Publications

- February 1, 2021: Vol. 8, Number 2

Data centers move from niche investors to center stage

by Casey Miller, Ben Wobschall, Sebastian Dooley and Giles Smith

Big data keeps getting bigger. And faster. And more valuable. Consider that 90 percent of all data was created in the past two years; then try to imagine that by 2025 worldwide data is expected to hit 175 zettabytes. To put that in perspective, if you were to store 175 zettabytes on DVDs, your stack would be long enough to circle Earth 222 times. Processing, housing, streaming and securing all that data has given rise to the evolving modern data center. The elements that appeal most to investors today include:

  • Unprecedented, sustainable growth in global data requirements that is driving demand for quality data center space.
  • Limited supply of data centers able to keep pace with exponential data growth from developments in outsourcing, cloud adoption and emerging technologies.
  • Longer leases with creditworthy tenants.

The global pandemic accelerated many real estate market trends that have been developing incrementally in recent years. Arguably, the most pronounced of these trends has been the significant growth of the data-center industry. Indeed, the pandemic created an unforeseen dependency on technology, and this new normal is accelerating the changing landscape for how data is used, stored and processed.

The combination of strong demand and limits on new supply is providing attractive risk-adjusted opportunities in the data center sector, driven by both individual consumers and corporate users. Many are trying to balance the need to control proprietary or mission-critical applications while outsourcing more generic needs. Every day, new technologies are being developed to leverage today’s high-bandwidth and low-latency data availability, driving the need for computing power to be in close proximity to the end users of the data.

Despite the rapid growth in data center demand, new supply is trailing due to significant barriers to entry, including unique power and fiber requirements along with the need for these facilities to be near end users. Moreover, as a specialized product type, the pool of qualified developers, as well as capital providers, remains fairly limited. These factors, along with data centers’ history of performing well in periods of economic growth as well as periods of economic decline, have led to returns that make investing in data centers compelling. In the public markets data-center REITs have significantly outperformed the overall U.S. REIT market.

ATTRIBUTES OF A DATA CENTER

Data centers are designed to house data and connect this data to users. These facilities are built to provide maximum uptime, which is provided through redundancy in every component of the building. Within a data  center, there are typically multiple sources of power and fiber, and backup power systems and generators. Often times tenants have invested hundreds of millions of dollars into the technology inside these buildings, so protecting these investments is crucial.

There are three main groups of users of data centers. The first are enterprise users, which are traditionally large Fortune 100 companies that have historically owned their own data facilities, often located on their corporate campuses. In the wake of the global financial crisis, many of these enterprises were forced to employ new strategies that allowed for continued digital-platform growth without spending huge amounts of capital. The best solution for many was outsourcing their data-infrastructure needs to leased space, which proved to be less expensive and more efficient. This is the approach many of these companies take today.

The second type of data center users are co-location service providers, which can be compared to co-working facilities in that they provide infrastructure on a smaller and more scalable level. This approach is best for small- to medium-size businesses that cannot or choose not to own and operate their own facilities.

Hyperscale cloud service providers are the third type of data center user. Hyperscalers, the fastest-growing segment of data centers, use a shared infrastructure to provide customers networking, infrastructure and applications as a service. This model provides economies of scale for tenants, allowing them to focus on core businesses.

Users are often trying to balance multiple factors when considering a data center. These include access to infrastructure, such as fiber connectivity, developmental and operational costs, and a low susceptibility to natural disasters. One additional factor that is becoming increasingly important is location — the proximity to the population the user serves. The reason this is growing in importance is because latency — the time it takes to request, process and return data — is becoming less tolerated as people have grown accustomed to applications loading quickly.

Several primary data center markets are in the United States, and demand is growing in secondary or “edge” markets. The largest data center market in the world is northern Virginia, a region that is attractive in all four of these location considerations. Although northern California is susceptible to natural disasters and has some of the highest power costs in the nation, it’s home to much of the world’s technology-related intellectual capital and will likely always be a top-tier data market. Phoenix is an emerging data center market, attractive given its growth potential and as an alternative to the West Coast, where operational costs can be high.

AN EXPONENTIAL DEMAND FOR DATA

The worldwide volume of data has been growing exponentially, doubling approximately every two to three years. Although data storage remains an important demand driver for data centers, the bigger driver today is the processing of data. This is a result not only of corporations moving many computationally intensive processes online, but also of consumers increasingly accessing the internet via connected devices, such as laptops and smartphones.

From a consumer perspective, the shift from physical media to media “on demand” has been a significant demand driver. This type of media must not only be stored somewhere, but also be sent from a device to a data center to package together the video or movie before it’s streamed. The increased usage of social media since the start of the pandemic has also been a large demand driver. During March 2020, for example, Facebook messaging app usage increased 50 percent, while Zoom daily users grew to 200 million, compared with only 10 million users in December 2019. The myriad of internet-connected devices, such as appliances and home security systems, also rely on data centers as an interface to turn commands into actions.

The data demand from corporations and other enterprises is also increasing. One example is the popularity of tailored marketing campaigns, which allow businesses to use algorithms and data-heavy analytics to target consumers. There is also an increase in the use of data science and predictive analytics, such as a supermarket aiming to understand how demand is impacted by things such as seasonality, general consumption trends, and even the weather. Additional ways corporations are driving demand for data centers include the increasing migration to mobile applications, as well as offering everything as a service, which has led to many software programs moving from laptops to servers.

Beyond the consumer and corporate demand for data, many new technologies will also drive demand, going forward. These include autonomous vehicles, which require a high level of data to operate under circumstances where low latency is critically important. Augmented reality essentially turns everything into a source of data, and artificial intelligence requires huge amounts of data to produce quality output. In addition, while some people think 5G mobile will limit the need for physical connectivity, the reality is 5G actually enhances the need for fiber infrastructure. This is because, although 5G is fast, it doesn’t have the range of 4G, so it will require a transition to physical connectivity via data centers.

KEY OCCUPIER TRENDS

In Europe, and increasingly globally, data-protection regulations have resulted in a focus on data security for corporations. The rise in digital espionage and media coverage has led to a reluctance to put personal data in a public cloud and, as a result, a hybrid approach, where low-risk data is put in the public cloud and higher-risk data in enterprise or co-location services, is emerging.

In the United States, corporate users are focused on location because they are trying to get closer to their end users, while at the same time they are looking to monetize company-owned and underutilized data centers to help with geographic diversification.

INVESTMENT STRATEGIES TO CAPITALIZE ON DATA GROWTH

Investment trends mirror many of the occupier trends noted above, as investors try to capitalize on supply/demand imbalances. In the United States, we see attractive relative value in a value-add acquisition strategy, which allows an investor to benefit from

an enterprise user selling an asset and then leasing back a portion of that asset. With this strategy, an investor can buy a high-quality and well-maintained asset at a significant discount to its replacement cost, with the ability to expand the facility under a multi-tenant scenario. In addition to this value-add strategy, ground-up development can also provide outsized returns for investors. With this approach, a state-of-the-art facility is developed that meets the user’s needs, providing the tenant exactly what it wants in its desired location.

For investors, the potential to create value through an aggregation strategy by creating a geographically diverse portfolio with a secure, long-term income return profile. Ultimately, high demand for diversified, institutional-quality portfolios from investors and REITs provides a natural exit strategy.

Regardless of the strategy investors choose to employ in this space, data centers will continue to be a highly attractive segment of the real estate market, well positioned to weather ongoing economic uncertainty and the rapidly evolving preferences of consumers and enterprises alike.

Casey Miller is managing director of asset management, and Ben Wobschall is managing director and portfolio manager, at Principal Real Estate Investors. Sebastian Dooley is fund manager, and Giles Smith is head of fund management, at Principal Real Estate Europe.

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