Jim Chanos: A Short Thesis on Data Centers - [Business Breakdowns, EP. 103]

Summary

In this episode of Business Breakdowns, Wall Street legend Jim Chanos discusses his short thesis on U.S data center REITs, arguing that legacy data centers have flawed business models with declining returns on capital. Chanos, known for his skepticism, shares insights on the digital infrastructure market, the impact of hyperscalers, and the broader implications for commercial real estate. He emphasizes the importance of critical analysis in investment decisions, especially when contending with market narratives that may not align with underlying business fundamentals.

Takeaways

• 😀 The podcast episode is sponsored by Tegus, a company that has evolved from an expert network to a full company intelligence platform, impressing the speaker's firm, Positive Sum, to the extent of making an investment.
• 📈 Tegus streamlines the investment research process, offering qualitative insights and access to public financial data, positioning itself as a gold standard platform for investing research for decades to come.
• 💼 Business Breakdowns is a podcast series that deeply explores individual businesses, their history, business models, competitive advantages, and operational secrets, aiming to provide lessons for investors and operators.
• 🏢 The episode features an interview with Jim Chanos, a Wall Street legend known for his skeptical approach to market analysis, particularly focusing on his short thesis on U.S. data center REITs and commercial real estate.
• 🔍 Jim Chanos outlines three main ways enterprises maintain their data: on-site with their own IT department, in co-location data centers, or with cloud providers like Amazon AWS, Microsoft Azure, and Google Cloud.
• 📉 Chanos criticizes legacy data centers, considering them flawed business models with poor unit economics, especially when compared to the growth and efficiency of hyperscalers.
• 💬 The discussion highlights the challenges faced by data center REITs, such as high valuations despite declining returns on capital and the impact of private equity deals on the market.
• 🏦 The conversation touches on the financial challenges of REITs, including the high cash burn and the need for continuous financing or asset sales to maintain operations.
• 📊 The episode points out the discrepancy in valuations between data center REITs and other digital infrastructure assets, suggesting that the former may be overvalued.
• 🏗️ Chanos expresses concern about the future of commercial real estate, particularly office spaces, due to changes in work patterns post-pandemic and the potential for increased regulations affecting property values.
• 📉 The script concludes with a discussion on the broader implications of the current macro environment on tech spending and its intersection with Chanos' short thesis on data centers and commercial real estate.

Q & A

What is the primary focus of Jim Chanos' short thesis discussed in the podcast?

Jim Chanos' primary focus in the podcast is his short thesis on U.S data center REITs, particularly the Legacy data centers, which he believes have flawed business models and are experiencing declining returns on capital.

What are the three main ways enterprises maintain their data according to the podcast?

The three main ways enterprises maintain their data are: 1) doing it themselves on-site with their own IT department, 2) using co-location data centers where a third party maintains the servers and provides network connections, and 3) using cloud providers or hyperscalers like Amazon AWS, Microsoft Azure, and Google Cloud, where the enterprise keeps its data on the providers' servers.

Why does Jim Chanos consider Legacy data centers to be a poor business?

Jim Chanos considers Legacy data centers to be a poor business because they have low or negative returns on capital, are capital intensive, and are losing market share to cloud providers or hyperscalers. Additionally, they are often overvalued in the stock market.

What does the acronym 'ROIC' stand for, and why is it significant in the context of the podcast?

ROIC stands for Return on Invested Capital. It is significant in the context of the podcast because it is used to evaluate whether businesses, such as Legacy data centers, are generating economic returns above the cost of capital, which is a key factor in Chanos' short thesis.

What is the role of private equity in the data center market, as discussed in the podcast?

Private equity has been involved in buying data centers at high valuations, sometimes at 25 to 30 times EBITDA. However, the podcast suggests that some of these purchases may become regretful as the capital-intensive nature of the business and the need to service debt and capex requirements could outweigh the cash flow generated.

What is the significance of the 'implied cap rate' mentioned in the podcast for data center REITs?

The implied cap rate is significant as it reflects the current market valuation of the REITs. A higher cap rate indicates a lower valuation and potential overpricing of the REITs' assets. The podcast mentions that data center REITs are trading at cap rates that may not be sustainable given the underlying business dynamics.

How does Jim Chanos view the role of hyperscalers in the data center market?

Jim Chanos views hyperscalers as both competitors and tenants of Legacy data centers. While they take up significant space in data centers, they also represent a threat as they can build out new centers more cost-effectively and are taking market share away from Legacy providers.

What is the potential impact of rising interest rates on the data center REITs, according to the podcast?

Rising interest rates could increase funding costs for data center REITs, making it more expensive to finance their operations and growth. This could put additional pressure on their valuations and cash flows, especially if they are already experiencing low or negative returns on capital.

What does the podcast suggest about the future of data center demand and supply dynamics?

The podcast suggests that there could be a potential tightening of supply in the data center market if new builds become less speculative and more谨慎 due to higher financing costs. However, it also raises the question of whether total data center usage growth will continue to support current valuations.

What advice does Jim Chanos give to CEOs who find themselves the focus of a short thesis?

Jim Chanos suggests that CEOs should address short theses thoughtfully and factually, rebutting points directly without resorting to emotional responses or non-denial denials. He highlights the importance of transparency and clear communication to avoid further scrutiny.

Outlines

00:00

🌟 Tegus Platform Endorsement and Business Breakdowns Introduction

The speaker begins by praising Tegus, a company intelligence platform that has evolved from an expert network, and discloses an investment made by Positive Sum, their firm, due to its potential as a gold standard for investment research. The script transitions into an introduction of 'Business Breakdowns,' a series that deeply explores businesses, their history, models, and competitive advantages. The series is hosted on Colossus, and opinions expressed are those of the hosts and guests, not investment advice. The episode features Jim Chanos, known for his skepticism in the financial world, discussing his short thesis on U.S. data center REITs, his views on commercial real estate, and management responses to short sellers.

05:00

🏢 Data Center Business Models and Market Dynamics

The paragraph delves into the different ways enterprises maintain their data, including on-site with an IT department, in co-location legacy data centers, or with cloud providers like Amazon AWS, Microsoft Azure, and Google Cloud. The speaker critiques the legacy data center business model, considering it flawed with poor returns on capital, especially when compared to the market valuations of these REITs. The conversation highlights the shift in market share towards hyperscalers and the challenges faced by legacy data centers, including high capital requirements for minimal revenue growth.

10:03

📉 Short Selling Process and Data Center Market Analysis

The speaker discusses the short selling process, focusing on identifying flawed business models and questionable accounting practices. They apply this to data centers, noting the decline in returns on capital since 2016 and the narrative-driven performance of data center stocks rather than performance-based. The speaker also addresses the role of private equity in the data center market, suggesting that high-priced acquisitions may lead to regrettable deals in a rising interest rate environment.

15:05

💹 Capital Expenditure and Economic Returns in Data Centers

This section critiques the accounting practices of data center companies, particularly the classification of maintenance capital expenditure as growth capex, which the speaker deems an 'accounting joke.' The discussion centers on the returns on investment, which are shown to be unimpressive or even negative when considering the actual capital expenditure required for maintenance and growth. The speaker also touches on the challenges of selling data centers in a market with shifting dynamics.

20:06

🛠️ Maintenance Capex and the Financial Strain on REITs

The speaker challenges the notion of maintenance capex in the data center industry, arguing that it is often misrepresented as growth capex to inflate EBIT. They discuss the financial strain on REITs like Digital Realty, which has a high cash burn rate and is under pressure to finance or sell assets to maintain operations. The speaker also addresses the risk of leverage and the potential for credit downgrades, which could increase funding costs.

25:07

📈 Financing Costs and the Impact of Rising Interest Rates

The paragraph examines the impact of rising interest rates on data center companies, which have locked in low rates but face increasing costs on new debt. The speaker questions the financial viability of new builds and the sustainability of current financing models, especially considering the negative cash flow and the need for asset sales to fund operations.

30:09

🌐 Tech Spending Slowdown and its Effects on Data Centers

The speaker considers the effects of a slowdown in tech spending and its potential impact on data center demand. They acknowledge that while hyperscalers are slowing their growth, the overall market for data centers may still be strong. However, they also raise concerns about the potential for a general downshift in data demand that could affect occupancies and rents.

35:10

🏦 Commercial Real Estate Concerns and Bank Exposure

The speaker shifts focus to broader commercial real estate concerns, particularly regarding banks filled with CRE loans, especially in the office sector. They discuss the challenges faced by office REITs due to a decline in demand and the potential for credit problems in the banking system. The speaker also highlights the risks of investing in commercial real estate with low cap rates and the need for careful analysis of cash flows and external factors like local laws.

40:11

📉 Reflections on Short Selling and Advice for CEOs and Fund Managers

In the final paragraph, the speaker reflects on the practice of short selling, offering advice for CEOs who find themselves the target of a short thesis. They advocate for a thoughtful, point-by-point rebuttal rather than emotional denial. The speaker also provides guidance for aspiring fund managers, emphasizing the importance of having a variant perception and being willing to back it up with facts. They conclude by discussing the role of short sellers in the market and the importance of basing opinions on facts.

Keywords

💡Tegus

Tegus is described as a company intelligence platform that has evolved from being a pure expert network. It is highlighted as an impressive platform that the speaker's firm, Positive Sum, has invested in, seeing it as a gold standard for investing research. This is relevant as it introduces the episode's sponsor and sets the stage for discussing investment research and platforms.

💡Business Breakdowns

Business Breakdowns is a series of conversations that dive deep into a single business, exploring its history, business model, competitive advantages, and what makes it tick. It is a podcast that aims to uncover lessons and secrets from various businesses for investors and operators. The mention of this series in the script introduces the format and purpose of the discussion that follows.

💡Data Center

A data center is a facility that houses a large number of servers used for remote storage, processing, and management of data. In the script, data centers are discussed in the context of their role in the digital infrastructure and their relevance to the average person, as they are integral to how we access and use digital services like social media and cloud computing.

💡Co-location Data Centers

Co-location data centers are a type of data center service where a company keeps its servers at a third-party location. The third party maintains the servers, air conditioning, and provides network connections. In the video, these are identified as 'Legacy data centers' and are the focus of the short thesis discussed by the guest.

💡Hyperscalers

Hyperscalers refer to companies that provide cloud computing services, such as Amazon Web Services (AWS), Microsoft Azure, and Google Cloud. They are called 'hyperscalers' due to their ability to scale their services rapidly and extensively. In the script, they are discussed as major players in the data storage industry, often acting as both competitors and tenants to legacy data centers.

💡Short Selling

Short selling is an investment strategy where an investor borrows a security and sells it on the market, with the expectation that the price will drop, allowing them to buy it back at a lower price and return it to the lender, profiting from the difference. The script delves into the process and rationale behind short selling, particularly in the context of data center REITs.

💡Returns on Capital (ROC)

Returns on Capital (ROC) is a measure of how effectively a company generates profits from its capital investments. In the script, the discussion around ROC is used to evaluate the financial performance of data center businesses, with a focus on whether these returns are above or below the cost of capital, indicating a flawed business model.

💡EBITDA

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a measure of a company's profitability that excludes certain expenses. In the video, EBITDA is mentioned as a metric that the guest believes is not the right measure for data center companies, implying that other factors should be considered for a more accurate assessment.

💡REITs

REITs, or Real Estate Investment Trusts, are companies that own, operate, or finance income-producing real estate. The script discusses data center REITs, which are publicly traded companies that focus on data center properties. The discussion centers around the high valuations and potential risks associated with these REITs.

💡CAPEX

CAPEX stands for Capital Expenditures, which are funds used by a company to acquire, maintain, or improve its fixed assets. In the script, CAPEX is a critical point of discussion when evaluating the unit economics of data centers, with the argument that high CAPEX relative to depreciation may indicate overstated EBIT and poor investment returns.

💡Private Equity

Private equity refers to investment funds that invest in private companies or buy out public companies, taking them private. In the script, private equity's role in the data center market is highlighted, particularly in terms of their high-priced acquisitions and the potential for regret as market conditions change.

💡Leverage

Leverage in finance refers to the use of borrowed money to increase the potential return of an investment. The script discusses the high leverage of data center companies, such as Digital Realty, and the associated risks, especially in an environment of rising interest rates and potential downgrades to junk status.

💡Implied Cap Rate

The implied cap rate is the capitalization rate implied by a company's current stock price, reflecting the expected return on investment. In the script, the implied cap rates for data center companies are discussed as being significantly lower than those in the private market, suggesting a potential disconnect between market valuations and actual investment returns.

💡Commercial Real Estate

Commercial real estate encompasses various types of properties, including office buildings, retail spaces, and multi-family units, used for business purposes. The script touches on broader concerns about the health of the commercial real estate market, particularly in relation to banks filled with CRE loans and the potential impact of changes in tech spending and VC investments.

💡Asset-Backed Securities (ABS)

Asset-backed securities are financial securities backed by a loan, lease, or receivable that generates cash flow. In the script, ABS is not explicitly mentioned, but the discussion around banks and their bond portfolios is relevant, as many banks hold ABS as part of their investment portfolios.

Highlights

Tegus is evolving into a full company intelligence platform, impressing Positive Sum to the point of investment.

Tegus streamlines investment research, providing qualitative insights and financial data access.

Business Breakdowns explores the history, business models, and competitive advantages of various businesses.

Round Hill Investments discusses the digital infrastructure ETF, tracking the performance of global digital infrastructure businesses.

Jim Chanos, known as a Wall Street Legend, shares his short thesis on U.S data center REITs.

Data centers can be maintained through on-site IT departments, co-location data centers, or cloud providers.

Legacy data centers are considered a flawed business model with poor economic returns on capital.

Data center REITs are highly valued despite Chanos' view of them as a poor business.

The narrative of data center growth does not align with the actual unit economics, which have worsened over time.

Digital Realty requires significant new capital to generate minimal new revenues, indicating poor investment returns.

Hyperscalers like AWS, Azure, and Google Cloud are taking market share from legacy data centers.

Private equity's high-priced data center acquisitions may lead to regret in a rising rate environment.

Digital Realty's large capital expenditures contrast with their need for asset sales to cover cash burn.

The implied cap rates of data center REITs suggest significant downside risk to their stock valuations.

Chanos warns of broader commercial real estate concerns, especially regarding overbanked CRE assets.

Low cap rates in commercial real estate pose significant risks, especially when considering additional expenses.

Chanos advises that CEOs facing short theses should address them thoughtfully and factually rather than emotionally.

Fund managers must hold variant perceptions and be willing to back them to outperform the market.

Transcripts

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I have compound 248 back to host another

episode of business breakdowns my most

recent podcasts have focused on digital

infrastructure and today we continue

with that theme but with a Twist Our

Guest is Wall Street Legend Jim chanos

famed for bringing a skeptical eye to a

credulous world together we walk through

his short thesis on the U.S data center

REITs his bear case for commercial real

estate and some broader wisdom on how

management can thoughtfully respond to

short sellers let's get started

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Exchange under the ticker symbol

b-y-t-e the fun tracks the byte index

which measures the performance of 40

leading Global digital infrastructure

businesses such as mobile Towers fiber

and fixed line connectivity and

Communications infrastructure industries

that grow with society's insatiable

appetite for more data faster everywhere

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Jim thank you for most listeners your

reputation as the world's foremost short

seller will have preceded you so I'm

grateful for you joining us we'll

hopefully have a little bit of a

wide-ranging discussion on markets and

short selling but I'd love to begin with

a timely call you made public last

summer on shorting data centers and with

Ryan Rising rates and the Crunch and

Tech and Venture slowdown you're already

part way home on that thesis as it's

beginning to play out and so I'd love to

just sort of dive into what you saw what

you see now and help the average person

understand what your short selling

process looks like and maybe we could

just start with what is a Data Center

and why does it matter why is it

relevant to the average person

there's really three ways for an

Enterprise to maintain its data one you

do it yourself on site and you have your

own I.T department they keep the servers

running maintain the software and the

cyber security second and that which the

Legacy data centers that were short

epitomizes the co-location data centers

whereby you keep your server

at a third party location the third

party maintains the servers keeps the

air conditioning on does whatever

routine maintenance is needed to do and

provides the network connections and

those are the so-called Legacy data

centers that is the focus of our big

short and then the Third Way which is

the way that is garnering the most

market share now is the so-called Cloud

providers these would be what we call

and others call the hyperscalers Amazon

AWS Microsoft Azure Google Cloud

Etc Oracle has one and this is just

simply you keeping your data on their

servers and they maintain them try to

sell you add-on services on top of just

a hosting fee that's the three ways in

which data is kept for Enterprises

the problem with the co-location Legacy

data centers is it's just really a bad

business and that underlines a lot of

what we do on the short side we're

looking for flawed business models first

and foremost and if they have

questionable accounting and bad balance

sheets and management that doesn't tell

the truth all the better but at the end

of the day return on Capital junkies and

we look for businesses where the true

economic Returns on Capital are below

the cost of capital and that applies to

the Legacy data centers really in a

major way and it's getting worse on top

of that the data centers is represented

by the big REITs are some of the

priciest stocks we see in the entire

Marketplace so there's a real dichotomy

between what we think is a really really

poor business and just towering

valuations no pun intended and the

Legacy data center REITs so these are

sort of the hotels of the internet so to

speak the way stations where if I'm

using my Facebook app or accessing my

Salesforce instance it's being served to

me across fiber and maybe across some

Towers but from a server in the data

center somewhere yeah either your server

on-site or in a co-location or one of

the hyperscaler servers yep so I hear

you basically calling them Legacy data

centers I suspect and we'll get into

this they have a view that's slightly

different which will be I think helpful

for you to sketch out but as you know

these have been favored assets along

with other digital infrastructure like

towers and whatnot and have had fabulous

long-term performance that's been

underpinned by demand growth and decline

in cost of capital I'm hearing you

basically say you think those Tailwinds

are shifting maybe you could sort of

just sketch out a little bit of what

made it particularly timely over the

past year if you go back and look at the

Returns on this business and Returns on

incremental Capital the business Peak

pretty much around 2016. ever since then

incremental returns have been terrible

and in some cases negative on Capital

and so although the stocks continued to

perform for a few years after that

really was on the back of a narrative

than it was analysis in our view and we

love those kinds of shorts where the

business is quite a bit different than

the narrative and the narrative was

these are the beneficiaries of growth in

data and therefore you should if you're

a real estate investor the one way to

play growth in Tech and growth in data

is to buy the data center reads and the

problem with that is of course is that

on a same store basis the returns are in

many cases flat or in the case of

digital Realty DLR negative on a same

store basis for the last handful of

years

so really the unit economics have just

gotten worse and worse and worse as the

hyperscalers have taken more and more

share and that's the real problem here

is that at the end of the day if you're

incremental return on invested capital

is negative then it doesn't matter how

fast you go in fact if you grow you're

liquidating faster even worse yeah

you're liquidating and so just to give

you an idea we did some numbers last

year and they're still pretty valid

since 2016 we calculated that digital

Realty

the largest of these players digital

Realty required 11 in New Capital since

2016 to generate one dollar in new

revenues

at a 50 even down margin and we'll get

to that why ebitda is not the right

metric for these companies in a little

bit but give them that so it costs them

incrementally eleven dollars of new

capital to generate 50 cents of gross

cash flow so a 20 plus year payback on a

gross basis that doesn't even charge

them for maintenance capex and things

along those lines exactly and I presume

2016 is sort of an interesting starting

point I'm guessing from your perspective

if I'm thinking about this right that

probably correlates pretty well with

when the hyperscalers really started

ramping their own spend and maybe you

could talk about how these Partners May

in fact be competitors one of the

interesting little aspects of the story

is that the hyperscalers themselves

represent incredibly large tenancy for

the Legacy guys and that's going to

continue we think for a while because it

doesn't make sense even though the

hyperscales can build out a new center

cheaper than the Legacy guys it doesn't

make sense if it's in a Locale where

they don't need an entire new data

center on their own they can take 20

percent of the capacity of a data center

in Milwaukee or St Louis or something

like that so you do have this bad

Dynamic where your largest competitors

are also your largest tenants that's

never a position you want to be in as a

landlord but be that as it may that's

the position they find themselves in but

you're right the cat-backs really began

to pick up at AWS and Azure and Google

in this space in in 2016 2017 and you

see it the numbers and so on top of that

you saw lots of private Equity activity

which became another part of the bull

case that we think is changing and that

is private Equity discovered this and

began buying up data centers at really

really pricey levels peaking out at

digital Bridges purchased of switch

which just closed a month or two ago at

40 times ebitda and a number of deals

were done around 25 to 30 times ebitda

in 2020 and 2021 but part of our thesis

last summer was that there was going to

be indigestion in the private space that

a lot of these purchases were going to

be regretful and that private Equity

buyers in a rising rate environment were

increasingly going to realize this is a

capital intensive business and we

haven't gotten to that part yet

servicing the debt and the capex

requirements was more than the cash flow

maybe buying them at 25 to 30 times that

cash flow wasn't so smart so part of our

thesis was as 2022 turned into 2023 we

thought that private Equity would become

a seller of data centers and that's

exactly what is turning out to be the

case right now which is why I think we

have this latest bout of weakness here

in March increasingly data centers are

being put up for sale at cap rates in

high single digits that's just

disastrous for the valuations for the

big guys we'll maybe make a little bit

more sense of this when we do start to

put in place some of these pieces around

unit economics so just generically if

digital Realty wants to build a new tier

force of the top end their core type of

data center that they build in the US

and Northern Virginia is the data center

capital of the world and digital Realty

as a big footprint there what might it

cost them building and I guess there's a

campus element to this too which might

add confusion but if you just kind of

give us some generic numbers so that we

can use that as a starting point to

figure out unit economics first you have

to start with the issue of depreciation

because now for years and years and

years the data center guys have had

cap-x at 100 to 50 to 175 percent of

their depreciation amortization we don't

think that the union economics worked at

all here in terms of the capital per

square foot and I'm not going to bore

you with all the dollars per square foot

cost the thing you have to focus and

your listeners have to focus on is the

Returns on investment

and that's where on an ebit basis the

numbers are just laughably low they're

two percent at DLR and they're five six

percent at eqix and even if you add back

the depreciation the numbers are still

single digits for DLR and low double

digits for eqix

but if capex is 150 to 175 percent of

your depreciation then your ebit is

overstated in our view if you're not

growing on a real basis and we don't

think they're growing on a real basis in

fact DLR is shrinking on a real basis it

gets back one of the real cruxes of our

story which is that depreciation

is not only a real expense it may be

understated

for these companies and most of them

sort of guide to a pretty low quote

maintenance capex number is that right

yeah so here's how that works the

maintenance capex number the company

saves roughly 10 of their total capex so

they're on a 15-year life on average if

you look at just total depreciation to

Capital employed so that means that

they're telling you with a straight face

that the maintenance capex for the air

conditioning the HVAC the forklifts the

racks and everything is 150 years and

150 years is of course absurd it was

finally explained to us by an Insider a

year or so ago what was going on here

and what was going on was simply the

fact that if you tell your Auditors and

your internal audit people say the air

conditioning goes to the data center and

you got to replace the air conditioning

you have no choice you have to replace

the air conditioning if you replace the

air conditioning and you can say that

you will bring in one lieutenant or you

will be able to raise rents on any kind

of meaningful number of existing tenants

you can call the entire ticket growth

cap exit so even though the HVAC has to

be replaced no matter what it's now

considered growth capex because it will

add to the economics of the Data Center

and that's of course absurd that's just

an accounting joke I presume the fact

these are campuses where they build them

in phases probably also allows them to

muddy the water between what's being

maintained and what's being expanded I

think that's right again if you just

look at the Returns on incremental

investment you'll see that there in some

cases negative but certainly way below

the cost of capital and then of course

you have the problem of digital Realty

which is now trying to sell data centers

and telling you with a straight face

that's

2.5 billion 2.7 billion of capex is all

growth well wait a minute if you scrap

for cash or you're trying to sell assets

why don't you just cut back on your

growth cap X and we haven't gotten a

good answer to that maybe that feeds

into this they obviously have

commitments to develop they've signed

agreements with potential customers

where they have to deliver a megawattage

in certain areas near Dulles Airport

Northern Virginia Etc I hear you saying

they're actually at a state where they

have to strip the Legacy data centers

most Legacy assets and try to sell those

how else do these guys fund builds

because they are REITs so they're a

little Capital constrained around

reinvestment

exactly and the problem that digital

Realty has is the cash burn inclusive of

distributions and before assets sales or

Acquisitions we have them burning 2.7

billion dollars last year so that's

about 220 230 million a month 230

million a month is quite a cash burn and

that's got to be financed or asset sales

need to be done just to keep the lights

on that's before Acquisitions that's on

a 30 billion dollar market cap price

yeah that's a lot it's a lot exactly I

think that particularly an environment

where capital is going to be more

expensive the need to raise that amount

of money every month is going to become

an increasing issue here and on top of

that when you've got private Equity now

turning better to the sell side than the

buy side a natural buyer of these assets

has turned into a seller competing with

you and then of course you've got some

of the more troubled smaller cap players

who are looking to sell assets as well

like six Terra or even digital Realty

Singapore listed Reit which is trying to

sell assets so a lot of the positive

flywheel stuff that was occurring

through 2022 has now reversed let's face

it these stocks are still trading

they're trading at 100 times earnings

and unlike towers and unlike warehouses

where you could argue that you can use

an noi or an ebitda basis I think that

for the Legacy data center Guys these

are technology Opera operating

businesses they're service companies

yeah and they should be valued really

like a tech company and they don't hold

water at a tech company valuations not

at 100 times and I guess maybe just

building on that point a little bit a

DLR my impression is is also attempting

to delever at the high end of a leverage

range which at the same time they're

attempting to quote expand with new

growth cap Acts sell assets

and we have this interesting interest

rate environment so I wonder just how

you think about the intersection of

Interest costs Rising

and the need to raise capital and how

that ties out to the unit economics

so again DLR is the weakest of the big

players here and you're right so net

debt and preferred is a little over 19

billion dollars on 2.2 billion of ebitda

you're almost at nine times

leverage that's almost real money that's

almost real money and we don't think

it's investment grade by the way the

rating agencies still have these guys

just barely at investment grade I don't

think it is not with the negative free

cash flow and where the Leverage is

going

they run the real risk of being

downgraded to junk sooner rather than

later which will of course increase the

funding costs dramatically but here's

the thing they were successful in

selling green bonds and basically

selling a lot of fixed rate debt over

the past handful of years to their

credit their interest costs on net debt

last year was I believe 1.6 or 1.7

percent now that's the good news the bad

news is it's only going up from those

levels as it gets repeated that's

largely unsecured so they have a

reasonable amount of flexibility as it

relates to selling assets and whatnot

yeah yeah they do but again your

interest costs are only going up and

they're not going down

and by the way equinix their interest

costs on net debt was below three

percent last year so these guys are

really have had it in a very good way

and again Democratic they locked up a

lot of those rates but again with

negative cash flow and asset sales

whoever the cost of debt capital is only

going up for them do you have a sense

for if they do a new build today what

the stabilized yield really is if they

start a new project and then I'm trying

to tie that back to this financing costs

I presume the yields have

not risen as much as their financing

costs have risen I could be wrong about

that their financing costs on the margin

have clearly risen more it all depends

on how you define this capex this is the

fulcrum part of the bear case is these

guys will tell you their cash on cash

marginal return is High Teens low 20s on

a stabilized Center and I can't even get

to a fraction of that it gets back to

this how are you defining the money you

plow right back into the business that

never seems to generate any free cash

flow and with dlr's case with no real

Revenue growth after inflation and so I

think that it's semantics if you're

ignoring 90 of your capex in calculating

your returns I think you're not only

fooling the market you're fooling

yourself

in case the average listener is curious

someone like DLR will state that they

basically sell space and Power

and you would think well with power

costs going up that might be clearly

negative in general power is a pass

through it's a pass-through for DLR it

is not a pass-through for equinix big

Lawton hedge got it we've talked about

the rate environment and the overstated

economics of these but we haven't really

talked about is how the current macro

Tech environment does or does not

intersect with your thesis I would just

assume as a lay person on the outside

that with the slowdown in Tech spending

and the big cutbacks both at the

hyperscalers but also in the VC

Community I could see Crosswinds there

that on the one hand that slows demand

maybe on the other hand it slows these

hyperscalers investments into new data

centers themselves I just wonder if you

have any thoughts on that mildew well

growth of the hyperscalers is

downshifting dramatically you know that

it's gone from basically 4 30 and 40

percent to ten and twenty percent

there's no doubt that the hyperscalers

are seeing a Slowdown now they were

taking share from the Legacy guys Legacy

guys weren't growing that fast so the

question will be going forward the

Legacy guys start the claw back here

because the total growth of the market

is still strong or is this a general

downshift in data demand that's just

going to keep downward pressure on

occupancies and rents that remains to be

seen we'll see we were talking about

what I presume are fairly thoughtful

Financial buyers whether it's Blackstone

or digital Bridge or Brookfield what are

they claiming to see that you just

strongly disagree with would you say

it's the same maintenance capex or do

you think there's something different

going on there I've had enough run-ins

with private Equity through my 40 years

that sometimes they see things and

sometimes they don't and often at the

end of long Cycles they end up doing

because they have money to put to work

they end up doing things they regret

later and I seriously agree that that's

what's happened here that in fact this

business once they got into it they got

into it on the later side is not what it

appears to be and as you know probably

most of these deals were financed in

their mortgage rates or in pools that

were not their buyout pools they're

basically earning a management fee off

the committed capital and I would bet at

this point they're not expecting to see

much in the way of performance fees now

my friends at digital Bridge are a whole

lot different I think they've just

totally drank the Kool-Aid as they got

out of traditional real estate and

embraced the Digital model and it's

everything they do so the highest prices

paid have been paid by digital bridge

for these assets if we're right that's

not good news for digital Bridge

shareholders because I think that the

equity AUM then has the risk of being

mismarked understood listeners will not

we have a podcast with digital bridge

and Mark anzi and they can go listen to

his perspective

I don't think they would deny that

they're paying premium multiples I think

they believe they have a strategic

growth plan to be able to bring

customers and also new geographies these

turn into development platforms I can

imagine some of your perspective on that

I would say that if you're paying 40

times existing ebitda you'd better hope

that that happens

if you were a financial buyer what would

you be looking for how would you think

about valuing these assets I wouldn't be

in this business I don't think there's

an economic return in it and I don't

want to be competing with Amazon Google

and Microsoft

General good rule of thumb what cap rate

is digital Realty implied at today

we just did the numbers this morning

apropos of what Wells Fargo pointed out

and Wells Fargo said they're seeing a

number of deals being priced in the

eight to ten percent cap rate in the

private Arena and we've been kind of

sounding that alarm as I mentioned

earlier as of last night's close or this

morning's open we have digital Realty at

a 5.4 implied cap and we had equinex at

A 5.6 implied cap added eight percent

implied cap the downside to the stocks

was considerable yeah I presumed that

would put them way down especially DLR

would be down 70 plus or something like

that DLR to be down 70 plus has to be a

9 or 10 cap but it still is a long way

down from where the stocks are digital

Realty's own subsidiary it's dcru Reit

in Singapore trades at a nine cap six

Terra trades at a nine cap GDs the

Chinese data center company that trades

on the New York Stock Exchange trades at

a nine cap so there's plenty of publicly

traded comps right now trading at nine

caps and then you've got the two big

guys sitting there in five caps and I

think sixterra on top of having its own

nine cap and economic troubles may also

be a substantial customer of DLR it

could be wrong in their dcru read

They're I think over 20 percent of that

and I think quite a bit less however in

the Consolidated but still a major

client let's imagine five years from now

you're looking from the perch of March

2028 somehow the financial system has

not collapsed between now and then

if you're wrong what do you think

happened that caused data center Equity

is to outperform what are the risks to

the short

I think risks to the short are a pick

back up in total data center usage on

the back of AI or what have you and firm

pricing and Returns on Capital that

begin to climb above cost of capital

people ask us where are you going to be

wrong where would you change your mind I

said show me roic's above the cost of

capital for a heavily leveraged business

and I'll change my mind but we are so

far below that level that I think from

here to there is going to be a pretty

bumpy road

I presume to some extent if these are

really call it seven or eight cap

businesses

in today's financing environment we're

just not going to see as much new build

certainly speculative new build and so

if I'm trying to think five years from

now I could see perhaps the supply

tightening a bit which might allow

pricing power but wait a minute I

thought it was all this growth capex

from these guys

you can't have it both ways I'm trying

hard to give the other side the other

would be I guess a return to QE in very

low interest rates which just bails them

out on the debt side if you like this

business buy Microsoft or Amazon they're

cheaper they're better businesses and

they're cheaper that's the ultimate

irony here is that the hyperscalers who

have a higher return higher growth uh

Returns on Capital multiples of the

Legacy guys trade it lower cash flow

multiples than the big reads that's a

fascinating framing that the handful of

best businesses in the World Trade cheap

to a bunch of buildings in Northern

Virginia in our hedge fund we're along

the NASDAQ the qqqs we're along those

guys in effect and short the data

centers well I think that's a wonderful

bow to put on the data center side I

believe you have a broader commercial

real estate worry and for those

listening in the future is March of 23

and we've just had a few bank failures I

think I've heard you talk a bit about

one of your concerns is that there are a

lot of banked chock full of

cre especially in the office side that

you might worry about and I wonder if

you could give us a minute or two on

your perspective there my firm's history

with commercial real estate goes way

back our first big score in the late 80s

was in the commercial real estate Arena

on the back of the SNL crisis and the

tax shelter Law changes in the late 80s

we were short a bunch of real estate

syndicators and snls and real estate

companies and the wreckage that occurred

there was kind of Epic in terms of what

it did to the banking system and snls

and interestingly enough the SNL started

out as a rate duration problem in these

late 70s early 80s and then morphed into

a credit problem and a fraud problem as

the 80s went on then what we just saw in

the last two weeks in the U.S was a

credit duration problem not an asset

problem in terms of quality it really

was banks that took on excess deposits

and gambled in the bond market that sunk

my trademark phrase is Silicon Valley

Bank drowned in deposits it did it did

that's a great way to put it first

Republic to a lesser extent with fixed

rate mortgages but we saw signs of

problems interestingly didn't get short

but saw signs of problems in the office

sector beginning in 2019 pre-pandemic

office rents and office occupancy peaked

in 2018. we kind of forget that there

was a building boom going on in most

cities and we weren't prior to the

pandemic yeah

and so it became apparent to us

I'm talking to you from Miami I have

Partners who are in Chicago New York

City and elsewhere it became apparent

that a lot of service businesses were

not going back to five days a week in

the office post pandemic and that

incremental demand for office space was

going to downshift so we got short the

office reads in 2020 and watched to our

horror as the stocks outperformed in

2021 as people saw them as safe

meanwhile as the vacancies increased

rent rolls dropped and then in 2022 and

2023 they've had their comeuppance the

office REITs are down dramatically and

we're not as short as we were back a

year ago

but what it also underscored for us as

it relates to Data Centers some

multi-family were short an odd Reit

outside of the U.S as well is the

Insidious nature of really low cap rates

for Real Estate Investors and again we

kind of touched on it in our discussion

on data centers but when you are paying

three caps and four caps and five caps

for commercial real estate everything

has to go right because that's a gross

cash flow number I would point out

there's two big problems with that the

first problem is is that it doesn't

include corporate overhead and for most

publicly traded REITs that's anywhere

from 50 to 150 basis points of capital A

year is it overhead and we suspect a lot

of companies are now putting more and

more building operating expenses in SG a

to make their nois look better if you

will that's number one number two

particularly as it relates to offices

but we think also to a lesser extent in

other areas spreading the cost to re-let

a property is capitalized so you can

capitalize your broker commissions you

can capitalize tenant improvements you

can capitalize free rent and write it

off over the estimated life of the lease

so we urge people to take a look at

capex which you would think in a

Contracting environment might be

declining in fact in many of these

companies it's not it's actually

increasing because all of the incentives

are being capitalized so you really have

to look now at noi adjusted by a few

different things and so if you were

paying a four or five cap for an office

the real economics might have been a one

or two cap that just doesn't work if

your duration of your leases is seven to

twelve years and so that's the re-rating

problem just on rates that commercial

real estate has before we get to credit

hey just the risk reward didn't look

good to us in 2020 and 2021 and then in

data centers in 2022 in some of these

areas because you're just not getting

compensated on a real true cash flow

basis for the risks you're taking and

then you get the externalities local law

97 in New York are you familiar with

that no I'm not a lot of people aren't

and so for example New York City passed

a law it's an ordinance now it's it's

law it's being challenged that all

buildings above a certain I think it's

25 000 square feet have to be completely

Green in terms of their energy sources

starting next year and even one

Vanderbilt the big SL green modern

building which has gas turbines in the

basement and has this elaborate

state-of-the-art cooling system in the

walls is not compliant so this goes back

in time it's not just for new buildings

it's retroactive including residential

and the reason for that is they're going

to charge fine if you're not compliant

and when I said to somebody well

nobody's going to be compliant my friend

the city government says exactly it's a

backdoor way to raise property taxes

sent to your point the cash flow even

the cash flow that we see at least in

New York City might be questionable you

are at the subject you can't move the

asset it's the advantage and

disadvantage of real estate location but

it's not portable you can't threaten to

move the business across the river or to

Florida and so for all those reasons

commercial real estate was really an

attractive asset on the way up it

becomes in bad markets poor credit

markets a really bad asset and everybody

forgets that from 88 89 the peak in New

York City real estate at that cycle New

York City real estate did not begin to

recover until 95 or 96 and everyone kind

of forgets that and so I think that you

have to be really careful if you're a

reed investor or a real estate investor

don't just take ffo or affo or n know

why at face value because there's so

many moving parts now that are below

that surface that will impact valuations

that you might not be aware of sounds

like you have to be really careful if

you're a bank investor too yeah the

regional banks have most of the exposure

again I think what happened in the last

couple weeks since we've been talking

has really been much more about Bond and

fixed mortgage portfolios than credit I

don't think we've seen the credit

problems yet well on that ominous note

it's a perfect way to wrap up discussion

on shorting before we do we'd love to

seek advice from the people who are

sharing wisdom with us and so I was

wondering if maybe I could get two

questions of advice the first

I've seen over time that when a short

thesis comes out on a company so many

CEOs lash out at the short seller Etc

it almost turns into its own sort of

flag for other short sellers to come

take a look if you were a non-fraud CEO

and you found yourself the focus of a

thoughtful short thesis what do you say

is the most effective way for them to

handle that one of the gold standards

was what Reid Hastings did a number of

years ago to a fair thesis where he just

rebutted it Point by Point thoughtfully

without recrimination saying well we

think he's wrong because of this and I

had that happen to me years and years

ago as a young analyst when I had put a

short recommendation on a well-known

company back when I was in the sell side

and the company actually invited very

rarely do companies invite short sellers

to come to see their operations and the

CEO invited me out to uh where they were

and spent the day with me and with the

CFO and thoughtfully rebutted what I

believed I think I was right on about

half of it and I think they ended up

being right on about half of it but that

is always a far better approach approach

than saying these are outrageous lies

and then you don't address them because

at the end of the day if you have this

sort of clinton-esque non-denial denial

and companies are very good about that

they'll say well this is a gross

exaggeration or this isn't and yet they

won't address the actual points of what

the short seller is alleging then you're

opening yourself up to further scrutiny

I think and having opinions about facts

is what makes markets we don't put out

big reports that's not our business

model I'm happy to post things from time

to time if we have observations but we

don't put out 40 page reports on short

candidates but I defend the right of any

short seller to do that as long as you

are basing your opinions on facts and

you're not knowingly misstating the

facts that standard applies to both

bulls and bears people get exercised

about short sellers doing this and I

keep keep saying again well you should

see the 48 buy recommendations I get in

my portfolio every morning in my inbox

no one says boo about that and yet if a

short seller puts something out they're

held to a much higher standard and

that's by the way how it's always been

any professional short seller knows that

as they say in The Godfather too this is

the business we've chosen you've known

this but on the other hand I don't think

short sellers should be held to any

higher or lower standard than anyone

else you cannot trade on or induce

others to trade on information you know

to be false and that's the bright line

as long as you are on the right side of

that line your opinion is based on the

facts is worth hearing then the market

should hear it and to your point if

you're wrong it sounds like the best way

for management to address it is through

a non-emotional fact-based rebuttal and

through execution yeah given the risks

on the short side and the asymmetry of

Returns on the short side the short

seller's wrong they're going to know it

I said I've had advice for two different

groups the second you've not just

survived the hedge fund industry you've

survived it in the hardest possible way

betting against what is Buffett called

the American tide of every boat getting

lifted and you're out there finding a

few that maybe aren't seaworthy so for

the aspiring fund manager what are the

couple things that you think they're

critical for them to get it right when

they're first beginning or inverted what

are the few mistakes you see managers

make that sort of undermine them in the

long run you have to have a variant

perception you're not going to

outperform the market it if you believe

the same things the market believes and

you might by the way do just fine but it

will be all beta and at the end of the

day this Market has been pretty vicious

in terms of competitiveness and not

paying for beta some exceptions to that

rule at the end of the day if you're

just performing in line with the broad

Market you're not adding any value to

anybody so what that means by definition

is you do have to have varying

perceptions and you have to be willing

to back those very imperceptions there's

a lot of asymmetries between the short

side and the long side but one of the

good asymmetries is that if I have a

fundamental thesis like data centers

it's really easy for me to find out what

the other side is I'll get attacked we

talked to the street we pay commissions

we have access to the sell side it's

quite easy to see highly paid highly

motivated people and what they're

thinking about stocks bullishly but it's

not so easy some sometimes to hear the

bear case on something or hear the

thoughtful bear case on something that

asymmetry is one of the few advantages

to the fundamental short side you will

have your hypothesis tested completely

should you want it to be as a short

seller because there will be no shortage

of people telling you why you're wrong

and if after that you still think that

your view of the facts is correct and

your opinion is based on those facts are

correct then you have a varying

perception that may be profitable and

that applies to the long side as well if

you're going to be successful you've got

to do better than the market over time

and the only way you're going to do that

is to have a Viewpoint that is different

from the Market's Viewpoint in a

meaningful way at major points and so

that General view on investing life I

think applies to whether you're a value

buyer or fundamental short seller well I

for one appreciate your willingness to

take your variant perceptions put the

skept critical perspective out there

publicly and share it and take the

arrows and in particular and I hope

others will hear this

I appreciate it the most when it's a

business I'm actually interested in

owning because it helps me refine my own

thinking and see my own soft spots I'm

grateful for what you're doing I'm

grateful for your time and thank you my

pleasure thank you

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