2020 Market Analysis: Strong Demand & Attractive

Despite market turbulence, the data center sector has held up well in 2020, with the broader sector* up 11.5 percent through the end of Oct. vs. the S&P 500, which was up 1.2 percent. The performance largely reflects the secular strength that has been present during much of the last few years

-despite various quarter-to-quarter gyrations in leasing trends-that has not only continued during the COVID-19 pandemic but has arguably increased. Hyperscale service providers (HSP) in particular, whose demand includes large multi-MW requirements from both large Internet companies (e.g., TikTok) and cloud companies (e.g., Microsoft), have seen their requirements increase as a result of increased underlying demand for their own services. Similarly, the net impact on enterprises, which typically includes smaller <500 kW requirements, has also been positive as the number of companies that have accelerated the digitization of their businesses appears to be surpassing the pullback from more hard hit industries like travel, hospitality, oil & gas, and retail, which are delaying certain IT projects. As a result, YTD leasing for CoreSite, CyrusOne, Digital Realty and QTS equated to $512MM vs. $363MM last year and represents the highest three-quarter combination in their history.

For HSPs in particular, though debate continues about whether they will shift more of their data center requirements internally as opposed to using third-party data center providers, particularly in markets where it is thought to be easier to attain land/power—that doesn’t appear to have materialized yet. Others have argued that, even if that was to occur, the absolute level of demand would continue to rise even if the percentage of the pie being allocated to third-party providers declines because the level of MWs required will continue to rise. To that point, Structure Research forecasts the third-party data center market will grow approximately 10 percent compounded annually over the next five years. In addition, over the last few years, pricing has come down to reflect an influx of private real-estate/infrastructure capital into the space, who recognized the data center sector was achieving outsized returns relative to other real-estate/infrastructure subsectors and began competing more aggressively on price. For example, in Northern Virginia, we believe the low-end of data center pricing for large footprint deployments is stabilizing in the $70s kW vs. $80-100 kW in 1H19 with implied unlevered returns of about 9 percent (mid-teens levered). This also has made the choice to lease vs. build more attractive.

The strong demand and still attractive returns have also helped sustain a strong M&A interest as a growing number of private real-estate/infrastructure funds look to enter the sector. Although the pandemic has made due diligence more difficult, the momentary lull in activity in March/April has proved to be just that, those involved have found ways to push the ball forward. Debt financing for most forms including ABS has also been very accessible this year and, what’s more, at record low rates. The problem, however, is there is arguably more money now pursuing the sector than there are opportunities. For example, in August one PE investor noted that over the past five years, $100B+ of equity capital has been raised to target the broader Communications Infrastructure sector. This is resulting in record multiples for not great assets, in some cases since not all data centers are the same, and more early stage investments than would be typical, including KKR’s partnership with the former founder of Zenium to form Global Technical Realty and Goldman Sachs’ partnership with the former Chief Investment Officer of Digital Realty to form Global Compute Infrastructure. It also could result in more take-privates, such as EQT/Digital Colony’s purchase of Zayo (fiber infrastructure) earlier this year.