Alternatives - Data Centres: Clouding the issue
Some investors are predicting a big future for this small sector, but are data centres a wise long-term investment? Lauren Parr reports
The data centre market took off with the dotcom boom in the late 1990s. In view of greater terrorist risk, companies increasingly opted to locate their IT resources outside of where they worked. Today, exponential growth of cloud computing is continuing to change the way businesses work.
The cloud model uses the internet to store and manage data rather than a local server and has driven growth in centralised, data centre facilities used to house back-end architecture. “IT tenants are now the biggest data centre clients (over banking) and this is being driven in part by the roll out of the cloud,” says Andrew Jay, who heads CBRE’s data centre team. Contrary to a common belief, “anything in the cloud actually sits in a data centre” he explains.
Some would say the asset class is on the path to being institutionalised and that it could be the retail warehouse sector of tomorrow. It certainly seems probable, considering the growth of the data centre market in the US, where there are several dedicated REITs.
“The US market is ahead, so the opportunity is to invest in European data centres now, and potentially capture good returns while there is a liquidity premium,” says AXA Real Estate’s head of alternatives and special situations, Riccardo Dallolio.
CBRE data shows that, each year over the past 14 years, the availability of stock has risen within Europe’s key hubs of London, Paris, Frankfurt and Amsterdam. The net requirement continues to grow with the continued digitalisation of society. An incremental need for more than 60 new large facilities across western Europe is expected by 2020, according to strategy adviser Boston Consulting Group (BCG).
BCG estimates that there could be investment opportunities worth €130bn as more companies outsource their data management – 20% of all data by 2016. These opportunities range from building new facilities and sale-and-leasebacks of existing premises, to buying operating businesses.
“We’re seeing increasing institutional interest in data centres,” says Mark Trevor, head of Deloitte Real Estate’s data centre transactions team. “These are large buildings occupied by investment-grade tenants, in some cases on 20-year leases. With a 3% per annum inflation-linked uplift, you’ve effectively created a bond, and yields are tight for that kind of money.”
In the broadest sense, data centres represent an annuity-style institutional match. Legal & General Property’s acquisition of three data centres during 2012, in London Docklands and Glasgow on leases of up to 30 years, fulfilled several company investment criteria, including income security and sector diversification. Its strategy – buying traditional real estate let to data centre occupants – is one of the simplest ways of investing in the sector.
“There are some investment benefits from doing this; tenants that occupy data centres tend to be ‘sticky’ and don’t walk away after five to 10 years,” says Jay.
At the most opportunistic end, fully-fitted data centres can command rents of up to £200 (€257)/sqft compared with just £10/sqft for logistics warehouses. “There are few investors competing to buy those investments, so yield does go out significantly,” he adds.
At up to 9% for quality real estate, “it’s no wonder institutions are looking more closely at data centres”, says L&G Property’s business-space research specialist, Bill Page.
“A lot of people have made a lot of money out of data centres,” Jay points out. Best known is property entrepreneur Andy Ruhun who built and sold data centre provider Global Switch to the Reuben brothers and, later, Sentrum to the world’s largest data centre company, Digital Realty.
Some of Europe’s biggest property investors have small exposures to the sector. Segro, the UK’s largest listed industrial specialist, has a 7% exposure, amounting to £300m, according to mid-year figures.
AXA Real Estate is the trailblazer in Europe, and is targeting a €1bn portfolio of data centre investments over the next two to three years. “You need a sizeable portfolio in order to benefit from the advantages of building strong relationships with tenants, and to be a real player in the European landscape,” Dallolio says.
That is precisely the reason data centres are predominantly a specialist sector – for now. The asset class has high barriers to entry due to the expense and complexity of running them. “You can’t dip your toe into data centres. It’s a high-octane investment,” says Jay.
Proof of the fact that data centres are a complicated investment requiring specific expertise is AXA Real Estate hiring a data centre specialist to build its in-house capabilities. “There’s a level of complexity in this asset class which warrants a bit more attention than more traditional real estate,” says Dallolio. “If you can understand both the property side and the data centre side of the business – ie, the mechanical and electrical components, data centre operation and how tenants wish to deploy and manage their data centre portfolio now and in the future – you can add value and generate pretty high returns,” says Dallolio.
“It’s one of the sectors where few institutional investors are focused. We think it’s possible to be at the forefront of investing in this niche sector, and by focusing on the potential challenges and gaining an understanding of how cloud computing, telecommunications and data centres interact, you get to know what major corporates want in today’s market.”
Investors remain sceptical
While some large institutions are moving in, others are sceptical about the asset class.
“There’s a disconnect between investors’ understanding, and what the opportunity is,” notes Trevor. “Some feel the data centres product is not real estate itself and that there are more opportunities for data centre operators than investors.”
A lack of liquidity is viewed as one of the fundamental problems. “The feeling is that this is not a big playing field – the quantum of this type of asset that is traded is small,” says Cordea Savills CIO, Kiran Patel. Cordea Savills has dabbled in data centres but the one office-turned-data centre it has acquired represents a small, opportunistic acquisition, which involved taking only marginal risk.
“Stock is tiny compared to other asset classes which often means funds don’t want to spend time getting up to speed on data centres,” says Jay.
The lack of comparable data is also problematic, making appraisal and investment decision-making difficult. For this reason, and the complex nature of data centres, due diligence can be demanding.
Another concern is obsolescence as a result of the speed of technological advancement. The differences between data centres built a decade and a half ago and today is stark. “One of the underwriting risks is the threat of technological advances. Is there a requirement for this amount of data centre space?” asks Patel, in reference to potential miniaturisation of data centre hardware.
The answer cannot be a categorical ‘yes’, of course, says Jay. “But if you look back in time, never has that been the case. Online shopping is never going to kill off retail, for example. It can’t compete with the retail experience of trying things on.”
Sustainability is another hurdle. Large institutions are often sensitive to their environmental credentials. So the enormous power requirements of data centres – equal to the 2% of global electricity use by the aviation industry – is an inevitable downside. Improvements are being made, though; there are discussions about decommissioning underground nuclear bunkers in the UK, which would require less plant and equipment cooling.
Perhaps the biggest call investors must make is anticipating in which direction they see the market moving. Do they support the perceived wisdom that demand for data centres will continue its decade-long trend based on exponential growth of data processing and storage, or is there merit in concerns about miniaturisation?
But if AXA Real Estate’s commitment to the sector proves to be the right approach, data centres could be set for institutionalisation in the future. Despite a lack of liquidity in assets traded, if investors can understand the issues surrounding the asset class, they will find ways of gaining exposure.
“It’s not a large market, which is why we need to be especially flexible in how we approach the opportunity – be that developing new assets, acquiring existing data centre real estate or buying data centre operators,” Dallolio says. “There is no magic formula one can apply; you need to spend a good amount of time understanding how the product and the market is evolving.”