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Investment sales of data centers 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 favor with investors who industry observers say are biding their time before jumping back into the market.

Last year, sales of data centers in the U.S. totaled more than $9.0 billion, according to research firm MSCI Real Assets, surpassing the $8.2 billion total reached in 2021. But the first quarter accounted for vast majority of that volume—before Fed began its quest to raise interest rates to combat inflation. In the fourth quarter of last year, only $453.6 million in data centers 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 center properties, according to Raul Saavedra, executive vice president, data center 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 will release its annual Investor Sentiment Report for 2023, the expectation is that it will show that investor interest in data centers “remains very robust,” said Kristina Metzger, executive vice president and leader of data center 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 percent—said they intend to increase their investment in data centers in 2023. Only 2% said they intend to decrease allocations.

One of the most meaningful statistics shows that the majority of those surveyed said that data centers make up less than 5% of their managed assets. But in five years’ time, 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 center development, as well as competition from major cloud firms. Hedge fund manager James Chanos said he’s made a bet against data center REITs, noting they face growing competition from major tenants like of Amazon Web Services, Google and Microsoft, who prefer to build their own facilities.

Of the $9.0 billion in U.S. data center transactions last year, MSCI reported that $6.9 billion involved institutional buyers; $1.69 billion involved private buyers; $149.5 million were 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 centers,” said Jacob Albers, research manager with commercial real estate firm Cushman & Wakefield.

In 2022, the top investors in the U.S. data center space included private equity firm KKR; global infrastructure fund manager Global Infrastructure Partners; data center operator DataBank Ltd.; private equity firm GI Partners and pension fund CalPERS, according to MSCI data. Other players include Lincoln Rackhouse, the data center 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 center investment.

Carl Beardsley, managing director and JLL’s capital markets data center lead, said the team currently has nine data center deals in the market, including both investment sales and debt transactions. In the first quarter, they closed $160 million in data center transactions.

“The data center 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 centers today are infrastructure funds, data center operators, data center 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 centers remains robust, it can be difficult to break into the sector due the limited direct investment opportunities, according to Metzger.

It’s clear that higher interest rates have cooled investment activity in the data center 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 centers 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 condition interrupting a decade-long trend of data centers being in demand among investors.

“It’s been the beneficiary of retail and office falling out of favor,” 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 centers 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 centers 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 center 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 center 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 center 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 transaction and new construction in the sector have fallen in recent months, the long-term growth prospects for data centers remain promising. “When you think about the needs that are served by data centers, those needs aren’t going away. We’re not going to become less digitally connected to each other. That’s only going to increase more and more as the population grows and as more services become available digitally.”

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