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Behind every cloud is a data center

Behind every cloud is a data center

31-07-2017 | Insight

No sector can avoid digitization and real estate is not an exception. Demand for data storage and related services is driving growth in data centers. Because of a lack of understanding, investors tend to underestimate their value creation potential. We consider data centers the best value/growth proposition in the Real Estate Investment Trust space.

  • Folmer Pietersma
    Folmer
    Pietersma
    Portfolio Manager

Speed read

  • Digitization drives demand for third-party data centers
  • Data centers connecting companies and service providers become a one-stop platform
  • Investors underestimate data centers’ value creation potential

In the past, data was only a side effect of business operation. The size or structure of databases made them unsuitable for analytical purposes and the computing expense was too high. Data was stored in an in-house cost-creator data center.

Technological progress has fully transformed the situation. Digitization drives immense growth in data volumes. It is estimated that by 2020 the data universe will exceed 44 zetabytes, which is a tenfold increase from the 4.4-zetabyte universe of 2013. The more we consume data, the cheaper it becomes, the more we consume it, and so on.

Data has become a valuable asset, a key business driver. The need for improved data storage facilities has driven the emergence of third-party data centers. For companies, outsourcing data centers has clear benefits, such as cost savings, scalability, data security and flexible adjustment to new technological developments.

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Two types of data centers

Data centers can be viewed as a physical location where the hardware of IT infrastructure is being stored. There are two types: wholesale and retail (colocation) data centers. Wholesale data centers typically offer a very large size of leased space, above 10,000 square feet. They are estimated to be economically viable for enterprises with needs above 1 MW of IT energy power. This is typically much more than the average enterprise requires. Hence, tenants typically are large enterprises, content providers, cloud players and social media platforms.

Retail centers are smaller deployments below 10,000 square feet. Given the smaller size, the type of tenants is highly varied, ranging from smaller enterprises, larger ones to all sorts of network related businesses which are a part of digital data ecosystems. Interestingly, the large number of tenants per data center has been an enabler of cost-effective interconnection possibilities, whether on a 1:1 basis or a one-to-many basis. Hence, retail data centers have evolved into platforms, as part of highly interconnected digital ecosystems.

One-stop platform

Besides data storage, companies need other services, such as cybersecurity and cloud computing. These are not offered by the data center providers themselves but by individual services providers that are also customers of the data center. A key growth driver of retail/ colocation data centers is therefore interconnectivity. They have evolved into one-stop platforms. We believe that the platform aspect of retail data centers is not yet fully appreciated by the wider market. This clearly creates investment opportunities, since platform firms typically provide strong investment returns on a consistent basis.

Facilities that provide a wide range of interconnection services are extremely valuable and difficult to replicate given their size and density (the industry leader offers a mind-blowing 230,000+ interconnection possibilities). Hence, we believe that the value of retail data centers lies in a wide selection of providers and interconnection capabilities which underpin the ‘one-stop’ platform business model. In an increasingly interconnected world, we expect the value of interconnection to grow as more parties will be forced to join to fully utilize their business opportunities.

Data privacy

There has been a trend of increasing tightening in data privacy legislation. Some investors see this as a risk to the business as it will likely drive capital outlay to ensure regulatory compliance. We acknowledge that this is a potential risk. However, the technology creates opportunities for turning the compliance challenge into a business opportunity for colocation data centers.

An increasing number of data centers are able to deliver compliance advice services to a wider range of businesses, which is mutually beneficial. From a company standpoint, the burden of research for compliant solutions to their individual needs is being taken off their shoulders, which provides cost savings and mitigates compliance risks. As for the data centers, they are able to provide additional value to their services, ensuring more ’sticky’ revenue.

Investment opportunities

The newest additions to the real estate universe remain quite neglected by the investor community. Their business models’ understanding require at least basic technology literacy and the information available is often highly technical and full of IT jargon. Historically, these factors were causing IT-related shares to be under-owned. However, given the high growth and good profitability profile, we see real estate investors gradually warming up to these stocks.

Typically IT-related real estate shares show much higher revenue growth (for instance data centers show an industry average revenue growth of 10%) than traditional property-related shares (which tend to be more GDP related).

We consider data centers the best value/growth proposition in the Real Estate Investment Trust (REIT) space. We particularly like interconnection-focused retail data centers, which are part of unique ecosystems that are difficult to replicate.

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