Investment sales of data centres slowed dramatically toward the end of 2022 and through the first quarter of 2023, as rising interest rates and capital constraints impacted acquisition activity. However, the asset class has not fallen out of favour with investors who industry observers say are biding their time before jumping back on the list of data centre REITs.
Last year, sales of data centres in the U.S. totalled more than $9.0 billion, according to research firm MSCI Real Assets, surpassing the $8.2 billion total reached in 2021. But in the first quarter, they have accounted for the vast majority of that volume—before the Fed began its quest to raise interest rates to combat inflation. In the fourth quarter of last year, only $453.6 million in data centres traded hands, the lowest volume recorded since the third quarter of 2020. MSCI’s transaction volume figures include individual property sales, portfolio sales and entity-level mergers and acquisitions.
The market remains in a price discovery phase with buyers and sellers attempting to get a pulse on market values for data centre properties, according to Raul Saavedra, executive vice president, of data centre advisory, with commercial real estate services firm Colliers. “If you are well-capitalized right now, and you’re an investor, why would you do anything right now? You’re going to take the mentality of ‘Let’s wait for the bad times to come.’”
Still, when CBRE releases its annual Investor Sentiment Report for 2023, the expectation is that it will show that investor interest in data centres “remains very robust,” said Kristina Metzger, executive vice president and leader of data centre capital markets team with commercial real estate services firm CBRE. “Many institutional groups are looking to allocate more in the sector.
Nearly all investors CBRE surveyed for the report—some 89 per cent—said they intend to increase their investment in data centres in 2023. Only 2% said they plan to decrease allocations.
One of the most meaningful statistics shows that most surveyed said that data centres make up less than 5% of their managed assets. But in five years, almost all of them said they would like for that share to be greater than 5%.
“Moving from under 5% to 5% to 10% is a tremendous amount of additional capital that’s looking to get in this space,” Metzger said.
There were some concerns raised in the past year over available power supply and land for data centre development, as well as competition from major cloud firms. Hedge fund manager James Chanos said he’s made a bet against data centre REITs, noting they face growing competition from major tenants like Amazon Web Services, Google and Microsoft, who prefer to build their facilities.
Of the $9.0 billion in U.S. data centre transactions last year, MSCI reported that $6.9 billion involved institutional buyers; $1.69 billion involved private buyers; $149.5 million was made by end-users; $130.7 million were made by foreign investors; $96.7 million involved unknown sources; and $34 million were REIT buyers.
“There’s a lot of funds looking to diversify what their allocations are to different real estate asset types, and across the board, we’ve seen a lot of funds reduce exposure to asset classes like office and retail and increase exposure to variety of alternative asset types, and a prominent one amongst those is data centres,” said Jacob Albers, research manager with commercial real estate firm Cushman & Wakefield.
In 2022, the top investors in the U.S. data centre space included private equity firm KKR; global infrastructure fund manager Global Infrastructure Partners; data centre operator DataBank Ltd.; private equity firm GI Partners and pension fund CalPERS, according to MSCI data. Other players include Lincoln Rackhouse, the data centre division of Lincoln Property Group, Brookfield Asset Management and Peterson Companies. Saavedra noted he has heard that even some large sovereign wealth funds are looking into data centre investment.
Carl Beardsley, managing director and JLL’s capital markets data centre lead, said the team currently has nine data centre deals in the market, including both investment sales and debt transactions. In the first quarter, they closed $160 million in data centre transactions.
“The data centre space remains extremely attractive to capital sources looking for higher returns versus other asset classes,” Beardsley said. “However, there are barriers to entry and limited opportunities in comparison to the core real estate asset classes.”
The typical buyers targeting data centres today are infrastructure funds, data centre operators, data centre REITs and cloud companies/end-users, Beardsley noted.
Cap rates in the sector are rising. MSCI reported the trailing 12-month cap rate on data centers expanded by 230 basis points, to 7.1% from the first to the fourth quarter of 2022. While investor appetite for data centres remains robust, it can be difficult to break into the sector due to the limited direct investment opportunities, according to Metzger.
Higher interest rates have cooled investment activity in the data centre space, according to BJ Feller, managing director and senior vice president with capital services provider Northmarq. If interest in a property type was measured from zero to 100, during the pandemic data centres were at 95, he noted. Today, they are closer to 75 on that scale, in Feller’s example, but he doesn’t see current capital markets conditions interrupting a decade-long trend of data centres being in demand among investors.
“It’s been the beneficiary of retail and office falling out of favour,” Feller said. “That pushed a lot of capital over the last decade into the segment, and I also think it’s the beneficiary of how aggressive pricing got in industrial over the last 36 months. As that happened, people said data centres are way closer to industrial than any other product type, and that led to the thesis for people to go in and get it.”
Investor interest is also driven by the fact that property fundamentals for data centres remain at their peaks, noted Metzger. With historic high demand, record low vacancy rates and development costs and timelines increasing, the firm is seeing strong rental growth across nearly all major markets, with some exceeding average rent growth of 20% year-over-year. In addition, vacancy is also averaging below 5% in many major markets, according to Cushman & Wakefield data.
JLL released its Global Data Center Outlook report Thursday that showed that the data centre industry continues to thrive despite economic uncertainty. The pandemic served “as the ultimate wake-up call for organizations to take their IT infrastructure to new heights and accelerate their timelines to become fully transformed enterprises,” according to Andy Cvengros, managing director at JLL. In turn, the mass adoption of cloud computing and artificial intelligence is driving “exponential growth” for the data centre industry, with hyperscale and edge computing leading investor demand, Cvengros said.
“Employees are looking to their companies to create a seamless experience wherever they choose to work, requiring intelligent technology solutions to bridge the gap between the physical and the digital,” he noted. “As this reliance on digital technology increases, the data centre industry is experiencing impressive growth and catching the eyes of investors and lenders as a strong, alternative asset class that has been relatively unimpacted by continued economic uncertainty.”
Similarly, Moody’s Analytics Economist Ermengarde Jabir said that while investment sales transactions and new construction in the sector have fallen in recent months, the long-term growth prospects for data centres remain promising. “When you think about the needs that are served by data centres, those needs aren’t going away. We’re not going to become less digitally connected. That’s only going to increase more and more as the population grows and as more services become available digitally.”
