Principal Asset Management on keeping pace with digital demand

This article is sponsored by Principal Asset Management

The oft-repeated refrain that data has become the oil of the 21st century might at first glance appear hyperbole, but digging into the numbers tells a story. Generated data is forecast to more than double over the next five years relative to the period since digital storage was first invented in 1956. Global consultant McKinsey & Company also estimates that the US data center market alone could more than double its power demand by the end of the decade.

No doubt, the secular tailwinds are a boon for data center operators. Many of these structural changes were accelerated during the pandemic and greater dependence on data storage is here to stay. Principal Asset Management has been investing in the sector since 2006 and has witnessed the asset class adapt and evolve. Paul Lewis, director of European data centers, and Casey Miller, managing director, portfolio manager at the firm, discuss the evolution of the asset class and how these various themes are playing out.

How has the data center sector performed through recent macroeconomic uncertainty?

Paul Lewis: From an occupational point of view, demand in Europe has been very strong and this is probably not a big surprise considering the rise of cloud computing and the growth of the digital economy. If we look at the five biggest markets in Europe last year – Frankfurt, London, Amsterdam, Paris and Dublin – we saw co-location data centers reach just below 400MW of take-up. That was close to record levels.

Brokerages are already forecasting a record year for 2023 and we have seen predictions of 480MW in take-up across those five largest markets. On the capital side, the sector has shown great resiliency despite all the market volatility.

Casey Miller: The underlying demand fundamentals are the same in the North American market. We are seeing demand at an all-time high and vacancy at an all-time low. The figures show vacancy at 3-3.3 percent, depending on the source, and if you isolate the top 10 markets this quarter, that dips to 2.7 percent. At the same time, power growth has been at 11 percent in the top markets and absorption even hit a record 934MW.

What makes data centers particularly stand out for investors?

PL: Firstly, there is a natural tendency towards long-term occupation because it is expensive to switch locations and incurs quite a lot of risk. That makes the sector very resilient. Long leases also provide cashflow from high-quality credit tenants at higher yields than most property types, which is obviously attractive to investors seeking income and total returns.

Data centers also offer a good inflation hedge, which is important in the current environment, and a good level of diversity from other real estate sectors. Demand is growing strongly and the value of assets therefore is only going to increase.

CM: Historically, the US data center sector is one of the few real estate sectors that does well when the economy is growing as well as shrinking. Over the past 12 months, we have seen businesses look to the cloud because of sheer financial necessity.

Firms want to cut costs and have looked at divesting expensive operated and owned facilities. This dynamic is fueling plenty of growth in data centers.

How is the drive for 5G and faster internet shaping investor interest in the sector?

PL: Those factors are all part of the demand story. The biggest driver behind demand and growth over recent years has been cloud computing, as mentioned. We all take that as the norm today, but it only really kicked off in earnest around 2008.

Today, 5G and AI are also drivers of demand and each in slightly different ways. It is important to realize that not all data centers are created the same. AI, for example, is causing a big push into lower-cost locations as people look for the extreme computing power needed to train algorithms.

In Europe, the demand for AI is driving people toward locations with large amounts of available, cost effective and green power. The Nordics are particularly picking up a lot of that interest.

By contrast, 5G is more about latency and sensitive type applications, which is creating a need for smaller urban locations. The growth story is therefore a combination of factors, but each one is coalescing to drive demand in the sector.

How important is government backing for further growth?

CM: Government support is always important, but it is difficult to fully assess right now as demand is still so strong. I think the first level of government is likely going to be the most important, meaning local municipalities and utility companies.

It is hard to say if there is going to be any sweeping legislative changes coming out of Washington any time soon. Ultimately, there could be a governmental mandate to become even more ESG focused like our friends in Europe, but the timeframe is hard to predict.

PL: Governments are very strongly backing the digital economy, but at the same time you have some concern around the scale of data center developments. In Ireland, we recently saw utility provider EirGrid pause new connections for data centers because of pressures on the grid. The days of just being able to build anything anywhere have probably gone, and we recently saw a moratorium against developments in Amsterdam. Today, there is a far more regulated permitting process.

How specialized is the market becoming and what does that mean for competition?

PL: It is certainly a sector where you need a good level of knowledge. You cannot just buy a plot of land and hope to develop a data center.

Given the highly specialized and niche nature of the data center industry, experience and access are both crucial. It is vital that you understand what customers want and where the demand from end users is going to be.

The asset class has evolved significantly since we first became involved in the sector more than 15 years ago. Today, you really have to be a specialist to succeed.

CM: It is not a sector where you are going to find immediate success. Even if you have the power, the site and fiber, it takes years to build relationships with users.

No one is going to use a facility that is unproven. You need to build credibility in the market, and users need to feel comfortable that you are someone that they can partner with, especially given the long-term nature of leases.

How is the availability of land and supply shaping the attractiveness of the asset class?

PL: In Europe, most of the major centers that have seen the largest scale developments are today land constrained. The rise in demand has put a lot of upward pressure on land value, particularly in the best locations with good access to power.

The most crucial factor is access to power. If you can secure power, you will probably be able to find a solution to access land. It is not always so easy the other way around.

CM: All of the same fundamentals exist in the US market, even if it is a little less mature than in Europe. The difference is that there are cities like Phoenix where it is still possible to buy large tracts of land that have access to power. Those areas are easier to build large scale campuses on and are just not as prevalent in Europe today.

What are the main challenges that the sector faces?

PL: In Europe, there is certainly some cost pressure. I mentioned land prices, but we have also seen construction costs inflate in recent years as well as pressures on supply chains. Development lead times are taking longer and are becoming far more difficult.

Another factor that the sector is facing up to is shortage of skills. We have seen a massive increase in the scale of the sector but unfortunately the rise in people with the prerequisite skills has not matched that.

It has always been an industry under the radar and people leaving school probably rarely think about a future working for a data center. That is starting to change as the sector becomes better known but there is probably still a lot more that can be done.

CM: Previously, most of the people that worked in data centers were homegrown and trained inhouse. It was never something that they studied at school.

Today, with the massive increase in the size of facilities it is no longer very practical to home grow someone, which is contributing to the skills shortage that we are seeing.

How are investors navigating the decarbonization implications of data centers?

PL: The sector uses a huge amount of power and operators realize that they need to think in a responsible way. Energy efficiency is also leading the sector toward decarbonization as much for financial reasons as environmental.

If you look at the largest users in the sector – Amazon, Google and Microsoft – they are now the largest offtakers of renewables globally. Eventually we will start to see more regulations, but the sector is already running ahead of that in terms of access to renewables and increasing the efficiency of facilities. There is a real push from the largest customers for ESG credentials, which is important, but crucially there is a sound commercial reason behind doing this.