SRVR ETF: How Data Center REITs Revive The Commercial Real Estate Market

Data is the new raw material of business. - Craig Mundie

If you're a subscriber of The Lead-Lag Report or have been tracking developments on the associated Twitter account, you'd note that I'd recently put out an intriguing chart highlighting the scope for a short-term bottom for real-estate stocks.

For the sake of additional clarity, note that a ratio measuring the strength of the real estate sector as a function of the S&P 500 (SP500) recently dropped to a level last seen at the start of 2021, an area from where one had previously witnessed a reversal. Could we see a recurrence of the same? Over the long term, things are still looking fairly ambiguous for the real-estate sector, but over the short term, things may be looking up after two straight months of selling.

If you're curious to explore this space and are looking for beaten-down options with promising long-term prospects, you may consider making a beeline for the Pacer Benchmark Data & Infrastructure Real Estate SCTR ETF (NYSEARCA:SRVR).

As noted in the image below, SRVR's clout relative to the broader real estate sector had been declining since mid-2020, but in recent months, things appeared to have stabilized with the downtrend coalescing into a bottom-formation of sorts. This could provide SRVR with a nice foundation to try and make up for lost ground.

Nonetheless, coming back to SRVR's profile per se, it's worth noting that this product focuses on 23 companies that generate a majority (at least 50%) of their revenue or profits from owning or managing real estate which is used to store, compute, or transmit a huge volume of data (aka, data centers, communication towers). These real estate investment trusts, or REITs, help keep servers and data safe, provide uninterrupted power supplies, air-cooled chillers, and also facilitate deeper greater thresholds of communication.

As noted in a tweet on the timeline of The Lead-Lag Report, vacancy rates in a lot of commercial real estate avenues, particularly the office and industrial sectors, are quite high, and this has impacted sentiment towards this sector.

However, that is not quite the case with data center REITs. Data from CBRE show that vacancy rates at the end of FY22 stood at record lows of 3.2%, and this is just a function of the demand-supply mismatch.

Fundamentally, people need to recognize that the data age is unlikely to slow down any time soon. If anything, with the growing proliferation of 5G, IoT, AI, VR, blockchain, etc. the demand for data centers is only expected to grow. For instance, the number of globally connected IoT devices is poised to more than double to levels of over 27 billion by 2025, from the levels seen in 2021.

Meanwhile, supply chain disruption and higher prices of materials still continue to dampen construction momentum and the overall supply side. It is believed that lead times for something like substations, which are integral to data center functioning are now over 2x what they were during H1-22. With limited supply and solid demand, rental rates remain solid enough, growing at double-digit rates.

Risks

At the other side of the equation, one can't but help wonder when inflationary trends will get to a point where the Fed would feel comfortable with shedding its rate hike plans. As noted in The Lead-Lag Report, inflation has been coming down at a very slow pace, and even if the most recent March number came in at 5%, it is still a good 300bps away from the Fed's comfort range.

Crucially, core inflation, The Fed's preferred measure which excludes the capricious effects of food and energy, still continues to stay elevated, coming in at 5.6% vs 5.5% in the previous month.

Last week, I flagged how the Fed Funds futures were signally increasing odds of a May rate hike, and the recent inflation report is unlikely to do anything to dampen that narrative. I suspect investors may need to wait till the end of Q2 to see the inflation base effect leave a mark. With debt getting more expensive and lending conditions becoming more stringent, expansion plans for these REITs would be hampered with much of the growth potential heavily linked to asset sales, which is not ideal.

Investors should also note that of late, a number of major cloud companies such as Microsoft (MSFT), Amazon (AMZN), Google (GOOG), etc. have also begun initiatives to build their own data-center facilities, which would only make the market even more competitive going forward.

Finally, I also want to reiterate what I've been stating on The Lead-Lag Report Instagram page. Recent intermarket relationships have been suggesting that conditions for risk assets look wobbly, and we could see an accident soon enough. During risk-off conditions, highly levered plays such as commercial real estate may find few takers and this may dampen sentiment towards Pacer Benchmark Data & Infrastructure Real Estate SCTR ETF as well.

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