Will Overbuilding Force Data Center Operators Out Of The Cloud?

Data center investment has reached new highs as investors on the hunt for solid returns look beyond core real estate assets like office and multifamily for better yields. 

“Huge leases are being signed all across the country,” Newmark Knight Frank Executive Vice President & Global Lead of Data Center Valuation and Advisory Miles Loo said. "This has prompted a building boom in many markets as developers are buying land to keep pace with demand. As a result, all of this attention is attracting new lenders to the market."

As the industry gears up to enter 2018 with a bang, panelists at Bisnow’s DICE Northeast event Thursday made abundantly clear that data centers will attract continued demand for space and billions of dollars in investment as public and private operators outperform other real estate asset classes.

With third-quarter earnings season in full swing, a handful of publicly traded data center REITs released earnings that beat Wall Street expectations. Major public REITs in the space include CoreSite, CyrusOne, Digital Realty (which recently merged with competitor DuPont Fabros), Equinix, QTS and Switch — the latest member of the group, which launched the third-largest tech initial public offering this year.  

The strong performance of publicly traded data center REITs is further testament that the sector, still in its infancy, is gaining recognition in the market as its own asset class. Robust demand coupled with data center operators' strong performance has new lenders and financiers entering the space.

“The growth and underlying fundamentals of the data center sector in the public space are still vastly superior,” Deutsche Bank Managing Director Andrew Bartrop said. "If you look at best-performing asset classes, data centers and towers, investors continue to want more and crave more."

Investment Sales Skyrocket

Investors poured $18.2B into data center real estate in the first half of 2017, according to CBRE research, double the total amount invested in all of 2016. 

“We’ve seen increasing amounts of private capital and institutional capital in the form of pension and sovereign wealth funds trying to get access to the sector. Capital is flowing from the equity side,” Bartrop said. “On the debt side, given the flow of capital [coming] into the space, lenders have become a lot more familiar with the asset class."

In the last five years, $45B has been invested in data centers, and half of that has come since Q4 2015. Major merger and acquisition activity tipped sales over the edge this year, including Equinix’s purchase of 24 U.S. Verizon assets for $3.6B, Digital Realty’s acquisition of DuPont Fabros for $4.95B and Peak10’s acquisition of ViaWest for $1.7B. Industry experts foresee more consolidation on the horizon. 

“I think there is a lot of room still for this market to grow and more capital to come in,” Landmark Dividend Senior Vice President of Digital Infrastructure Christof Hammerli said. “I’m also hopeful the debt finance will get a little more attractive than it is. It’s out there, but not as attractive as it should be.”

A Coming Bubble? 

Leasing volume in the U.S. broke records in 2016, driven particularly by hyper-scale cloud users such as Microsoft, Google, Apple and Facebook. Users absorbed nearly 250 megawatts from January through June.

Things have slowed a bit this year, as absorption paces behind 2016’s highs. JLL reports users leased a total 182 MW in the first half of the year, down 10 MW from the previous year. 

“The biggest potential headwind is around leasing,” Bartrop said. “When you look at the small guys, at least in the public sector, they’re still spending half a billion or a billion a year of [capital] on projects predominantly in the U.S. That’s a ton of new stock coming online. So far, the market has been able to absorb it reasonably well, but I think any sort of blips in that would cause potential concern for investors.” 

The moderate cooling of leasing, coupled with this year’s jump in construction has some wary of overbuilding, Loo said. Roughly 506 MW is under construction in North America as of the first half, JLL reports, a sizable increase compared to the 353 MW of data center space in last year’s pipeline.

“There are headwinds, however,” Loo said. “Many are expressing concerns for the volume of new construction and wonder if the … leasing activity could lead to a cloud bubble.”

But IO Data Centers’ Anthony Wanger is confident the sector still has room to run.

“The demand story is still not fully appreciated. We are, as a society, as a global community, digitizing everything we do,” Wanger said. “Whether its travel information to get here, or people communicating on laptops or phones, or medicine or education, on and on and on. So I think what the markets are catching on that this demand story vastly exceeds what they expected five or 10 years ago — like by multiples. As an industry we got caught short of capacity.”

Fifteenfortyseven Critical Systems Realty CEO and Managing Partner J. Todd Raymond said demand in the space is sustainable, particularly because it is more a function of overall cloud growth and not necessarily delivery growth. As the world creates new content on a day-to-day basis that needs to be housed in the cloud, it drives absorption.

“I think every one of these [major data center] markets we’ve seen ebb and flow in terms of demand cycle,” Raymond said. “There’ll be a period of time where everyone starts getting nervous [about] too much inventory and not enough absorption. But those of us who have been around know it is a short-term problem and it cycles through.”