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Seeking a slice of the data center pie

As the world continues to digitize, and people consume ever more data, We look at the evolution of an asset class that appeals to investors in both real estate and infrastructure.

Investor interest in data centers has continued to build over the past year, as the appeal of an asset with a crucial role in the future of the global economy has increased. Despite concerns about economic growth and the arrival of higher inflation, data centers seem well placed to weather the current uncertainty dogging markets.

“Generally speaking, there is a continued increase in demand for data centers due to digitization, whether in our personal lives or industrial,” says Esther Peiner, managing director, co-head private infrastructure Europe at manager Partners Group. “This is exponentially increasing the amounts of data being produced, transported and ultimately stored.”

Sitting at the confluence of investment opportunities for real estate, infrastructure and tech investors, data centers represent the blurring of boundaries in the real assets space. This broad appeal among different investor types has resulted in huge deals over the past year.

“Both infrastructure and real estate investors are increasingly attracted to the data center space given the high-growth data usage and migration of data to the cloud,” says Minesh Mashru, global head of infrastructure at investment firm Cambridge Associates. “This trend continues to accelerate across North America, Europe and other markets.”

As the role of data in the modern economy remains strong, the appeal of the sector is growing. Not only is the demand for data storage continuing to grow at a fast pace, translating into a good return on investment for these assets, but attractive yields are also drawing more investors.

Energy price increases in the inflationary, post-covid environment mean data center operators can often pass on costs to customers at the end of their contract. And this increases their appeal to a broader range of investors.

“Once data centers have matured and are fully operational, they ultimately become income yield assets,” says Peiner. “For our own data center portfolio, it’s likely that once we come to exit, the vast majority of interest will come from real estate investors looking for yield.

“This is because these assets are not only sustainable but also, even for a mature data center, have good growth prospects on a year-on-year basis. Customers do not migrate unless there’s a material issue, so you have huge stickiness, and the intrinsic demand keeps increasing.”

“Real estate firms are later to the party than their infrastructure counterparts but have significant funds to apply”
David Bloom
Noé Group

As a result, the sector is attracting a lot of attention. According to property consultancy JLL, M&A activity in the data center space hit new heights in 2021, following a record year in 2020. Last year, there was $47.1 billion in activity, compared with $34.5 billion in 2020.

Spearheading this record dealflow, KKR and Global Infrastructure Partners announced in November they would acquire publicly listed data center giant CyrusOne for $15 billion, with plans to expand its international presence.

In June, Blackstone Infrastructure Partners acquired US data center provider QTS Realty Trust for around $10 billion. And in July, data center colocation company Cyxtera Technologies was bought by special purpose acquisition company Starboard Value Acquisition for $3.4 billion.

Different data centers for different profiles

As interest in the space continues to build, fresh challenges and opportunities are emerging. While data centers can offer strong growth potential, investors can also take advantage of a range of different types of investment with varied risk/return profiles.

“Current investment opportunities come in a variety of guises – from speculative development, to backing existent platforms, to buying mature assets,” says David Bloom, partner at family office Noé Group, set up by multi-millionaire British property investor Leo Noé.

“Secondaries investors can access data centers either as part of larger or more diversified fund positions or as single-asset/GP-led continuation fund vehicles”
Dinesh Ramasamy
Pantheon Ventures

“Real asset firms are trying to find where they are comfortable on this curve, but there is tension between the levels of risk and the return profiles on offer.”

Dinesh Ramasamy, partner in manager Pantheon Ventures’ Global Infrastructure and Real Assets Investment Team, says data centers can be split into three buckets: wholesale or hyperscale data centers, retail colocation data centers and carrier hotels.

“Wholesale data centers are the most vanilla infrastructure-like assets you will get in the data center space,” he explains. “It’s partly because you’re effectively a landlord managing a building for five to 15-year contracts for the likes of the FAANG companies, and you’re only really dealing with maybe five to 10 tenants. You don’t really take any risk with the equipment that sits in the data center.

“On the other end, you have colocation data centers, where you’re dealing with somewhere between 500 and sometimes up to 1,500 customers. Contract lengths tend to range, on average, from two to five years. For us, that feels more like a core-plus/value-add strategy, and is arguably riskier.”

Then “smack in the middle,” adds Ramasamy, are carrier hotels. These are “extremely specialized buildings that house a unique ecosystem of customers, who specifically demand to be within the same unique ecosystem as the others so they can switch into each other.

“And as the landlord, you can charge a premium rate. There are not many of these unique data center ecosystems that exist. So, they tend to be highly priced assets, and arguably higher barriers to entry because of the uniqueness of the ecosystem.”

While data latency will be a significant issue for many technology- and data-focused companies, there is a growing realization that not all data needs to be stored locally. And this is fueling new development and investment opportunities.

Data centers and the supply chain

While the global economy continues to return to pre-covid operations, different countries remain at various stages of recovery and so rules and restrictions are inconsistent.

This has disrupted the global supply chain, which is having significant knock-on effects for many industries. The data center market is no different and has faced its own challenges over the past couple of years.

“Supply chain shortages do impact the sector,” says Partners Group’s Esther Peiner. “It impacts time to market. So, a generator that had a two-month lead time just 12 months ago would have a three-times longer lead time, or even longer. That’s quite material, and it requires clear planning.”

Rising inflation and the Russian invasion of Ukraine have also seen energy prices skyrocket in recent months, putting pressure on some energy companies – particularly in Europe – to source oil and gas supplies from non-Russian sources.

“Energy costs are less of an issue for data centers, partly because power costs are passed through to the customer and reflected in the revised rent at the end of the contract,” says Pantheon Ventures’ Dinesh Ramasamy. “The question is whether the customer is sensitive enough to the increased rent they need to pay to the data center operator for it to stomach the increased charges.

“When you’re talking about bigger customers – like the Oracles, the Microsofts and Amazons of the world – it’s a drop in the bucket. But, if you’re dealing with more small and mid-sized customers, there is probably going to be an impact on their ability to re-contract. It’s unlikely, and it would be quite disruptive. So, I think this space is a bit more immune. But not completely.”

Location, location, location

The US remains the biggest data center market globally in terms of construction and demand. According to JLL’s most recent data center outlook, the construction pipeline grew by 18.9 percent year-on-year in 2021, while data absorption rose by 44.3 percent compared with 2020 – which itself recorded a significant increase on 2019 as a result of the pandemic. Within the US, expanding hyperscale footprints in Phoenix and Dallas drove “significant gains in absorption” last year, while social media and technology companies are driving demand in Northern Virginia and Chicago.

$47.1bn
Total M&A activity in the data center space in 2021, up from $34.5bn in 2020 and a new record, according to JLL

18.9%
Growth of the data center construction pipeline in the US year-on-year in 2021, while data absorption rose by 44.3%, according to JLL 

In Europe, JLL noted, the construction pipeline decreased year-on-year. However, the market is still seeing strong demand, with core FLAPD – Frankfurt, London, Amsterdam, Paris and Dublin – markets recording an increase of 9 percent year-on-year.

Yet, many developed economies are more expensive to access for data center investors. New opportunities and fresh sources of demand might be found in regions approaching the steepest part of the digital adoption curve, according to global consultancy Townsend & Townsend, such as parts of Africa and South America. Its 2021 Data Center Cost Index found low construction costs and rising demand in cities such as
Bogotá in Colombia and Montevideo in Uruguay.

“Some emerging markets are more advanced when it comes to renewable power generation because you often find that renewable installations will have grid parity and operate even without subsidies,” says Partners Group’s Peiner. “And that makes for a good starting point if an investor were to look at backing an operator and developer which wants to source from renewable generation.

“But we are predominantly a developed markets investor – about 80 percent of Partners Group’s investments tend to be in developed markets – and I personally don’t see any major driver to change that from a data center perspective, because while there is more growth in emerging markets, there are also a lot of systemic risks that have nothing to do with data centers.”

A secondary affair

As the data center market has evolved, a vibrant and attractive secondaries market has also emerged. Indeed, Pantheon’s Ramasamy says the market should grow to around $45 billion in the next two to three years.

“Data centers now feature as one of the many digital infrastructure assets in most of our generalist and digital infrastructure specialist GP fund portfolios,” he says. “Secondaries investors can access data centers either as part of larger or more diversified fund positions or as single-asset/GP-led continuation fund vehicles.”

“Once data centers have matured and are fully operational, they ultimately become income yield assets”
Esther Peiner
Partners Group

Like other digital infrastructure assets, says Ramasamy, data centers are also capital hungry with robust capex programs. Therefore, when faced with the need for capital, GPs will often turn to the secondaries market to provide an exit path for investors seeking liquidity and onboard new investors as part of a GP-led recapitalization or continuation fund process.

Secondaries investors can also benefit from the same J-curve mitigation characteristics as those offered by the private equity market, he adds.

“Given the inherent long-lived nature of the infrastructure assets which are held within defined-life funds, the infrastructure secondaries market also becomes a more natural exit alternative, as GPs contemplate avenues to provide liquidity to their investors,” Ramasamy explains.

Real estate vs infrastructure?

While real estate and infrastructure investors may view data center assets from very different standpoints, there is much that the specialists in both spaces can do to work together and unlock value.

For real estate investors, not only is the data center sector an attractive proposition, it is also an area where they can add real value.

“The sector is an ‘alchemy’ between highly technical delivery on the one hand and an increasing collection of real estate markers on the other, such as planning, location and environmental,” says Noé Group’s Bloom. “Real estate firms are later to the party than their infrastructure counterparts but have significant funds to apply, which in a heavy capex environment is always going to be an important factor.

“There is also a longer-term consideration in terms of land use and repurposing existing assets, which currently sit in real estate portfolios. This starts to play into development pipelines in key areas.”

There is little evidence of direct competition between real estate and infrastructure investors, given their different focuses, adds Cambridge Associates’ Mashru.

But there may be much that they can learn from each other. “Collaboration can thus be evident in understanding trends to establish attractive locations with strong fiber and spectrum connectivity or gaining insight into requirements of key customers to support diligence and implementation of opportunities,” he says.