In March, as covid-19 spread across Europe and North America, it brought most forms of commerce to a halt. Offices and shops were closed by government order, bringing the physical exchange of goods and services to almost standstill. Travel restrictions left otherwise vibrant hotels and leisure destinations empty.
Not all business has been stifled. Teams, Microsoft’s online workplace communication platform, saw its monthly users soar 775 percent. Zoom, the video chat service, hit 200 million daily users – up from a December 2019 peak of 10 million. Calls through Facebook Messenger and WhatsApp nearly doubled overnight. But the retreat by large swathes of the world’s consumers and workers to a virtual alternative reality has had an immediate impact on most types of commercial real estate. Work, shopping, socializing, even medical appointments have shifted online.
We think of it as defensive growth – a way to invest in future growth but be defensive about it.
-Edward Mikolay, director of private markets, Municipal Employees’ Retirement System of Michigan
Yet, the online versions of these functions require some form of physical accommodation. They are underpinned by a network of real assets: data centers, cell towers, small cells and fiber lines. The longer the pandemic persists, the more important this digital real estate is to become to societies at large, but also to investors hoping to future-proof their investment portfolios.
“It’s been pretty amazing how quickly institutional capital has entered the space and really impacted pricing in the core data center markets, making it very competitive,” Christy Fields, head of real estate portfolio solutions at the Boston-based consultancy Meketa, tells PERE. “Post-covid, people see the property type as quite prized and one of the few that’s proven to be truly resilient. It’s realizing a significant increase in demand in this environment.”
Cushman & Wakefield, the Chicago-based broker, has tracked $100 billion of investment globally into data centers during the past decade. But most of the appetite for digital assets has grown during the past five years, PERE hears through conversations with more than a dozen managers, operators and advisors.
Edward Mikolay, director of private markets for the US pension Municipal Employees’ Retirement System of Michigan, says his team began seeking digital assets in 2015, starting with cell towers and later expanding to data centers, to achieve better returns than from traditional property types. “Real estate had felt a little bit toppy and we viewed digital infrastructure as an area where demand would continue to grow,” Mikolay says. “We think of it as defensive growth – a way to invest in future growth but be defensive about it.”
Private capital comes knocking
However, private capital’s exposure to the digital real estate sector has been limited. High barriers to entry render the space hard to access. For one, data centers are expensive to build; land and construction costs range from $1,200 per square foot, according to the research firm Green Street Advisors, to more than $2,000 per square foot, by some accounts. A typical 500,000-square-foot warehouse, meanwhile, ranges from $45 to $170 per square foot, according to a 2018 CBRE report. Data centers are also difficult to operate and, without a track record to lean on, hard to lease, given the sensitive nature of data storage. Cell towers are less costly, but subject to significant oversight and require scale to achieve profitability. These have been better suited to public REIT ownership than private institutions, given their typically lower cost of capital.
PODCAST: Why the future of private real estate is digital
Listen to Digital Bridge CEO Marc Ganzi and National Real Estate Advisors CEO Jeff Kanne discuss the evolution of private investment in data centers and why the covid-19 pandemic could be a net-positive for the sector.
Yet, there is a growing cohort of private money managers finding a place for digitally underpinned real estate assets in their portfolios. A handful have even raised sector-focused funds, or taken on separate accounts. Others have formed joint ventures with listed operators eager to recapitalize their portfolios to fuel further expansion.
Los Angeles-based Colony Capital is the standout manager staking its future on the space. Last year, it merged with specialist Digital Bridge to form manager Digital Colony Partners and raised a $4 billion fund to buy assets. Colony plans to have the bulk of its business in the space within two years.
Marc Ganzi, head of Digital Bridge, says investors have taken to the digital space in droves, following the massive capital outlays from mobile carriers and endorsements from world powers. The US alone has seen $315 billion of wireless investment since 2005, according to CTIA, a trade organization representing the wireless industry. In China, meanwhile, President Xi Jinping put 5G infrastructure and data centers at the forefront of his post-pandemic economic recovery plan.
“Every LP in the world now knows what digital infra is, and it’s the asset class they have to have,” Ganzi says. “Look at the total amount of more than $400 billion global mobile capex spending and the percentage of GDP dedicated to digital. Understanding those pipes and the real estate that supports them is absolutely where institutional investors need to be right now.”
The coronavirus pandemic has showcased the vital role the internet plays in the global economy. Institutions previously slow to grasp this reality are under immense pressure to do so now. Indeed, sources say once the virus is thwarted and investors look to make fresh capital commitments in a world reshaped in its wake, data-focused strategies may be the only palatable approaches to real estate for an extended period.
“The environment we’re in right now has created a surge in demand from both end users of data as well as service providers, which is driving a tremendous amount of usage,” says Doug Weill, managing partner of the New York-based advisory firm Hodes Weill & Associates. “That is apparent to institutions who are looking at macro fundamentals and identifying anything data-related as an interesting strategy. This is also playing out with the relative outperformance of the data center REITs over the last couple of months. We expect to continue to see demand for these types of strategies, but when you get beyond that to other real estate strategies, it’s going to be pretty slow in terms of new allocations.”
Compared with traditional segments of commercial real estate, data centers are still in their infancy. The business model was conceived to connect competing networks during the dotcom boom. Equinix, the pioneering firm in the space, was launched in 1998. The California-based company went public in 2015 and now operates more than 200 data centers. Today, it has an enterprise valuation of $70 billion, according to Green Street.
Network-dense data centers that cater to providers such as Comcast and AT&T still make up 60 percent of Equinix’s portfolio. Typically, there are one of these centers per major metro. However, the broader market has shifted toward the co-location, or enterprise, model, in which companies pay to house their servers. Most of the data generated daily by websites and apps are housed in these properties. Cloud storage providers, such as Google, Amazon Web Services and Microsoft Azure, are also driving demand for co-location space. Nowadays, enterprise centers account for 56 percent of data centers operated by listed REITs, according to Green Street.
Private capital has been active in this space since the early days. In 2001, GI Partners was launched as an initiative between the California Public Employees’ Retirement System and manager CBRE Global Investors to invest in the intersection between real estate and technology. In 2004, the San Francisco-based firm took its data center portfolio public as Digital Realty, which is now the second-largest data center REIT, with more than 260 properties, of which 70 percent serve co-location tenants.
Andrew Power, chief financial officer of Digital Realty, says the trust was seeded with properties compiled after the dotcom bubble burst, which was the sector’s last moment of disruption. “The secular trends in our industry since that time, over the past 15 years, have been our friends.”
Thus far, North America has been the dominant market for digital assets. Across the top four data center REITs – Equinix, Digital Realty, CoreSite and CyrusOne – 64 percent of assets are in the Americas, followed by 23 percent in Europe and 13 percent in Asia. Subsequently, of the top 10 data center markets globally, as ranked by Cushman & Wakefield, seven are in the US and two – Amsterdam and London – are in Europe. Singapore is Asia’s lone representative.
This is, in part, because of how online-oriented North America is. As of 2018, the continent had 328 million internet users and 313 million people with mobile phones, or 90 percent and 86 percent of the population, respectively, according to Cisco. Those percentages are expected to hit 92 percent and 88 percent by 2023. Western Europe, despite its advanced economies, had just 82 percent internet adoption and 84 percent mobile usage.
Asia already has the most internet and mobile users, by Cisco’s calculations, with more than two billion in each category. However, that is because of the sheer number of people in the region. Adoption rates are still relatively low, with just over half the population accessing the internet. Cisco projects another billion Asian-Pacific internet users by 2023. China plans to spend 200 billion yuan ($28.4 billion; €26 billion) on high-tech infrastructure this year and 1.5 trillion yuan over the next eight years, according to a report from the South China Morning Post.
Hong Kong-based manager Gaw Capital Partners is seeking to take advantage of this increased investment through its joint venture with Centrin Data, a Chinese operator. Formed last year, the partnership is developing a data center in Kunshan, a city just west of Shanghai. The site already has more than 35,000 completed server racks and tenants such as Tencent, the Chinese tech conglomerate.
Humbert Pang, Gaw Capital’s head of China, says the center became critical during the country’s coronavirus lockdown, as it facilitated online transactions carried out by WeChat, Tencent’s messaging and mobile payment app. Pang says the crisis has encouraged people who were slow to move online to embrace the internet in new ways. “It’s driving people who were not familiar with online shopping to do it every day,” Pang adds. “If there’s anything positive to come out of covid-19, it’s that people are doing more online commerce and communication.”
Power in power
Even non-digital companies are feeding the demand for off-site data storage. The grocery wholesaler Costco, for example, is a substantial tenant of Seattle-based Sabey Data Centers, one of the largest private operators in the space. Three of its five data campuses are in Washington state, which benefits from some of the cheapest electricity courtesy of its hydroelectric dams.
Sabey has financed its expansion over the past decade through a partnership with National Real Estate Advisors – a Washington, DC-based manager and subsidiary of the National Electrical Benefit Fund, the pension provider for US electrical workers and contractors. Jeffrey Kanne, chief executive of National, says his group was drawn to Sabey as a partner in part because it recognized the benefit of cheap, renewable power.
“People thought we were nuts,” Kanne says. “The general idea amongst real estate professionals was that data centers were some kind of complicated magical activity that only geniuses from California could work on. Nobody was taking the time to dig down and analyze and see what exactly is it that the real estate owner is providing. They didn’t value the things that made it valuable.”
Unlike traditional real estate, data center leases are not defined by floor space, but by power usage. Tenants pay for electrical capacity, typically measured in kilowatt or megawatt hours. Power, Digital Realty’s CFO, says the REIT often uses a master lease structure, in which tenants are assured a certain level of power usage, physical storage space and connectivity. Large data centers can use up to 40 megawatts of electricity, according to Green Street, enough to power 40,000 single family homes. This electricity keeps the servers running and, critically, provides air conditioning to prevent overheating.
Network-dense centers, where providers converge, need to be close to end-users. This is why there is one in most cities. However, co-location centers, which mainly cater to cloud service providers, have less of an imperative to be near their end users. Instead, the cost of power and the proximity to fiber networks are the two main factors distinguishing markets.
These demands raise alarms for investors with stringent environmental policies. Hydroelectricity is the power source of choice for the sustainable investor and is also the most cost effective. Three of the five most affordable markets for data centers – Montreal, Portland and Vancouver – all run on hydro, according to Cushman & Wakefield, as does Seattle, another highly sustainable market. Cities such as Las Vegas also cater to energy conscious investors with solar and wind power.
However, there is no correlation between clean energy and data use. Despite a heavy reliance on coal, Northern Virginia is the dominant data center hub in the world thanks to its dense fiber network. The market has 166 centers and 1,027 megawatts of total capacity, according to the Northern Virginia Technology Council.
Chicago-based brokerage Cushman & Wakefield has ranked the top 10 global markets for data centers based on size, cloud capacity, fiber connectivity and other factors
1) Northern Virginia
2) Silicon Valley
5) New York/ New Jersey
8) Los Angeles
Users across the US can access data housed in Virginia within a few seconds. This is why groups such as Amazon Web Services have flocked to the market. The same goes for other well-connected hubs, such as Silicon Valley, Dallas-Fort Worth and, to a lesser extent, Chicago. For these places, the competition for tenants is more a matter of utility costs and provider reputation than physical location.
Some users, however, want to be close to their data, either because of concerns about latency – the delay in delivery of data that is anathema to video streamers and online gamers – or for simple peace of mind. “Some people just like to have their computers nearby even though they could just as well be on the moon,” Kanne says. “In the industry it’s called server hugging.”
Financial firms are also keen to use local servers, even if it means paying a premium. New York, London and Singapore have fewer centers and less robust fiber networks than the elite hubs, but each qualified for Cushman & Wakefield’s top 10 list, in part because of their strong financial industry demand.
Enterprise centers, the beating heart of the data center universe, seek to appeal to both large wholesale clients requiring half a megawatt or more of capacity, as well as smaller co-location tenants, which tend to rent individual server racks. Co-location leases are typically five years or less, while 15-year commitments are common in the wholesale space, according to Green Street. A third model is the powered shell approach, in which the tenant executes the electrical buildout of a center themselves. For these, their occupancy functions as triple-net leases for landlords.
John Sabey, executive director of Sabey Data Centers, says tenants of all sizes are reluctant to switch providers if they are well served: “It’s just a very sticky category. Once you move your servers in, it’s very expensive to move them out and it’s disruptive to your services.”
Outside the box
While data centers most closely resemble traditional property types, other assets fall under digital real estate despite lacking four walls and a roof.
The cell tower space, like data centers, is dominated by public market entities – American Tower and Crown Castle International are the two largest US REITs by market capitalization – though private capital is finding ways to partner with established operators. As with traditional real estate, these assets are leased to tenants. The taller the tower, the more tenants can use it and the more revenue it can generate.
As the need for denser networks increases, operators in this space have also begun investing in small cell nodes, antennae typically attached to streetlights or utility poles. When the next generation of wireless communication, commonly referred to as 5G, comes online, more of these assets will be needed.
People thought we were nuts. The general idea amongst real estate professionals was that data centers were some kind of complicated magical activity that only geniuses from California could work on.
-Jeff Kanne, CEO, National Real Estate Advisors
The final part of the digital infrastructure world is fiber, the cable lines that carry information across great distances in the form of light. While this might seem like infrastructure, Ganzi says the management of fiber lines is like commercial real estate property. “The premise of every business we’re in revolves around the concept of a lease and those leases generate long-term cash flows,” he says. “We work with predictable, investment-grade counterparties. Most of our leases are for between five and 25 years, so our business is predicated and rooted in real estate cashflows from a global portfolio with strategically-located assets.”
Not all investors see it that way. For many, digital assets are better suited for infrastructure portfolios because the strategies carry more development and operational risk. Short-term returns can also lag real estate benchmarks.
The Teachers Retirement System of Texas counts digital assets under its energy, natural resources and infrastructure umbrella, which accounts for 6 percent of its strategic asset allocation compared with 15 percent for real estate. This umbrella also carries a lower return expectation. Last year, Carolyn Hansard, senior director of TRS’s energy, natural resources and infrastructure portfolio, told sister publication Infrastructure Investor that her team would prioritize towers, data centers and fiber. “Across the spectrum, telecoms are big on our list,” she said. “You don’t go anywhere today and not expect to have wi-fi and high-speed internet. It’s just part of the way we live, and its an area that has a lot of growth potential.”
The real estate versus infrastructure debate comes up when trying to set benchmarks for digital assets. Unlike other property types carved out of broader industry benchmarks, such as the NCREIF Property Index, data centers are lumped into industrial, so its returns are muddled with fulfillment centers and other warehouses. Listed vehicles give a broader overview of the segment, but do not encapsulate the value-add strategies pursued by private managers. Fields says the data centers her team has observed tend to perform 300 to 400 basis points better than the NCREIF ODCE index.
Mikolay says MERS compares its digital investments to public infrastructure funds, “which is a little challenging because of the immediate mark to market, which sometimes work to your favor and other times it doesn’t.” Overall, the pension looks for core-plus returns from its digital investments.
Cell tower and data centers REITs have traded for a premium to their gross asset values in recent years, something only a few sectors can claim. While REITs, like all public equities, were battered by the covid-19 disruption, digital-focused trusts saw only modest declines in value.
“Private markets can learn a lot from looking at the public market because it’s a very forward-looking indicator,” David Guarino, Green Street’s lead data center and cell tower analyst, says. “I’m impressed, and surprised, how well data centers and towers have held up in public market [during the crisis]. In terms of pricing asset values, that’s something private investors can look at when trying to quantify what are defensive sectors moving forward.”
Some in the private market have been focused on these defensive qualities for years. Ganzi says he broached the subject during a meeting with Colony boss Tom Barrack in 2017. It was this conversation that led to the creation of Digital Colony Partners and its $4 billion fund.
Post-covid, people see the property type as quite prized and one of the few that’s proven to be truly resilient. It’s realizing a significant increase in demand in this environment.
-Christy Fields, head of real estate portfolio solutions, Meketa
Two years ago, digital real estate made up 2 percent of Colony’s assets under management, Ganzi says. By the end of last year, it was 30 percent of the firm’s portfolio and now it is more than 40 percent. “The demand for digital infrastructure is unprecedented and so is the opportunity. We are on a journey over the next two years to invest 90 percent of our assets in digital real estate and digital infrastructure,” he says. The firm has deployed 80 percent of its fund to acquire 10 operating companies globally.
Brookfield Asset Management, the private markets mega manager, has also made digital assets a focus for its fourth infrastructure fund, which closed on $20 billion earlier this year. Last spring, the Toronto-based manager partnered with Digital Realty to acquire Ascenty, Brazil’s leading data center operator. Power, Digital Realty’s CFO, tells PERE this is a prime example of when the REIT taps the private market: “We turn to private capital for more episodic and bespoke situations. In this case, we wanted a partner that would not only bring their half of the capital to the table, but one that also had experience on the ground, that’s why we selected Brookfield as our partner in Brazil.”
Large investors can also partner with operators to access the data center space. Last year, QuadReal, the real estate investment arm of the Canadian investor British Columbia Investment Management Company, formed a $2.5 billion joint venture with Atlanta-based operator T5 Data Centers. Similarly, in 2017, the Canada Pension Plan Investment Board, another Canadian investor, committed $350 million to a co-investment with Singaporean manager Alpha Investment Partners’ Alpha Data Centers Fund to target assets in Asia-Pacific and Europe.
Via commingled funds, on the other hand, investors have had scant access to digital assets prior to Digital Colony. Sculptor Capital Management, for example, has invested in cell towers since its first fund in 2005, but only as part of a broader mix of property types. “We try to build very diversified portfolios so our LPs get additional real estate allocation, but without the same correlations as traditional assets,” says Nick Hecker, Sculptor’s chief investment officer. “We’re looking for diversification, and if you look at the demand drivers for towers, over time, they have proven to be decently less correlated than the traditional, more cyclical commercial real estate asset classes. We saw that during the global financial crisis and we’re seeing that now.”
Alex Yekelchik, a Chicago-based managing director for the advisory firm PJT Park Hill, says despite the widespread interest in digital real estate, most activity he sees in the space comes through non-fund structures, which favors large institutions.
“If they’re a traditional fund investor and their ticket size tends to be relatively smaller, really the only way for them to access this space is through a fund investment,” he says. “The challenge is how do investors access this space in scale where a single large hyperscale asset may be $300 million to $400 million when their typical ticket size is $50 million.”
Some managers are starting to fill this gap in the market. IPI Data Center Partners raised at least $242 million for its first data center-focused fund, according to a 2017 filing with the US Securities and Exchange Commission. Last fall, the group – a joint venture between Iron Point Partners and Iconiq Capital – secured a $25 million commitment from the Maine Public Employees’ Retirement System for its second fund, according to meeting minutes. Another upstart in the data center fund space is Washington, DC-based BlackChamber Real Estate, which reportedly raised $107 million of its $500 million target for an opportunity fund, according to a November 2019 filing with the SEC. Neither IPI nor BlackChamber responded to requests for comment.
Yet these examples stand out as a minority. How the surging demand brought on by coronavirus changes that remains a question unanswered. But if a large-scale shift toward data accommodating real estate – potentially at the expense of people-populated assets – is in the cards, this crisis will surely bring it to the fore. As businesses and consumers alike shake off the grips of the virus, they could do so with a new set of priorities. Firms may decide they need less office space; shoppers might make even more purchases online; people could reduce travel and avoid large gatherings in numbers unthinkable before covid-19 became a household name. Or, things could revert to the way they were a year ago.
Some outcomes are more likely than others. To some of PERE’s sources, the shift to mass isolation has simply accelerated trends already in motion. And to those private capital providers and managers already subscribed to a future replete with data-oriented assets, this crisis represents a resounding vindication of their convictions.