Despite Confidence From Industry Giants, Small Data Center Operators Worry About Losing Tenants

Small data center operators are worried that rising energy prices and rents could cause them to lose tenants, a concern that their large, publicly traded competitors don't have. 

Colocation giants Equinix and Digital Realty said on earnings calls last week that their business is all but recession-proof, expressing confidence that even as soaring power costs and other inflationary pressures drive up monthly bills for tenants, the market will absorb these higher costs with little impact on demand. But those at the helm of smaller colocation operators say their position may be more precarious.

Several colocation leaders — speaking last week at Bisnow's DICE Northeast conference at The Westin New York at Times Square — expressed apprehension about the willingness of their tenants to take on higher costs, and about their own viability if they won’t. 

“I think Austin Powers had it right: first I plan to soil myself, then I plan to regroup, then come up with a new plan,” said Phillip Koblence, co-founder and chief operating officer of NYI.

“The one nice thing is that it’s not just this industry that’s experiencing these dynamics, so you can go to customers and communicate to them that this inflationary pressure that you hear about in the news is real, and operating expenses are going up," Koblence added. "And generally, they want us to continue to achieve our margins so we can continue to offer services that meet their expectations.”

The comparatively confident projections coming from the data center REITs appear to be more than just public companies painting a rosy picture for shareholders. For starters, the massive global scale of operators like Digital Realty or QTS Realty Trust allows them to negotiate more favorable power purchaser agreements and implement energy hedging strategies across different markets, limiting the impact of spikes in energy prices. Smaller operators have far less ability to hold down prices being offered by utilities. 

Experts said the larger multinational data center providers are also better equipped to hang on to customers if rents and tenant costs jump significantly. Most leases signed by hyperscalers and other companies that have large deployments with providers like Equinix already pass the power costs directly through to tenants, meaning occupiers are already footing the bill with no change in the status quo.

By contrast, the smaller leases more common with independent data center operators commonly have tenants pay a power fee that operators would have to increase to account for rising power rates — a potential friction point. 

Colocation executives said past experience has shown that passing sudden cost increases through to tenants, even if contractually permitted, can come with consequences.

365 Data Centers CEO Bob DeSantis points to the industry’s last encounter with a sudden energy price surge in 2013. He said many operators who passed through those higher energy prices were punished by tenants, some of whom walked away when prices came back down soon after. He said operators are now treading a lot more carefully when it comes to passing through costs, for fear of alienating tenants. 

“When prices came down right away, we took a lot of client fallout for that," DeSantis said. “This year, everybody is looking at their contracts and asking not just can I pass it through, but should I pass it through?” 

Yet the scale of inflationary pressures hitting the industry and the economy at large mean that some operators won’t have a choice. Staying solvent will require passing costs to clients where contractually viable and negotiating new leases that limit the provider’s exposure to price volatility for power and other operating expenses. 

So how can data center operators maintain their margins while avoiding the fallout they faced in 2013? NYI’s Koblence said the answer begins with actively engaging tenants, helping them understand and anticipate future shifts in pricing and offering solutions to help them mitigate rising power rates.

“Communication is key,” Koblence said. “Setting expectations with customers is key and trying to move to where you incentivize the customers to introduce efficiency into their systems on the basis of understanding that these costs go up.”

Providing this kind of transparency into costs, particularly power, may need to go beyond simply communicating with tenants, and could involve reworking lease agreements and fundamentally changing the pricing model for some tenants.

With smaller colocation leases occupiers commonly pay a monthly fee for a set amount of power that they may or may not use; some operators said they are looking to move smaller tenants to so-called metered power agreements. Under this arrangement, common in multi-megawatt data center leases, tenants are billed only for the power they use. While they are exposed to greater short-term volatility, tenants avoid paying for expensive power they don’t use and have better visibility into their own energy usage to improve efficiency and drive down costs. 

“If you would normally offer up metered power on a deployment of 100 KW or higher, you might look at a smaller deployment and look at that option as well,” Hudson Interxchange President and CEO Tom Brown said. “You also have to introduce flexibility — enabling customers to design their own deployment, as opposed to telling them what they need to do in a particular facility.”

At the same time, experts said colocation operators need to be prepared to present tenants with a spectrum of options when negotiating leases. This may mean clearly communicating the tradeoffs behind a range of different pricing models to companies that may not be well-versed in the economics of data centers to structure a lease that protects both parties in an increasingly unpredictable pricing environment.

“It comes down to good communication and the parties understanding the others’ economic perspective,” said Jeffrey Moerdler, the head of Mintz's real estate and communications practices. “The tenant doesn’t want the data center operator to go out of business and to incur the substantial loss on a particular transaction. It isn’t good for anyone if the data center goes dark because it’s bankrupt or refuses to provide services.”