Investors Are at Odds
On Digital Realty's Tech Bet

Digital Realty Trust Inc. is going where few real-estate investment trusts have dared to go since the technology-stock bubble burst in late 2000.

It has been spending hundreds of millions of dollars to buy data centers and Internet hubs, sprucing them up and renting them out to technology and telecommunications companies. Digital Realty Trust is one of the U.S.'s largest landlords for this type of property, which was overbuilt during the tech run-up.

Some investors and analysts have been wary of the company, even though Digital Realty was one of the top-performing REITs in 2005 -- its first full year as a public company. They are skittish because some of the company's largest tenants still are vulnerable to the volatile tech and telecom sector.

By some measures, Digital Realty's stock price remains relatively cheap compared with its earnings and growth potential. Digital Realty's PEG ratio -- its price-to-earnings multiple, divided by its growth prospects for 2006 -- is 57%, compared with an average of 166% in the office REIT sector, according to KeyBanc Capital Markets, which is based in Cleveland and has done investment-banking work for Digital Realty.

"I don't know if investors are convinced the model can keep going," says Richard Moore, a REIT analyst for KeyBanc. But he has a "buy" recommendation on the company's shares, based on expected growth in funds from operations, an industry benchmark that measures cash flow, of as much as 25% per share this year over 2005.

The bulls believe Digital Realty is carving out a niche that can withstand the sector's ups and downs. The San Francisco company owns buildings that have electrical capacity to handle power-guzzling computer equipment and fiber to carry data. It leases the space to companies that manage and "host" computer networks for large corporations and to the corporations themselves. It also leases space for regional Internet hubs, where digital information is exchanged and relayed.

Jim Corl, chief investment officer for real-estate securities at Cohen & Steers Inc., a New York money manager with about $21 billion under management, says Digital Realty might have some risky tenants, but the company is able to charge high rents because few other landlords rent this kind of specialized space.

By the end of the third quarter, Cohen & Steers owned 1.2 million shares of Digital Realty. "We like the risk-return trade-off," Mr. Corl says.

Digital Realty was spun out of a private-equity fund, called GI Partners, which was formed with funding from the California Public Employees' Retirement System in 2001. Digital Realty Chief Executive Michael Foust, who was a managing director at GI Partners, says that, after the tech bubble burst, many data centers had high vacancies, but he was convinced the space would fill up again soon.

Digital Realty last year boasted a 78% total return, measured by the increase in its share price plus dividends, compared with an average total return for the office REIT sector of 13.11%, according to the National Association of Real Estate Investment Trusts. When the company went public in October 2004, the stock fetched $12. In 4 p.m. trading Friday on the New York Stock Exchange, the company's shares were down 15 cents at $26.51, giving Digital Realty a market capitalization of about $727 million.

Since its IPO, Digital Realty has nearly doubled its portfolio to 44 properties, and its occupancy stood at 93.2% in the third quarter, up from 87%. At the beginning of last year, Digital Realty expected to rent its tech space for an average of $60 a square foot. By the third quarter, it was charging an average of $66 a square foot.

Still, many analysts share a concern about Digital Realty's tenants. "There is a real risk that some of the company's tenants may not be in business within the next few years," Citigroup Inc. analyst Jonathan Litt wrote in a report late last year. Citigroup has done investment-banking work for Digital Realty.

Mr. Litt, who has a "hold" on the stock, also says there is a risk that demand for Digital's data centers will decrease, as technology equipment grows smaller and needs less space to operate. By Mr. Litt's measure, the stock trades at a premium when compared with the underlying value of the company's real estate, or its net asset value. On Dec. 8, Mr. Litt calculated Digital Realty's estimated NAV was $17.06 a share.

Digital Realty's largest tenant is Savvis Inc., a Missouri-based company that provides information-technology services. Its stock closed Friday on the Nasdaq Small Cap Market at 71 cents a share, after falling 74% over the past two years. Savvis says its stock price isn't a good measure of its financial performance. It says many investors tend to be deterred from buying the shares because the company issues a sizable amount of preferred stock, which can be converted into public shares and have a dilutive effect. In June, Wells Fargo Foothill Inc. took the lead on an $85 million loan to the company, says Savvis Chief Financial Officer Jeffrey Von Deylen.

Mr. Corl of Cohen & Steers says investors should look beyond some of Digital Realty's tenants and focus on the end users of the data centers and Internet hubs. Those include major financial institutions, which hire companies such as Savvis to host their computer networks and backup servers that are located in Digital Realty's buildings. Even if a tenant runs into financial trouble, Mr. Corl says, its customers would likely keep their computer equipment stored in Digital Realty's space because it costs too much to relocate.

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