The Cloud Effect – Is There a Silver Lining For Data Centre Real Estate Investment?

By Martin Miklosko, Director – Head of Data Centre Valuation at CBRE

Given the rapid emergence of cloud technology over the last decade, there is a common misconception that the role of data centre real estate, including investment into this sector, will become less significant. Driving this belief is the inherent flexible nature of cloud, meaning data centres can now theoretically be located anywhere, regardless of any issues of latency. Therefore, some hold the view that the advent of cloud is causing the data centre sector to become less reliant on the real estate industry for investment.

A crucial factor, often missed, is that real estate and data centres have gone hand in hand for decades. Born in the late 1980’s, companies began to move IT infrastructure from in-house server rooms to purpose-built enterprise locations, and later on colocation data centre facilities. Over time, investment into data centres from the real estate sector has created some of the largest owners and operators in the world. Many of which are now listed as Real Estate Investment Trusts (REITS) and a number of these have been established for many years. The last 12 months has seen the creation of a further number of data centre REITS and this trend suggests that data centres continue to be seen as an investable real estate sector, despite the recent growth of cloud.

Critics would argue that this could be short lived given the increasing dominance of cloud and the number of facilities being constructed by the large cloud providers themselves, such as Amazon, Google, Facebook and Microsoft. Importantly, and in many cases, such data centres are in remote locations where there is restricted or no sustainable colocation demand, or the potential for other high value uses. Furthermore, such cloud data centres do not benefit from underlying real estate-style contracts, or leases, as seen in colocation facilities, which ultimately create the secure income streams so prised by real estate investors. This means there is often limited scope for investment into such facilities from the real estate sector.

However, the perceived threat of diminishing real estate investment into traditional colocation facilities is not as bleak as some predict. There is still room for investment, irrespective of the emergence of cloud technology.

Investment Attraction - The Data Centre Proposition

In order to understand the future for real estate investment into data centres we first must delve into its attraction. Like any good asset, the potential for secure long-term income streams cannot be understated. The difficulty for users to relocate once deployed given the risks and challenges of data centre migration, in addition to the expense of the initial fit out means large scale end users typically enter into long leases, or contracts. The sole intention of this is to minimise the risk of having to relocate in the short term, with the knock-on-effect being a perception of customer or tenant “stickiness”. Furthermore, in order to effectively forecast expenditure, annual rental payments are either subject to pre-determined periodic increases or linked to inflation. This also creates investment appeal, as the rental income tends to go one way, which is up. Finally, the largest data centre space requirements were historically taken by global corporates including banks and financial institutions, providing extremely strong income security.

All such characteristics combined, are seen as very attractive to real estate investors and this, coupled with the specialist nature of the sector, has resulted in very healthy returns in comparison to more traditional real estate.

Is Cloud The End Of The Colocation Model?

The main question, often posed, is whether colocation will remain a sustainable data centre model going forward. Or, will the impact of cloud result in a move of the majority of companies’ IT infrastructure to the growing number of facilities owned and operated by the cloud providers themselves.

Current indicators and our own CBRE research suggests that rather than threatening the colocation model, it appears that the growth of cloud is actually driving increasing colocation demand. While cloud companies continue to build large data centres in traditionally non-core locations, the need to have a presence in the established data centre markets with high levels of connectivity and proximity to end users appears to remain.

Third party data also backs this up. In 2013, 68% of cloud providers’ servers were housed in colocation data centres, up from 65% in 2012. Even more tellingly, the proportion of servers located in their own data centres actually decreased from 39% to 34% over the same period. At this stage it is impossible to predict to what extent, or for how long, this trend will continue given the investment by cloud operators into colocation facilities over the last few years. That said, any reversal does not appear particularly imminent at this stage.

Does Cloud Make Colocation Facilities Less Attractive Investments?

It is important to understand that while cloud technology does give end users greater flexibility in terms of IT infrastructure, the actual cloud providers are far less mobile when it comes to the facilities they use. While the corporate and financial institutions that drove data centre growth during the 1990s and early 2000s took vast quantities of space, much of this remained unused. This resulted in a perceived weakening of income security and lower likelihood of lease renewal on expiry. Today, this means that cloud providers are taking up colocation space in smaller initial quantities. However, given the growing demand for their services and potential for attracting new customers to facilities, once a cloud provider is established and has invested in a colocation facility, the risk of them vacating is significantly reduced.

To The Future?

With growing demand from cloud providers for, and continuing expansion within, colocation facilities, such assets can undoubtedly continue to provide long term secure income streams for investors. This, after all, was how real estate investors became attracted to the sector in the first place. While the nature and dynamics of the data centre market may be changing, real estate very much continues to have a pivotal role to play in the sector as a result of the growth of cloud.