Institutional investors eye data centers with higher risk tolerance

Strong fundamentals coupled with soaring global demand for digital products and services are attracting increasing numbers of institutional investors to the U.S. data center sector.

Absorption rose to 885.7 megawatts across 14 domestic markets in 2021, according to JLL. This was 44.3% higher than the 2020 figure, which itself had risen 70% year over year to a record 614 megawatts, the size benchmark used instead of square feet on account of their significant consumption of electricity.

Demand is expected to remain high. Almost all — 95% — of respondents to a CBRE survey of global data center investors plan to increase their allocations to the sector in 2022. A significant number of them are among the world’s largest institutional real estate investors.

"[Private equity firms] remain interested in the space, but we've seen a huge influx of institutional investor interest," CBRE Executive Vice President Kristina Metzger said.

Interest across the risk spectrum

Investing in data centers is not without challenges. Strong investor appetite means more investors want to enter the market than there are opportunities, Metzger said.

As interest has grown, investors have had to become willing to take on more risky assets. Data center facilities with stabilized long-term leases to investment grade tenants were key targets, but soaring demand in locations with expensive and limited land has forced investors to consider facilities with shorter lease terms and tenants of varying credit, as well as value-add properties that likely require some improvements.

"Going back three or five years, you probably didn't see a very deep bench for value-add data center product. And today, there's a lot of groups that are targeting value-add data center products, they've got a lot more comfortable with it," Metzger said.

For all the demand, the data center sector has experienced a turbulent start to 2022. Total returns for the sector were 25.5% in 2021, but -13.6% at the end of the first quarter of 2022, according to industry association Nareit.

Rising development costs, inflationary pressure and the higher cost of energy to run the facilities are affecting returns, which have so far lagged 2021 and fallen below the S&P 500. Recent interest rate movement is also impacting buyer profiles, as many foreign and private equity funds that have historically been reliant on market financing at higher leverages are finding it difficult to be competitive in the current environment.

"If we continue to see a widening of the debt market, I think that will only further push and constrain certain investors from being successful," Metzger said.

Betting on the long-term

Despite these factors, powerful fundamentals like the growth of the cloud, 5G, artificial intelligence and augmented reality are all fueling long-term investor demand for data centers, with no sign of slowing down.

While the cost to lease data center space has been dropping for a while, vacancy rates are now hovering in the single digits for most primary U.S. markets and prices are stabilizing, BMO Capital Markets analyst Ari Klein said. That's positive news for investors seeking to offset the cost of developing or buying data center facilities.

"There's hope, and especially in inflationary environments as well, that we could potentially see pricing increase," Klein said.

For private investors, acquiring a REIT is a fast and effective way to gain a portfolio and ramp up in desirable markets, according to Klein.

Among those that have acquired U.S. data center assets in the past year are Blackstone Inc., which acquired QTS Realty Trust Inc. in August 2021 for $10 billion, and American Tower Corp., which struck a $10.1 billion deal for CoreSite Realty Corp. in December. KKR & Co. Inc. and Global Infrastructure Management LLC also moved to acquire CyrusOne Inc. in a $15 billion take-private deal, which closed March 25.

"For someone like a KKR, which didn't have much in data centers, this was an opportunity to quickly grab something that was meaningful," Klein said.

Only two public U.S. REITs now specialize in data centers — Equinix Inc. and Digital Realty Trust Inc. — with the prospect of a third on the horizon. Switch Inc. announced in its third-quarter 2021 earnings release that the company's board of directors voted in favor of converting to a REIT. The firm aims to complete the conversion by Jan. 1, 2023.

Klein expects Equinix and Digital Realty Trust to mostly focus on buying data centers overseas, as they already have facilities in the U.S. markets they want to be in.