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Cloud Explosion Is Boosting These REITs

We expect good growth from all four data center firms we cover, with CoreSite being our favorite.

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Matthew Dolgin: The data center industry has been hot in recent years due to the explosion of cloud services. That growth has dramatically increased cloud providers' needs for data centers, and they often outsource to third-party providers. What's more, many cloud customers use hybrid cloud models, meaning they use a mixture of their own hardware and that of their cloud providers. In such a model, they often co-locate equipment on the same premises as their cloud providers and run physical connections between them. The result is data centers realize even more demand for space, and they monetize the connections.

We expect the favorable environment to continue in the near term and for all four data center companies we cover to put up good growth numbers, but we don't think they are equally well positioned for the long term.

Our favorite name in the space is CoreSite, which we currently find fairly valued. We think it has a unique core competency and sticks with it, rather than chasing commoditized industry growth. CoreSite has data centers only in eight U.S. cities, and it runs Internet exchanges in each of them, making its properties key components of the Internet's backbone. With hundreds of network service providers exchanging traffic, these buildings are very difficult to replicate and highly valuable to tenants that need proximity to Internet exchange points. We think this protects CoreSite even if industry trends slow.

We also like the businesses of Equinix and Digital Realty, which are the two biggest data center companies globally. Equinix was built on Internet connections and is arguably the most important Internet exchange provider in the world. It connects over 1,700 networks and its assets would be very difficult to replicate. Digital Realty has also moved more in the connection direction and has scale advantages. We think each name is attractive on a pullback.

We don't like CyrusOne's business as much because it is the only of the four that we think lacks sustainable competitive advantage. It is doing well now, but we don't see unique traits that ensure customers will continue flocking to it even if industry capacity outstrips demand.

Matthew Dolgin does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.