When companies decide to host their IT operations with a third-party data center colocation operator, the resulting negotiations can cover a fairly extensive myriad of important clauses imperative for the successful transition and ongoing reliability of its mission critical operations. After all, these service-level agreements cover portions of the lifeblood of a company’s IT infrastructure.
The renewal option is one of several agreement provisions that can be overlooked or lightly negotiated by the customer. As each contract term gets closer to its expiration date, taking a proactive approach well ahead of any trigger dates to exercise the renewal option can result in significant savings to the customer. The following will provide some effective guidance as to how the colocation customer should approach the renewal process at the end of their current agreement to shift the leverage to the customer’s favor rather than the data center operator.
How the data center and colocation renewal clause is structured
Back when the original colocation contract was negotiated — sometimes more than 10 years ago — the customer believed they had peace of mind with one or two renewal options. The rate, terms and notice would be clearly defined in the agreement. The new renewal rate to be paid would either be determined at a defined percentage increase or at an operator-determined market rate.
The reality is the renewal option, in any of the variations mentioned above, favors the data center operator due to how they are structured in the agreement. Most options provide for a defined percentage increase, usually 3% to 5% of the prior year’s license rate for space and power fees. Since the customer is accustomed to paying a similar increase each year over the initial term, this increase would seem to be reasonable.
But what if the third-party colocation operator is actually quoting and installing new customers at a lower rate? The renewal option does not provide for this scenario. Should the tenant exercise its option, then they have now committed to the higher rent and not a market rent. Over the past 10 years in many Tier 1 markets, such space and power charges have decreased due to substantially increasing competition among the enterprise-class, third-party developers.
Some renewal options may be defined as granting the tenant a market rate, though the contract wording also provides for a minimum rate, which would typically be last year’s license payment. In this case, the data center landlord can propose a new license fee much higher than what the customer is paying and base this fair market rental on “comparable” space in the enterprise-class facility. So who benefits most from this language? The hosting operator, of course, since “market” provides for all upside and no downside.
Start the renewal negotiations early to test the market
Starting the negotiations with your current provider six to nine months in advance of the notice date can be a very effective strategy. The data center tenant may have to trigger its intent to exercise the renewal option up to 12 months in advance, so commencing negotiations could be 18 to 24 months in advance of contract expiration, which is reasonable. This “pre-period” allows the customer to gain important market education about the competition while showing the data center landlord your serious intent of getting the most aggressive rate.
“Colocation tenants can lock in substantial savings with their current provider by testing the market or at least understanding the market both locally and regionally. We rarely have our clients resort to exercising their option. Using your renewal option should be a worst-case scenario since you would then be locked in to pre-determined rents,” says Michael Rareshide, Executive Vice President of Site Selection Group, a leading data center consultant who represents such colocation and data center users in their mission critical site selection including existing sites across North America.
Using a data center consultant can maximize leverage
Using an outside data center consultant can further enhance the negotiations. Many times the customer has a great working relationship with the developer, their on-site team and their account manager. But this personalized relationship also ensures that the tenant is generally inclined to extend with the current landlord with little or no discussion.
Similar to retaining a commercial real estate broker to negotiate an office space renewal, the consultant can deploy several strategies using local and national market knowledge to ensure a market renewal rate while also preserving the landlord-tenant relationship. In addition, the tenant may gain additional lease rights for future IT scalability, reduction of other fees and needed flexibility that simply would not be available in simply exercising the renewal option.
Time is certainly on the customer’s side. If you commence these negotiations well in advance and are well-prepared, the results can be significant for a successful extension.