A Diamond in the Rough

Oh the irony of it all. Consumer spending is way down, and so the retail sector has been hit hard. Unemployment is at 8.1% 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.

The one niche sector that hasn't been touched? 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.

1. Demand is Different

Back at the turn of the millennium, data center demand was bursting at the seems 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. As society as a whole becomes more comfortable with doing things online, and as generations who grew up with computers become the majority of the workforce, it is only logical that more and more of our lives will be connected via the computer. As this happens, there will be ever swelling waves of data that 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.