With 145 properties spanning 23 million square feet of space, Digital Realty is the biggest player in the global data center industry. Amid active growth and consolidation, the company is focused on staying strategic, which sometimes means passing on a huge cloud deal or potential acquisition.
“We’re going to remain disciplined in our approach,” said Scott Peterson, the Chief Investment Officer at Digital Realty. “We’re not going to jump on any opportunities that will really only serve to make us bigger and not better.”
Yesterday’s earnings reflected another strong quarter for Digital Realty, which is seeking to broaden its portfolio of products as well as properties. The company’s leadership team says it wants to proceed prudently in an environment with many avenues for growth. The earnings call offered a window into how the company sees the data center market evolving. One thing is clear: As the digital transformation continues, there’s plenty of demand.
“We are as confident as we’ve ever been in the long-term demand profile,” said CEO Bill Stein, noting the record absorption of data center space in the sector during 2016. “Current market vacancy rates are in the mid-single digits in most core markets and demand continues to outpace supply. The long-term trend is clearly marching up and to the right.”
Cloud Deals Get Bigger and Lumpier
The shift to cloud computing has been driving the industry’s growth. As large cloud platforms sign super-sized leases, developers have accelerated their development efforts. Digital Realty was been actively building and filling data centers, leasing 12 megawatts of space in the fourth quarter of 2016. Amid reports of single leases of 15 to 30 megawatts in major markets, Stein says Digital is competing hard but also sticking to its criteria.
“Deal sizes are getting bigger and lumpier,” said Stein. “And the biggest and lumpiest deals do not necessarily translate to the most value creation. For our part, we’re taking a much more selective approach to landing the right mix of customers to maximize the long-term value of our global Connected Campus footprint.”
After establishing itself as the largest player in wholesale data centers (leasing entire turn-key data halls), Digital Realty has recently focused on building its colocation and interconnection business. The acquisition of Telx made Digital Realty a larger player in both those sectors, and its Connected Campus strategy seeks to bring together its real estate and connectivity assets, using fiber to tether urban interconnection hubs with suburban data centers.
A key priority for Digital Realty is its new Service Exchange offering, which provides a network fabric that allows customers to privately connect with popular clouds and services, including both Infrastructure as a Service IaaS clouds like Amazon Web Services, as well as SaaS offerings like Office365.
Digital still likes large deals, the company said. But most of the largest “super-wholesale” and build-to-suit deals have been landed by competitors – including CyrusOne and DuPont Fabros among the publicly-held data center REITs, as well as newer privately-held players like EdgeConneX and Cloud HQ.
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“Our competitors are largely behaving rationally,” said Stein. “But we have seen an uptick in fresh capital targeting the sector. To date, recent investments have mostly been focused on stabilized assets, perhaps reflecting a tacit acknowledgment that barriers to entry may be higher that meets the eye.”
Deal Criteria In Focus
The strong performance of data center REITs has boosted investor interest in the sector. That has prompted a number of companies to place assets on the market, seeking to take advantage of strong demand and valuations. While there has been plenty of M&A activity, there are also plenty of assets that have not found the right buyer.
“We look at everything,” said Peterson. “We’re looking for opportunities that are strategic and complementary, that we can prudently finance and represent a good investment value for our shareholders. Many of the opportunities that were out there really had neither a strategic value nor represented good value, and it’s easy for us to be interested observers on those.”Digital Realty CEO Bill Stein: We are as confident as we've ever been in the long-term demand profile.Click To Tweet
“The floodgates have opened for data center packages coming to market, but the supply of products on the market has not depressed pricing,” said Stein. “In fact, values have firmed considerably. This can be somewhat of a double-edged sword. On the one hand, it has very positive implications for the value of our existing portfolio, and it makes our recent acquisitions look particularly compelling. On the other hand, it also makes it harder for us to achieve external growth through acquisitions, and it potentially introduces new competitors.”
Here are some other notes of interest from Digital Realty’s earnings call:
- London Still Solid: Stein said the impact from the Brexit vote doesn’t appear to have eroded demand in London- at least not yet. “Post Brexit, we actually signed a fair number of deals in London, while before Brexit we hadn’t done much business at all,” said Stein. “So I think, from that standpoint, Brexit perhaps has been good for the London market. But having said that we are building in Frankfurt and Amsterdam, and we’re definitely seeing demand in both of those markets as well.”
- Supply in Downtown Chicago: Digital Realty now has 1 megawatt of data center space available at 350 East Cermak, its massive connectivity hub in Chicago. The company has taken back powered shell space from a colocation reseller customer. “We are actively negotiating the lease for roughly 25% of the former customer’s capacity that will bring us back to break-even, and we expect to create additional value for our shareholders from lease-up of the rest of this capacity over the next several quarters,” said Chief Financial Officer Andrew Power. Digital Realty recently announced plans for a new data center next door at 330 East Cermak.
- Slow in Jersey: “New Jersey continues to be our weakest market,” said Stein. “I wouldn’t say that there is irrational pricing there. There just is weak demand. I think where you find potentially irrational pricing is when there is a significantly sized deal, a very large deal that you’ll find people that price very competitively for those.”
Stein said he is encouraged about the rising profile for data centers as a real estate investment class. Investors’ growing comfort with Digital Realty and its cohorts may help establish data centers as a “core” investment – a stable property with high occupancy rates and steady income from tenants with strong credit – which would open the sector to a wider universe of potential investors.
“Over time, we expect property types that are levered to the digital economy will become increasingly core holdings,” said Stein. “Not only do we have the good fortune to be operating in a growth industry, but we believe that we have the best platform.”