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Late in the Real Estate Cycle, Data Centers Continue to Outperform

There doesn’t appear to be any slowdown in the demand for this product type, particularly with the increasing use of technology and the growth of remote working.

As rumors of mergers circulate in the data center sector, there appears to be no slowdown in investors’ interest in this property type.

Over the past several months there have been announcements of big deals in the space and rumors of potential transactions on the way. The year kicked off with the launch of a new player in the space, EdgeCore Internet Real Estate, a private company that in February said it was planning $2 billion in North American data center development. In June, AT&T Inc. said it would sell its data centers for $1.1 billion to Brookfield Infrastructure. The Australian firm Macquarie Group Ltd. is, as of early July, reportedly close to buying a majority stake in T5 Data Centers. And data center REIT Digital Realty Trust Inc. is also in talks to buy Ascenty, a Brazilian data center operator.

“There is a lot more interest in the data center space,” says Lukas Hartwich, a senior analyst at Green Street Advisors, a Newport Beach., Calif.-based real estate research firm. “We’ve been seeing that over the last few years.” And the interest is coming from all sides.

While data centers represent a relatively new real estate sector, they have been around for enough years now that people have grown more comfortable with them as an investment play, Hartwich says. “The performance of the sector has been so strong over the last few years, and people are having a hard time ignoring it,” he adds.

A May report from Green Street found that leasing in the sector during the first quarter was above the historic average, hitting slightly more than 500,000 sq. ft. for Digital Realty and CoreSite. Rent growth on lease renewals was in the 2.0 to 3.0 percent range, which the firm noted is consistent with the typical annual rent increase.

Among the five data center REITs, their year-to-date return as of the end of June was down 3.11 percent, though for that month, the REITs’ total returns totaled 6.68 percent, according to industry group Nareit. Last year, the sector saw total returns of 28.43 percent.

Other REIT sectors have been seeing more M&A activity this year, and the timing may be particularly good for the data center operators. The cost of capital for data center REITs has improved, making it more possible for these companies to step up their acquisition activity, Hartwich says.

Pat Lynch, senior managing director, data center solutions, with real estate services firm CBRE, says there might be more companies looking to get into the tech real estate space, particularly after AT&T’s sale to Brookfield. And as the real estate cycle is in the late innings, it could be possible that technology-related real estate may be less impacted in a downturn.

However, acquisitions still pose a challenge—there are not many data center companies left to snap up, Lynch notes.

Despite increased acquisitions in the space, Hartwich says that development returns are higher for this property type, in the 10-12 percent range vs. 5-7 percent for acquisitions. Green Street’s report noted that the REITs have profit margins of over 60 percent, and their balance sheets are healthy, with slightly less leverage than the average REIT.

And there doesn’t appear to be any slowdown in the demand for this product type, particularly with the increasing use of technology and the growth of remote working. The proliferation of streaming services such as Hulu and Netflix, plus the rise of colocation and autonomous vehicles, also fuel demand for more data centers, particularly outside major markets, Lynch says. “I think there maybe an unmet need in some of these secondary markets, as these technologies emerge,” he notes.

While there is always some risk of overbuilding in the real estate business, it’s not currently as big of a concern as it has once been. In 2012 and 2013, the market saw some oversupply that has since been absorbed, says Hartwich. While there is a lot of development today, space is still being leased up at a brisk pace; supply and demand are at equilibrium.

Because of the sector’s growth, cap rates are falling, according to Green Street. For the powered-base, network-dense assets in the private market, cap rates are in the low 5-percent range, the firm’s researchers estimate. For turn-key data centers, cap rates are in the high 6-percent range. “Because of all the players that are getting involved in data centers, values have been going up,” Hartwich says.

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