Expert Blog: Data Centers - Imbalance Between Supply and Demand

Jordy Kleemans

As COVID-19 moved life into the online world, the amount of data skyrocketed. Between February and mid-April 2020, global Internet traffic increased by nearly 40% due to the rise of video streaming, video conferencing, online gaming and social networking.

And all this while demand for digital services had already increased dramatically over the past decade. By 2020, 59% of the world’s population was connected, up from 26.6% in 2010. During the same period, global Internet traffic increased twelvefold. The amount of data collected by business is also increasing at an unprecedented rate, spurred by the rise of the Internet of Things (IoT), artificial intelligence (AI), augmented reality (AR) and blockchain.

Devices with IoT functionality are widely accepted for surveillance and monitoring purposes, especially in healthcare. By 2023, Cisco Systems estimates that machine-to-machine (M2M) communications will account for 50% of the projected 14.7 billion connections. In 2018, these M2M communications made up 33% of the 6.1 billion connections. New applications that will emerge from the introduction of 5G will play an important role in the growth of M2M connections over the next two years.

Meeting Future Storage Needs 

To meet this explosion in demand for storage capacity, the number of data centers of all types and sizes (hyperscale, cloud, edge, micro and modular) is rapidly increasing worldwide.

By 2026, the global data center market is expected to have grown to $251 billion, with an average annual growth rate of 4.5% between 2020 and 2026. Strong growth is also evident in the Netherlands, for example. The most favored location remains Schiphol Airport, according to an analysis with Savills Maps. Over the past 5 years, the number of square meters of commercial multi-tenant data centers has increased by almost 50% (source: PB7 2020).

Cloud infrastructure has played an important role in the ability of companies and governments to quickly apply solutions to respond to the pandemic. In Snow Software’s global survey of 250 IT leaders conducted last June, 82% of respondents said they had increased their use of the cloud to enable remote working, while 45% of respondents said they planned to accelerate cloud migration.

As the unprecedented shift to the cloud will become critical for many businesses and institutions, the demand for cloud data centers will continue to grow for the foreseeable future and new demands will be placed on collocation facilities. We are already seeing cloud service providers and colocation data centers increasingly collaborate to deliver better connectivity and networking across a global data center infrastructure.

New Opportunities for Market Leaders

This rapidly increasing demand for cloud and data center colocation services has caused a race for scale and global reach within the industry, with fierce competition between IT giants and smaller players in the market.

Since 2015, consolidation among service providers has increased. In 2017, Digital Realty acquired DuPont Fabros for $7.6 billion. March 2020 saw a new record: Digital Realty’s acquisition of Dutch data center company Interxion for $8.4 billion, the largest acquisition transaction for a data center ever.

In the first 11 months of 2020, 113 data center acquisitions and mergers were recorded worldwide, worth $30.9 billion, according to Synergy Research Group. Digital Realty and Equinix, the world leaders in data center colocation, accounted for 35% of the total transaction value recorded since 2015.

In addition, due to the rise of edge computing, an ecosystem of modular data center providers has emerged in recent years, including companies such as Vapor IO, EdgeConneX, EdgeMicro, DartPoints, DataBank, Baselayer and Switch. Mergers and acquisitions within this ecosystem are already beginning to attract the attention of the traditional major players in the data center colocation market. In 2018, Compass Datacenters acquired EdgePoint Systems. Last year, Smart Edge was purchased by Intel for $27 million to enable the network transformation to 5G.

A consolidation trend is also evident in the Netherlands. Despite the growth in the number of square meters of data centers, the number of data centers decreased slightly over the past 5 years to 189 (-8%). This indicates an increase in scale and a further professionalization of the market.

Increasing Investor Interest

COVID-19 has brought data centers into the spotlight, but investor interest in this sector has been increasing for five years. The sector has a strong foundation and demand is expected to grow dramatically over the next five years.

Since relocating a data center is a very complex process, tenants typically stay at a location for a long time, ranging from 10 to 30 years. Thus, the industry offers a long-term source of income and security.

Yet high barriers are causing investors to invest massively in the sector. The three main reasons are:

• High infrastructure costs make data centers expensive to build
• They are difficult for non-specialists to manage and require large scale to be profitable
• The speed of technological developments means that there is a risk of obsolescence, which entails high maintenance and upgrading costs

As a result, most existing data centers are user-owned, mainly a few specialized public REITs that dominate the market. These are notably the US REITs Digital Realty and Equinix and the Asian REIT Keppel DC. The strong polarization of market players has had a catalytic effect on market liquidity and transparency, making the market less open to private capital.

New Market Strategies

Nevertheless, over the past three years, non-specialist private institutions have slowly begun to invest in data centers, including general REITs, asset managers, institutional investors, sovereign wealth funds and infrastructure funds.

To circumvent the lack of transparency and high degree of specialization required by the market, private investors will increasingly use partnerships, joint ventures and acquisitions to enter the market. Given the imbalance between supply and demand, new construction and repurposing will continue to be the best gateways into the market.

Yields are generally attractive compared to other types of buildings, but there are large differences globally, related to the liquidity premium. According to the FTSE Nareit, the data center sector delivered a total return of 20% in 2020. In the U.S., the most liquid market, prime property yields range from 4% to 12%; a big difference that depends heavily on size, maturity and location within the country.

In Japan, prime data center yields range from 4 to 5%, in Western Europe from 5 to 7%, in Singapore from 6 to 7%, in Malaysia from 7 to 7.5% and in China from 8 to 12%.

With the market maturing rapidly and catching up, we expect strong yield compression over the next one to two years. This is particularly true in China, where yields are still relatively high and demand for data storage is expected to be one of the fastest growing in the next five years.