A Big Bet Against Data Center REITs Is Turning Heads, But Industry Experts Aren't Buying It
A famous investor’s public bet against data center REITs is being met with skepticism by digital infrastructure investors and data center real estate professionals.
High-profile short-seller Jim Chanos — well-known for predicting the collapse of Enron — told the Financial Times last week he is raising funds to execute a large-scale short of data center REITs including Digital Realty and Equinix.
Chanos argued that hyperscale cloud providers will eventually develop almost all of their own data center space, pulling the rug out from under the big colocation providers that currently rely on them as a primary source of demand.
While Chanos’ prediction garnered a great deal of attention and prompted a public response from Digital Realty's CEO, his position is being widely panned by a range of players within the data center and telecom investing space. These industry experts say that while there may be reasons to worry about data center REITs, his reasoning doesn’t stand up to scrutiny.
“Chanos's argument is not only unoriginal, as we have heard the same short thesis for over five years, but in conflict with the current and past behavior of the hyperscalers,” Wells Fargo analyst Eric Luebchow wrote in a report critical of the short-seller’s position. “Chanos may have made some discerning bets on past shorts like Enron, but we don't think he understands the data center market very well.”
Outlining his “big short” to the Financial Times, Chanos argued that large colocation providers, for whom cloud giants like Amazon Web Services, Google and Microsoft are the largest tenants, are effectively in bed with the competition that will eventually render them obsolete. According to Chanos, companies like Digital Realty and Equinix are dramatically overvalued because hyperscalers will increasingly build their own data centers instead of outsourcing much of their IT infrastructure to third-party providers as they currently do. Such a shift would strip major colocation providers of their largest tenants, leaving them out in the cold.
“The story is that although the cloud is growing, the cloud is their enemy, not their business," Chanos said. "Their three biggest customers are becoming their biggest competitors. And when your biggest competitors are three of the most vicious competitors in the world then you have a problem.”
This public pessimism from an influential investor turned heads across the data center world, prompting Digital Realty CEO Bill Stein to go on CNBC to issue a rebuttal.
"I think Jim maybe isn't aware that demand has never been stronger in our space," Stein said.
Longtime telecom investors and veterans of the data center and digital infrastructure space are also dismissive of Chanos’ claims.
Calling his position “outdated,” Cushman & Wakefield Global Data Center Advisory Group Executive Director Ali Greenwood is one of many industry insiders pointing to similar predictions of data center doom that emerged when cloud infrastructure started gaining widespread adoption a half-decade ago.
“The headline of: ‘The cloud is going to destroy the multitenant data center industry’ circulated years ago, and simply did not come to fruition,” Greenwood told Bisnow. “The cloud industry heavily relies on the multitenant data center industry for its scale, expertise and speed to market. The growth and velocity in which the hyperscale cloud companies are taking down and signing up for multitenant data center space across the globe is absolutely incredible and insatiable.”
Cushman & Wakefield's data shows that the cloud industry’s reliance on third-party data center providers is increasing, at least in the short term. Hyperscale cloud data center demand and absorption are at an all-time high and have shattered records over the last nine months, according to data from the firm.
This has driven demand for colocation providers like Digital Realty, which was one of many providers that saw record bookings in the first quarter of 2022 amid historically tight supply. According to Wells Fargo, hyperscalers have historically outsourced 40% to 50% of their data center needs to third-party providers. This year it estimates the figure will be closer to 60%, with long equipment lead times and tight markets for both land and power making it harder for hyperscalers to self-build.
The sheer amount of data center space hyperscalers are expected to need in the years ahead ensures that cloud providers will continue to turn to the major colocation operators, according to Wells Fargo’s Luebchow. He said hyperscalers will need around 2 gigawatts of capacity in 2022, a figure that he predicts will soon grow by more than 4 gigawatts each year. According to his analysis, self-building to create that sort of capacity would require hyperscalers to collectively incur around $40B in annual capital expenditure costs just tied to real estate for data centers.
"In an environment in which all companies are looking to conserve cash and put it to its highest possible return, we think it's nearly inconceivable that would happen," he wrote.
But even if hyperscalers wanted to spend that kind of money to insource data center development, experts say it may not be possible for them to do so effectively.
In key data center markets like Northern Virginia, Chicago, Phoenix and Hillsboro, Oregon, available land and available power are becoming increasingly scarce, driving data center developers into adjacent submarkets.
Andy Cvengros, executive director of JLL’s Technology Solutions Practice, said that while companies like AWS can effectively self-build in established data center hubs like Loudoun County, the major colocation providers are much better equipped to handle the added challenges of building in new markets — from skeptical local governments and zoning challenges to utilities unfamiliar with the industry’s needs.
“If you look at the hyperscalers, they generally move pretty slow, they’re not entrepreneurial and they’re not likely to take on risk from a zoning entitlements standpoint, whereas the operators are,” Cvengros said. “They can say that they want to build themselves all day long, but they’re not going to be able to execute on that in key submarkets.”
According to Cvengros, there are reasons to be concerned about the future performance of REITs and other public data center operators, just not the reasons put forward by Chanos. He said the threat to companies like Digital Realty isn’t from hyperscalers, but from other colocation providers backed by private capital.
The past year has seen four major public data center operators — REITs QTS, CoreSite and CyrusOne, as well as Switch — acquired and taken off public markets. It is a trend many experts attribute, at least in part, to disadvantages faced by public providers in trying to achieve the pace of growth necessary to keep up with unprecedented demand.
“They’re now competing with a lot of private companies who were previously REITs that are some of their biggest competitors,” Cvendros said. “It’s allowed these companies to be a lot more flexible with their capital and a lot more risk-tolerant, whereas the REIT structure, for guys like Digital Realty, is more prohibitive in terms of going after big deals and more speculative-type stuff.”