VPN - VPN Fundamentally Safe But Could Be Exposed To Market Gravity

2023-03-31 05:00:43 ET

Summary

• VPN is a lot of specialty REITs and other assets that pertain to connectivity infrastructure that is essential to modern life.
• But multiples are also extraordinarily high, and as rates rise, gravity of the markets has an outsized impact on stocks like these.
• Moreover, VPN remains correlated to even non-specialised real estate, and we see potential risks on the horizon for commercial real estate.

The Global X Data Center REITs & Digital Infrastructure ETF ( VPN ) contains mostly REITs related to key connectivity infrastructure. Duration risks have been low, but now the issues are around real estate and capital market conditions. VPN is not insulated from real estate downgrades, and is exposed if commercial real estate takes more hits as loans pressure real estate owners. VPN is safe fundamentally, but it isn't uncorrelated to the market dangers and should be given a second thought, especially when components are so expensive.

VPN Review

We've covered VPN before , but the situation has changed substantially. VPN is composed in its plurality of specialty REITs focused on data and connectivity. Equinix ( EQIX ) is a really interesting REIT that acts as internet exchanges, valuable locations at which networks can peer with each other at low incremental cost. This is a 12% allocation . Then there are other REIT exposures that concern telco infrastructure. These exposures in general allow for rent hiking and minimal duration risks, as well as minimal solvency risks on the REITs. There isn't any demand risk either, as they support essential infrastructure for modern life.

Macro Considerations

The trouble is that VPN has still underperformed despite a strong profile in terms of fundamental resilience. There are good reasons. Rate hikes mean more gravity on high multiple stocks. VPN is relatively high multiple. Equinix, American Tower ( AMT ), Crown Castle ( CCI ), SBA Communications ( SBAC ) and others are all very high multiples - easily above 60x PE on average.

The reason high multiple stocks are more affected by the gravity of interest rates is because the high multiples usually originate from very long horizons on forecast cash flows in whatever the market implied model is for those stocks. REITs are generally considered very safe, and investors look to them for reliable and easily forecast cash flows, so this is consistent. Long cash flow horizons are going to be more sensitive to revisions in discount rates driven by higher risk-free rates.

The good news is that further rate hikes aren't as likely as they used to be due to the issues in the banking sector . The bad news is that more issues in the banking industry are likely to have an outsized hit on the real estate sector, specifically because the next line of vulnerabilities is in commercial real estate loans. If loans on things like office properties go bad, then on top of conditions that are already likely to see tightening credit in the West, real estate should see another major drop as financing conditions will be perceived to have deteriorated. Even specialty real estate assets will not be insulated from these pressures.

Bottom Line

The specialty skew has always meant that VPN has low yields. With the real estate markets likely to remain choppy in the markets in which VPN is invested in, it is probably best avoided considering the lack of total return. The 0.5% expense ratio is also a little too high considering specialty REIT alternatives can come a lot cheaper, or just buying one specialty REIT exposure within VPN which would already be diversified, since REITs are also portfolios.

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