Lenders dialing up interest in data centers

There are limited opportunities and high barriers to entering the data sector market. That is not stopping institutional lenders and investors from trying to gain market share.

Commercial real estate lenders, which have been increasingly turning to niche sectors to diversify their portfolios and enhance returns, are taking a harder look at opportunities in the data center market.

The rising interest in data centers comes amid a growing need for high-quality colocation and hyperscale services, driven by both individuals and corporations. But the sector is not one that a lender or investor can simply jump into, says Jacob Albers, head of alternative insights at Chicago-based Cushman & Wakefield.

“There is a reason why the entrance of various types of institutional capital is through partnerships or very nuanced and carefully thought-out merger and acquisitions. [This is] because the actual operations of a given entity are really important to how successful building out a data center pipeline is going to be,” Albers says.

Getting a byte

Data centers have been one of the few commercial real estate asset classes that have seen an increase in transaction volume in a year-over-year basis, according to research from New York-based data provider MSCI. In the first half of 2023, existing data center transaction volumes neared $1 billion, 5 percent higher than the same period year-over-year.

Additionally, research from Cushman & Wakefield found that roughly $41.09 billion of capital raised for commercial real estate funds in 2022 included data centers as a target asset class. By comparison, that number was at $11.89 billion in 2021.

There are a number of factors which contribute to the success of a data center transaction, including location, the experience of the operator and the background of the real estate sponsor. And as with any investment, timing is paramount, Albers says.

“[There is] a finite field of operators and a finite pool of experienced capital,” Albers says. “A lot of colocation providers already have committed capital from sources that they have long-term partnerships with.”

“You have to be on the lookout for when an experienced data center entity begins looking for a substantial amount of capital injection, as these opportunities are becoming rarer and more competitive as the industry matures.”

While data centers have become a critical part of technology infrastructure, there are two key factors to consider which make data centers less accessible to commercial real estate lenders and investors. First, the overall pool of data center providers consists of about two dozen colocation providers, which allow users to rent equipment, space and bandwidth. And there is also a handful of major hyperscalers, which make it possible for an IT system to expand as demand from users increases.

The second factor is geographic constraints, Albers adds. The power draw needed to make a data center development viable depends on municipality or state government in which the asset is built or will be constructed. After years of data center expansion, the sector is running into electrical grid obstacles in many of the most popular markets.

Powering up

Patrick Wilson, a portfolio manager within the real estate securities group CenterSquare Investment Management, based in Plymouth Meeting, Pennsylvania, tells Real Estate Capital USA the main US data center markets are hitting power constraints both in terms of generation and transmission.

For municipal utility companies more attuned to providing power to suburban homes, planning out the future of residential developments alongside data center developments is becoming untenable in some towns and cities, Wilson adds.

Research from the US Office of Energy Efficiency and Renewable Energy shows data centers consume 10-50 times the energy per floor compared with a standard office asset. The niche as a whole accounts for about 2 percent of total electricity use in the US and is expected to account for more as a collective group as usage increases nationwide.

Per Cushman & Wakefield research, North America uses more than 8GW  of power to fuel the information technology sector, and that total is actively growing. Coincidingly, data centers will need to source 10-100 percent more of that 8GW  total to properly fuel power usage in the sector on a national basis.

“When you start to think about a megawatt being able to power up to 1,000 homes, it very quickly starts to snowball into: ‘How could we have ever planned for this?’” Wilson says.

This means high-supply US markets including Northern Virginia, Dallas, Phoenix, Chicago and Silicon Valley, among others, are not necessarily ideal options for building a data center pipeline, despite the low vacancy rates and high rents seen within all of these regions.

Wilson says there have been more forays into secondary and tertiary markets to get affordable and available power in a business-friendly environment.

“Low cost of power is very important, too,” Wilson says. “That has been a benefit to markets like suburban Portland, Ohio and recently Wisconsin. You see markets that are usually off the map for data centers getting some of these big, multi-megawatt campuses recently.”

AI tailwinds

Although the market today is dominated by the largest institutional lenders, there is a tailwind that will boost lending and development: artificial intelligence.

AI and machine learning technology are driving development among the largest data center operators who are looking to invest in such capabilities for the future viability of their own businesses, Albers says.

When it comes to building data centers that house AI training facilities, the prevailing wisdom is that these assets will not have to be located as centrally as those in primary data center markets. This would help clear some of the power supply hurdles that existing and inbound lenders may encounter, Albers adds.

“Everybody is trying to learn as fast as they can as to how these will execute,” Albers says. “But AI is driving interest in a lot more outlying rural areas and tertiary markets across the board where hyperscalers will not be as pressed when it comes to power or land, and there will not be as much competition between established players in a given market.”

Wilson says he expects 2024 to continue being a good environment for data center rent growth, even with more supply coming online and entering development in the primary markets next year. “Supply is out there, and you will see it beginning to ramp, but the new capacity being delivered will be heavily skewed outside the traditional core data center markets,” he says.

Wilson says opportunities instead will arise in business-friendly jurisdictions with affordable power and large land availability that may be considered uncommon data center markets acting as escape valves from the primary regions.