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Competition Remains Fierce in the Data Center Space

Prices are rising for data center properties–but even the most experienced operators are subject to the risk that the technology behind data centers could change quickly.

The ever-rising demand for data storage and the rise of more cloud-centric services has fueled rapid development of data centers and driven investor interest. But the challenges of operating data centers along with fierce competition for top assets make it a tough market to close deals.  

As with other sectors, cap rates and yields continue to compress. Buyers accepted cap rates averaging close to 5 percent in primary markets in early 2020, according to Cushman & Wakefield. In secondary and tertiary markets, buyers accepted cap rates in the mid 7-percent to 8-percent range. That’s down from cap rates over 10 percent a decade ago.

“We expect to see further compression in coming years, as the sector moves closer to maturity and more capital moves in,” Dave Fanning, executive managing director and data center advisory group leader for Cushman & Wakefield. “There is a large amount of capital chasing a handful of available assets, as well as risk exposure due to a lack of diversification within the asset class... Most deals are happening ‘off market.’”

Cushman & Wakefield recently published a global data center market comparison. It found that average data centers are becoming larger and more complex to keep up with the demands from the market. Overall it looked at 1,162 data centers in 38 markets and ranked the top global markets across various metrics.

Prices have risen as more debt and equity investors become willing to invest in data centers and more comfortable with the asset-type. Once viewed as an alternative asset class with some risk (and therefore higher caps), now data centers trade at the same ranges as more traditional commercial real estate property types.

“Capital no longer requires the premium associated with a specialty asset class,” says Michael Hochanadel, senior managing director for JLL Capital Markets, based in San Francisco. “In general, data centers trade tighter than office and retail but not quite as aggressive as industrial and multifamily.”

But good deals are hard to find. A growing number of investors are partnering with experienced operators that can help them understand the complexities of data center properties.

“The lack of transparency and nuance is also what makes data centers so attractive,” says Kristina Metzger, leader of CBRE’s data center capital markets. “There are definitely groups who achieve outsized returns given their knowledge of the space and partnership with experts.”

These operators are often happy to sell partnership interests in their existing properties—they can then recycle the capital into new development, while maintaining operations and management of the existing assets, says Metzger.

Partnerships with proven operators helps investors navigate a complicated, expensive asset class, in which the demand for a property is often decided by unusual factors like the cost of electricity, local infrastructure, sales tax and connectivity.

“The largest barriers to investing are technical understanding of underlying infrastructure and the impact that design, age and connectivity have on investment basis,” says Hochanadel. “Without fully understanding the underlying technology, it is hard to have conviction paying pricing that is three times the basis associated with an alternative re-use.”

The success of publicly-traded REITs focused on the sector has also fueled pricing trends and helped draw in other investor classes. “Lenders are more comfortable with the asset class than several years ago,” says Hochanadel. “Additionally, the underlying demand fundamentals are exceptionally strong.”

“As the asset class is institutionalized and more generally accepted, we are seeing investors of all types,” adds Metzger. That includes traditional private equity players, in addition to institutional investors, infrastructure funds, triple-net-lease investors, and more, says Metzger.

International investors are adding to the bidding wars over properties. “The most significant trend is the emergence of foreign capital, primarily from Asia, the Middle East, Germany and Canada,” says Hochanadel.

In the past, many passive real estate investors built portfolios of data center properties triple-net leased to the companies that use them. “There is more capital chasing these deals than there are available opportunities,” says Hochanadel.

Future obsolescence?

Data centers are also subject to the risk that they technology that makes that properties valuable will change—perhaps suddenly.

“The largest risk is changing technology and the degree to which it may drive obsolescence,” says Hochanadel. “The largest and most obvious example being the emergence of the cloud computing and the growth of the hyperscale cloud providers.”

Up until now, hyperscale providers have been a source of significant data center absorption. “But ultimately they prefer to own their facilities. It is unclear at this point if the Cloud continues to be part of data center demand or if it becomes alternative supply that reduces demand going forward,” says Hochanadel.

Also, many businesses are moving their data into public cloud environments managed by firms like AWS, Microsoft, Google and other public cloud providers.

“More enterprise clients are migrating out of their owned data centers as they adopt more cloud-based applications to scale their business,” says Manning. “Investors looking into the data center market need to assess whether a client is going to maintain tenancy in their data center and for what length of term. Assuming a client will remain in their current data center beyond the current term is a major risk.”

Correction: January 29, 2020
The quote in final paragraph of the story was inadvertently attributed to CBRE's Kristina Metzger. It was from Cushman & Wakefield's Dave Fanning and has been corrected.
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