Colorado Real Estate Journal - June 3, 2015
Since businesses across North America are outsourcing their information technology infrastructure needs and using cloud computing at an increasing rate, the data center industry is experiencing rapid expansion. The industry’s annual growth rate continually exceeds 20 percent. At the same time, commercial real estate professionals are noticing that many data center operators are choosing not to buy the real estate they occupy, instead electing to rent. This could be for a variety of reasons, but often it is because data center operators believe their cash is best spent on constant upgrades of the technology. Nonetheless, the decision to rent creates tremendous opportunity for commercial real estate investors. Because data center operators have very specific needs, they are willing to pay significant rent premiums compared with more traditional tenants, so it is not surprising that many real estate investors are seeking data centers as tenants. Due to the high rents that data center space will command, some owners of traditional industrial (and office) properties are creating value by converting all, or a portion, of their properties into data centers. The largest concentration of data centers is in high-tech areas like Silicon Valley, California, and major cities like Chicago, Boston, Los Angeles, New York and San Francisco. While Denver doesn’t fit into this category of tier-one data center markets yet – our concentration is somewhat thin – Denver is an emerging market. While Colorado real estate investors entertain leasing space to data center users, investors should consider the differences in how data centers are valued compared with traditional asset classes, and also how different types of commercial real estate lenders will underwrite data center properties.
Converting traditional industrial and office buildings into space suitable for data centers is costly, but the good news is that appraisers recognize the value-add. Lenders that are underwriting data centers also appreciate the value created by this special use. Data centers are considered special-use properties because the facilities have several unique characteristics, and when assessing the value of a property, an appraiser will consider the following:
In order to attract a data center tenant, a property needs access to two separate sources of power and two sources of broadband, so there is always a backup in the event that a source fails. Generally speaking, few properties are located in areas that offer such extensive utilities. Because of this, proximity to redundant utilities is one of the first characteristics of a property that an appraiser will assess.
In order to house a data center’s information technology equipment, an industrial or office asset requires expensive improvements to infrastructure and environmental controls. Typically, data centers are constructed on top of a raised floor, which allows for mechanical and electrical systems to be assembled between the floor and concrete slab. These systems will connect a data center’s components, control the temperature of the floor, and contain power supply backup systems that ensure constant power. Building this infrastructure is a costly investment, for which appraisers tend to give full credit.
Because data centers are considered special-use properties, appraisers will compare a subject property’s vacancy and rental rates with that of other data centers in similar regions. Appraisers generally won’t compare a data center’s rental and vacancy rates with traditional industrial and office space.
Data center properties are sometimes considered to be riskier than traditional industrial and office assets for a few reasons. First, if a data center operator vacates the space and a replacement data center cannot be secured as a tenant, a significant amount of income will be lost. Second, the costly improvements previously described can require significant upgrades to ensure that the improvements don’t become obsolete; as technology evolves, a building’s infrastructure must keep pace. Because of these risks, investors in data center properties should be prepared for an appraiser to apply a cap rate that’s higher than that of traditional industrial and office product in the same geographical area. This cap rate differential typically will range from 0.5 to 1 percent, however, it should be noted that this is not always the case. In tier-one data center markets (major cities), the cap rate applied might be similar to traditional property types.
Life companies will offer the most competitive interest rates on data center properties. However, life companies tend to take a conservative approach compared with other nonrecourse lenders. When presenting a loan request for a data center to a life company, borrowers should be aware of a few common concerns that must be mitigated. First, even though an appraiser may recognize the value of infrastructure investment, life companies will be cautious. As previously noted, because information technology evolves so quickly, the possibility exists that a building’s infrastructure will need to be upgraded often. Regardless of whether these upgrades are the responsibility of the tenant or landlord, some life companies will be apprehensive to give credit to the value of existing infrastructure for fear that it quickly may become obsolete. Furthermore, in the event that a data center tenant vacates, without up-to-date infrastructure, securing a replacement data center user may be challenging. Because of this concern, sometimes life companies will mark down underwritten rents to traditional industrial and office rental rates – unless the data center tenant has investmentgrade credit, and a lease term that does not expire until two to three years after the proposed loan maturity. Typically, a low-leverage loan request on a well-located property is the best way to mitigate a life companies’ concerns about data centers. Conservative leverage and superior location allow room for life companies to underwrite higher cap rates and lower rents. Interest rates offered by commercial mortgage-backed security lenders will be more expensive than life companies, however, because they are usually able to offer longer amortizations and potentially interest-only payment periods – loan constants are very competitive. CMBS lenders will also offer higher-leverage loans. Colorado, and Denver in particular, already was identified as an emerging market by the data center industry, and as Internet traffic continues to grow, operators of data centers are likely to seek opportunities outside of the major coastal cities in an effort to reduce operating costs and increase overall efficiency. Consequently, data centers should become increasingly relevant in Colorado’s commercial real estate market.