Landlords of the cloud: Data centres as investment opportunity

How to get a piece of Asia Pacific’s data centre action and avoid potential storms. Nimble investors have spotted a new growth story.

Amazon and Google plan to build clouds over Hong Kong in 2018, just their latest mega-investment project as they plot to capture a slice of the data stored across the Asia Pacific region.

It’s not cloud-cuckoo land either; the widespread adoption of cloud computing, the internet of things, smart cities, and big data analytics are all generating a dazzling explosion of data.

Asia’s fast-growing middle class will propel the region into a leader of this trend. By 2021 there will be twice as much mobile data in the region than in North America and Western Europe combined, according to US IT hardware firm Cisco Systems.

Businesses across the region are rapidly outsourcing their data storage into the cloud to amplify their computing power. This helps corporates analyse the petabytes (250bytes) of information that their businesses capture, enabling them to rapidly mould services to changing customer behaviour.

“In the fullness of time most organisations will be all in, in the cloud,” said Dean Samuels, a team leader for Hong Kong and Taiwan at cloud services operator Amazon Web Services.

But cloud operators have struggled to find enough available land or suitable warehouses to stack their computer servers in crowded Hong Kong, where property prices are among the highest in the world. One Amazon source said it would have to rent space for data storage.

The cloud, rather prosaically, is made up of non-descript looking storehouses called data centres that keep servers sitting on racks safe and cool. To build from scratch, their specifications are exacting. The Burj Khalifa, a skyscraper in Dubai, cost $485 per square foot; a fully kitted out data centre can cost nearly three times as much. 

“Data centres are literally the real estate on which the cloud lives,” Eric Solberg, chairman of Hong Kong-based investment firm EXS Capital that buys and develops buildings for data centres, said during an interview with FinanceAsia.

While data centres have proliferated across the US, where rules on building them are relatively uniform and cookie-cutter development finance can easily be secured, Asia has lagged behind.

That shortfall has created an opportunity for cashed-up institutional investors to build data centres – which are basically warehouse-sized secure refrigerators – and then rent them to cloud service providers such as Alibaba, Amazon Web Services, Microsoft, and Google.

Asia Pacific’s data centre market will generate revenues of $31.95 billion by 2022, according to business consultancy Frost & Sullivan. The market was worth $14.13 billion in 2016.

“Asia is still underserved compared to the West. There are not that many players and the industry is very opaque,” said Jimmy Phua, head of real estate investments across Asia for the Canada Pension Plan Investment Board (CPPIB) in an interview with FinanceAsia

Internet firms, or hyperscalers in the jargon of the industry, are the fastest-growing users of data centres in cities such as Sydney. Their data centres are running upwards of 100,000 servers.

There were 86 data centres operated by 24 hyperscale operators across Asia Pacific at the end of 2016. This number is expected to grow to 160 by the end of 2020, according to Cisco’s estimates, which supplies the equipment for building and connecting data centres.

Renting saves tenants the cost and headache of setting up their own IT hardware across Asia’s patchwork of jurisdictions, each with their unique legal and tax rules. It also avoids the awkwardness of renting from potential competitors, such as telecoms providers, which are the largest owners of data centres in the region.

“The hyperscale guys like Amazon and Google don’t want to share – they want a whole building for themselves. They have so much pent-up demand but don’t want to be a real estate company,” Solberg said.  

In Asia private equity firm Warburg Pincus, global real estate investor Blackstone and CPPIB are among the early movers in terms of privately negotiating ownership of data centres.

“We want to get in early, before more institutional investors get their head around data centres and compress the cap rate,” CPPIB’s Phua said.

 

AHEAD IN THE CLOUDS
Investors searching for alternative asset classes with rewarding returns on investments are finding that data centres offer twin benefits: the security that comes with owning land and long-term leases with wholesale customers and the excitement that comes from being part of the global transition to a service-based economy. 

Property services firm CBRE estimates the return on capital from renting data centres to large wholesale tenants at 12% to 15%.

“Returns are still higher than for light industrial buildings, maybe somewhere between 100 and 200 basis points higher, depending on land costs and location,” CPPIB’s Phua said.

In addition, growth seems assured. Cisco Systems projects that cloud traffic in Asia Pacific will expand at a compound annual growth rate of 31% in 2012-2020, driven by companies outsourcing their data centres from a small server rack on the premises.

One industry insider, who deals with directly with hyperscalers, said they are only planning three to six months ahead because that is the only way they can keep up with demand for cloud usage. Given the time it takes to build a data centre, renting is the only solution that makes sense. 

Apart from hyperscalers, financial firms and government agencies are also migrating rapidly onto the cloud.

“It is not our intent to manage such expensive IT infrastructure,” Micky Lo, chief technology risk officer for Asia Pacific at BNY Mellon, said. Lo wants to remove such fixed assets from the US bank’s balance sheet and use cloud services much like the bank would pay on-demand utilities.

But for most investors this asset class is still virgin territory in Asia.

Only 5% of real estate investors in Asia polled by CBRE said they had invested in data centres to date, but a further 8.2% said they were open to the idea. For its survey, CBRE collected 504 responses from property investors between December 2016 and January 2017.

For institutional investors there is a smorgasbord of options to gain exposure to data centres. Aside from just buying shares in publicly listed real estate investment trusts, such as US-listed Digital Realty Trust or Equinix, which between them own 37 data centres in the Asia-Pacific region, or local players like Singapore’s Keppel DC REIT, there other investment vehicles available.

“There has been an increase in data centre-specific funds, with managers coming from both infrastructure and real estate backgrounds,” Steve Gruber, a managing director on the real assets team at Hamilton Lane, said in an emailed response to FinanceAsia’s questions. Hamilton Lane is an alternative investment management firm that advises big investors.

Real estate and infrastructure funds have also seen increased allocations toward data centres, while co-investment gives an investor direct exposure to data centre platforms, he added. 

CPPIB is going the co-investment route. It said in October that it is partnering with Singaporean conglomerate Keppel to invest up to $500 million in data centres across the Asia Pacific region and Europe.

As a result of rising investor interest, data centre developers are starting to change hands at a faster clip and at higher prices.

Telecoms companies trying to focus on their core businesses are sometimes willing sellers to this new group of investors. Vocus Group, for example, has appointed advisers to help it sell its data centre business in Australia.

And at least one investor has pounced on this trend already. Warburg Pincus backed a fund in 2017 set up by former Tata Communications executive Rangu Salgame to buy from telcos

STORM CLOUDS
Easy money? Not quite.

Classifying data centres as an asset class internally is taking some investors more time than it should. Is it private equity, real estate, or infrastructure? 

Their conundrum is that data centres require some real estate know-how and yet are also operationally intensive businesses that need tech-savvy management teams.

“The investment opportunity has moved so far away from real estate that the building is just the vehicle, powered on data and running on technology,” said Paul Dwyer in Hong Kong, who heads an Asia Pacific data centre team at property advisers Jones Lang LaSalle. “If funds can understand that there is a whole heap more to do.”

The idiosyncrancies of data centre investment have spawned varied approaches. Private equity funds tend to buy a platform and management team, real estate funds look to develop existing properties in their portfolios, while infrastructure teams see data centres as a natural extension of their other investments in power supply and telcommunications.

That global infrastructure investor I Squared Capital was able to justify a $1.9 billion price tag – equating to an enterprise value over 2016 Ebitda of 12.1 times – for Hutchison Global Communications on July 31 was partly because of its plans for data centres in Hong Kong.

The best fund managers combine the varied disciplines, but they are few and far between.

Warburg Pincus is one of a handful of private equity firms tackling the opportunity from multiple angles. It looks for companies or platforms that it can back as shareholders for five to eight years. An example is its joint venture with Nasdaq-listed 21Vianet in the wholesale and built-to-suit segments of China’s data centre market, which counts Microsoft as one of its tenants.

Data centres feature in the business parks belonging to a portfolio company of Warburg Pincus called D&J China. The private equity firm is also looking at its existing real estate portfolio across Asia Pacific for opportunities to convert warehouses into additional data centres.

“We’re different from passive money managers; we’re active investors who will build in local countries as well as weave it together to create a consistent pan-regional platform,” Ellen Ng, a managing director at Warburg Pincus, told FinanceAsia in an interview.

SUPPLY GLUT
While few doubt the long-term exponential growth potential of data across the region, one possible glitch for investors could be a sudden glut in the supply of data centres and mounting competition.
Though Hong King has scarse additional greenfield land and a smaller data centre market than Northern Virginia, London or Amsterdam, it has about 40 data centre providers with more than 50 data centres, according to Digital Realty, citing consulting firm Structure Research and Digital.

“Inevitably, there will be periods where excess capacity accrues – or where market maturity does not quickly keep pace with pricing – and this will pose a risk for investors,” said Andrew Kitson, the head of information and communication technology research at London-headquartered BMI Research in an emailed response to FinanceAsia’s questions.

Some of the global, listed data centre platforms are building capacity in Asia before they have confirmed orders in place, according to some industry players. These companies are also able to use their high stock market valuations to bid aggressively for land and buildings.

The pipeline of new supply in Hong Kong, Singapore, Tokyo and Sydney measured in terms of the power they would use is 334.1 megawatts, according to CBRE. 

The sector certainly has the potential to be volatile. Take Equinix’s share price, which peaked in 2000 at $504, just before the dot.com bubble burst sending its shares down to $2.95 in 2003. The US firm’s stock is now trading around $400.

In December Equinix put some of its capital to work and bought Australian data centre business Metronode from Ontario Teachers’ Pension Plan for A$1.035 billion ($792 million).

Digital Realty REIT,  the world’s biggest data centre company, meanwhile, saw its share price hit an all-time high in October. It is currently trading at a price-to-earnings multiple of 100. 

Analysts are not proclaiming a bubble or even a short-term supply glut as yet as demand for data centres in Asia, handily, still outstrips supply.

CBRE estimates that Hong Kong, Singapore, Tokyo, and Sydney alone could easily absorb an additional 4 to 9 new data centre facilities or 2 million to 4 million square feet of additional real estate. This estimate does not take into account the exponential growth in computing demand driven by advances in technology such as big data.

Of course, it’s always wise to plan in a disciplined fashion, and not simply by extrapolating macro trends.

“We’re conservative about building data centres speculatively. Clearly that means we are de-risking the project but we believe the current environment is underestimating the risks associated with speculatively development,” said Kishore Moorjani, a senior managing director at Blackstone who leads its tactical opportunities group in Asia.

Blackstone has invested in Singapore-based DCI Data Centers, which is building a pan-Asian platform, and Brazil’s Ascenty, both of which have long-standing relationships with global internet firms. 

Another challenge for investors is the paucity of debt financing in Asia to juice returns. 

“Loan-to-value rates are not attractive at all at the moment,” said one acquisitions adviser. Singaporean banks recently offered his US client 30% to 50% leverage on a US billion-dollar data centre deal, which is relatively low leverage.

Bankers in Asia, who are used to extending loans for industrial buildings, often struggle to get their heads around data centres. Partly because the building is only worth between 7% and 20% of the total value of a data centre; the rest is the mechanical and electrical equipment inside, such as monitoring systems and fire suppressants, which bankers are not sure how to value.

“Bank financing in some geographies is woefully inadequate because they don’t understand the sector and seem to attribute a higher level of risk than necessary,” Blackstone’s Moorjani told FinanceAsia.

Having hyperscalers as tenants is a mixed blessing from a financing perspective. Banks will agree more favourable loan terms if a building’s tenants have high credit ratings, which would make a stable cash flow from rents more likely. However, hyperscalers have cottoned on to this and are using their credit strength to negotiate down rents with their landlords.

LOCATION, LOCATION, LOCATION
Developing and operating a data centre platform across Asia is more complex than, say, in the US.
Data centres use vast amounts of power, in some cases the same amount of electricity as a small town. So historically, many have sprung up on top of the submarine cable nodes of Hong Kong and Singapore.

Data centres often need to be built near large cities to ensure businesses can quickly retreive their data, an issue known in the industry as latency. Areas such as Tseung Kwan O in Hong Kong or Jurong in Singapore are popular data centre locations.

However, building from scratch instead of converting warehouses is increasingly necessary to cope with advances in technology. Some of the cooling equipment used in the US nowadays simply doesn’t fit in a smaller vertical industrial building in Hong Kong and Singapore.

A slow shift out from the major hubs is accelerating this year due to the rise of a new form of nationalism, data sovereignty. Governments are increasingly ordering that digital information must be subject to the laws of the country and kept in data centres within their borders.

China implemented a cyber security law on June 1, 2017, which stipulated that foreign companies must store data that they gather on its citizens must be stored locally and support law enforcement investigations. Apple said it would build a data centre in Guizhou in partnership with a local firm.
The US technology giant also plans to build a data centre in Ulanqab City, according to a February report by China’s news agency Xinhua, citing the local government in the Inner Mongolia Autonomous Region.

In Australia, the sale of Asia Pacific Data Centre for A$280 million ($220 million) is under review by the Foreign Investment Review Board, which has become more vigilant of data ownership according to M&A bankers.

More than two-thirds of new data centre supply will be constructed outside the major data centre hubs over the next four years, with the majority situated in mainland China and India, according to CBRE.

LOCAL NUANCES
Asia has myriad of rules and regulations around data storage that have sprung up in response to local concerns. In South Korea, which faces the constant threat of conflict with the North, mapping data that is not stored in local servers is banned, much to the chagrin of US internet firms such as Google.

Across Asia there are many such idiosyncrasies to watch out for, such as the numerous collection of ministry and local government chops – seals used in place of signatures – in China. According to lawyers the Ministry of Industry and Information Technology, China’s telecommunications industry and internet regulator, feels most comfortable when a cloud operator limits itself to providing technical cooperation with a local partner. It does not own the end customer nor can it sole brand its services.

Singapore, on the other hand, offers attractive incentives for foreign direct investment such as data centres. Amazon Web Services revealed in January that it plans to launch its third cloud zone in Singapore during 2018.

For the hyperscalers, private institutional investors can offer data centres across Asia with consistent specifications that eliminate the hassle of local nuances, as well as help them navigate Asia’s many regulatory and tax regimes.

“We’ll take care of the property side and the operators can just move in – like in the aircraft leading business; companies don’t have to weigh down their balance sheet with property,” said Solberg. 
 

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