Data Centers

Data Centers: A Diamond in the Rough

By Dave Jacobs, Llenrock Group

Oh the irony of it all. Consumer spending is way down, and so the retail sector has been hit hard. Unemployment is at 9.5% and climbing by the day on its way to 10%, and so the office sector is hurting. People are traveling less, and have less discretionary income, so the hotel sector has been battered. Portfolios of industrial property that would have traded sub-7 CAPs 18 months ago are now trading at double digit CAP rates. Even multi-family, a sector success by way of comparison, has felt the impact of tenants looking to double up, rent growth beginning to flatten, and has yet to see, in some markets, a wave of supply from condo projects-gone-bust mess with occupancy rates.

Another BLACKSWAN niche that may prove resilient Data Centers. That’s right, the same sector that fueled the mini recession earlier this decade and is lovingly referred to as the dot-bomb era is currently partying like its 1999. How is that possible, you ask? Several factors are at play.

Demand is Different

Back at the turn of the millennium, data center demand was bursting at the seams from seemingly every start up company on Earth. Of course, the ability to grow was fueled mostly by venture capital, and every start up needed, or wanted, data center space. When these low revenue/ridiculously highly leveraged companies failed, data centers emptied out and were sold at bargain basement prices.

Now, instead of poorly capitalized start ups driving demand, heavy hitter companies are leading the charge. There are several reasons for this. First, since 9/11, major corporations are legally required to have backup sites for information to protect against the threat of a terror attack on their main infrastructure. These have to be off site, and since most major corporations are located in urban centers, that means these sites are often in suburban areas at least an hour away from headquarters. Secondly, we have seen the rise in bandwidth sucking websites like Facebook, You Tube and MySpace. These types of social networking sites demand a huge amount of electricity that only data center space can provide.

2. Supply is Constrained

When the data center stock was sold after the fallout, many of the suburban buildings were adaptively reused for other purposes. This constrained supply naturally. Furthermore, as construction costs soared a few years ago, nobody built much of anything on spec, let alone a data center whose bad taste was still in every developer’s mouth from 2001.

Furthermore, many of these powerful electricity-sucking facilities need to be strategically located close to a major power source like a substation, or a fiber conduit. Locating further away from these sources makes it more expensive to gain access to the necessary power, which isn’t conducive to keeping costs down for landlords or tenants. This is especially the case in urban environments, which makes adaptive reuse of old vacant office buildings or warehouses much more challenging if they aren’t in the ideal location.

3. Growth is Organic, not Economic

Unlike most other sectors whose growth is usually tied to economic factors like jobs, consumer spending and housing prices, data centers are not. Demand is outstripping supply by a healthy margin, and demand for this type of space is projected to grow substantially over the next 5 years. One only need to look at the newspaper industry to see why. Newspapers are failing across the country because more people are choosing to get their news either via the television or online.

The availability of broadband to all but the most rural of areas has changed our society in dramatic ways. We all know how its changed the way we live; now the growing importance of data centers is real time evidence of its impact to our infrastructure and the real estate investment community. The ever swelling waves of data need to be stored somewhere and data centers are where that will likely be. Corporations will move their file rooms to online servers. Warehouse and stock room inventories will be tracked and managed online. It is a natural progression of the way we will work, and live.

Don’t believe the hype? Digital Realty Trust, the biggest REIT of data center space, has an 11-million-square-foot operating portfolio that is 95% leased. Demand appears high and new average rents are three-times higher than expiring rents. Hence its strong fourth quarter earnings report a few weeks ago, which included a 43.4% jump in FFO to $68.9 million ($0.76 per share). For the year, FFO was $230.3 million ($2.62 per share), up 27.8% from 2007, and adjusted FFO was $2.48 per share, a 21.0% jump from 2007.

As Baird analyst Will Marks points out, “We believe that many corporations are likely to look for ways to cut costs in 2009 and one way to cut costs is to outsource data center operations.” “This trend should benefit DLR.”

While there are industries and niches that run cyclical with, and counter cyclical to the economy, the data center market, unlike all of the rest, seems to know no valley no matter what the economy is doing. Sounds like a sales pitch you say? Then just click on the following - Cloud Computing – and imagine the future.

Case In Point

In my former life as an investment sales broker, I had my hand in selling several data carrier hotels. While at Marcus & Millichap’s Philadelphia office, we listed for sale only a 42,000 square foot, former Hires rootbeer factory turned data carrier hotel, due to its proximity to the old Philadelphia B & O rail line, which you might recognize from a Monopoly board. In a grid based city like Philadelphia, access to fiber lines that run underneath rail lines is essential to harnessing power for a data carrier hotel. It was for this reason that this obscure, dated four-story building was bursting at the seams with tenants big and small, institutional and startup, who sometimes rented as little as 43 square feet of space to house fiber conduits and racks, but paid over $100 per square foot for the space.

In a market where even at the top of the cycle, product seldom traded for more than $175/per square foot, this building eventually sold for $15.3 million dollars, or $364 dollars per square foot, more than double the cost of trophy office buildings in Center City. The truth of the matter is that if these buildings are well situated with access to robust power sources (substations or generators) and conduit fiber lines and have little competition or low barriers to entry, they can be just as big cash cows as the best parking garages or self-storage facilities, if not even better. These items are of paramount importance, because when you look at a price per square foot figure as healthy as the one cited above, you can quickly understand that replacement cost must be thrown out the window. While it is important to understand the supply and demand factors, as it is with any property, you need to understand that you are essentially buying cash flow in the form of the value of the sum of leases, rather than the brick and stick real estate that houses them.