Publications

- April 1, 2021: Vol. 8, Number 4

Data centers going green

by Sheila Hopkins

It wasn’t very long ago that a data center was simply a corner cubicle where an employee input data into the company’s database — which was often just multiple excel worksheets or perhaps the buggy Filemaker program — for eight hours a day. If anyone needed that data, they had to ask the data inputter to find the appropriate pages, print them off and deliver them to the requester. Rarely was this accomplished within the hour or even several hours. If it was an external request, those pages had to be faxed or mailed. Things moved at a slower pace in those days.

Today’s demands for data services, privacy and security far exceed the ability of most inhouse data storage systems. Enter the remote data center. These warehouses full of servers, modems, racks, cables and blinking lights have become an integral cog in the world’s ability to communicate and innovate. Some of these centers are built and managed for a single enterprise, such as Google, Microsoft or Amazon. But many others are owned by third parties that rent space to multiple tenants. Ranging from small, local centers of 5,000 square feet to behemoths covering more than 1 million square feet, it is these third-party data centers — which sit squarely at the intersection of the real estate and infrastructure asset classes — that have caught the eye of real assets investors.

According to Nareit’s ReitWatch, the equity REIT sector had an average annual return of –5.12 percent as of Dec. 31, 2020. The S&P 500 returned 18.40 percent during the same period. The five data center REITs, however, returned 21.00 percent. This was the best performance for any REIT sector, with others ranging from a low of –37.15 for regional malls to highs of 12.17 for industrial and 12.91 for self-storage. The data center sector did even better in 2019, when it returned 44.21 percent.

Given the exponential growth in demand for cloud and other computing services (according to the CIM Group, 20 typical U.S. households produce more internet traffic data today than was generated across the entire internet in 2008), it’s no surprise that data centers have been one of the strongest sectors during the past couple of years. But can it continue?

THE WORLD IN ZETTABYTES

The characteristics and trends that have made data centers attractive to investors during the past few years are still going strong.

“We are seeing a digitization of the human experience,” explains Sam Bendix, managing director, investor relations, at National Real Estate Advisors. “Financial and healthcare transactions were some of the first activities to move to the internet. But now, how people manage their daily lives has also moved online. How people manage their relationships and social networks, how they date, how they get their groceries, how they get from point A to point B — all of these things have migrated to the internet. The pandemic did not start these trends, but it definitely accelerated them. People who hesitated to order their groceries online or conduct video meetings now do so daily. That means the internet is producing tons of data and it requires tons of storage. Data centers are where that data is processed and stored. They are the digestive system for the internet.”

The demand for data centers doesn’t just come from data users, however. Demand from investors is also driving valuations. Data centers pull from both real estate and infrastructure investors, giving the sector a larger universe of capital suppliers than many other sectors. At its core, a data center is a warehouse that rents space to tenants. The center owner supplies a secure building, as well as uninterrupted heating, cooling and power, usually with failsafe backup systems, but the tenants are responsible for their own equipment. This structure is similar to an office net-lease structure, and protects the data center operator and investors from unexpected costs, as well as running into inherent technological problems, such as obsolescence.

“One of the most common questions we get is about technological obsolescence,” says Bendix. “How long can you expect a data center to remain current? The answer is that the data center landlord is primarily responsible for providing a climate-controlled, secure and reliable environment for a tenant’s servers, but the tenants are responsible for providing the newest and greatest server infrastructure or the computers within the data center. Avoiding technological obsolescence for the servers is up to each individual tenant rather than the data center operator.”

On the infrastructure side, data centers have become an integral part of our society. They are needed for the efficient transfer of data and continued growth of the economy. We simply couldn’t function as a society without them, which is pretty much the definition of traditional infrastructure.

In addition to being appropriate for several different allocation spots in a diversified portfolio, data centers exhibit characteristics that make them particularly attractive to those looking for stable, long-term income returns, though value-added and opportunistic investors can also find appropriate investments. For example, the leases tend to be very sticky. It’s expensive to move equipment from one center to another, so once a company is ensconced in a particular center, it is unlikely to leave. These long-term leases, which are typically tied to inflation, make data centers less vulnerable to short-term economic cycles, so income returns are relatively certain. Data centers are also a good portfolio diversifier, as they have a low correlation to other real estate property types, as well as other investment classes.

But possibly the greatest positive for data centers is the continued growth in demand. According to researchers at JLL, the worldwide volume of data, currently estimated at more than 50 zettabytes, will more than triple to an estimated 175 zettabytes by 2025. Currently, internet users generate about 2.5 quintillion bytes of data each day, with every person generating 1.7 megabytes each second. We have become increasingly dependent on the efficient movement and storage of data, and there is no reason to believe this trend will decrease soon.

“The world is only going to get more dependent on data connectivity,” says Indraneel Karlekar, global head of research and strategy for Principal Real Estate Investors. “By 2023, the number of global internet users is expected to soar from 3.9 billion in 2018 to 5.3 billion, which is roughly two-thirds of the world’s population. Businesses continue to migrate their activities online to improve efficiencies. Many are using predictive analytics or other data science tools to improve customer experiences and provide competitive advantages. And technological advances are increasing the demand for low-latency and high-bandwidth data, too, driving the need to have computing close to end users. Innovations like artificial intelligence and virtual reality in new applications will require a high level of processing power.”

The impact of COVID-19 has exponentially accelerated this need for connectivity.

“The use of social media, streaming services and online sales have all accelerated, making the processing and storing of this huge volume of data even more critical to the global economy,” Karlekar continues. “To put it in perspective, daily Zoom meeting participants ballooned from 10 million in December 2019 to over 200 million in March 2020, while Netflix added 16 million new customers in the first quarter of 2020 and closed out 2020 with over 200 million subscribers.”

The demand for space in current facilities is likely to remain strong as new supply is trailing duew to significant barriers to entry, as well as disruptions in construction during the COVID-19 shutdowns. These specialized and highly technical facilities aren’t easy to build. They need to be located close to population centers to reduce lag times, as well as have access to reliable sources of energy and data transmission lines. Moreover, as a specialized product type, the pool of qualified developers, as well as capital providers, remains fairly limited.

FORECAST: PARTLY CLOUDY

Despite its sunny future, the data center sector needs to contend with a few clouds on the horizon. One of the most vexing questions facing data centers is what to do about the amount of energy and cooling these buildings require. The amount of energy required to keep these centers cool and running can overwhelm power grids in many otherwise desirable locations, as well as raise eyebrows among carbon-footprint-aware customers.

To decrease costs, as well as satisfy customers who are demanding green solutions from operators, the industry is moving toward sustainable sources of heating and cooling. Initiatives include green rooftops, fuel cell adoption, gray-water usage and innovative cooling systems. Some estimates forecast the global green data center market to grow by nearly $45 billion by 2024.

The move toward green solutions, however, isn’t just to satisfy customers. It is also proving to be a way to reduce costs and manage a more profitable center.

“Renewable power makes a lot of sense from several perspectives,” says David Sher, co-CEO at Greenbacker Capital. “One of the most compelling reasons to use sustainable power is that renewable power sources typically allow the customer to enter long-term contracts that specify the amount of power to be purchased at a negotiated pre-set price, which will generally be less than the going rate for traditional energy. Right now, renewables are the cheapest form of power in the country — cheaper than natural gas, cheaper than nuclear, certainly cheaper than coal — so data centers can lock in the long-term price, and they can also get a better price for the electricity over that locked-in term. That’s a very compelling reason for why data centers are looking at renewables as a great place to get power.”

In fact, the development of renewable power plants and data centers has become something of a symbiotic relationship. When developed near each other, the data center is able to access an efficient, reliable source of electricity while the sustainable energy plant has a guaranteed customer.

“Solar and wind developers and data centers developers tend to locate their assets in similar locations,” says Sher. “It is very expensive to build transmission lines from a power grid to a data center, so the center developers are going to want to locate their center near an existing connection. Not surprisingly, solar or wind developers are going to look to also have easy access to the power grid. In addition, sustainable developers aren’t going to build on land that has other, higher uses. They are not going to build a solar farm on prime real estate that might be developed for residential housing. They’re going to be built on some kind of marginal land, such as a brownfield or near watersheds. And that’s also where they’re going to build the data center because it’s inexpensive. So, the supplier of green energy and the user of green energy matches up nicely.”

Water usage is also a challenge. Traditionally, these plants have used massive amounts of water to air condition the facility. Operators are looking for ways to mitigate the amount of water used for both ESG and cost reasons. For example, the CIM Group has opened a new center in Salt Lake City that uses ambient air for cooling. This is estimated to save 4.5 million gallons of water per day, or 1.64 billion gallons annually. That equates to more than 13 percent daily water usage savings across the entire Salt Lake City population.

While the increase in demand is good for investors, it can cause problems if it overwhelms the supply of centers. Because the cost of developing new data centers can be daunting, operators are looking to find ways to handle more data with the facilities they already have. Operators have always used algorithms to optimize the movement of data among servers and allocate incoming workloads, but now they are turning to artificial intelligence to improve efficiency. Researchers at MIT have found that artificial intelligence systems complete jobs about 20 percent to 30 percent faster than standard human-produced algorithms, and twice as fast during high-traffic times. In addition to increasing speed, the system learns how to compact workloads efficiently to leave little waste. Results indicate that using artificial intelligence–based systems could enable data centers to handle the same workload at higher speeds, using fewer resources, and thus reduce, though not eliminate, the need for new or expanded buildings.

Finding qualified labor to operate new and existing plants is also beginning to emerge as a potential obstacle. Customers want to know that the operators have robust track record and that those running the center know what they are doing.

“There is a growing percentage of individuals running data center facilities who are at or nearing retirement age,” says Karlekar. “Given the massive increase in demand and sheer number of new facilities that need to be built and operated to keep up with that demand, the question of ‘who is going to run them?’ is being raised more regularly.”

THE LONG TERM

Data centers have increasingly moved from a niche to mainstream investment opportunity. Given the structural transformation of the use for data by individuals, businesses and new technologies, data centers can provide opportunities to suit a variety of investor risk profiles — whether it is targeting high returns via build-to-core strategies or aiming at more stable incomes secured by high-quality leases. With the explosion of the internet of things, artificial intelligence, driverless cars, online transactions and other data-dependent innovations, the demand growth seems unlimited. Data centers are likely to remain a secular growth opportunity for years to come.

Sheila Hopkins is a freelance writer in Auburn, Ala.

 

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