Despite Boom, Data Center Landlords See Lease-Up Challenges

Internet Giants Building Their Own Enterprise Facilities As Supply Swing Brings Better Balance with Demand

Even as computing and social media giants embark on huge projects to keep pace with rising Internet usage, some investors and analysts say the supply of new wholesale data centers and colocation space is finally beginning to catch up with tenant demand, most notably in certain highly competitive markets such as Northern Virginia, Silicon Valley, New York and New Jersey.

Companies such as Apple Inc. and Facebook, Inc. are increasingly opting to build their own server and data center facilities rather than lease from large developers and landlords. Corporate users such as Chevron and Wal-Greens have decided to make their own capital expenditures for enterprise data center space to take advantage of tax benefits and avoid paying rent to landlords.

Amid concern from some analysts that the slowing economy may further dampen demand, particularly from financial services tenants, publicly traded REITs such as Dupont Fabros (NYSE: DFT) and Digital Realty Trust, Inc. (NYSE: DLR) and CoreSite Realty (NYSE: COR) have responded by focusing tightly on the lease-up of new projects coming onto the market. While Digital Realty logged the second-best leasing quarter in its history and CoreSite also reported solid second-quarter activity, Dupont Fabros reported slower leasing and also announced that Yahoo! would not renew a lease in Reston, VA.

"We did admittedly have a slower quarter in leasing," said Hossein Fateh, DFT co-founder, chief executive officer and president. "But we don't feel any different about the market or the growth of the Internet."

A slowdown in the overall economy could be another blow to the critical taking of space at new datacenter developments, "at a time when leasing is already slow and competition is fierce," said Citi analyst Emmanuel Korchman in a recent research note.

"Development yields and earnings are likely to take a hit as new developments are delivered with lower occupancy than originally anticipated and stabilization timeframes are stretched out."

Korchman noted that the current hyper-competitive market may be a short-term issue. Over the long term, however, he expects data center demand will remain strong as cloud computing and social media continue to drive demand.

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The strong leasing momentum generated by San Francisco-based Digital Realty appears to be carrying over into the current quarter. The company announced this week that it has fully leased the first redeveloped building, a 105,000-square-foot facility built out as a multi-tenant data center facility with 13 megawatts of capacity, at its Datacenter Park-Dallas property in Richardson, TX.

However, according to a spring 2011 report on the U.S. sector by Jones Lang LaSalle, the gap between future supply and demand is currently shrinking as more players have gotten into the market.

Private users, consultants, developers and investors have increased their interest in and knowledge of data center real estate over the last year. Governments have actively courted capital investment and infrastructure development associated with data center growth.

"More and more municipalities, counties, regions, and states believe there are ancillary economic benefits to landing a data center development, and are drafting incentive legislation to attract mission-critical buildings and developers," JLL said in the report by Brian Oley, vice president, mission critical solutions, and Matthew Samler, lease associate with Jones Lang LaSalle in Dallas.

"All signs... anticipate that the gap between supply and demand in the data center marketplace will diminish over the next two to three years," JLL said.

"Current data suggests that the previous supply and demand imbalance is approaching a more balanced equilibrium," the Jones Lang report said. "Those in the public sector are realizing the benefits of attracting new data centers to their markets, thereby increasing incentives for developers, creating an environment for the private sector to begin to address data center supply shortages.

"While the imbalance continues, only those regions at the forefront of innovative legislation and those in the private sector with keen market acumen will fully capitalize on this growth industry."

Jim Kerrigan, executive vice president and director of Grubb & Ellis National Data Center Group, noted that it’s difficult to measure demand change in the broader data center market in smaller quarterly increment -- in part because the data center market is relatively small but also because many deals by private companies aren’t immediately disclosed due to confidentiality restrictions.

"Demand is measured market by market. One deal can make the difference between undersupply and oversupply in the data center sector,” Kerrigan said.

For example, new supply is flowing into Santa Clara, CA in the Silicon Valley, even though some analysts recently believed that the market was over built. The New Jersey market is now perceived as being slightly over developed -- largely because New York financial firms to date have not recovered and fulfilled space requirements as quickly as expected. But that could change quickly, Kerrigan noted.

One aggressive new player in the Silicon Valley is Vantage Data Centers, backed by technology focused private equity firm Silver Lake Partners, which hopes to invest more than $1 billion in wholesale data centers and has one of the best shots of eventually competing with industry leader Digital Realty, Kerrigan said.

While leasing may be slower at the three largest publicly traded companies, private wholesale providers like Vantage, Cincinnati Bell and CyrusOne have seen tenant interest and activity, Kerrigan pointed out.

“You could argue that the influx of new companies into the data center space has put pressure on the major publicly traded companies. There’s a lot more competition than there was a year ago,” he said.  Brought to you by CoStar.