Data Center Giants Scramble For Cash Needed To Meet Demand
Demand for data center server space has remained relentless despite the turbulent economic landscape, but it is becoming much harder for developers to meet that demand.
In the face of rising interest rates and construction costs, the two major data center REITs are rushing to bring in billions of dollars to ensure they can deliver the new capacity they have promised.
Data center giants Digital Realty and Equinix both posted record leasing numbers for the three months ending Sept. 30, they revealed in their third-quarter earnings reports, with their aggressive development pipelines already been largely pre-leased.
While demand may not be slowing any time soon, the already challenging development landscape — hampered by supply chain chaos, little available land, and power and labor shortages — is becoming even more difficult. Inflation is bumping up development costs by 5% to 10%, according to Digital Realty, while rising interest rates and general economic volatility have made financing far less certain.
Bracing for this uncertainty, the public data center REITs are quickly increasing liquidity to ensure they will be able to build the facilities they have pre-leased. At the same time, leaders at both providers say the stormy landscape has changed how they will evaluate future development, land-banking and other growth opportunities in the months ahead.
“While the underlying fundamentals of our business remain strong and fortune can indeed favor the brave, experience has taught us that an ounce of prevention is worth a pound of cure,” said Digital Realty CEO Bill Stein, speaking on the company’s Oct. 26 earnings call.
“We feel that it is most prudent today to adapt to the current environment by first prioritizing and sharpening the lens through which we view new investments to ensure that we are focused on the most strategic transactions that offer the highest potential risk-adjusted returns," Stein added.
Nearly 60% of Digital Realty’s 400-megawatt development pipeline has already been pre-leased, mostly to hyperscale cloud and social media giants. And while Equinix didn't reveal specific pre-leasing numbers for the 41 major projects it has underway, it projects them to be cash flow even in as little as six months and at least 80% occupied in as little as two years.
Failure to deliver this promised inventory on time could spell disaster.
With interest rate hikes driving up the cost of capital and future access to debt markets no longer a guarantee, both Equinix and Digital Realty have rushed to increase their liquidity through debt and raising cash to ensure their development capital expenditures are funded through at least the end of 2023.
Equinix released new shares to boost its cash reserves, which combined with access to a $4B credit line gives the company $6.4B in total liquidity, up $1B over the previous quarter. Within 60 days of the first round of interest rate hikes, Digital Realty rushed to secure $2B in various forms of debt financing and sold off properties to get cash fast.
“While leverage is above our historical average, we have bolstered our liquidity to ensure that we have the capital in hand to fund our committed development spend throughout the end of next year and maintain a comfortable cushion,” Digital Realty Chief Financial Officer Andy Power said.
Digital Realty’s urgency to access liquidity was enough to make some on Wall Street uncomfortable, with one analyst on the earnings call questioning whether the company’s credit rating was at risk. Power said the company plans to reduce its debt in the coming months through the sale of assets and other measures.
Conversely, Equinix Chief Financial Officer Keith Taylor said the firm will look to take on more debt in the coming months, if conditions allow, in the wake of an improved credit rating that effectively pushed up the company’s debt tolerance of investors.
“I think you'll see more debt activity over the coming quarters,” Taylor said. “I've spoken quite openly that we want to raise more debt even in the current environment — the question is where do we source that debt from, and can we take advantage of different markets around the world based on prevailing cost to borrow?”
Beyond current pipelines, the uncertain economic future has driven strategic changes in how some data center providers approach development and other real estate investments.
Digital Realty’s Power said the REIT is “refocusing” its capital deployment, eschewing long-term investments like land-banking or builds outside of core markets in favor of expenditures that will drive immediate yields.
“The world has become more volatile, the capital markets have become more challenged, there’s talk of a looming recession — I think there is a very likely scenario where we spend a little bit less on speculative development,” he said. “We're focused on projects that are delivering on strategic priorities and delivering the highest risk-adjusted returns.”
Prices Keep Rising For Data Center Tenants
Rising rents and growing power rates are dramatically driving up costs for data center tenants.
With low vacancy rates across the industry and new inventory trailing well behind demand, data center operators say rents have been climbing throughout the third quarter. According to Digital Realty’s Power, rate increases between 10% and 15% have been standard, with the most significant price hikes in constrained markets like Loudoun County.
And even as rents climb, operators are negotiating additional rent escalators into leases to help hedge the value of portfolios against inflation. Digital Realty has begun pushing rent escalators tied to the consumer price index during negotiations, and the evidence suggests that these are terms even hyperscale tenants are willing to accept. While less than 20% of previous leases were tied to CPI, these clauses were written into 40% of the record bookings signed during the third quarter.
But it’s not just rent increases driving up costs for tenants. Most data center occupiers are billed for the power their servers use, and the global energy crisis has led to dramatic spikes in power rates in many markets. Equinix CEO Charles Meyers told analysts that while the company’s energy hedging program has held down costs for now, in the months ahead some tenants will see their monthly bills rise between 15% and 20% due to the cost of power alone.
While mitigating the impact of rising energy pricing for customers through hedging can be a competitive advantage over other operators, Meyers said, the need for data center space is so great — and the supply so constrained in key markets — that rising costs will likely have little to no impact on overall demand.
“For most people, we don't believe that is something that will impact their overall commitment to their digital transformation,” Meyers said. “We think we're going to be able sustain the demand levels that we're seeing.”
Power Crunch Has Digital Realty Unsure It Can Deliver Promised Capacity
With more than one data center campus facing significant delays due to unexpected power constraints in Virginia’s Loudoun County, Digital Realty has yet to secure alternatives for the tenants that pre-leased the space.
In July, utility Dominion Energy revealed it wouldn't be able to deliver power as promised to a number of data center developments in Ashburn’s so-called Data Center Alley, with delays lasting until 2026.
Multiple Digital Realty projects face uncertain delivery dates due to this power pinch - and some of that space has already been preleased. More than three months later, Digital Realty’s leadership said they have yet to figure out whether they will be able to relocate tenants who had preleased space at the affected properties elsewhere in Northern Virginia.
“I cannot guarantee it right now,” Power said. “I think we're optimistic that the responsible parties in Loudoun will work with Digital to deliver on behalf of those customers that have signed contracts to grow with us and are sitting in our backlog.”
Viable alternatives may exist, although whether bringing that capacity to market is realistic remains in question. Digital Realty owns an undeveloped parcel with access to 200 megawatts near Manassas in neighboring Prince William County, which Power points to as a possibility. Although the company is among the largest data center providers in Loudoun County, with around 500 megawatts of capacity, most of that space has been leased. Vacancies are rare, with fewer than 200 megawatts even up for renewal in the next three years, according to Power.
“We probably, in hindsight, wish we didn't do so well, but who knew this was going to come?” Power said. “I don't think any market participants expected this.”
CORRECTION, NOV. 17, 11 A.M. ET: An earlier version of this story incorrectly identified a specific Digital Realty project in Loudoun County as one of the preleased sites. This story has been updated.