For Rick Magnuson, founder and executive managing director at GI Partners, the San Francisco-based private investment firm’s latest real estate deal is a sign of what is to come in the data center space.

GI Partners closed on Friday on the acquisition of a 65 percent ownership interest in two hyperscale data centers in the Chicago metropolitan area from Austin-based Digital Realty Trust, one of the world’s largest data center real estate investment trusts. GI Partners purchased the ownership stake through its US open-end core-plus fund, Essential Tech + Science Fund. Digital Realty – which GI Partners formed in 2004 by consolidating a portfolio of 21 data center assets and taking the company public that same year – will retain a 35 percent interest in the properties.

“It’s fascinating what’s happening with AI and how it has to have very large deployments and data centers,” Magnuson remarked. He noted that while the average data center has around 10 megawatts of IT capacity, the newly acquired assets have approximately 67MW of total capacity.

He explained that Digital Realty sold a majority interest in the properties to free up capital to develop new large-scale data center projects for AI applications being deployed by Big Tech. “The larger operators – Microsoft, Facebook, Google, Nvidia – are trying to grab as much power as they can before it runs out, because these AI applications require two or three times the amount of power per square foot” compared with a typical data center, he said.

Third wave of demand

During GI Partners’ 20-year-plus investment history in the sector, “there’s been three macro events that propelled demand for data centers,” Magnuson observed. The first was the regulatory changes driven by the Health Insurance Portability and Accountability Act of 1996 and the 9/11 terrorist attacks; the former put medical records previously kept in hospitals onto the cloud, and the latter transferred securities information out of New York to other parts of the US.

The second wave of demand came from Web 2.0, or the rise of technology giants such as Google and Facebook. “We find ourselves today in a market where there’s not much excess capacity, with traditional demand from both the regulatory side and the Web 2.0 side,” he said.

AI, meanwhile, is driving the third wave of demand for data centers, Magnuson noted. “You have this mad rush to deploy AI across a variety of markets where there’s constrained supply, there’s constrained power and a limitation on equipment,” he said. “So it’s a huge explosion, which is really yet to present itself in the public markets or in discussions, but it’s there. We’re seeing the leases, we’re seeing it in the demand of the companies.”

Rick Magnuson GI Partners
Magnuson: expects AI will be a long-term driver of data center demand

Both supply constraints and tenant demand have rapidly driven up market rents in the data center sector. For GI Partners, the acquisition of the ownership interest in the two data centers – which are more than 90 percent leased – was a rare opportunity to achieve mid-teens total returns over time in a core-plus strategy, Magnuson said.

For data center development projects, returns have increased 400 to 500 basis points on internal costs, he continued: “That’s huge because the demand is so great. And we don’t see that in any other real estate sector.” Indeed, digital infrastructure was considered the property type most likely to outperform by investors, closely followed by healthcare/life sciences, according to law firm White & Case’s 2023 real estate market sentiment survey.

Although large-scale AI deployments began only about nine months ago, Magnuson expected AI will be a long-term driver of data center demand. This is in contrast to cryptocurrency, which was all the rage two to three years ago but ultimately was an ephemeral source of tenant demand in the sector.

AI-driven demand, however, “is very sustainable,” he remarked. “It’s got all sorts of applications, and it’s backed by real companies like Microsoft, Facebook and Google as opposed to bitcoin.”

Indeed, GI Partners’ deal pipeline today is almost exclusively data centers. “I think that we’re ahead of the curve here in terms of the opportunity set, so we’re focused on data centers,” Magnuson said. “This is a pretty unique transaction and I think there’s going to be more of them.”

In a July 6 report, Green Street senior analyst David Guarino also anticipated AI being a game changer for the data center sector. “Historians looking back on the data center sector may very well point to the AI craze of ’23 as a pivotal turning point,” he wrote. “While it’s too early to measure how much demand could be generated, initial estimates suggest it will be sizable. Coincidentally, this is occurring at the same time the sector is experiencing severe supply constraints which are showing no signs of alleviating. For data center landlords, the future looks more promising than ever.”