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The Next Data Center Real Estate Boom

11/20/2011 12:00:00 AM

News has been dismal for the real estate market at large, and in particular for residential real estate. Even the commercial real estate market has suffered. Although some segments still have yet to find the bottom of the downward spiral that began several years ago, one segment is still robust: data center real estate. Since many companies held back on capital purchases (including land and building space) during the recent recession, could a boom be in the works as these companies struggle to keep pace with rising demand for IT services?

Insatiable Demand for IT The increasingly information/knowledge-based economy of the U.S. and other western nations means that IT infrastructure is a critical component of success in a wide range of businesses. Naturally, then, as these companies grow, internal demand for IT services increases commensurately, as does demand from customers. Virtualization, increasing power densities, higher operating efficiency and similar strategies for getting more capacity out of less space only go so far. Eventually, a company must add data center space to meet rising demand. Thus, the data center real estate market is fundamentally driven by growing demand.$0$0According to a recent Jones Lang LaSalle report (“Data Centers One of the Bright Spots in the Commercial Real Estate Landscape”) on the U.S. data center market, this market “will continue to grow in the latter half of the year as demand shows no signs of slowing.” Furthermore, freer-flowing capital will encourage companies to expand, “releasing years of pent-up demand and resulting in higher deal volume.” This latent demand grew during the recession as credit tightened dramatically, leaving many companies with few opportunities to add data center space. Furthermore, the slowing economy also made businesses cautious about spending, owing to the gloomy financial outlook.$0$0Digital Realty Trust reports that a recent survey (“What is Driving the US Market? 2011,” released in April, 2011), which queried 300 senior executives from enterprise-level businesses, 28% have added data center space in the past year, and a total of 65% have added space within the past two years. Furthermore, large businesses are also planning to continue adding more space: according to the survey results, 49% will “probably” increase data center capacity in 2011, and 36% “definitely” will. This means that 85% of these enterprise-level businesses will likely be adding space this year. The survey report indicated similar numbers for 2012 plans as well.$0$0But beyond just “needing more room,” the reported requirements for these enterprises were quite expansive. Of those companies planning expansion, one-third intend to construct one new facility, but the remainder plan two or more, with 26% planning for three or more new data centers. Digital Realty Trust projects that the average new data center will have about 18,000 square feet of space, meaning most of the companies expanding their data center footprints will do so by roughly 36,000 to 72,000 square feet.$0$0Market Drivers$0$0Energy is the lifeblood of the data center, and as energy costs rise and companies continually increase their demand for power, energy becomes an increasingly large portion of the IT budget. Jones Lang LaSalle’s Bo Bond, co-lead of the firm’s Data Center Solutions group, stated, “Energy will continue to be one of the biggest market drivers. As power consumption in data centers continues to increase, users are increasingly concerned with power redundancy, capacity and cost.” Within the data center real estate market, energy is also a driver for development in certain areas—in particular, those with low energy prices and greater opportunities for free cooling (such as air-side economization). For instance, Northwestern states like Oregon and Washington provide ample opportunities to use outside air instead of traditional cooling approaches (air conditioning, essentially).$0$0But metropolitan areas still have a strong draw: they offer a wealth of potential local customers, data center talent and existing infrastructure that more rural areas do not. Although real estate is generally more expensive—as are property taxes—the cost is worth the proximity. This is particularly the case for financial companies that must reside close to trading centers to enable fast-paced transactions (such as trades). $0$0Boom Conditions$0$0In light of the ever-growing IT demand, development that was forestalled by the recession, and increasing available capital, the data center real estate market seems poised for a boom. According to the CoStar Group (“Data Center Developers Rack Up Another Strong Quarter”), “Major publicly traded data center developers and operators reported solid third-quarter results, with strong leasing of wholesale data center and colocation space reflecting the rapid growth of cloud computing, social networks and Internet shopping.”$0$0Perhaps the main factor that could put a damper on this potential boom is the stagnant economy. Hopes for a fast recovery from the recession have dwindled, and the stubborn unemployment, lack of significant growth, continued profligate spending by every level of government and the failure of the larger real estate market to find its bottom means that another recession may be in the works. Demand for IT services will likely continue to increase, but the lack of strong overall economic growth will add some restraint.$0The Danger of the Boom: The BustWhen you talk about booms, you must also consider busts. The data center real estate market appears to be underpinned by some strong fundamental drivers, but the current (and, arguably, artificially low) interest rates and easing credit set the stage for speculation. Owing to the lack of significant growth in the wider economy, it is unlikely that the Federal Reserve will raise these rates much anytime soon. This leaves speculators an opportunity to move into the data center real estate space, potentially pushing up prices and increasing supply beyond what the market can bear.$0$0The danger of this situation is that eventually, companies needing data center space will recognize the inflated prices combined with the excess inventory, and they will refuse to pay such high amounts. The result? A bust, with prices falling as owners and operators seek to liquidate inventory (according to their respective position relative to the data center space). Bond of Jones Lang LaSalle summarized the situation in the above-mentioned press release, saying, “There is an insatiable amount of demand happening across the globe. . . As speculative development commences, we will begin to see a new crop of winners and losers in the data center arena.” Steady growth of the data center real estate market seems to be a virtual given, but the pace at which this proceeds will determine whether the market growth will be sustainable. Credit may still be tight enough to avoid excess speculation, thus avoiding the kind of bust seen in the residential housing market. Nevertheless, with investors seeking ways to make money in an economy with few sure bets (the Dow Jones Industrial Average, for instance, has fallen about 3% compared with its value five years ago), any strong market is a potential target for speculation. $0$0Conclusions Growth seems to be the order of the day for the data center real estate market. The question is how much growth we will see, and whether this growth will be sustainable. Residential housing was once seen as a sure bet: houses were an investment (contrary to their current “money pit” status) with a virtually guaranteed return over time. After all, everyone needs a place to live, so the market must continue to grow. Right? Wrong. Soaring prices for housing lost their wings and are still waiting to find the ground.$0$0Does the same situation apply to the data center real estate market? Eventually, demand for IT resources must level off. Resources are limited, and only so much growth can be sustained. But if supply outpaces demand by too much—a situation likely instigated by central banking through artificially low interest rates and fractional reserve banking—the data center bull could quickly become a bear. Thus, the data center real estate market seems to be in for a strong future, but any boom must be watched carefully for signs of a bust.$0

Jeffery Clark

Data Center Journal