Crunch Time: Credit May Limit Data Center Supply

Real estate losses are starting to spread from the residential sector to commercial real estate, and will begin to generate large losses for lenders, analysts say. Those losses will prompt even tighter credit conditions, which will likely constrict the amount of new supply in the data center market, making it difficult for new players to finance and build planned data centers.

Analysts at Goldman Sachs are now predicting that the value of commercial real estate will decline 21% to 26% in the next two years. Goldman's William Tanona says that trend will prompt write-downs of $7.2 billion for leading Wall Street firms in the first quarter of 2008. Those losses will likely have a chilling effect on the already-tight credit conditions.

The recent erosion in the commercial real estate market introduces a new wrinkle into the supply and demand outlook for data centers, as analysts have expected that a flurry of new projects announced over the past 18 months would eventually meet the booming demand for premium space.

A Constraint on Overbuilding

Even with slowing demand, the tougher outlook for new construction reduces the likelihood that a new wave of overbuilding will lead to a repeat of the data center glut of 2002-03, when dozens of data centers were built on speculation to house an expected flood of Internet businesses. Facilities built by Colo.com, Exodus, Relera, MCI/WorldCom and AboveNet were sold through bankruptcy auctions or distress sales.

Data center executives say the liquidity to support that type of overbuilding is not available anymore. "Raising debt on this asset class will be very, very difficult, especially for a private company," said Hossein Fateh, president and CEO of Dupont Fabros Technology (DFT). "If someone wanted to build a data center right now, they'd have a very difficult time raising debt."

Tighter credit "is absolutely a constraint on supply," said Tony Wanger, Senior Managing Director of i/o Data Centers. "There's much less capital available and far fewer suppliers. You just have fewer lenders in this space. You're now down to balance sheet lenders."

Fateh and Wanger are industry veterans who had front-row seats during the dot-com boom-and-bust cycle, and emerged with successful properties. Wanger says the demand side of the data center business is now very different, but the psychological shift among lenders is familiar.

"There are two forces driving the markets: it's fear versus greed," said Wanger. "Greed was winning for several years, but now fear is ruling Wall Street. It's a different discussion (between data center builders and lenders). It's very focused on 'what happens if this doesn't work' and 'what's the liquidation value.' They're taking a tough look at these projects."

No Data Center 'Glut'

In the last year, securities analysts have pressed executives of publicly held data center companies about the possibility that new supply from a flurry of announced data center projects might once again create a surplus of premium space. In conference presentations last summer, Daniel Golding of Tier1 Research said rumors of a "glut" of data center space had begun to circulate, which didn't reflect an accurate appraisal of the market. Tier1 has predicted that "explosive demand" will outpace supply for the next several years.

Analysts say the commercial real estate market is healthier than the residential market, where the subprime lending crisis has led to huge losses for financial institutions and raised concerns about a wave of home foreclosures. But even if the losses are smaller, the prospect of losses in the commercial real estate has had a chilling effect on lending.

The availability of financing is important in the data center sector, a specialized market which has historically had a high barrier to entry. Thus far, most of the concern about the data center market has focused on the possibility that tighter IT budgets will reduce demand for data center space. Analysts like Gartner and IDC expect slowing of IT spending in 2008, particularly in the hard-hit financial sector.

The Building Boom

For the past two years, demand has outstripped supply in major data center markets, creating a bullish scenario for data center builders and a favorable pricing environment for colocation providers. 2007 was a huge year for construction projects by data center specialists including Equinix (EQIX), Terremark (TMRK), 365 Main, Digital Realty Trust (DLR) and Savvis (SVVS), as well as Microsoft (MSFT) and Google (GOOG).

The new construction has been driven by demand from a wide cross-section of users, along with sharply escalating power loads and cooling requirements, which have created capacity problems for many existing data centers.

The specialized nature of data center real estate may make lenders wary of new market entrants without a track record building and managing these facilities, which cost as much as $1,000 a square foot to build. The credit crunch may also affect the pricing and terms of credit, with some borrowers being required to put more of their own money into a project. At the very least, changing conditions present challenges for data center projects that have been announced but are yet to finalize financing, as well as projects that are still in the design phase or awaiting a build-to-suit tenant.

In some cases, credit issue may also mean stricter terms for data center tenants. Fateh said the issue came up in DuPont Fabros' leasing efforts at its new ACC4 data center in Ashburn, Virginia. "We've got a couple of openings in ACC4, and we're being picky about who we take," Fateh said last week in the company's conference call with analysts. "There a couple of (prospective) tenants where we weren't entirely sure about their credit, so we asked for either a deposit or a higher rate."