As a global shift towards remote work, online schooling, and e-commerce demonstrated during the pandemic, we increasingly rely on cloud computing technology. As such, data centers — which house the hardware of cloud-based technology — have become central to our daily lives.
Data centers allow us to securely and efficiently do everything from joining a Zoom call and processing credit card payments to directing autonomous vehicles and booking international flights. Though hyperscale data centers have more than doubled in quantity since 2016, demand for new sites remains high. This growing interest for data centers has created a new, wholly viable real estate asset class.
In a post for the Bay Area-based Finkel Law Group — which represents commercial real estate clients across the Golden State — attorney Hugh Greenup explains: “the advent of 5G networks, data-intensive technologies — and the continued digitization of our professional and personal lives” are all expected to drive “strong demand for data centers…well into the future.”
While the COVID-19 pandemic negatively impacted other commercial real estate asset classes, it spurred investment activity in data centers. Investment by private equity firms in data centers has exploded in recent years, with the most expensive acquisition in history occurring earlier this year.
Greenup notes that “data centers are increasingly attractive to investors because their yields are currently higher than yields realized for more traditional real estate assets.” In fact, writes Diana Olick in a March 2021 article for CNBC, “data center real estate investment trusts were the highest-performing REIT sector [in 2020].” As the data real estate sector expands, investors anticipate even greater returns. Below, we outline reasons for this continuing expansion and ways to invest in data centers while mitigating risk.
What Are Data Centers and How Do They Work?
Data centers are large buildings or complexes that securely house dozens of data servers — the hardware of cloud computing technology — in climate-controlled environments. To ensure servers function reliably, data centers must be kept relatively cool.
Data centers connect their servers to the internet through traditional infrastructure like fiber optic cables and coaxial cables — 113,000 miles of which traverse the continental US. Though many imagine the internet as a network managed by satellites orbiting the earth, most data travels through underground cables. In the United States, these cables follow trafficked roads. As such, developers often choose plots of land on the outskirts of cities to maintain proximity to the internet’s physical infrastructure without paying sky-high real estate rates.
In his article for Forbes, “Data In The Dark: How Big Tech Secretly Secured $800 Million In Tax Breaks For Data Centers,” David Jean notes that data centers “consume large amounts of energy and water resources in the communities where they are built.” Because of this, most US data centers can currently be found in Northern Virginia, where energy and land costs are low.
How Many Data Centers Are There and Who Operates Them?
According to an estimate released by Synergy Research Group Inc in early September 2021, there are now more than twice as many hyperscale data centers worldwide than there were in 2016. Synergy’s global estimate increased from 600 hyperscale data centers in January 2021 to 659 in September 2021. A PR Newswire press release last month noted that the majority of “major cloud and internet data center sites” are in the US and China, with Japan and Germany not far behind.
Most operators of hyperscale data centers are tech giants like Amazon, Google, and Microsoft. The press release notes that these three companies “collectively account for over half of the current data center footprint.” Companies that have spent the most on data centers worldwide in the last year are Amazon, Google, Facebook, Apple, Microsoft, and China-based Alibaba, Byte Dance, and Tencent.
Who Invests in Data Centers?
As mentioned above, investment in data centers is skyrocketing. Over the last few years, private equity firms in the United States have noticed how significant the real estate asset is to publicly traded data center operators and to everyday users of cloud services. In his January 2020 article “Private Equity Firms Are Taking Over The Data Center Market” for CNN, Mark Haranas noted that PE firms “accounted for approximately 80% of all data center acquisitions in 2019.” According to Haranas, this “injection of private equity funding” resulted in more than a hundred data center mergers and acquisitions that year.
The number of data center M&As in 2019 was double the number in 2017 and quadruple the number from 2016. Last year, however, set new records. Writing for Data Center Dynamics in December 2020, Tanwen Dawn-Hilscox noted that last year saw “nearly $31B in data center deals close, significantly up from 2019’s $15B.” Though the fourth financial quarter of 2021 has just begun, this year has already seen the most expensive data center deal in history. In June, alternative asset management firm Blackstone acquired center real estate investment trust (REIT) QTS for $10B.
How to Invest in Data Centers in 2021
Building New Data Centers
As mentioned above, tech giants, private equity firms, and investment management companies have chosen to invest in data centers by acquiring providers and developing their own sites.
Of course, constructing a brand-new data center is incredibly costly. The United States Chamber of Commerce Technology Engagement Center estimates the average cost to build a data center is $215.5 million at $1,304.94 per square foot. However, tax breaks might be available to developers who choose to undertake such a massive real estate investing project.
Tax Incentives for New Data Center Development Projects
Local governments have recently offered developers and tech companies like Apple, Google, Facebook, Amazon, and Microsoft attractive tax breaks to build data centers in and around their communities. States like Ohio, Virginia, Connecticut, and Pennsylvania have altered their legal codes to allow local municipalities to offer such incentives.
Referencing a Forbes analysis in his article “Data In The Dark: How Big Tech Secretly Secured $800 Million In Tax Breaks For Data Centers,” David Jean notes that “on average, cities and counties [that offer tax breaks to tech companies in return for data centers] are forgoing $1 million in potential tax revenue for every permanent data center job.” According to Jean, Apple received “$208 million in tax breaks for a [data center] project in Waukee, Iowa” that created only fifty full-time jobs for local workers.
While developers unaffiliated with these tech giants are unlikely to secure such enormous tax breaks, many states offer abatements for projects above a certain investment minimum. In his article “US tax breaks, state by state“ for Data Center Dynamics, David Chernicoff elaborates. He notes which states have specific tax abatement programs for data center development projects. The highest minimum investment amount required to qualify for any of these abatements — including those on sales, use, and property taxes — is $200 million.
Acquiring and Developing Land for Future Data Centers
Building a data center independently without a commitment from a user or group of users can be risky — as with any other type of speculative development. Another option for prospective data center investors is purchasing and developing vacant land to support a data center once that land is sold to a company like Amazon, Google, or Microsoft.
Buying land in desirable areas for data center development instead of actually building a data center prevents the investor from overleveraging. Attractive sites for data center development are those near major highways and access to massive amounts of clean, renewable energy.
Sites that can support solar, wind, or hydroelectric power generation are all desirable because data centers require a lot of energy to cool and operate their servers. To mitigate future operational costs, investors can limit their search to sites in colder climates. Appropriate sites for data center development must also be protected from extreme weather and natural disasters.
Investing in Data Center REITs
REITs are another investment option for those interested in data centers. For those unfamiliar with real estate investment trusts, James Chen explains in an article for Investopedia:REITs are companies modeled after mutual funds that “own, operate or finance income-generating real estate.” Because real estate investment trusts “pool the capital of numerous investors,” individuals can earn dividends based on these investments without purchasing or managing any actual real estate.
REITs are often viewed as low-risk alternatives to stock investments because most are publicly traded and easily liquidated, like stocks but less volatile. REITs invest in most types of commercial real estate including “apartment buildings, cell towers, hotels, medical facilities, offices, retail centers…warehouses” and, of course, data centers.
Returns Offered By Data Center REITs
Though most REITs “offer little in the way of capital appreciation,” data centers offer investors incredibly high returns. According to Diana Olick in a March 2021 article for CNBC, there are currently only “a handful of data center real estate investment trusts [but] they were the best performing REIT sector in 2020.” Data center REITs ended 2020 “up 21%.”
In his article “Data Center REITs” for Million Acres, certified financial planner Matt Frankel writes that Equinix — one of the few data center REITs operating in the US — “ produced a staggering 760% total return over the past decade.” Frankel recommends REITs for “investors who want to capitalize on technology trends with a source of steady income [because] it helps avoid the risk of investing directly in high-momentum technology stocks.”
Factors that Could Impact the Viability of Data Center Investments
Of course, there are no risk-free investments. There are a number of elements that could impact the viability of data center investments. In his article “Data Center REITs” for Million Acres, Matt Frankel notes that both rising interest rates and oversupply could impact returns on investment. Climate change, however, could pose an even more significant threat in the coming years. As mentioned above, much of the internet’s physical infrastructure exists in copper wiring, power stations, and underground cables. The location of major lines was once kept secret from the public because officials felt making such information widely available could constitute a security risk.
In 2015, the Department of Homeland Security made a map created by University of Wisconsin researchers — available online. Today, anyone can access Infrapedia’s interactive global internet infrastructure map — which details both submarine and terrestrial internet infrastructure around the world — here.
In the article “Fibre optic wires, servers, and more than 550,000 miles of underwater cables: Here’s what the internet actually looks like” for Business Insider Australia, Prachi Bhardwaj notes that now we have access to these maps, we can see that “this ecosystem of cables depends largely on the country’s infrastructure.” Bhardwaj writes that in the United States, “most of the long-haul cables are located along major roads and railways” near major cities.
How Climate Change Could Impact Critical Internet Infrastructure
Unfortunately, the locations of these cables place our internet infrastructure at greater risk of damage due to natural disasters and extreme weather. In a recent article for NPR, Rebecca Hersher noted that developers tend to build in disaster-prone areas of the US. Referencing data from a new study, Hershey wrote that “disaster hotspots account for about 30% of the contiguous US, but are home to nearly 60% of buildings in the country.”
Because the internet’s cable system echoes other existing physical infrastructure, it is at risk of flooding, sea-level rise, heatwaves, and other events. Sadly, these types of disasters are only expected to multiply and intensify in the coming years.
In another article for NPR, Rebecca Hersher elaborates, noting that these disasters have already taken some data centers off-line in the past. First, an unexpected heatwave in Australia in 2015 “fried air conditioners at a key data center, cutting off a major company’s Internet service for hours.” Several years prior, “Superstorm Sandy knocked out some internet in New York City when floodwaters cut off power and drowned the underground cables that carry data.” In addition to these past examples, Hersher writes that experts anticipate “4,000 miles of fiber optic cable along US coastlines will be underwater by the early 2030s.”
Final Thoughts on Data Centers as an Alternative Asset Class
Though some risks are involved in investing in data centers, these risks apply to most other real estate asset classes. Over the last ten years — particularly since 2017 — the need for investment in data centers has skyrocketed. During this time — especially during the COVID-19 pandemic — the introduction of new data-heavy devices, services, and applications has cemented our dependence on cloud-based technology.
Despite the development of hundreds of new data centers in the last couple of years, supply is still struggling to keep up with demand. Fueled by recent changes to our culture — such as the shift to remote work and online learning —, demand for new data centers shows no signs of slowing. As such, data centers remain an attractive asset class for real estate investors.
