There’s more to data center lease renewals than paying an escalated rate or moving
Digital Realty Trust and DuPont Fabros introduced turn-key data centers to the market in 2007-2008. The data centers were built speculatively and the density of these structures varied by region — in Chicago and Dallas it was approximately 1.3MW and 10,000 sf, whereas in Santa Clara, Calif, and Ashburn, Va., the square footage was closer to 1.8MW and 12,000 sf.
Fast-forward 13 years, many tenants are utilizing their space differently and might not need all the space or power as they have migrated some of the load to the cloud or changed the load from production to storage. However, during the first nine months of 2019, Digital Realty reported more renewals than 2018 and 2017 combined, reinforcing that there is a need for physical data centers and it is often easier for tenants to remain in place.
Pricing data center renewals are far more challenging than renewing any other type of real estate. Rental rates for most types of real estate are based on amortizing the construction costs, concessions (ramp or free rent) over the term of the lease and backing into the rental rate through a metric such as sf or in the case of data centers, kilowatt (kW).
Renewal rates are often set forth in the lease and or amendments. Most data center leases/licenses are written that the renewal rate is at the then escalated rate but no less than the last year. Some are written at fair market rate based on a variety of variables.
Even though at the end of the initial term all of the costs have been amortized and presumably the landlord has made its profit, most tenants go into a lease renewal with the assumption the rate is going to escalate and they have no choice but to pay that rate or move. THIS DOES NOT NECESSARILY NEED TO BE THE CASE.
As the data center market has grown over the past 13 years so has the landlord’s interest in retaining tenants and attracting new occupants. The publicly traded companies including Coresite, CyrusOne, Digital Realty Trust, Equinix and QTS all report tenant renewals, rental rates, and average lease terms as part of their earnings on a quarterly basis. Data shows that on average they are renewing 80% of their tenants, which means this is room for negotiation..
Tenants should begin the renewal process well in advance of their lease expiration. We recommend as far out as 18 to 24 months. First and foremost, it provides ample time to assess the market and pose a credible threat to migrate racks and updating servers. In addition, it allows a tenant to be flexible related to concessions, such as square feet power and timing, which could work in their favor. For instance, one large bank renewed several data centers with a REIT in January 2020 instead of December 2019 at a significant discount in rate as the REIT didn’t want the lower rental rate to adversely report their fourth quarter averages, creating an optimal solution. for both the tenant and landlord.
Other options to consider include taking a smaller footprint inside a suite or a cage, shifting some of that load to another and creating options to grow into excess capacity as a license agreement with a different service provider expires. Any incremental growth that the tenant can demonstrate would even allow the tenant to renew some or all of the lease early, while reducing current rental rate in what is known as an extend and blend.
In 2019, North American Data Centers was able to negotiate 10 MWs of renewals in Santa Clara, Chicago and Ashburn saving our clients 63% on average over their escalated rental rate. These rates were not necessarily less expensive than a new transaction in a newer property. Construction costs have dropped significantly since many of the original data centers were built and given the increase in competition it is almost without exception that a new building will be less expensive. However, when you weigh in migration costs, downtime and churn of clients (whether internal or external), and racking and stacking in a new location, there is parity.