The sector is going through its first consolidation and providers are scrambling to get bigger. Christopher O’Dea reports
When it comes to projecting demand for data centre space, forget Moore’s Law. Pay attention to sales of brush grommets. The sleek black plastic fittings seal openings in the raised flooring of modern data centres, neatly channelling power and communication cables, while preventing chilled air from leaking out of the rooms where computer servers hold data and applications critical to every business today.
And data centre providers are going to be buying a lot of them. There is a boom in new construction and refurbishment as providers scramble to keep pace with demand for data storage and transmission capacity.
The sector has discovered that bigger is better. Just a few years after working through a supply glut and weak rental rates in the wake of a building spree by private equity-backed providers, the data centre industry is in the early stages of global consolidation.
Providers are offering more services, and at the same time bolstering their standing in key markets by snapping up smaller players that are unable to meet the high capital outlays required to compete.
Consolidation is driving up asset prices, but demand is so robust that new deliveries are absorbed quickly enough to enable providers to raise rental rates. While that would look like a red flag in most property markets, there is no end in sight for the key factors behind the sector’s growth – the importance of data and analytic applications to businesses, rising demand for streaming video content, and the need to keep businesses and consumers connected with their data and each other, wherever they are on earth.
As private equity firms sold stakes in data centres this year, data centre real estate investment trusts (REITs) emerged as leaders of the consolidation phase. They sometimes compete with tech giants like Amazon and Google that offer commodity-priced cloud services, as well as with computer services companies like Japan’s NTT.
Customer demand for seamless service has reduced some forms of competition between data service providers. Cloud storage providers, for example, sometimes lease server space from data centres, rather than build their own facilities. And because corporate users tend to maintain critical applications at in-house data centres, traffic between those applications and data stored in cloud sites increases. Data centres that specialise in connecting to the internet also benefit as users move data and other content across networks to run applications and communicate with each other.
If that sounds complex, it is. It is also expensive, which is why specialised firms have supplanted private equity funds in this sector. Institutions that take the time to learn the technical language can access investments expected to deliver mid-teen returns for the next three years.
At a time when other major property classes in primary markets are posting cap rates of about 4% (often based on economic assumptions less robust than the demand for data) implied cap rates on data centre REITs also provide an opportunity for appreciation. Strategic options range from a core-style, blue-chip approach to a value-add approach that refurbishes some of the largest industrial properties to create the massive, multi-service data environments in demand today.
“Data use has only increased since the invention of servers and the internet,” says Jonathan Petersen, an equity analyst at Jeffries, who covers several data REITs. “The world of spending on commodity data centres is antiquated,” he adds. “We’ve moved to a world where connectivity is more important.”
As a result, “a lot of positive demand for data centres is tied to growth in the use of the internet,” Petersen says. In a recent outlook on the sector, Petersen notes that the number of hours of video uploaded to YouTube every minute increased from six hours in June 2007 to over 300 hours as of December 2015, an annual growth rate of 68%, before accounting for the increase in video quality and file size during that period. Similarly, the number of hours video Netflix streams each month has increased at a 54% annualised rate in the past two in a half years.
All that video is stored on a server in a data centre somewhere, and the most-frequently accessed videos and live streaming video needs to be stored at or near major internet gateway data centres. There is no let up in sight: Cisco’s Global Cloud index projects that total data centre traffic will grow at a compound annual rate of 23% to the end of 2018.
The industry is scrambling to stay ahead of demand for storage and interconnectivity. In 2014, the top seven data centre markets absorbed 175MW of new data centre space, which represents growth of 18%, according to CBRE.
While strong, deliveries in 2014 still were not enough to keep the vacancy rate in the US from declining 160bps during the year to 9%. The pipeline remains full, CBRE says, with about 100MW of new data centre capacity completed in the first half of 2015, and another 184MW under construction at mid-year, up from only 77MW at that same time in 2014.
The surge in demand reflects the increase in the amount of data and how companies and consumers use it, says Kelly Morgan, research director for Multi-Tenant Datacentres – North America at technology consultancy 451 Research. Customer needs in turn dictate the size and location of data centres for storage and connectivity, she says. Companies still keep most applications in-house, using a combination of cloud storage and co-location or managed-service providers to handle processing and transmission of data. The result is fewer, larger facilities, concentrated around strategic connection points that enable content providers and companies to connect efficiently with telecom services.
New property is being developed at breakneck speed in light of the high cost of building data centres that meet the latest standards – duplicate incoming power supplies, redundant backup generators to provide power in the event both supplies fail, duplicate chilling, security and other building systems. “Our clients are generally quite paranoid people – and I mean that in a nice way,” says Andrew Jay, EMEA head of data centre solutions at CBRE.
A data centre costs approximately five times as much to build as an office building, says Jay. “Eighty per cent of the cost is in the secure, watertight building shell,” he adds. “This is the most expensive property in the world.”
“Eighty per cent of the cost is in the secure, watertight building shell. This is the most expensive property in the world”
As such, JLL says “access to funding is a critical factor in building new supply due to the capital intensity” of running data centres. Capital is most readily available to proven providers with verifiable cash flows and properties in multiple markets, JLL says, helping drive consolidation, with large providers looking globally for supply-demand mismatches that offer higher returns in markets including Indonesia, Stockholm, Vienna, Madrid and Milan.
This is making it too costly for financial players such as private equity funds to compete with industrialised providers. As requirements continually increase “it costs more money to refurbish to maintain the income flow”, Jay says.
Despite the need for capital, the market is now consolidating and larger players “don’t want to be left out.” This has pushed prices higher over the past two years, with EBITDA multiples for quality assets rising from about 12x to between 15.5x and 18x, Jay says.
Consolidation is prompting leading data centre providers to secure capital sources and acquire assets to form global networks. The scramble is taking place as data centre providers migrate to a new business model, building ever-larger facilities that offer a wider range of services, virtually ironclad guarantees of reliability, and hotel-style amenities for IT personnel who spend all or most of their time tending to corporate data.
Strategies differ: while listed REITs dominate the data centre industry, some providers have opted to obtain capital and global reach through corporate tie-ups. In 2014 RagingWire, a Reno Nevada-based data centre provider, sold an 80% stake to Japanese telecom giant NTT Communications for $350m. The resources are helping RagingWire “replicate its new large-scale facilities”, says Morgan.
RagingWire, whose customers include Twitter, purchased 42 acres of land in Garland, a town north-east of Dallas, where it is building one of its signature properties, a massive campus featuring sleek interior design, a gym, a games room and a climbing wall. When completed, the campus will consist of about 1m sqft across five buildings, each housing 16MW of capacity. The service offering will range from retail co-location to 4MW vaults for corporate clients – the company says it will sell capacity in 1MW increments, which will include 1,000sqft of office space.
Dallas-Fort Worth is one of the largest and fastest-growing data markets in the US. The new campus will benefit from cheap power, an incentive Garland could offer from its own power generation plant, and proximity to a big concentration of fibre-optic network infrastructure in the Dallas data centre cluster in nearby Richardson, Texas. To back up service agreements that promise 100% availability, the company says the new facility will have two to four separate connections to the fibre-optic network.
The tie-up with NTT links RagingWire to the Japanese company’s global network. NTT has been an active buyer in Europe, acquiring significant stakes in Gyron in the UK in 2014, and e-shelter in Germany this year, says 451 Research. Along with its Netmagic unit in India, NTT’s network comprises 140 data centres.
Among REITs, Petersen gives high marks to CyrusOne and QTS Realty Trust. CyrusOne has a large presence in the Texas market, and is expanding into the interconnection business. QTS employs a value-add strategy of buying large, unused industrial properties such as printing plants and retail warehouses, and refurbishing them as modern data centres offering a complete range of services.
Petersen says data centre REITs as a sector should average 13% average annual growth in funds available for distribution over the next three years. And with mainstream property classes in primary markets now posting cap rates in the 4% to 5% range, or lower for trophy assets, the implied cap rates on data centre REITs suggest there is room for capital gains (see table above).
While the technology jargon of data centres can be a barrier to investing in the sector, it is certain to grow in institutional asset allocations. “No one can say people are using less IT,” says Jay. And despite the technical patina, says Petersen, “at the core, it’s property. But with an entirely new vocabulary.”