Public Owners and the REIT Machine

A real estate investment trust, or REIT, is a company that owns income-producing property and, in exchange for meeting a set of tests in the United States Internal Revenue Code, pays little or no corporate income tax. The central test is distribution: a REIT must pay out at least ninety percent of its taxable income to shareholders as dividends each year. The tax is paid by the shareholder instead. Income flows through.

That single rule shapes everything a data center REIT does. Because it must distribute most of its income, a REIT cannot fund growth from retained earnings the way an ordinary company can. It must go to the capital markets again and again, issuing new shares, issuing bonds, selling assets or bringing in partners. A REIT is therefore a machine for turning outside capital into new buildings and passing the rent back out. Its cost of capital is its central competitive variable.

Two companies dominate the public data center REIT category in the United States. Equinix, the retail colocation and interconnection operator, elected to be taxed as a REIT effective January 1, 2015, after a multi-year conversion. Digital Realty, which grew up in wholesale leasing, has been a REIT since its listing in 2004 and has since added retail and interconnection businesses. It bought the European operator Interxion in a combination that completed on March 13, 2020. The two are often grouped together, but they began at opposite ends of the market described in the first module, and their earnings still reflect it.

Now the measurement problem. Ordinary accounting subtracts depreciation, the gradual write-down of a building's cost over its assumed life. For a company that owns long-lived property, depreciation can be large, and it may not reflect any real decline in value. Net income therefore understates the cash a REIT generates. The industry's answer is funds from operations, or FFO, a measure defined by Nareit, the REIT trade association. FFO starts from net income, adds back depreciation and amortization on real estate, and removes gains or losses from selling property. It is intended to show the recurring earning power of the portfolio.

Most data center REITs go one step further and report adjusted funds from operations, or AFFO. AFFO subtracts the recurring capital spending needed to keep buildings competitive and strips out non-cash items such as stock-based compensation and straight-line rent adjustments. Equinix's filings, for example, describe an AFFO calculation that deducts recurring capital expenditures. The adjustment matters more for data centers than for most property types, because a data center's equipment wears out and falls behind far faster than an office building's structure. AFFO is not standardized across companies, which means comparing it across REITs requires reading each company's definition.

Why the attention to these measures? Because public REITs are valued on them. Analysts compare a REIT's share price to its AFFO per share, a multiple that plays the role a price-to-earnings ratio plays elsewhere. They track growth in AFFO per share, because issuing new stock to fund buildings only creates value if the new buildings earn more per share than the dilution costs. And they compare the dividend to AFFO to judge whether the payout is covered.

There is also a second valuation lens, net asset value. Here an analyst estimates what each building would fetch in a private sale, sums the result, subtracts debt and divides by shares outstanding. When a REIT's shares trade above that figure, it can issue stock cheaply and grow by buying or building. When shares trade below it, issuing stock destroys value, and the REIT may instead sell buildings or bring in private partners. That gap between public and private pricing is a recurring driver of deals in this sector.

The model has a clear dependency on interest rates. REIT dividends compete with bond yields for income-seeking investors, and REIT growth is funded partly with debt. When the United States Federal Reserve began raising interest rates in March 2022, the cost of both kinds of capital rose together. Faraday's read is that public data center REITs are best understood not as property companies but as capital allocators whose advantage depends on buying money more cheaply than their private rivals, and that advantage is not permanent.

One more structural point. A listed REIT offers something private capital does not: daily liquidity for its shareholders and public disclosure of its results each quarter. That transparency is useful to anyone studying the sector, including people who will never buy the shares. The quarterly supplemental packages that Equinix and Digital Realty publish are among the richest free sources of data on leasing, pricing and development in the industry.

Read a REIT, then, by three numbers and one question. The numbers are AFFO per share, its growth, and the dividend it supports. The question is whether the company can keep raising capital more cheaply than the buildings it funds will return.