State of the Data Center IndustryAn Analysis of Washington’s CompetitivenessIn This Fast-Growing High-Tech FieldJanuary 2018Report to the LegislatureBrian Bonlender, Director

AcknowledgementsWashington State Department of CommerceChris Green, Assistant Director, Office of Economic Development and CompetitivenessJoseph Williams, Ph.D., Governor Inslee’s ICT Sector Lead/AuthorMoh Kilani, Lead Researcher/WriterNoreen Hoban, Project Manager, Research ServicesSteve Salmi, Ph.D., Editor, Research ServicesConsultant on Electricity CostsRobert McCullough, Principal, McCullough ResearchEric Shierman, Research Associate, McCullough ResearchRobby Gottesman, Research Associate, McCullough ResearchSpecial ThanksCody Arledge, Principal, Johnson Arledge StrategiesConan Lee, Managing Director, JLLJohn Sabey, President, Sabey Datacenter PropertiesLisa Goodman, Vice President of Marketing, CenterisSimon Lee, Managing Director, Sapience Capital PartnersJoseph Williams, 206-256-6118, [email protected] State Department of CommerceOffice of Economic Development and Competitiveness1011 Plum St. SEP.O. Box 42525Olympia, WA 98504-2525www.commerce.wa.govFor people with disabilities, this report is available on request in other formats. To submit arequest, please call 360-725-4000 (TTY 360-586-0772).State of the Data Center Industry

Table of ContentsExecutive Summary. 1Introduction. 3Data Center Economics . 4Data Center Market Trends . 11The State of Washington Data Center Market . 17Analysis . 24Closing Observations. 27Appendix A: Urban Competitiveness, Hillsboro vs. Seattle. 28Appendix B: Report on Electricity Cost Comparison . 49State of the Data Center Industry

Executive SummaryThe data center industry is experiencing explosive growth globally and nationally. Althoughdata centers do not create many direct jobs, studies show that a vibrant data center clusterstimulates job growth in related information and communications technology (ICT) industries.This, in turn, drives significant local economic growth.In recent years Washington has captured relatively little new business. As recently as 2011Washington was considered the data center hub of the Pacific Northwest, but that is no longertrue.To better understand what happened, the Washington State Department of Commerce(Commerce) was directed in the 2017-19 Operating Budget (SSB 5882, Section 128, Subsection44) to “conduct a study on the current state of the data center industry in Washington andwhether changes to existing state policy would result in additional investment and job creationin Washington as well as advance the development of the state’s technological ecosystems.”Key FindingsThe national data center market has been booming since 2012, both in terms of newconstruction and global demand. Profit potential for data center owners remains strong andmargins are better than those available for other kinds of commercial construction, includingClass A office space. Market competitiveness and improving technologies have made it morecost-effective for enterprises to move their workloads off-premise into independently operateddata centers. Explosive growth in cloud computing has radically increased the size andeconomic impact of data center investments made by the four major service providers(Amazon, Facebook, Google, Microsoft) in the United States.Growth in the Washington data center market has been on the low end of the market, both interms of new construction and in terms of measurable gross business income.The Seattle market has grown at about 3 percent year-over-year (YoY), which is essentially nogrowth given that market’s unique demand for retail co-location next to the Seattle InternetExchange (SIX) for interconnection purposes.Three probable causes for Washington’s lagging growth are identified: (1) lack of aggressivepromotion of the state’s data center economy and opportunities compared to other states; (2)historic confusion in the market about Washington’s data center incentives, which may nolonger be that competitive; and (3) concession of the urban data market to Oregon because theSeattle market is not competitive on the basis of sales tax.State of the Data Center Industry1

Conclusions Data center growth in rural Washington is at the lower end of the growth rateexperienced by other major competitive markets. The competition among states fordata center projects has increased dramatically and, if the state desires to attract moreprojects, Washington should improve its promotional strategy for this industry segmentand reexamine the competitiveness of its overall incentives strategy. Urban Washington counties that do not have access to sales and use tax exemptions fordata centers are at a competitive disadvantage to other urban data center markets suchas Portland that either do not have sales tax or that offer tax incentives that abate thesales tax.State of the Data Center Industry2

IntroductionThe data center industry is experiencing explosive growth but Washington has capturedrelatively little new business.To better understand this issue, the Washington State Department of Commerce (Commerce)was directed in the 2017-19 Operating Budget (SSB 5882, Section 128, Subsection 44) to:conduct a study on the current state of the data center industry in Washington andwhether changes to existing state policy would result in additional investment and jobcreation in Washington as well as advance the development of the state’s technologicalecosystemsReport OrganizationThis report provides an update on current data center economics to explain how data centermarkets now operate and what motivates its primary actors. It then provides an overview ofmeasures of data center market health. Data center market trends and recent deal flows forthe United States are presented along with a benchmark growth metric for a healthy datacenter market. The Washington data center markets are described and evaluated vis-à-vis thatbenchmark growth metric, followed by analysis. Appendices provide additional insight into theregional competitive situation with Oregon.State of the Data Center Industry3

Data Center EconomicsThere are two perspectives important to understanding data center economics. First, there isthat of the data center owner, typically also the operator, who views the data center much likeany other real estate investment. They are motivated by the overall profit that can be obtainedfrom the project, so they are focused on their return on investment (ROI). Second, there is thedata center tenant, the customer that leases space, power, and telecommunicationsinterconnect from the data center owner. The data center tenant is motivated by their totalcosts of ownership (TCO).A variant of these is the off-premise enterprise data center, such as those run by Microsoft orAmazon, where the owner and the tenant are one and the same. These operate as cost centersto the enterprise, so their operators are focused on TCO, but at construction the enterprisedata center is also motivated by the same capital-cost issues that data center owners have.There is an important caveat to any treatment of a data center economy. Data center ownersand tenants treat their customers, finances, contracts, and construction data as confidentialinformation. While local economic development authorities, site selectors, and governmentofficials do release data center project information to the public, often that information isincomplete.Moreover, there is no consistent repository for this information nor are there any consistent setof reporting metrics. Even the physical size of a data center can be misconstrued, as there is adifference between the amount of space available for housing servers (i.e., the data centerfloor) and the overall size of the building, which includes space for offices, HVAC, and otheroperations – and companies are not always clear about or consistent in what they report. Inshort, there is an inherent lack of precision in the data. This imprecision follows also in state ofWashington data, where “data center” is not its own North American Industry ClassificationSystem (NAICS) category. This report thoughtfully distills and presents what is salient; while thenarrative is accurate, there is some inherent roughness in the data.The Data Center OwnerMany data center owners started as real estate development companies that branched intodata centers. In Washington, examples of this would include the Sabey Corp. and Centeris.Others are global real estate investment trusts that specialize in data centers, such as Equinixand Digital Realty Trust. Data center owners can also be telecommunications companies (e.g.,CenturyLink) or enterprises (e.g., Apple or Google).Data centers require high-capital investments to build, not just for the buildings themselves butfor the roads, power, fiber, water, HVAC, fire suppression, and other infrastructure costs thatmust be incurred. Customers demand sophisticated designs and services, so data centerState of the Data Center Industry4

owners have to stay current on globally accepted criteria such as the ANSI/TIA-942 standard.1These standards evolve over time,2 so to stay certified data center owners have to continuallyinvest in upgrading their equipment and processes. Thus, the ROI calculation used by datacenter owners includes a large initial outlay of capital at the beginning of the project andupgrades to the infrastructure on a perpetual three- to five-year cycle.The economically productive life span of a typical data center is 10-15 years, so this defines theROI horizon of these projects.3 Aging data centers do not capture the premium rents thatnewer and more efficient data centers command, so the data center ROI profile is not dissimilarto that of Class A office space.Data center owners are as knowledgeable and sophisticated as large-scale commercial builders.As such, their investment decisions are based on complex models that take into account asmany as a hundred decision attributes. The critical decision criteria that most impact their ROIare:4 Land costs. Power costs. Net taxes (after incentives). Construction costs. Equipment costs, especially costs specific to a particular geography. Labor availability and cost. Regulatory and operating environment.The data center owner is also going to account for customer proximity, geographic and weatherstability, geographic accessibility (airports, roads, etc.), fiber density, and other risk factors.However, the criteria bulleted above are the most economically significant. Facilityconstruction and infrastructure provisioning average about 71 percent of overall project costs.Power and taxes account for about 22 percent of project costs, while land acquisition and laborcosts account for the rest.5 Land costs, construction costs, equipment costs, and labor costs donot greatly vary among potential sites outside of very large metropolitan areas, so power costsand net taxes tend to be the most significant economic differentiators.6Despite very high capital costs, data center owners have a capitalization rate of around 6.5percent, compared to 3.3 percent for Class A office space.7 The higher returns are due to1 Data report/2State of the Data Center Industry5

increasing demand for data center co-location capacity8 and data center services.9 In order tocompete for capital and investors, data center owners are extremely sensitive to the keyvariables in project economics.10A recent shift in the data center market is an appetite for mega-data centers (aka, hyperscale)that can handle large tenants and can capture scale efficiencies. Where a 150,000 square footdata center used to be considered large, now “large” is 600,000 to 1,000,000 square feet.11Projects that were in the 120 million range are now being upsized to over 1 billion.12 Thehyperscale project economics are even more sensitive to power costs and net taxes, but theyalso need prodigious fiber densities and proximate access to transoceanic cable to improve thecustomer attractiveness of these very large data centers.13Data center owners not only use business complex models to determine site selection, they’vealso gotten aggressive in seeking tax and regulatory relief to improve overall projecteconomics.14 Many states have responded by expanding their incentives to attract these verylarge projects.15 Jobs, taxes, and local infrastructure improvements are what motivates thestates and municipalities to respond to these incentive requests.16Similarly, electricity rates are an important tenant location consideration, and nationally powercosts can vary market-to-market by as much as 300 percent. Data center owners will seeklower electricity rates in markets where that is negotiable or subsidizable.17The data center market is extremely competitive and is undergoing a historic wave of mergerand acquisition activity.18 However, while competition does effect lease rates, the compoundedannual growth rate (CAGR) for data center capacity has resulted in market pricing stability. Inother words, while increasing capacity might be expected to decrease lease rates, offsettinggrowth in demand is actually keeping lease rates nter-park-expects-todraw/article rch/US-Data-Center-Outlook-2017-JLL.pdf9State of the Data Center Industry6

Data center owners can be retail, such as Equinix, which specialize in smaller-tenantconfiguration (e.g., one rack), or wholesale, which specialize in providing services to tenantsthat consume 150 kW or more. A number of data centers provide both wholesale and retailservices. It is also common for a retailer to lease from a wholesale owner in markets where theretailer does not have its own physical presence (e.g., Equinix leasing space from Digital Realtyin a market where Equinix has a customer, but Equinix has no facilities and Digital Realty does).Retail tenants pay higher lease rates than do wholesale tenants. The services model forretailing differs somewhat from wholesale, but the ROI model for a data center owner is thesame regardless of sales model.The Data Center TenantA data center is one of the most expensive assets of any organization.19 As with any costlyasset, enterprises routinely confront the build or buy decision. Increasingly, enterprises arechoosing to outsource some or all of their data center functions to a data center operator,which are referred to as a co-location facility.20 Co-location is where the enterprise controls itsown servers, racks, routers, etc., and the data center owner provides the facilities, includingcooling, power connects, telecommunication interconnects, and security. Tenants pay for thenetwork connectivity they consume from any number of third-party providers, such asCenturyLink, Wave, or Comcast. Tenants also usually pay for the actual electricity they use.Overall infrastructure costs are shared across all co-location tenants. Moreover, the co-locationoperator is able to offer management, maintenance, and security services in the aggregate thatwould otherwise be expensive for enterprises to staff on their own. The largest data centerscan often attract better deals for power, connectivity, and resiliency, which also adds to colocation economic dynamics and could result in savings opportunities that are passed along totenants.Data center tenants have a wide variety of economic motivators for choosing where they colocate. Some key non-monetary concerns are geography (proximity to headquarters, airports),environment (weather, natural disasters, cooling, green energy), and telecommunications (fiberdensity and redundancy, latency). They might even look at the long-term impacts of climatechange.21 Data center resiliency is measured in “tiers,” and enterprises will try to match theirneeds to the offerings of the data centers they are considering for co-location.22After solving for these variables, tenants look at lease rates (typically expressed as /kW butactually is a proxy for how much space and reserved power the tenant requisitions from tandards-overview.htm20State of the Data Center Industry7

data center), electricity expenses, management costs, and taxes.23 Thus, tenant co-locationmodels tend to focus on an overall TCO for occupancy.24 The single largest cost born by tenantsare for the one-time purchases of their servers and related infrastructure. As these costs tendto be constant regardless of location, sales tax become an important TCO differentiator.25Similarly, personal property taxes are a consideration. Servers and related equipment tend toneed replacement every three years or so, and taxes are a recurring operating cost for tenants.On a 10 million equipment deployment, sales taxes can add 1 million or more in costs to atenant in each re-stock cycle. To improve competitiveness, many states have begun offeringincentives to co-location owners and tenants, particularly around sales tax and property taxabatements.The Off-Premise Enterprise Data CenterThe off-premise enterprise data center is a remote facility wholly owned and operated for thebenefit of an enterprise, su