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Bill Stoller
March 20, 2019
4 Min Read
Rendering of QTS's future data center in Manasas, Virginia, using the company's Optimus designQTS Realty Trust
Hyperscalers’ relentless data center expansion is pushing more data center developers, including the largest publicly traded players, to look at joint ventures to help fund construction of the massive campuses these clients require.
Data center are expensive to build – ask Cologix – and even the largest and most sophisticated developers can face challenges funding projects at the scale required by the likes of Microsoft, Google, or Facebook.
Digital Realty Trust, the world’s largest hyperscale data center provider, has used the joint-venture mechanism for years, but others are now taking this route as well. QTS Realty, one of Digital’s main US rivals, last month announced a joint venture with Alinda Capital Partners, selling half of a massive facility it’s building for a single cloud company in Virginia to the infrastructure fund; the strategy for Equinix’s recent push into the hyperscale leasing business relies heavily on joint-venture funding; CyrusOne executives have been talking about wanting to find an insitutional joint-venture partner for more than a year.
A factor contributing to this trend is that institutional investors, such as infrastructure funds, are more eager than they’ve ever been to put their money in data centers. They like facilities leased to investment-grade cloud providers, social media, ecommerce, and content companies, and a net-lease data center occupied by a single tenant is usually the most attractive to them.
These assets have the same characteristics that make traditional real estate assets attractive. Notably, either the tenant or the data center developer is usually responsible for operating these specialty assets.
Digital Realty’s Capital-Recycling Playbook
Presenting at a recent Citi conference, Digital Realty execs detailed their various strategies for utilizing existing net-lease data center properties with the goal of making them self-funding though joint ventures.
About 45 percent of Digital's revenue comes from tenant-operated “Power Base Buildings” and from Digital-operated net-lease data centers. This provides a massive portfolio of data centers that can be either be sold or contributed to joint ventures to generate cash.
Digital CEO Bill Stein and CFO Andy Power clarified that PBB buildings, as well as other types of assets in “non-core markets,” can be sold outright. Net-lease assets can be contributed to joint ventures.
“The third would be joint venture capital for the assets that we plan to keep,” Stein added. “That may well be an 80-20 deal. Those would be the hyperscale deals that we do, which have bumps of 2 percent to 3 percent, 10 to 15 years. We think it makes sense to joint-venture that with the private capital money that's out there.”
Asked by Citi analyst Michael Bilerman whether the goal was “to get to the self-funding model effectively, where asset sales, and joint ventures, and the combination of free cash flow plus the value creation and the development pipeline funds your growth so that you become less reliant on the equity markets,” Power said, “Correct, absolutely.”
A Virtuous Cycle
Data center operators with a track record of meeting daunting construction schedules and delivering on service level agreements for facility uptime often get repeat business from hyperscale clients. This results in successful developers owning portfolios of massive data centers. In an ideal situation, they are generating attractive returns compared to the cost of equity and debt capital deployed.
However, this success can also create a need to monetize stabilized properties to help fund future projects. Additionally, publicly traded companies must balance long-term strategic goals with delivering solid quarterly results for investors. Institutional investors are increasingly the solution, providing huge amounts of capital in a joint-venture format.
This is project-level financing rather than investment in a corporate entity. If properly structured, it can increase a REIT’s shareholder returns.
Investor Edge
Building data centers designed to attract hyperscale customers has become a big part of what the biggest data center developers do.
Accounting rules require that a REIT carries commercial real estate on the books on a cost basis. Each year this "book value" gets reduced by depreciation on the building and its components, further obscuring the variance between market value and asset valuation on financial statements. So, the potential gain on sale from embedded profit can be harder for investors to quantify.
One way for a REIT management team can demonstrate to Wall Street that its shares are undervalued is to sell one or more assets outright. But there are many reasons an outright sale isn't always attractive. Contributing a portfolio of assets to a joint venture is another way to do this. Partners’ ownership percentages in the venture can vary widely based on their cash needs and goals. But in any case, the price of the assets is revealed.
Publicly traded REITs, including data center operators, have another issue to contend with from time to time: low earnings multiples. This can create a situation where a company’s shares trade at lower prices than its portfolio’s net asset value. Many variables can contribute to such a valuation paradox. Even well-managed public companies can find themselves in a frustrating situation where private real estate valuations are higher.
Having an institutional partner in the wings can create a virtuous cycle that among other benefits can help avoid this.
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