Managers ride the data wave

The data center market is set for growth, and it is a genuinely global phenomenon, but the strength of demand and the availability of power and land mean some locations offer better opportunities than others. The sector operates rather differently to other real estate niches, however.

More data means more data centers and 90 percent of all the data created thus far in history was created in the past two years. This is also likely to be the case two years hence. Three streams of data are powering the data center market: content, the cloud and artificial intelligence. Content, whether films or TikTok videos, adds data, as do companies moving billions of emails and stored files to the cloud.

Meanwhile, the data requirements of AI are huge. Mike Forman, managing director, real estate, at Blackstone, says: “As a simplistic example, a ChatGPT interaction requires 10 times the computing power of a regular Google search. So, as more and more AI services are embedded into the technology we use, the data center infrastructure needs will be enormous. Large technology companies are going to invest nearly a trillion dollars into their digital infrastructure over the next five years and that will be almost entirely in data centers.”

Firms such as Amazon, Microsoft and Google – the hyperscalers’ driving much demand – expect to see their cloud service revenues grow from $41 billion in 2018 to $230 billion this year.

“Large technology companies are going to invest nearly a trillion dollars into their digital infrastructure over the next five years”

Mike Forman
Blackstone

“The important feature of these trends is their potential resilience to recession,” says Kirill Zavodov, head of real estate equity EMEA, at PIMCO. “Cloud services can provide customers with greater flexibility and potential cost savings as they can scale their capacity up or down depending on their needs. Also, during a recession many companies may actually increase their IT spending as they seek to automate various processes.”

Hyperscale data centers, large facilities often occupied by the large cloud companies, are the fastest-growing part of the market but not the only one. Co-location centers will have a specialist operator providing services for a variety of companies, while enterprise centers host a company’s servers.

Real estate investors can own or develop all of these types of data centers. However, they need a specialist operator on board. Blackstone’s infrastructure and real estate arms joined forces to privatize specialist REIT QTS Realty Trust in 2021, for example, whereas other real estate players choose to partner with a range of operators. Some have opted to create their own in-house operating business.

Specific needs

Data centers tend to be built to shell and core, with the all-important power supply guaranteed. Rather than a conventional lease for a square foot of space, data center tenants sign a service-level agreement (SLA) for a guaranteed amount of power, on top of which they pay for actual power consumed.

The need for power, especially renewable power, is perhaps the key driver for data center location, says Greg Blank, senior managing director, infrastructure, at Blackstone. “Location is first and foremost about access to infrastructure: renewable power availability, transmission infrastructure, fiber connectivity to reduce latency, and proximity to other customer deployments. Customers do not have one data center in a region, but perhaps 30. You also need proximity to high-quality engineering and construction talent.”

The most significant global cluster of data center activity is in North Virginia, where proximity to large cities and availability of power have driven the development of significant capacity. Overall, the data center market is massively skewed to the US, which has more than half the world’s hyperscale data center capacity, according to services firm JLL. Europe is considered to be five years behind, and Asia-Pacific still further back.

In Europe, the key markets are the large financial centers of Frankfurt, London, Amsterdam and Paris, known as the FLAP markets. “They have seen disproportionate growth. However, because of data privacy regulations and limited availability of power and land in those markets, among other reasons, we will see clusters in other markets,” says Blank.

Zavodov says: “Tier 2 and 3 markets – such as Madrid, Milan and Warsaw – are even further behind the US in terms of installed capacity, are expanding a lot faster than FLAP markets and have greater runway for future growth, making them increasingly attractive.”

Historically, data centers have needed to be near to a power supply but also near to their customers in order to minimize latency, the lag caused by distance between server and client. However, the huge capacity for training AI systems does not necessarily require response times as rapid as cloud computing, says Morgan Laughlin, head of Japan and global head of data center investments at PGIM Real Estate. “Huge capacity is required for AI training, and low latency within that training loop is extremely important. However, there is more flexibility in the location of that AI campus relative to the ultimate consumer of the applications being ­created.”

Data center rents, expressed in dollars per kilowatt of capacity, have moved up and down in response to local supply but are now heading upwards globally due to demand and rising costs. Laughlin says: “The rapid turn in data center rents tied to supply constraints and exploding demand means there are a lot of under-rented data centers out there – offering significant capital growth opportunities for those data center owners holding tenant leases with mark-to-market renewal clauses.”

Rising rents are just one of the factors behind institutional interest in the sector, Laughlin says. Investors also like the long-term leases with annual escalation and exposure to blue-chip tech tenants with excellent credit ratings. “Over the decade we have been investing in the sector, we have seen the hyperscale data center sector rapidly evolving from a niche investment opportunity into an institutional asset class.”

Zavodov adds: “Investors are also attracted by the strong supply-side fundamentals: power transmission infrastructure limitations and high barriers to entry into the sector, as data centers are large capital-intensive projects, which require specialized technical expertise to build, to deal with power and fiber aspects, and ultimately to operate as critical infrastructure.”

5.6x

Hyperscalers’ revenues have
shot up in the last five years

Those barriers to entry are also factors that need to be considered by investors, says Devashish Gupta, chief investment officer for data centers at Hong Kong-listed manager ESR Group. “The gestation period of some of these assets is significantly longer than most other sectors: it can take two years to start construction once you buy land, then another four to five years to stabilization. So investors are coming to realize that it is not as straightforward as other real estate.”

Yields for stabilized centers in developed markets tend to be in the low 4 percent range, while total returns for development can be in the teens or higher, depending on finance costs. Gupta says: “Lower borrowing costs in Japan mean returns of late teens to early 20s are possible, compared with mid to late teens for Sydney, Singapore, Hong Kong or Mumbai.”

At present, more institutional capital is being invested in funds or platforms that are developing new data centers, says Blackstone’s Blank, reflecting the demand for new supply. However, he says: “We have seen sales of stabilized assets at attractive valuations this year. Going forward we expect to see meaningful interest in these assets.”

One of the significant challenges for data center owners is sustainability, as they use tremendous amounts of power, mainly for cooling servers.

This is a particular challenge in warmer regions such as Asia, says Diarmid Massey, chief executive for data centers at ESR. “It is always going to be a challenge to cool data centers in Asia compared to a colder climate. However, we are seeing data centers run warmer, at 25-26 degrees and technological improvements being developed for tropical climates.”

Data center efficiency is measured by power usage effectiveness (PUE), the ratio of total power required by the facility to power supplied to the servers. Older centers might have a PUE of 2; newer centers are averaging below 1.5.

Laughlin says: “The overall industry – hyperscale tenants and co-location operators – has made a strong commitment to offset the carbon footprint created by the growth of data center capacity. This has increasingly evolved toward actively supporting and investing in the development of new renewable energy to offset the needs of their businesses.”

He also notes that SLAs are akin to green leases in that charging for power drives tenants to the most efficient centers and to use their servers more efficiently.

Overall, however, data centers make business more energy efficient, even if this is hard to quantify. As Forman notes: “A video chat uses a lot of data center power, but not as much as flying to California for a meeting.”

Refurbishment opportunity?

Data centers have become far larger and more energy efficient in recent years, leaving older facilities at risk of obsolescence. However, they may offer a refurbishment opportunity.

Morgan Laughlin, head of Japan and global head of data center investments at PGIM Real Estate, says: “Historically, refurbishing older data centers has not been financially viable. However, as rents rise and cooling technology evolves, I expect opportunities will begin to emerge.”

The small size of older centers, compared with modern hyperscale facilities, will remain a challenge, he adds.

Diarmid Massey, CEO for data centers at ESR Group, says: “We will see older centers refurbished but, in many cases, they are not designed in a way that will make them easy to refurbish, so I think you will see some of the 20-plus-year-old data centers shut down.”

Other industrial buildings may also be refurbished. ESR was granted planning permission in 2022 to convert a Hong Kong cold storage facility to a data center.