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How Attractive Is Data Center Development?

Today, the construction pipelines for publicly-traded REITs specializing in multi-tenant data centers are quite large, thanks in large part to cloud computing.

Cloud computing is spurring growth in the market for data centers, with cloud services providers like Amazon Web Services, Google, IBM, Microsoft Azure and Oracle driving the demand.

A new report from commercial real services company JLL found that among the 15 major data center markets it tracks in the U.S., nine were seeing at least 30 percent of user demand stemming from cloud computing. In the U.S., cloud-related demand was especially strong in Chicago, Austin-San Antonio, Texas, Northern Virginia and Northern California, according to the report.

Bo Bond, managing director at JLL and co-leader of its data center group, says space absorption by multi-tenant data centers was down a little during the first half of 2017, in the wake of record-level absorption in 2016.

Last year, U.S. data centers witnessed 350 megawatts of absorption, the JLL report notes. In the data center market, absorption is measured by power generation rather than square footage. U.S. markets absorbed 182.1 megawatts in the first half of this year, compared with 249.1 megawatts during the same period in 2016.

For data centers, 2016 was “an absolute frontier,” Bond says. “It turned the industry on its end. We’ve seen an unbelievable amount of supply have to come on-line to catch up with [demand].”

Compared with 2016, JLL researchers say, a drop-off in absorption this year shouldn’t be interpreted as a sign of weakness in cloud-oriented demand for data centers. Users are still clamoring for cloud-based services, while Amazon Web Services and Microsoft Azure are still sifting through the data center inventory they added last year.

“We still have a long way to go before we get to saturation,” says Alen Lin, senior director at Fitch Ratings, a credit-rating service. “You have the tailwinds pushing and propelling this industry forward.”

Today, the construction pipelines for publicly-traded REITs specializing in multi-tenant data centers are quite large, thanks in large part to cloud computing, says Bond.

Data centers form the backbone of the digital economy. These industrial-style buildings contain computer servers and other IT equipment that gather, process and store data for an array of users. Growth in the data center market comes against the backdrop of substantial M&A activity in the data center industry.

In early August, for instance, Peak 10 completed its $1.7 billion acquisition of ViaWest. The new company, called Peak 10 + ViaWest, now controls 40 data centers covering 2.7 million sq. ft. An even bigger deal is pending. Data center landlords Digital Realty and DuPont Faros Technology are merging in a $7.6 billion transaction. The combined company will run nearly 170 data centers, mostly in the U.S., encompassing approximately 28 million sq. ft.

In a June report, Cohen & Steers, an investment manager with hefty stakes in two data center REITs, noted that data center operators have been among the top REIT performers, with better-than-expected bumps in leasing volume in the first quarter of 2017. The report notes that demand for data center services is outstripping supply, with growth prospects remaining “solid.”

A separate June report from Cohen & Steers highlights the relative stability of the data center market. Leases for large wholesale tenants typically run seven to 10 years, while leases for smaller retail tenants last less than five years. Rent normally is tied to how much electricity a tenant uses, rather than how much space a tenant leases. “Historically, high customer retention rates have generally resulted in stable cash flows, and contracts usually contain yearly rent increases tied to inflation,” the report’s authors write.

But while the sector remains attractive, Bond cautions developers who aren’t familiar with this product type to think carefully before trying to capitalize on it. For one thing, location requirements are strict, as data centers must be built away from potential danger zones, such as floodplains, and must have ready access to fiber-optic and utility infrastructure. Additionally, top-dollar cooling systems must be installed to prevent IT equipment from overheating.

Developers can avoid these concerns by concentrating solely on the buildings’ shells, not the build-outs, although that conservative approach can reduce potential profits, says Stephen Boyd, managing director at Fitch Ratings.

“The barriers to entry are there, and they’re there because it’s a very expensive piece of real estate to build,” JLL’s Bond says. “It takes a large amount of experience and depth of knowledge to be able to get into this business.”

One of the barriers to entry is the less-than-robust availability of mortgages for data centers compared to office, retail and industrial projects, he adds.

If you do decide to get into the data center business, Boyd notes that you should be mindful of location. For instance, a lot of data centers tended at one point to be built in more remote places. Now, they’re more frequently being put in big metro areas.

Rapid growth in data consumption “almost guarantees” opportunities for commercial real estate professionals, Boyd says, but the “sweet spots” for development can vary in terms of location. Although the typical focus is on data centers in top-tier locations, Lin points out that second- and third-tier markets are also viable options for data center development.

No matter where a data center goes up, though, it does come with built-in investment risks, according to a recent Fitch report about Digital Realty Trust. Data centers are niche properties that are susceptible to their technology becoming outdated, the Fitch report notes.

Boyd says that once money has been poured into setting up a data center, a developer or owner must be aware that, by a long shot, a data center represents the “highest and best use” for that property.

“Compared with other real estate assets, data centers have a less liquid investment market with fewer potential buyers, making these assets potentially more difficult to divest or borrow against in a depressed market,” Fitch researchers write. “These market characteristics can reduce the ability of data centers to serve as a source of contingent liquidity.”

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