Navigating the CRE sector: Data centers in the age of GenAI

As we've explored the transformative impact of GenAI on portfolio monitoring and regulatory compliance, it's evident that the ripple effects of this technology extend far beyond traditional banking practices. In this new post, we pivot to an evolving sector within commercial real estate (CRE) - data centers. These pivotal infrastructures support the GenAI boom and redefine niche real estate sectors, demonstrating resilience and adaptability in the face of evolving digital demands.

Data centers are a hot CRE commodity at the moment, powering the Generative AI boom and proving that niche real estate, given the right circumstances, can both establish itself as its own sector and go from strength to strength. In fact, Equinix and Digital Realty, two US-headquartered real estate investment trusts (REITs) that are the premier/market-leading developer-owner-operators of data centers that are leased to third parties, are consistently ranked in the top 10 largest REITs by market capitalization globally. Part of this is because their operations span multiple countries across six continents (neither operate in Antarctica, for the obvious reasons). In fact, Equinix is currently the third largest REIT in the world by market cap, having held the second spot on the list for years. Ironically, or perhaps exactly as expected, it was unseated by American Tower, a worldwide provider of digital communications infrastructure. All of this is to say that the longstanding data center companies have an existing commanding presence in the investment real estate ecosystem. However, the boom in demand for data centers, resulting from the proliferation of GenAI in particular and the general increase in the amount of information transferred between people, has allowed for new market entrants and existing operations to expand rapidly.
 

The unique nature of data centers in CRE

Data centers clearly differ from much of the rest of CRE in terms of the contents of the real estate – multifamily and office are built for the comfort of those who live and work in these edifices; retail and industrial are tailored to accommodate the combination of goods and people (whether customers or workers) that sustain these properties. But perhaps the most notable difference is that data centers almost exclusively house machines and once operational, can function with as little as one person onsite (usually security), save for visits when specialists when technical maintenance is being conducted. These differences extend to the lending landscape. While no specific category of lender is known in particular for its lending activities related to data centers, there are many partnerships and joint ventures forming in the data center lending space, usually between a data center developer-owner-operator and a private equity entity. One such example is a $7B joint venture recently announced by Digital Realty and Blackstone to further expand their data center presence in some of the largest and most sought-after data center markets worldwide: Northern Virginia, Frankfurt, and Paris.

Interestingly, due to the nature of the interior buildout of data centers, the capital markets have also customized their practices to better suit this unique CRE sector. Many lenders are splitting loans for data centers between the strictly CRE portion (land acquisition and construction financing) and the portion that is used to finance the requisite interior technology and equipment (frequently a C&I loan) for a data center. This structure provides the borrower with more favorable financing terms, as the cost of the latter can often exceed that of the former although C&I loans also frequently have lower interest rates as the loan length is shorter.

The Competitive Landscape and Future Projections 

Data centers are some of the most valuable, if not the most valuable, properties in the investment-grade commercial real estate universe. New supply cannot be built fast enough to keep up with demand. Over the next four years, an estimated 2,840 MW are expected to be constructed across five of the top 10 largest data center markets in the US.[2] For context, this additional supply is still less than the current size of the data center market in Northern Virginia, which at approximately 3,000 MW is the largest globally. 
 

Valuation and Capital Market Performance

Not only have the sector’s space market performance metrics seen a boost, so too have capital market metrics. Data centers frequently trade at some of the most competitive cap rates across CRE sectors (~4-6% prior to the series of interest rate increases by the Federal Reserve aimed at reestablishing price stability in the economy), akin to Class A multifamily cap rates. Data centers, of course, have not been immune to the higher borrowing costs that span CRE, which has caused their cap rates to spike. Nonetheless, data center cap rates remain tremendously competitive, indicative of the value that these properties are able to maintain as well as their ability to appreciate despite CRE stress. High demand and strong confidence in the sector, as well as market participants’ opinions on the proximity of potential interest rate cuts, are reflected in the low to negligible risk premiums currently built in to data center cap rates for many transactions as the effective federal funds rate currently stands at 533 bps (the same level it has found itself at since July 2023).

Footnotes:

[1] The cap rate figures for the core four sectors denote the 12-month rolling transaction cap rate nationally in the US.

[2] Source: Newmark.