By Bill Alpert

For years, profits were flat or falling at the data center operator Digital Realty. That changed last year, as demand for artificial intelligence computing capacity soared, but data center space remained constrained.

On Tuesday, UBS analyst John Hodulik changed the Hold rating that he has had on Digital Realty since 2021, raising it to a Buy. Admittedly, he is late in appreciating the changed fortunes of the data center real estate investment trust. Digital Realty rose 32% last year, outpacing the 23% gain of the S&P 500's, and trouncing its data REIT rival Equinix, which rose just 17%,

Call Hodulik's change a capitulation, if you will. Digital Realty's $181 price had far exceeded his previous price target of $147. His new target is $205. That upside will be driven by rising rents at the REIT's existing centers, and fat yields on its new developments.

Other analysts warmed to Digital Realty much earlier. Bank of America's David Barden has rated it a Buy for several years, and on Dec. 18 he anointed the stock as his pick for 2025.

Power is the limiting factor in the supply of data center space, as evidenced by recent utility industry deals to feed hungry hyperscale AI centers planned by Amazon.com, Meta Platforms, and Microsoft. Digital Realty owns large amounts of the third-party data center capacity in markets like Northern Virginia and Chicago -- where there is little new power available.

As customers chase capacity, data center vacancies are down to 1.5% across North America, and as low as 0.4% in Northern Virginia. Digital Realty seems on track to report record lease signings for 2024, with half of its bookings related to AI.

UBS's Hodulik doesn't see much relief to the industry's power constraints before the end of the decade. That will let Digital Realty raise rents as much as 3% this year, and 5% next year. Where the REIT is building new capacity in North America, it expects investment yields of 14%.

Adding Digital Realty's other revenue sources to its rents, the analyst expects cash flows at the REIT to grow at an 8% annual rate for the rest of the decade, using the industry-favored measure of "adjusted-funds from operations." He sees AFFO rising from $6.46 a share in 2025, to $9.04 in 2029.

Hodulik acknowledges that Digital Realty now trades near the high end of its historic valuation range, with the stock going for 26 times his estimate for 2026 year AFFO.

As the last skeptics throw in the towel, however, he thinks that ratio can rise to 28 times -- lifting Digital Realty shares another 12%.

Write to Bill Alpert at william.alpert@barrons.com

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January 07, 2025 14:42 ET (19:42 GMT)

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