- The growing demand for data centers has piqued interest for many real estate investors over the past couple of years.
- Factors for investors to consider include a data center’s power capacity, size/footprint, fiber connectivity/latency, real estate market fundamentals, jurisdictional regulations and environmental factors. Each plays a significant role in shaping investment decisions.
- Risk factors we are focused on include technological obsolescence, future tenant pricing power and limited historical performance information.
- Real estate investors who want a “neutral weight” allocation to data centers may target a 2% portfolio allocation, although we are currently recommending an overweight and a 3% allocation to data centers.
The Rise of Data Centers
In recent years, data centers have undergone a remarkable transformation, shifting from overlooked utility infrastructure to becoming one of the most sought-after property classes in the institutional real estate market. These specialized facilities serve as the backbone of our digital world, housing the essential components of computing systems, networking equipment and storage infrastructure.
The surge in demand for data center services has been fueled by the proliferation of cloud computing, big data analytics and artificial intelligence (AI). These technological advancements, especially in the post-pandemic era, have boosted demand and increased revenue for big tech cloud businesses (Exhibit 1).
Exhibit 1: Cloud Business Annual Revenue ($bn)
Third-party landlords own 55% of U.S. data centers, with the remainder owner-users[i]. Within the third-party landlord space, there is a large concentration of ownership by a few data center REITS, including Equinix and Digital Realty. This concentration allows these REITs to have considerable influence over pricing, service offerings and market trends. The investable universe[ii] is estimated to be similar to other smaller property-type segments like self-storage and cell phone towers.
Types of Data Centers
Data centers, with their diverse physical characteristics and usage patterns, offer a tapestry of opportunities for investors. They can be categorized based on their physical characteristics, such as powered shell and turnkey facilities. Powered shells comprise landlord-owned finished structures, connected to power and fiber, rented to a tenant that installs, maintains and owns the long-lived infrastructure (generators, batteries, cooling equipment, power equipment) and short-lived infrastructure (servers, racks, networking equipment) needed to operate the data center. Powered shells typically have a net rent per square foot lease structure. Turnkey data centers offer a fully built-out exterior and landlord-owned long-lived infrastructure; tenants own and maintain their own short-lived infrastructure. Leases are typically structured as gross plus electric, although net leases are not uncommon but nearly always on a $/KW/month basis. Due to the significant capital investment by turnkey landlords, turnkey tenants pay substantially more rent than powered shell tenants, regardless of the lease structure. Typically, turnkey data centers are priced with higher returns to compensate the investor for the risk of owning the equipment, which can depreciate quickly.
Data centers can also be categorized by use, including:
1. Hyperscale Data Centers – These data centers, operated by tech giants like Amazon Web Services, Microsoft and Google, boast extreme scalability capabilities. Engineered for large-scale workloads, they feature optimized network infrastructure, streamlined connectivity and minimal latency. Hyperscale data centers tend to have a larger physical footprint and are often entirely leased to a single major tenant.
Colocation Data Centers – Colocation data centers offer an alternative option for organizations with in-house or on-premises servers and/or workloads that don’t require vast power consumption that require an entire data center, or whose capital allocation strategy doesn’t prioritize the hardware investment. These facilities are occupied by multiple tenants who share operational costs such as power, cooling, bandwidth, communications and security.
These two types of data centers present different risk profiles. Hyperscale data centers, with their single-tenant leases, may lack the tenant diversification found in colocation data centers. However, hyperscale tenants generally boast excellent credit quality, as they are some of the most profitable and largest companies globally. On the other hand, leases for colocation centers tend to be shorter compared to hyperscale data centers, which may be favored in the current market conditions as they offer rental rate mark-to-market opportunities. The use, tenant diversity, and lease terms across different types of data centers make them suitable for various investors based on their risk tolerance and investment objectives.
How to Select a Site
Considerations for data centers include power, size/footprint, fiber connectivity/latency, fundamentals and regulation/environmental that all have separate impacts on data center investment decision making. Due to a unique set of requirements, data center markets are currently highly concentrated, with several MSA’s serving the majority of U.S. computing needs (see Exhibit 2).
Exhibit 2: Largest Data Center hubs in the United States
Power Availability
Power is the most critical factor in data center investments. Turnkey data center rents are typically charged on a dollar-per-kilowatt basis, while powered shell data centers are charged on a per-square-foot basis. The availability of power is heavily influenced by utility providers, and new developments often face delays due to infrastructure build-outs. Regions with abundant, ready-to-use power are desirable, especially those sourcing power from renewable energy like wind, solar, and hydroelectric.
Size and Footprint
Data centers vary in size, from small-scale facilities serving local businesses to hyperscale centers operated by tech companies, housing thousands of servers. The energy consumption of these facilities is vast, and their size must align with the intended use and scalability needs.
Fiber Connectivity and Latency
Fiber optic infrastructure is crucial for data transmission. Sites should offer redundant fiber paths from multiple carriers, with dark fiber available for dedicated use. Low latency is essential for applications requiring real-time interactions, such as autonomous driving and online gaming. Data centers closer to end-users typically have lower latency, which is why major hubs are near population centers. The Northern Virginia region, for example, has a high concentration of data centers due to its proximity to government data needs.
Regulatory and Environmental Considerations
Local regulations and environmental factors play a significant role in site selection. Jurisdictions with favorable regulatory environments and renewable energy sources are preferred. Challenges such as water usage, noise complaints, and tax implications can impede development. For instance, power constraints and legislative changes in Atlanta have affected its data center market growth.
Real Estate Fundamentals
The demand for data centers is driven by the rise of cloud computing, big data, AI, and digital streaming. The global data volume is expected to grow from 33 zettabytes in 2018 to 175 zettabytes by 2025. Despite projected supply growth, vacancy levels remain low, indicating an undersupplied market through 2028. Hyperscale data center revenue per available foot is expected to grow by at least 10% annually over the next three years.
Exhibit 3: Strong occupancy levels despite expected heightened levels of new supply
In tandem, supply growth across many key markets is projected to average ~10% annually for the next five years (Exhibit 3). Vacancy levels are at record lows across nearly every market, with little evidence they will return to average historical levels in the near term. Exhibit 3 indicates MIM’s data center market grade for a select group of markets based on several key factors. The overall market grade suggests where MIM believes the best markets are for stabilized data center investments.
Given the known supply pipeline and current occupancy rates, most markets are anticipated to continue to be undersupplied through 2028. As a result, hyperscale data center revenue per available foot (RevPAF) growth is expected to average at least 10% per year over the next three years.
Exhibit 4: MIM Property Type Scorecard
Challenges and Risks
Investing in data centers carries risks, including technological obsolescence due to advancements in hardware, software, and quantum computing. Energy efficiency improvements could make non-traditional locations more viable, increasing supply. Smaller, single-tenant data centers face risks of consolidation into larger facilities. Tenant concentration in hyperscale centers can impact pricing power, as these tenants have significant leverage.
Exhibit 5: Cap rates of various commercial real estate sectors
Data centers generate substantial amounts of heat, requiring robust cooling systems that can prevent overheating that can damage equipment. They also require security from cyberattacks or physical security breaches. There are a multitude of additional risks to data centers, including natural disaster risk, hardware and software failures, regulatory compliance, etc. that all require an experienced operator.
Another risk involves tenant concentration in hyperscale data centers and its impact on pricing power. Hyperscale tenants, with their robust financials, present low credit risk. However, their limited number grants them significant pricing leverage, potentially securing favorable rental rates and terms. Should the data center market weaken, these hyperscale tenants might gain even more pricing power. This was hinted at before the pandemic-induced surge in demand when Rev PAF growth for data centers was flat or negative (Exhibit 6), in part reflecting the pricing influence of hyperscale providers.
Exhibit 6: Average Data Center Rev PAF growth across the United States
The sector also faces challenges related to underwriting and performance forecasting due to limited data availability. The scarcity of comprehensive and standardized information across the industry hampers efforts to understand data center operations, sustainability, economic impact and investment prospects. While some operators voluntarily disclose data on their facilities, such as energy consumption and efficiency measures, the industry lacks transparency compared to more established sectors like industrial, residential, retail, hospitality and office. This opacity complicates benchmarking performance, assessing environmental impacts and making informed investment decisions in the sector.
Conclusion
Investing in data centers offers compelling opportunities to capitalize on the digital transformation of industries and the exponential growth of data-driven technologies. While data center investments entail challenges and risks, strategic allocation of capital to data centers can enhance returns, while offering portfolio diversification, given that the sector is driven by a unique set of economic and technological factors. As businesses and consumers increasingly rely on digital services and applications, data centers will play an integral role in shaping the future of the digital economy.
This article presents the authors’ opinions reflecting current market conditions. It has been prepared for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. This article has been sponsored by and prepared in conjunction with MetLife Investment Management, LLC (formerly, MetLife Investment Advisors, LLC), a U.S. Securities Exchange Commission-registered investment adviser. MetLife Investment Management, LLC is a subsidiary of MetLife, Inc. solely for informational purposes and does not constitute a recommendation regarding any investments or the provision of any investment advice, or constitute or form part of any advertisement of, offer for sale or subscription of, solicitation or invitation of any offer or recommendation to purchase or subscribe for any investments or investment advisory services. Subsequent developments may materially affect the information contained in this article. Affiliates of MIM may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives) of any company mentioned herein. This article may contain forward-looking statements, as well as predictions, projections and forecasts of the economy or economic trends of the markets, which are not necessarily indicative of the future. Any or all forward-looking statements may turn out to be wrong. All investments involve risks including the potential for loss of principal.
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i Global Data Center Outlook, GreenStreet, April 2024.
ii Estimating the Size of the Commercial Real Estate Market (reit.com), North America Data Center Report | H2 2023 (jll.com).