Principal Real Estate on why core-plus is the optimum strategy

This article is sponsored by Principal Real Estate.

With every passing day, the digital revolution accelerates, and data is generated in volumes that are increasingly beyond comprehension. Annual data production now must be measured in zettabytes (a zettabyte equates to 1,000,000,000,000,000,000,000 bytes). In March 2021, the International Data Corporation estimated that 64 zettabytes of data were created or replicated in 2020 – a figure it expects to grow at a compound annual rate of 23 percent over the next five years.

The world is scrambling to create the infrastructure needed to process and store such colossal volumes of data. The result is that data centers – a type of facility that did not exist in a recognizable form before the 1990s – are fast becoming the engine rooms of the new global economy.

Data demand surges

For many, internet access has become a key utility akin to water, heating or electricity. The most advanced European economies are therefore in an enviable position, with well over 90 percent of households connected to the internet, according to data provider Eurostat. Relatively fast and reliable connections have allowed millions of Europeans to work from home during the pandemic, often spending hours each day videoconferencing, and reliance on data-heavy streaming services has grown; for example, in January this year Netflix reported that it had added 37 million subscribers worldwide in 2020.

At the same time, the advent of the Internet of Things means a growing range of devices function through the processing and transfer of data. Findings reported by insurance company Aviva in 2020, show that in the UK, the average household contains 10 devices that are connected to the internet. And new technologies will only add to demand for data. Artificial intelligence, virtual reality and 5G will all contribute to ever-increasing needs for data infrastructure.

While the regular internet user may never think about where their data is being stored and processed, data centers serve an indispensable role in meeting the demands of consumers and businesses. Much of the traditional data center market has been made up of enterprises and colocation providers. But it is cloud service providers, which allow customers to store data remotely rather than on their own devices, that account for the lion’s share of demand. In 2019, cloud providers accounted for 80 percent of data center take-up, according to data published by investment firm CBRE.

A good time to be a landlord

The European market offers a multitude of investment opportunities in the data center space. London boasts the largest data center capacity in Europe, followed by Frankfurt, Amsterdam, Paris and Dublin. These cities already host a critical mass of infrastructure that will reinforce their position as Europe’s data center hubs.

Demand for data infrastructure in Europe’s leading cities was growing at a frenetic pace even before covid-19. The pandemic has deepened a supply-demand imbalance that makes market conditions highly favorable for data center landlords.

This is particularly the case given that new players in the data center market face high barriers to entry. It is difficult to find a suitable location for new data centers, which need to be within reach of major cities, while also able to access fiber and electricity infrastructure.

The need to reduce latency and locate data closer to major centers of population has seen new cloud availability zones open in cities such as Madrid and Milan, thus also driving data center demand in these locations and allowing them to grow their market share.

Tenants in an established data center tend to be highly stable. Operators are generally deterred from switching facilities due to the huge costs of relocating, which can amount to as much as 40 times annual rent. As such, landlords can be confident that operators will renew their leases, which typically exceed 10 years in length. Most leases are indexed to inflation, further protecting cashflow in real terms.

The asset class is therefore especially attractive for institutional investors that prioritize stability of revenues. An allocation to data centers also contributes to portfolio diversification, given that data centers are much less vulnerable to short-term economic fluctuations than traditional real estate investments, as they have proved during covid.

Not only can investors potentially achieve a stable income stream through investment in data center infrastructure, they may also benefit from higher yields. Data centers typically enjoy yields of around 5 percent in major European cities, according to July 2020 data by CBRE, Savills and Principal Real Estate. This is considerably greater than can usually be achieved through other types of real estate investment in these markets at present, including in residential, office, industrial or retail space.

And the availability of debt on favorable terms, both in the UK and EU, offers opportunities for investors to improve total and leveraged returns. Most data centers seek refinancing every few years, so we can expect the debt market for data centers to become deeper and more sophisticated over time. Debt providers that are able to get to grips with the highly specialized nature of the data center space can expect to be rewarded with attractive returns.

Choosing the right investment approach

In theory, an investor seeking to maximize returns from data centers in Europe would opt for a build-to-core strategy, in which they develop new facilities to meet latent demand. But this is also a high-risk approach. Investors pursuing new development will have to navigate the treacherous bureaucratic waters of Europe’s municipal planning and zoning regulations. Sourcing power and fiber connections also entails potential for delay and disruption.

We believe that a core-plus strategy, in which investors focus on acquiring existing data centers, is a very attractive option at present. This approach also allows investors to benefit from the surging demand for data infrastructure in London, Frankfurt and other European financial hubs. But focusing on sites that have already been built puts investors in a position to work with existing operators that serve an established customer base. If there is an opportunity for re-leasing or expanding capacity, tenants would compete to operate the site, lowering any risk of void periods and driving rents upwards.

The investor can thereafter enjoy a potentially reliable revenue stream. Security of revenue is further protected by the structure of a typical lease, which places responsibility for upkeep of equipment and machinery owned by the landlord onto the operator. In fact, for operators, ensuring that equipment performs properly is a critical task, given the fines they will incur from their clients in the event of downtime or malfunctions. This structure thus de-risks the investment from the landlord’s perspective.

How core-plus can create further value

In many cases, it may be possible for landlords to capitalize on growing demand by physically expanding the data center itself. Alongside this, or as an alternative, expanding the power density of the facility can allow the data center to scale-up. An experienced landlord can alleviate the capital expenditure and lower the speculative risk of this additional investment through a cost-sharing mechanism with the operator.

Meanwhile, the fragmentation of the European market and the lack of information on letting and tenants can hand further advantages to an adept data center landlord. Indeed, the relative absence of strong and consolidated letting intermediaries has resulted in a surplus of capital chasing longer-let data center assets compared to short-let assets. This gives landlords the ability to capture re-leasing rental spreads and helps drive potential yield compression when assets become available.

Why data centers are real estate investments

Data centers are a hybrid that have features which make the sector suitable for both real estate and infrastructure investors

Overall, there is no doubt that a data center investor in Europe that pursues the right investment approach can reap substantial rewards. A core-plus approach, in our view, is best suited to current market conditions and gives investors the best protection against risk, while also providing opportunities for value creation. Data center owners that successfully execute this strategy can expect to benefit from a revenue stream that is not only highly stable but may also deliver high yields.

We at Principal Real Estate, however, take the view that they are better considered from a real estate perspective.

A data center shares many features of an office block or manufacturing facility, including heating and cooling equipment as well as back-up generators. Triple net leases, which pass plant, machinery and operating costs onto the tenant, are increasingly common in data centers, as with other forms of real estate. This lease structure is, therefore, a good way to access the data center sector with risks best aligned to those that can be managed by real estate investors.