022 report
DCREIT listed on SGX in December 2021. The joint issue managers, global coordinators, bookrunners and underwriters were BofA Securities, Citi and DBS Bank. When we released our most recent report on the Governance Index for Trusts (GIFT) in November 2022, we did not include DCREIT in our assessment and ranking as it had not issued an annual report yet.
However, a three-page section titled “Foreign-based trust and complex structures: An under-appreciated risk?” was largely dedicated to it (see below for this).
We pointed out a number of unique features and concerns about DCREIT. First, its sponsor and manager, Digital Realty Trust, is listed on NYSE and was the sixth largest publicly traded US REIT. It is the first time that a SGX-listed REIT has a sponsor and manager which is another (listed) REIT.
Unlike its sponsor REIT, which is internally managed as is the common practice in the US, DCREIT is externally managed. We have in various editions of GIFT mentioned our strong preference for the internally managed model as it is better mitigates conflicts of interest between the manager and unitholders.
The sponsor carved out 10 freehold data centres in US and Canada out of a global portfolio of 290 facilities in 26 countries to form the initial portfolio for the listing of DCREIT. We questioned how the 10 data centres were selected and valued.
While the media release for its listing clearly spelt out “key strategic and financial benefits” for the sponsor Digital Realty, we pointed out that “the same cannot be said about the benefits of the listing to the unitholders of Digital Core”.
Another issue we raised is that the five-member all-male board of the manager includes an independent director who “spent 30 years with DBS Bank until his retirement in 2019 and was responsible for the bank’s equity markets business in Singapore”. While he may meet the technical requirements for independence, it is surprising that an independent director who has such a close relationship with DBS Bank – one of the three issue managers, global coordinators, bookrunners and underwriters – was appointed. This does not reflect well on the search and nomination process and raises questions as to whether those involved in assembling the board had adequately considered whether this particular director would be perceived to be independent.
Our writeup on DCREIT also mentioned that its fifth largest customer, which it did not name, had filed for Chapter 11 bankruptcy on 11 April 2022. This customer is Sungard, which contributed around 7.1% of DCREIT’s total revenue. Sungard had just come out of a prior bankruptcy three years earlier. DCREIT mentioned this in its first quarter business and operational update on 21 April 2022 – or 10 days after Sungard had filed for bankruptcy. There is a question of whether material information was disclosed in a timely manner.
DCREIT also mentioned in bold, underlined font: “This customer event is not expected to impact DPU”. The sponsor was however not covering any shortfall from the bankruptcy of Sungard as it was clear from a subsequent announcement that it was only providing temporary cash flow support which will be paid back by DCREIT in cash or units. We questioned whether the earlier statement that the “customer event is not expected to impact DPU” is factually accurate.
We concluded our writeup with this statement: “Digital Core REIT has a financially strong sponsor listed on the largest stock exchange in the world. However, the sponsor has its own unitholders to account to, and the interests of those unitholders may not necessarily be the same as the unitholders of Digital Core REIT here.”
Directors of the sponsor are subject to fiduciary duties and to U.S. law and the U.S. legal system. If there is a conflict between the interests of the sponsor listed in the U.S. and the interests of DCREIT listed here, there is no prize for guessing whose interests will take priority. Would one expect the highest quality assets to be put into the portfolio that is listed on SGX?
DCREIT’s disclosures in the prospectus
DCREIT’s IPO prospectus disclosed that as at 30 June 2021, “the IPO Portfolio contains 12 unique customers, including leading global platforms and service providers, each with numerous deployments across the Sponsor’s global platform. Approximately 68.6% of the Base Rental Income for the month of June 2021 of the IPO Portfolio is generated by customers that are investment grade or equivalent rated.”
The prospectus disclosed the top six customers without identifying the customers (see chart below).
A digital infrastructure-focused website identified these six customers as Microsoft, Cyxtera, Facebook or Meta, IBM, Sungard and AWS respectively[1].
At the point of the IPO, Cyxtera was rated B-/B3 (non investment grade) and Sungard was not rated. Therefore, DCREIT’s portfolio had a mixed bag of strong and weaker customers. Both major customers with low credit quality have since run into problems within 16 months.
While the disclosures in the prospectus were factually correct when it stated that “approximately 68.6% of the Base Rental Income for the month of June 2021 of the IPO Portfolio is generated by customers that are investment grade or equivalent rated”, ordinary investors may not be aware that approximately 31.3% of the Base Rental Income is generated from customers who may not be that financially sound. Of course, it may be unfair to expect a prospectus aimed at attracting investors to wave such a red flag around.
We think that unitholders should pay heed to what is not being said by managers as well as what is being said. To put out an announcement to assure unitholders on its non-exposure to US regional banks while not mentioning the issue faced by a key customer may give investors a false sense of assurance. DCRM even updated that 75% of annualised revenue are from customers who are investment grade. Unfortunately, the well-informed segment of the market has already reacted to the negative developments related to the 25% of its revenue that is due from customer(s) who are NOT investment grade.
Meanwhile, we wonder why SGX has not queried the REIT following a 13% single-day drop when other REITs were relatively stable. We hope SGX will issue a query to ensure that the market is fully informed about what is happening at DCREIT.
[1] https://dgtlinfra.com/digital-realty-core-data-center-reit-ipo/
___________________
Chew Yi Hong is an active investor and a researcher in corporate governance who holds an MBA with Distinction from the London Business School. Mak Yuen Teen is a professor (practice) of accounting at NUS Business School. Each year, they publish the Governance Index for Trusts (GIFT), the only published governance index in Singapore that specifically caters to listed REITs and BTs in Singapore. The views in this article are their personal views.
