THE manager of Digital Core real estate investment trust : DCRU 0% (Reit) on Monday (Jun 5) warned that the Reit&rsquo s distribution per unit (DPU) could be reduced by about US$0.02 cents if the annual revenue of its second-largest tenant were to be completely eliminated.

 

This comes after the tenant, a &ldquo global co-location and interconnection provider&rdquo , filed for Chapter 11 bankruptcy protection on Sunday.

 

Digital Core&rsquo s FY2022 DPU stood at US$0.0398, 4.8 per cent lower than the US$0.0418 forecasted.

 

The Reit manager did not name the tenant, but The Business Times understands it to be Cyxtera, a Nasdaq-listed data centre operator.

 

Dan Tith, chief financial officer of Digital Core Reit&rsquo s manager, said: &ldquo We want to reassure investors that we have several lines of defence prepared for this scenario and feel very good about the contingency plans we have in place.&rdquo

 

According to the Reit manager, the tenant in question represents about US$16.3 million or 22.4 per cent of the Reit&rsquo s annual rental revenue.

 

It currently occupies 100 per cent of five shell and core facilities in Silicon Valley and Los Angeles, and 4 per cent of a fully-fitted facility in Frankfurt.

 

The tenant&rsquo s facilities are spread across six of the Reit&rsquo s data centres, representing 26.6 per cent of the Reit&rsquo s total portfolio value as at end-2022.

 

Digital Core&rsquo s manager noted that the data centre operator has remained current on its rental obligations through May 2023 but has yet to pay rent for June.

 

It added that its tenant obtained a commitment for up to US$200 million of debtor-in-possession financing, stating it intends to pay vendors and suppliers in full for goods and services provided on, or after, the filing date.

 

Assuming that 100 per cent of annual revenue from the Reit&rsquo s second-largest customer will be eliminated, the manager expects aggregate leverage to increase by approximately 200 basis points, to 36.5 per cent from 34.4 per cent.

 

Its total asset value would also be reduced by about US$85 million or 6 per cent, and net asset value per unit would fall about 9 per cent to US$0.74, from US$0.81.

 

Digital Core Reit&rsquo s manager nonetheless said it expects to be able to minimise any potential DPU impact on the Reit, in view of mitigating factors such as below-market rents and favourable fundamentals of the locations where the Reit&rsquo s assets are located.

 

The manager also said it is &ldquo well-positioned&rdquo to step into agreements with existing end-user co-location customers.

 

Tith said: &ldquo Should any of our leases be rejected during the court process, we would either be able to step into agreements with the existing end-user co-location customers currently relying upon these facilities to support their digital infrastructure requirements, or re-lease the assets, which are all in top-tier markets with favourable demand-supply dynamics.&rdquo

 

John Stewart, chief executive officer of Digital Core Reit Management, said he is &ldquo disappointed&rdquo by news of the tenant&rsquo s bankruptcy filing.

 

&ldquo We stand prepared to guard against any potential near-term disruption while capturing long-term upside potential as the opportunity presents itself,&rdquo he said.

 

&ldquo We remain committed to our strategy of investing in a diversified portfolio of mission-critical data centre facilities in top-tier global markets and remain focused on preserving and creating long-term value for Digital Core Reit unitholders.&rdquo

• Cyxtera Technologies have initiated a pre-arranged Chapter 11 filing to deleverage
• Despite the negative development on this issue, we believe that all negatives have already been priced in
• We believe that the worst-case scenario (fully vacating all properties and impacting c.35% of DPU) will unlikely happen risks are probably concentrated on the two assets in LA (c.11% of DCREIT&rsquo s DPU)
• Maintain BUY with TP of US$0.90 until there is more clarity on the leases with Cyxtera

What has happened?

Cyxtera Technologies just announced this morning that it has initiated a pre-arranged Chapter 11 filing. As compared to a traditional Chapter 11 filing, a pre-arranged (or pre-packaged) Chapter 11 filing is a &ldquo fast-tracked&rdquo route where the aim is to save on expenses and shorten the turnaround time for the company to emerge from Chapter 11. To shorten the time taken for the process, a pre-arranged filing would imply that Cyxtera has already negotiated and gotten the approval by its creditors for the restructuring prior to filing for the Chapter 11. 

Below are some of the main difference of a pre-packaged Chapter 11 filing as compared to a typical bankruptcy process:

• Company has already negotiated the restructuring terms and received approvals from its creditors prior to the filing of the Chapter 11
• Time spent under bankruptcy protection is shorter and there is much greater certainty on the results and eventually exit from Chapter 11
• Lower administrative costs spent on the process legal, accounting and audit fees, etc.
• Management retains control over the company and operations as the necessary approval has already been sought from the creditors

Meanwhile, Cyxtera has received a commitment for US$200m in financing from lenders to provide sufficient liquidity to support Cyxtera during the process. This financing will ensure that Cyxtera continues to pay its employee wages, vendors and suppliers without interruption as it continues its operations. Cyxtera will continue to operate its data centres normally and without interruption, and customers will continue to have access to their sites and equipment as usual.

What are the implications?

Although a pre-arranged Chapter 11 filing is the preferred option as compared to a typical bankruptcy filing, it will pose a tenant risk for the three REITs (DCREIT, MINT, KDCREIT) with exposure to Cyxtera. Having said this, we understand that the impact to the REITs will be contained in the near-term as Cyxtera continues its business as usual, and its creditors will likely support this as operations remain profitable.

Moreover, as highlighted in our previous report (Datacenter S-REITs: Turning challenges into opportunities), rentals that Cyxtera are paying for its leases with DCREIT in Silicon Valley and LA are significantly below market rates. This implies that Cyxtera (or its potential acquirer) will want to continue with their leases at most of these properties on such favourable rents, or DCREIT could benefit from some potential uplift in the event they have to lease out the properties to other tenants. We understand that market rents in many of the major data centre markets in the US have been rising steadily due to  strong demand and rising occupancy rates. Rents that Cyxtera is paying at DCREIT&rsquo s Silicon Valley and LA properties are anywhere from 10% - 40% below current market rents, and demand in these markets remain healthy. 

In the case of MINT and KDCREIT, exposure to Cyxtera remains limited (c.3% for MINT, and c.2% for KDCREIT). Moreover, these assets are either located in the major data centre markets throughout the US and in London (for KDCREIT), where the data centre industry continues to ride on the tailwinds of the sector and rents continue to trend up due to strong demand.

Our thoughts

Although this latest development with Cyxtera is a negative for DCREIT and for MINT and KDCREIT to a lesser extent, we believe that this should provide some clarity on the issue that has been ongoing for the past few months. Based on our estimates, the impact to DCREIT&rsquo s DPU in the worst case scenario would be c.35% if Cyxtera does indeed vacate all their leases immediately. However, we believe that this is an unlikely scenario as the market occupancies at their properties in Silicon Valley and Frankfurt are relatively healthy at 95% and 70% respectively. The only market that we would be a little more cautious on will be in LA, where market occupancies are c.57%.

Assuming that the Cyxtera chooses to only reject its leases at the two properties in LA, we could potentially see c.11% downside to our FY23 DPU estimates. Again despite the negative connotations with this, we believe that current valuation on DCREIT have already fully priced in the worst case scenario of Cyxtera vacating all of its leases. However, if we only account for the income void from the LA properties, current valuations implies a potential forward yield of c.8.0% at current trading price. 

With more updates on the Chapter 11 filing over the coming months, we will revisit our recommendations once there is more clarity on the outcome of the Cyxtera leases. At this point, we believe the worst case scenario is unlikely, and we could potentially look to DCREIT' s Sponsor stepping to provide some form of support again for the REIT. 

As such, we will be maintaining our  BUY  recommendation on DCREIT with a TP of  US$0.90.

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