The Coming Digital Real Estate Bust

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Real estate. They're not making any more of it. Demand is only increasing. Those arguments helped fuel an epic real estate boom and bust over the past decade -- except when it comes to Internet data centers, which have continued to boom on explosive growth in cloud computing. They haven't been able make those fast enough. But that may be changing, too.

A warning shot over the bow
On its recent earnings call, Akamai (AKAM) was asked about co-location price trends in Internet data centers. Here's what the company had to say:

... it's like a real estate market. There are some places where our prices are holding. There are other places where there are very aggressive price declines, and we try to take advantage of that gain in terms of how we deploy our network assets. ... The other lever we have on co-location costs, of course, is to make our servers more efficient and get effectively more throughput for our footprint in the co-lo facility.

Based on Akamai's comments, co-location supply is still constrained in some markets. In others, it's starting to meet demand. That brings to mind a classic real estate maxim: location, location, location.

Economics 101 teaches us that supply and demand affect pricing. When supply is constrained, prices rise. Internet data centers have been benefiting from that situation. But high prices attract more supply, and eventually supply will catch up with demand. When that happens, prices -- and profits -- are destined to fall. And that's starting to happen.  What's more, increasingly efficient IT equipment can offset much of the growing demand for more processing, bandwidth, and storage.  What's good for Akamai can be the opposite for co-location and hosting companies.

Growing up
One factor affecting demand is companies that are shifting from the consumer equivalent of renting to buying their own home. Much like a young adult moving out of Mom and Dad's place for the first time, companies moving onto the cloud often rent a temporary meets-my-needs-for-now space with no intention of a long-term commitment. As the companies mature, gain a better understanding of their needs, and gather cloud assets, they often began building their own data centers.

Generally, it's the largest, most attractive tenants that make that shift. Recent examples include Apple and Facebook. They're following the example of Google, which has built its own data centers for some time. As the horde of young companies pursuing cloud strategies gain scale and mature, many more are likely to follow in Google's, Apple's and Facebook's footsteps.

Other tenants are likely to go bust. From a co-location landlord's perspective, that's the corporate equivalent of having a tenant lose his or her job and move back in with Mom and Dad. Too much of that, and rental rates take a hit.

Build it and they will come?
Many data-center developers are doing the equivalent of building on speculation that there will be a tenant. To wit, the CEO of Equinix (NAS: EQIX) , a large data-center operator, has acknowledged that overbuilding is a "main concern." Equinix invests heavily in the IT infrastructure used to serve its clients. Given the rapid depreciation on IT equipment, pricing pressure could make Equinix's capital expenditures less profitable than anticipated. Pricing pressure is potentially a huge risk for the company.  

Say when
When might co-location and hosting supply catch up with demand? Tier1 Research estimates that data-center utilization in key markets is currently running between 81% (Northern Virginia) and 88% (Silicon Valley). That's less than I'd expect in an exceptionally tight market.

And it's a fast-moving market. In the San Francisco Bay area, which includes the Silicon Valley, rental rates for large tenants have reportedly declined 20% over the past 18 months thanks to new supply that's coming online. A fresh surge of supply is expected in the area before year's end. In the coming two quarters, data-center landlord CoreSite Realty (NYS: COR) predicts that the new supply will outpace demand by as much as 50%.

A recipe for getting burned
With the sector viewed as a cloud play, valuations are sky-high. P/E ratios typically exceed EPS growth rates -- that is, when EPS is positive. Over the last four quarters, CoreSite's EPS was -$0.31 while Internap's was -$0.10. 

Company

Business

P/E Ratio

Dividend Yield

EPS Growth (Most Recent Quarter)

Internap (NAS: INAP) Co-Location and Managed HostingNA0.0%NA
CoreSiteData-Center REITNA3.0%NA
Rackspace (NYS: RAX) Managed Hosting108NA41%
EquinixData-Center Operator950.0%77%
Digital Realty Trust (NYS: DLR) Data-Center REIT734.3%51%
Dupont Fabros Technology (NYS: DFT) Data-Center REIT451.8%296%
InterXionData-Center Operator230.0%NA

The trouble is, supply will catch up with demand sooner or later... and it looks like it might be sooner. When that happens, prices, profits, and P/E ratios are likely to plummet. A UBS analyst stated last December that data-center developers were grappling with slowing growth, rising competition, and pricing pressure that made their valuations "unsustainably high."   

Foolish takeaway
When prices sneeze, revenues catch a cold and profits catch pneumonia. Akamai's comment about pricing trends in co-location centers signals that it may be time for investors to break out the handkerchiefs.

What do you think: Are digital real estate stocks about to bust? To help you stay abreast of developments that affect stocks, The Motley Fool recently introduced a free My Watchlist feature. You can get up-to-date news and analysis by adding these companies to your Watchlist now:

At the time this article was published Fool contributorCindy Johnsonowns no shares of any stock in this story.Motley Fool newsletter serviceshave recommended buying shares of Rackspace Hosting and Akamai Technologies. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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