Latest / Bull Market Conversations with Fexingo: Rallies, Momentum, and Riding Market Strength / The New Bull Market Leaders Are Data Center REITs
Transcript
- Lucas: The Russell 2000 is up more than three percent in just the last five trading days. The S&P 500 is sitting at 7,491. And yet if you look under the hood of this broad rally, one niche is quietly beating almost everything else: data center REITs. Luna: Data center REITs — the landlords for the cloud. They've been on a tear, but I want to know: is this a structural shift or just another rotation play? Lucas: That's exactly the question. And the numbers suggest it might be structural. Look at Digital Realty and Equinix — two of the biggest names. Their funds from operations, or FFO, which is the REIT version of earnings, has been growing at a compound annual growth rate of about twelve percent over the past three years. And the market is rewarding them with a price to ffo multiple that's now around 35 times. Luna: Thirty-five times is rich. The broader REIT sector trades at what, around 18 times FFO? Lucas: Yeah, roughly 18 to 20. So you're paying nearly double the multiple for data center REITs. The bull case is that AI infrastructure demand is basically creating a new wave of tenants — hyperscalers like Microsoft and Amazon that need massive amounts of power and cooling, and they'd rather lease than build. Luna: And the bear case would be that we're pricing in perfection. I remember the telecom towers REITs in the late 90s — they had similar multiples before the bubble burst. Lucas: Right, but the difference is the demand driver today is more concrete. Cloud spending is still growing at double digits. And the supply side is constrained — you can't just throw up a data center in six months. Permitting, power availability, construction timelines — it takes years. Luna: So you're saying the moat is real. But what about the Fed? Rates are still at 3.62 percent on the effective fed funds rate. REITs are interest-rate sensitive — higher rates make their dividend yields less attractive. Lucas: That's the twist. Data center REITs have actually been less rate-sensitive than traditional REITs because their rent growth is so strong. When your same-store rents are climbing eight to ten percent a year, a 3.6 percent risk-free rate doesn't look as threatening. The yield on the ten-year Treasury is also elevated, which normally would pull money out of REITs — but investors are chasing growth, not just yield. Luna: And that growth is coming from AI inference workloads, not just training. Every time someone uses ChatGPT or runs a Copilot query, it hits a data center. The usage growth is exponential. Lucas: Exactly. And that's why the market is willing to pay up. But here's the subtle thing — not all data center REITs are created equal. The ones with exposure to primary markets like Northern Virginia, Silicon Valley, and London are commanding the highest rent growth. Secondary markets are lagging. Luna: So the investor needs to be selective. You can't just buy the iShares U.S. Real Estate ETF and call it a data center play. That ETF holds a lot of mall and office REITs. Lucas: Right. The pure-play data center REITs are a very small slice. Digital Realty, Equinix, and then some smaller ones like CyrusOne and CoreSite. But even within those, the valuation dispersion is wide. Equinix trades at a premium because it has a global interconnection moat — it's not just a landlord, it's a network hub. Luna: That interconnection piece is key. Equinix has over 2,000 networks in its data centers. That switching cost for a customer is huge. Lucas: Exactly. And that's why its retention rates are over ninety-nine percent. So when you pay 35 times FFO for Equinix, you're buying that recurring revenue stream. Digital Realty is more of a wholesale play — bigger leases, but less switching cost. Luna: Which one do you think has more upside from here? Or is that too tactical for this conversation? Lucas: I think the bigger question is whether the entire category can sustain its premium if AI spending disappoints. The headlines this week about the U.S. pushing AI in China and Asia after the Trump-Xi meeting suggest the geopolitical push is only accelerating. So demand is likely to stay robust. Luna: But there's also the risk of overbuilding. If every developer piles into data centers, we could see a supply glut in three to four years. Lucas: That's the classic cycle risk. But right now, vacancy rates in primary markets are at historic lows — around three to four percent. And the cost of capital for new builds has gone up because interest rates are higher. That actually acts as a natural brake on new supply. Luna: So in a weird way, higher rates are helping the incumbents by keeping new entrants out. Lucas: Yes. And that's why the bull case has legs. But let's ground this in today's market context. The Russell 2000 is up 3.4 percent in five days, and the small-cap rally is broad. But data center REITs are in the S&P 500 too — they're not just small caps. They're part of this rotation into real assets with pricing power. Luna: And the S&P 500 itself is at 7,491, up 1.2 percent over the same period. So the small-cap outperformance is a theme we've talked about before, but the data center REITs are a distinct subset that's performing even better. Lucas: Right. And I want to highlight one more data point: the nominal GDP is now nearly $32 trillion, with real GDP growth annualized at 2 percent. That's a solid backdrop for business investment. Companies are spending on IT infrastructure, and data centers are a direct beneficiary. Luna: So if an investor wants to get exposure, what's the simplest way? Individual stocks, or are there ETFs that focus on data center REITs? Lucas: There's the Data Center REIT ETF, but it's relatively small and has low liquidity. The more common approach is to pick the two largest names — Digital Realty and Equinix — and build a position. They're both liquid, well-covered, and have strong balance sheets. Luna: And for someone who wants to stay diversified but still tilt toward the theme? Lucas: Then you could consider a broader technology REIT ETF, but you'll get exposure to cell tower REITs and other infrastructure too. The pure play is still the individual stocks. Luna: I want to go back to the valuation concern. At 35 times FFO, what kind of growth is priced in? Is it reasonable? Lucas: If FFO grows at 12 percent annually for the next five years, and the multiple compresses to 25 times — which is still a premium to the sector — then you'd get a mid-single-digit annual return from the stocks. That's not spectacular, but it's decent in a low-return world. Luna: But if growth disappoints and the multiple goes to 20, you could have negative returns. Lucas: Exactly. That's the risk. The bull case requires sustained double-digit rent growth and no supply glut. The bear case is that AI investment peaks and the market realizes these are still real estate assets with cyclical exposure. Luna: So it's a high-conviction bet on AI infrastructure demand staying strong for years. Lucas: It is. And that's a bet many investors are willing to make right now. The question is whether the market is already pricing in perfection. But the data we have today — low vacancy, strong rent growth, and a supportive macro — suggests the trend is still in its early innings. Luna: And with the Fed on hold at 3.62 percent, there's no immediate catalyst to break the momentum. Lucas: Right. So for listeners who want to drill deeper, I'd recommend looking at the lease expiration schedules and the power purchase agreements of these REITs. That's where the real insight lies. Luna: Thanks, Lucas. And next time, maybe we'll look at whether the AI software stocks are catching up to the infrastructure plays. Lucas: That's a great idea. The rotation from picks and shovels to applications is a classic pattern, and we might be seeing early signs of it. Luna: Until then, keep riding the rally — but know what you own. Lucas: Exactly. Thanks for listening.