Flipping the Switch
- Aug 20, 2013
REITs come in all sizes and specialties, but few can lay claim to the invention of an entirely new asset class. One such innovator is Digital Realty Trust Inc., the San Francisco-based data center specialist. Under the leadership of co-founder & CEO Michael Foust, the company has assembled a 22.7 million-square-foot portfolio of 122 data centers in 32 cities on four continents. During that time, Digital has implemented strategies to trim construction time, enhance connectivity and foster sustainability. Last year, revenues grew to $1.3 billion, an 18.2 percent year-over-year increase.
Nine years after Digital’s initial public offering, the firm is riding a global wave of demand for these specialized facilities. “The outsourcing trend is really starting to pick up speed,” Foust explained. “Especially coming out of the recession, a lot of companies are seeing the value of investing capital into their creative activities, and not necessarily into data centers.” That is driving demand for resilient, secure facilities, he added.
Digital’s performance and practices have quickly earned respect. In 2011, Forbes magazine named the young REIT one of the nation’s most trustworthy public companies, a citation based on such factors as financial transparency, risk management and the integrity of its leadership.
In the United States, Digital operates properties in 22 markets from coast to coast. Highlights of its activities during the first half of 2013 reflect that geographic diversity. In early June, it opened a 130,000-square-foot facility in Needham, Mass., that is the first to be built specifically as a data center in Greater Boston in more than a decade.
On the acquisitions side, in early April, Digital closed on the $37 million sale-leaseback of a 329,000-square-foot data center in Eagan, Minn., a Minneapolis suburb. Delta Air Lines occupies the property under an eight-year triple-net lease. Digital also used a sale-leaseback structure recently to expand its footprint in metropolitan Paris, a longtime favorite market. In January, the company closed on the 60 million-euro acquisition of three properties from the French telecommunications provider Bouygues Telecom.
All told, the company will probably buy between $300 million and $400 million worth of properties worldwide this year, Foust estimated. In 2012, Digital’s investments hit a company record of $1.6 billion, largely on the strength of a single deal: the $1.1 billion purchase of three data centers in metropolitan London, another Digital favorite. (For more about Digital’s global strategy, see “Global Connections,” at left.)
Colleagues say that Foust’s background is well suited to running a digital-age REIT. “He’s able to take his knowledge of technology and knowledge of real estate and blend the two,” noted Richard Magnuson, a co-founder of the company’s privately held predecessor, GI Partners, which spun Digital off in its 2004 IPO. “He’s a shrewd tactician; he can see three or four years out, which is very important, especially in the technology sector,” added Magnuson, who served as Digital’s non-executive chairman until earlier this year.
In conversation, Foust soon reveals the eclectic interests that characterize his leadership: They range from real estate strategy to music, sports to philosophy, noted Michael Elizando, executive managing director of Long Wharf Real Estate Partners L.L.C., a Boston-based investment management firm. “I think Mike is as good a student of these things as anybody you will ever find,” said Elizando, who has known Foust since both were students at Harvard Business School.
Foust’s acquaintance with technology dates back to the dawn of the Digital Age. After graduating from Harvard with high honors in anthropology, he worked from 1979 to 1985 for two affiliated telecommunications companies, Consortium Communications International and Progressive Systems Inc. The firms provided message switching and turnkey networks to multinational corporations. “Little did I know that I’d be getting involved many years later” in the technology industry, he says.
While staying involved with the firms, Foust returned to Cambridge, Mass., in 1981 and enrolled in Harvard Business School. There his classmates included at least one other future real estate CEO: Matt Khourie of CBRE Global Investors (profiled in the April issue of CPE). During business school, Foust already showed signs of the kind of entrepreneur he would become, according to Elizando. “I always thought that Mike was more interested in the strategy and the building of the business than he was in being a deal junkie,” he recalled.
After completing his M.B.A. in 1983, Foust spent two more years with Consortium Communications and Progressive Systems while mulling his next move. Commercial real estate intrigued the multi-faceted young entrepreneur, and in 1985 he signed on with Trammell Crow Co. The company posted him to Los Angeles and assigned him to developing and redeveloping suburban office and flex space. Like other executives who apprenticed with Trammell Crow, Foust benefited from its namesake founder’s practice of conferring early responsibility on the company’s young recruits.
When a recession slowed Trammell Crow’s project pipeline in the late 1980s, Foust switched to investment management. In 1990 he joined Newport Beach, Calif.-based Karsten Realty Advisors, working there for the next three years. Next came two years at UBS Asset management. In 1995, he joined CB Richard Ellis Inc. as senior vice president for asset management services in the Southern California region. Four years later, he moved to CB Richard Ellis Investors, where he spent two years as a senior director.
In 2001, Foust and Magnuson, a CB Richard Ellis Investors colleague, launched GI Partners, a technology-focused investment management company. As a managing director, Foust oversaw acquisitions and management of technology-related properties and started cultivating an interest in data centers.
Three years later, GI Partners spun off its technology affiliate as Digital Realty Trust Inc. in an IPO. Many institutional investors greeted the fledgling company with skepticism. “I don’t think any of the traditional REIT buyers participated,” Magnuson recalled. He speculates that those players hesitated because they had never seen a data-center REIT before.
Any reluctant investors notwithstanding, Digital Realty’s IPO raised a respectable $240 million. In the first months after the IPO, Digital Realty made strategic investments in key markets. By early 2005, the company had added $92 million worth of data centers in Minneapolis-St. Paul, Philadelphia and Burbank, Calif. Large-scale transactions during that first year included Lakeside Technology Center in Chicago, a 1.1 million-square-foot property acquired for $140 million. All told, Digital’s acquisitions totaled $466 million during its first year as a public company.
Besides fresh capital and an expanded portfolio, Digital Realty’s IPO brought ample challenges. Foust himself counts the transition as a personal milestone. Taking the company public and “working in the public environment was a big change,” he explained. “We adapted pretty well. It took a couple of years to get our sea legs, but we established ourselves as a qualified management team.”
Weathering the Recession
Only a few years into the REIT’s life, the recession presented challenges on an altogether different scale. As wary users cut back on their commitments to new data-center space, Digital’s lease signings slipped to $472 million in 2009 from $1 billion only a year earlier. In response to the slump, Foust stayed disciplined, limiting acquisitions to just $252 million in 2009. Similarly, he slowed development and re-focused Digital’s energies on maximizing the value of existing properties.
As a result of those measures, Digital thrived while many other REITs endured hard times. In 2009, Digital increased its revenues more than 20 percent to $637 million. Its conservative approach to debt and equity helped the company withstand the recession. Foust cited the contributions of Bill Stein, who has served as the company’s CFO & chief investment officer since 2004. Stein, he noted, “did a great job of positioning our balance sheet. When the recession hit, we had no fiscal issues at all.”
Stein’s efforts helped ensure that Digital had the resources to keep growing. In January 2010, the company exceeded the previous year’s acquisitions in a single stroke when it paid $375 million for three properties in Bedford and Needham, Mass., and Trumbull, Conn. Today Digital’s debt carries an investment-grade triple-B rating that lowers its cost of capital.
About six years ago, the company started rolling out its development program in earnest. Foust realized that the step was necessary to meet demand and expand its portfolio. At first glance, Digital’s strategy may seem counterintuitive. Rather than shunning speculative building, Foust is willing to launch construction without tenant commitments. But in the data-center niche, a well-planned spec building program is actually less risky than the alternative. Foust explained that the dynamics of Digital’s speciality—fast-paced demand, a need for flexibility and competition to serve clients—means that staying a step ahead is paramount.
Digital carefully sizes up demand for data centers and starts building in markets where demand is expected to grow. Data-center users themselves drive the need for speculative projects. “The customers want to see the facility,” Foust explained. Moreover, clients want to know that they can count on occupancy on a certain date. (Click the button above to see charts from a study commissioned by Digital to determine data-center customers’ top markets and what they want in their facilities.)
As in other specialized real estate categories, data-center development is a capital-intensive undertaking. Depending on location and other variables, development costs can range from $650 per square foot to upwards of $1,000 per square foot, Foust noted. Digital has adopted a number of strategies to maximize efficiency and reduce risk. “We’re building on a pretty good scale,” he reported—about 1.4 million square feet in the pipeline. That enables it to buy materials in big batches, creating economies of scale.
In addition, Digital likes to develop in phases so it can respond rapidly to market shifts. “Because we don’t have to build 150,000 square feet or 200,000 square feet at the same time, it gives us a lot of flexibility,” Foust explained. Time is of the essence in data center delivery, so Digital takes a modular approach to mechanical and electrical systems. Components are pre-fabricated, pre-commissioned and stored in warehouses. The strategy is central to the firm’s proprietary Turn-Key Flex service.
When needed, the mechanical and electrical systems are then delivered and re-commissioned. Besides offering efficiency and economy of scale, the modular approach allows clients to custom-design their projects. Last year, Digital delivered more than 49 megawatts of capacity, and another 89 megawatts are on the way this year. In January, the company released the latest iteration of POD Architecture, which provides the underpinning for the Turn-Key Flex solution. The latest version of POD Architecture increases critical load capacity from 1,125 kilowatts to 1,200 kilowatts without increasing costs.
As a specialist in running data centers, Digital Realty has little margin for error. “Computers don’t like glitches in power delivery, even for milliseconds,” Foust noted. Disruptive service exacts a heavy toll on the properties. During the past six years, however, Digital Realty has achieved the “five nines” standard—in other words, operational availability 99.999 percent of the time. Digital’s data centers passed the test of Superstorm Sandy with flying colors. As tens of thousands of businesses lost power, all 15 Digital sites in locations hit by the storm continued running without missing a beat.
In the decade leading up to that performance, Digital Realty grew from modest origins to a global powerhouse in a brand-new asset category. Technology has re-shaped the business world and real estate during that time, and as they adapt to rapid change, Michael Foust and Digital Realty embody constants: a core leadership group that has been together from the start, focus on a highly specialized development and investment category, an emphasis on technological innovation. To this list, co-founder Magnuson adds the practice of under-promising and over-delivering. It is, he noted, “a skill that people need to understand in the public markets.”
Anyone searching for a lesson in exceeding expectations might want to take a look at Michael Foust.