Commercial Mortgage Insight

Financing Considerations For Telecom-Oriented Properties

Want to be one of the first lenders to finance a carrier hotel? Demand for telecom space has exceeded supply, but the new asset class carries significant risks.

BY PETER MORRAL

Within the last five years, there has been a significant amount of activity clustered around the conversion of older office, industrial and retail buildings into assets that serve a telecommunications-related use.

Although telecommunications-oriented buildings have served companies such as AT&T and Western Union for many years, the emergence of these properties as a commercial asset class is a recent phenomenon that correlates with the growth of the Internet and the deregulation brought about by the Telecommunications Act of 1996.

Sometimes referred to as telco hotels, carrier hotels, cyberports, cybercenters or data centers, these properties tend to house mission-critical voice, video, data networking and transmission equipment, such as servers, switches, routers, fiber optic transmission and other data networking equipment.

Often well-situated near major fiber optic lines in metropolitan areas, quality telecom assets combine unique physical and technological attributes to create a highly reliable and secure infrastructure.

Historically, the creation of these assets has generally been associated with the conversion of an underperforming and possibly obsolete building into an asset that commands higher rents than its former use and any foreseeable alternative uses.

In their current forms, telecom properties have some resemblance to office buildings due to the lease structure, the capital investment required to build out a property and the fact that an office use, in most instances, is presumed to be the most viable alternative.

Characteristics that are often associated with quality properties include:

proximity and connectivity to fiber optic carriers and local power grids;
large horizontal floor plates with load-bearing capacity for heavy equipment;
high ceilings for raised floors and racking systems;
riser space for fiber optics, power cabling and chilled water;
roof space for antennas and cooling towers;
advanced security and cooling systems; and
ability to house redundant backup power systems, including generators and battery farms.

Operations and tenancy

Given the unique needs of the tenants and the rapid pace of change in the telecom industry, the proper operation of a telecommunications facility requires the involvement of a responsive and knowledgeable manager.

Consideration must also be given to the ease with which the infrastructure at a facility can be upgraded, whether a facility provides access to competing telecommunications carriers and the degree to which future technological upgrades are the responsibility of either the landlord or the tenants.

The tenants themselves generally utilize a facility to offer uninterrupted services such as switching, co-location or Web hosting. Given that Internet and telecom concerns are often growth companies, some of the tenants at these properties may be of uncertain credit quality.
In such instances, contractual tenant obligations, the existence of letters of credit and/or security deposits, and a tenant’s investment in capital improvements to its space take on added importance.

Location

To date, there has been a favorable bias for assets that are well located in top-tier metropolitan areas, such as Boston, Chicago, Miami, New York, San Francisco and Washington, D.C. In large part, the preference for these areas over secondary locales is based on the perception that they provide superior access to power, as well as proximity to major fiber optic lines and established customer bases.
Recognizing that most tenants have significant power requirements, it is important to note that the availability and cost of power could evolve into competitive issues in some regions. When evaluating these properties, therefore, it is important to take into account the ways in which power-related issues can impact an individual asset.

In a similar light, there is currently strong demand for both co-location and Web-hosting space in most top tier cities; however, the long-term superiority of these areas over potentially lower-cost locations with ample power capacity is unproven.

Other considerations that should be taken into account when assessing the strength of a specific location include proximity to fiber optic lines, regional Bell assets and other major telecom buildings, and a customer base.

In addition, it is important to think about potential barriers to adding new supply, the availability of skilled technical workers and the likelihood that a location can support an alternative use.

Telecom assets are expensive to create and, historically, traditional development financing has largely been absent from the market. As such, a significant amount of upfront equity is generally required and opportunistic investors have played an active role in developing these assets.

Standard & Poor’s considers the amount of upfront investment and the amount of time it takes to bring a new facility online as potential barriers to future competition.

Additional supply-related considerations include the strength of competing properties, the number of potential conversion opportunities in the market, the existence of any moratoriums or municipal constraints to adding new supply, the degree of difficulty a tenant may encounter when relocating to a new facility and the likelihood that current rents will spur new conversions and ground-up construction.

Strong demand

Throughout the short history of this asset class, demand for quality telecom space in the U.S. has exceeded supply. Key drivers of recent demand growth have included higher Internet adoption rates, the continued growth in data storage, the growth of business-to-business communication and the data-intensive nature of new communications technology.

Although some analysts are predicting significant long-term demand growth for telecom space, Standard & Poor’s takes a moderate approach to industry growth, based on the absence of meaningful historic information on this asset class and the telecom industry’s rapid rate of change.

As a function of telecom-oriented properties being a relatively recent phenomenon, there is limited information available on sustainable market rents and cap rates, the performance of these properties over a full economic cycle and the long-term need for certain service providers, such as co-location and Web-hosting providers, to be located in high-rent areas. Additional concerns center on the volatility of the telecom industry and the fact that tenants and service providers at a telecom facility may be of uncertain credit quality.

To date, established telecom properties have been essentially sheltered from industry volatility and associated credit risk by pent-up demand for space in the market. Nevertheless, credit quality is an important consideration, and a stable income stream will maintain greater value as the industry matures and the ease of backfilling space decreases.

Overbuilding risks

It also must be acknowledged that any segment of the real estate industry that appears to have above-market rents potentially runs the risk of overbuilding. This concern can, in some instances, be partially mitigated by the switching costs and disruptions to service that a tenant may incur when relocating to a competing facility and by any existing barriers to adding new supply that may be present in the market.
It also should be noted that these are service-intensive assets and, as such, there may be a limited universe of qualified managers and potential buyers for these properties at some point.

A major area of uncertainty surrounds potential obsolescence. Traditionally, the telecom infrastructure in the U.S. has resembled a hub-and-spoke system and, to date, there have been no indications that any future technological changes will result in the emergence of a decentralized system.

Within this framework, these properties are part of the infrastructure that currently allows the industry to operate. It is also important to note that future technological advances are widely anticipated to have a more dramatic impact on the equipment that is housed within a property than on the property itself. Nevertheless, the industry moves rapidly, and a fundamental shift in communications technology cannot be ruled out.

Ideally, a property will be master-planned and easily upgradeable. Additional factors that could mitigate concerns about obsolescence include a diversified rent roll, improvements that can be adapted to an office use and shorter loan amortization schedules.

In light of recent power shortages in California, it is also important to note that most telecom assets have substantial power requirements and that the ability of utilities in some regions to deliver on their agreed upon-power obligations has been called into question.

Because power capacity and power costs vary by region, it is important to note that power could, at some point, evolve into a competitive issue.

Financing history

Based on the limited financing history for telecom assets, the exit strategy for investors and telecom lenders remains somewhat unclear. There has been a limited amount of securitized lending so far, and lenders are generally more interested in providing financing based on shorter amortization schedules and moderate loan-to-value (LTV) and loan-to-cost (LTC) ratios, instead of offering fully-leveraged loans.
Given that the emergence of telecom properties is a recent phenomenon, the market is still in the formative stages of developing a framework for evaluating this property type. As such, investors in these properties should carefully consider a wide range of factors when reviewing each asset. Of significant importance is the underlying reality that the long-term performance characteristics of these assets are untested.

Perhaps the biggest source of uncertainty centers around the potential technological obsolescence of each individual property and the volatility of the telecom sector. With that said, the amount of uncertainty surrounding these assets is expected to decrease as the telecom sector matures and more information on this asset class becomes available.

Peter Morral is an associate director in Standard & Poor’s Real Estate Finance group.

This article was previously published in the April 2001 Issue of Commercial Mortgage Insight