Are Colocation Prices Heading Higher?

Will the credit crunch lead to higher colocation prices in the busiest Internet markets? With projections of IT budget cuts and weaker demand for many products and services, why would colo prices go higher?

The talk of rising colocation prices has been stoked by a recent report from Tier 1 Research that sees the credit crunch creating a tight market for data center space. Some of the report's key findings have been discussed this week at Nortia Research and Telecom Ramblings.  

"The recovery of the economy from the current slowdown will likely result in a temporary exacerbation of price increases, as demand will grow significantly faster than supply during the first 12 months of a recovery," said Jeff Paschke of Tier 1. "This is due to the datacenter construction cycle, which varies from nine months (for a phased expansion) to 18 months (for a greenfield build). Demand, of course, has no built-in delay, which will likely cause the sort of cross-market price increases seen during 2005." 

A recovery may not seem close at hand. But financing for new data center projects is hostage to the banking/credit crisis, and largely disconnected from market conditions. Tier 1 says demand for data center space grew 14 percent over the past 12 months, while supply grew by just 6 percent, "exacerbating an already lopsided supply/demand curve."

Financing for new projects has dried up, a trend we first noted in March 2008. As conditions in the credit markets worsened late in the year, data center REIT DuPont Fabros (DFT) to halt construction on nearly 500,000 square feet of raised floor space in high-demand markets (New Jersey, Virginia and Santa Clara, Calif.).

In the short term, colocation providers say they expect to benefit from revised spending priorities at enterprise companies seeking to reduce capital spending projects. This has led some companies that had originally planned costly data center expansions to instead lease colocation space. The lack of new supply serves to reinforce the incumbent advantage of long-term players in the sector.

“I believe we are well positioned to grow our business in this environment, and we will see even more business coming at us due to constraints on CapEx and OpEx,” said Steve Smith, the CEO of Equinix, in the company's most recent earnings call.

After a period of prolonged weakness and a space glut during the dot-coom crash, colocation prices have rebounded since 2005, with many providers raising rates 4 to 7 percent a year upon contract renewal - and more in some cases. 

Expected strength in the colo sector led Wachovia this week to initiate coverageof colo specialists Equinix (EQIX) and Switch and Data (SDXC) with an "overweight" rating.