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December 2021 - Data Centers: Demand and the Middle Market Investment Opportunity
When we founded Chestnut Funds in 2012, our investment thesis was that opportunity existed in the middle market space to manage funds in an institutional manner but with a focus on assets that typically did not attract institutional capital. We focused on property types that we had first-hand experience with - office, retail, industrial, and medical office properties. During 2021, our Viewpoints series has discussed the property types that we invest in, outlined some of the reasons we make these investments, and shared our view of what the future might hold.
The COVID-19 pandemic accelerated many trends over the last 20 months. A trend that Chestnut began to monitor and evaluate prior to the pandemic was the increase in digital data use that results in demand for data centers. So, as a fourth installment for the 2021 Viewpoints series, we are focusing on a particular property type in the industrial sector - data centers, its demand story, and how Chestnut intends to continue to access investment opportunities related to this property type given our focus on middle market real estate.
Data Centers – A Primer
Data center demand growth is driven by internet traffic. Data centers are purpose-built and specialized storage facilities through which internet traffic is routed and data is stored. As a result, increases in the demand for data that come from online activities, such as mobile video and video streaming, as well as increases in per capita connections and faster overall connectivity, are expected to drive growth.
For North America, Cisco’s Annual Internet Report projects a per capita average of 13.4 internet connected devices by 2023, up from 8.2 devices per capita in 2018. Also, the average broadband speed is forecasted to increase 2.5 times between 2018 and 2023, and the average mobile connection speed is expected to increase 2.7 times during the same time period. These advancements enable and encourage increased internet use in fixed locations and on-the-go. In alignment with anticipated growth across the globe, Cisco projects a 36% CAGR (compound annual growth rate) for mobile data traffic between 2017 – 2022 for North America in its 2019 Visual Networking Index report.
In addition to mobile video and streaming, increases in artificial intelligence (AI) and machine learning, virtual and augmented reality, autonomous vehicles, cloud-based gaming, Internet of Things, smart facilities and infrastructure, and video surveillance will all drive growth.
Data centers typically are owned by users, such as Google, Amazon, or other technology companies, or are colocation facilities - data centers owned by developers where server space is then leased to third parties needing server capacity for storage or other data needs.
Data Center Development
Demand for data centers is tied to the underlying increasing demand for consumption of data. As data demand has increased so has the pace of data center development.
Based on our recent first-hand conversations with operating partners and industry participants, the development cost for a data center is approximately $950 to $1,000 per square foot, translating into a development budget of roughly $300,000,000 for a 300,000 square foot data center. The cost is driven by several factors:
Data centers require huge amounts of air conditioning to remain cool and prevent overheating due to servers generating tremendous heat.
Additionally, data centers require redundant power systems, leading to an enormous investment in diesel-powered generators to ensure an uninterrupted power supply.
Furthermore, the structure of the building and its systems are designed in such a way to withstand heavy floor loads and extreme power usage.
Finally, the equipment housed in the facility is very expensive.
Due to the amount of capital involved and the importance of delivering facilities in a timely fashion, data center developers and owners are very concerned about speed of development. Cost is important but speed to market is equally important. This is because most data center developers wait until leases/contracts with data center users are signed before identifying the land to build the desired facility. Because of this, data center developers are keen to find sites that are “ready to go,” free from encumbrances and appropriately zoned for data center use. At the same time, returns on data center facilities are quite high and land costs as a percentage of total projects costs are low. As a result, data center developers are not particularly sensitive to land prices.
An important consideration for data center development is access to necessary infrastructure. Affordable and reliable electrical service and access to a robust fiber internet network are particularly important. This infrastructure is most readily available in an area of Northern Virginia in Loudoun County that has become known as Data Center Alley. The area is unique in that the region traces its connectivity roots back to the U.S. Government’s early development of wide-area fiber optic networking in the late 1960s. Loudoun County is currently home to over 60 data centers with more than 3,000 technology companies housed within them. Loudoun County touts that up to 70% of the world’s internet traffic flows through data centers located in the county each day. Companies that have built data centers in Loudoun include Amazon Web Services, Cyrus One, Digital Reality, Dupont Fabrus Technology, Equinox, Google, RagingWire, and Sabey Corporation.
The Middle Market Investment Opportunity
Investments in data center development projects are typically too large for Chestnut’s investment strategy. That said, we have found ways to stay true to our middle market real estate focus and be able to participate in the data center demand story.
Chestnut’s related investment strategy is tied to developers’ demand for sites that are zoned appropriately for data center development and have received the necessary entitlements, i.e. “ready to go” vacant land. The barriers to develop these “ready to go” sites are far less complicated when compared to redeveloping a site that houses an improved commercial property, such as an office building. This is because properties that are improved may have leases in place with tenants that would prohibit data center development in the near-term. As development speed is so important, developers are typically unwilling to acquire improved properties. Because of this, there is often a disconnect between higher raw land pricing on a per acre basis compared to improved property values.
To benefit from this value disconnect, which has only grown due to office valuations being negatively impacted by the pandemic, an investor has an opportunity to acquire an improved property at a discount to “ready to go” land values and then do intensive asset management work. This includes setting up the appropriate zoning and entitlements and also working with existing tenants to change their lease terms to allow for near-term development. Because Chestnut invests alongside proven, experienced operating partners with the ability to take on those intensive asset management projects, we have been able to secure two investments on behalf of Chestnut Real Estate Fund III that benefit from data center demand.
Current Data Center Projects
Chestnut’s two investments that benefit from data center demand are both located in Data Center Alley. The first is a five-building, 120,000 square foot, single-story office park acquired in 2019. Approximately 50% leased at the time of acquisition, some of the tenant leases stretched out to 2027, prohibiting potential near term development. By working with existing tenants to restructure leases and securing the appropriate development entitlements, the property was successfully repositioned and sold to a data center user.
The second investment that Chestnut made shares many similarities to the first. However, instead of acquiring a 50% leased office property, this investment was in a 90% leased office property and acquired in 2021. The challenge with this investment was that one tenant occupied much of the office building but had options to renew that would potentially allow the tenant to remain in occupancy for nine plus years. However, should this tenant exercise their renewal option, the current yield on the investment prior to lease expiration is still expected to be very attractive, protecting the potential downside investment risk. Once the appropriate entitlements are received and the lease with the tenant is restructured, this property will be marketed for sale.
Consumers and businesses’ increased reliance on online shopping, video conferencing, streaming services, cloud-based software applications, and other digital data use cases that accelerated during the COVID-19 pandemic will collectively continue to drive data center demand. Through continued analysis of data center location drivers, working with seasoned operating partners, and employing a strategy aimed at repositioning existing middle-market properties for data center redevelopment, Chestnut Funds will continue to seek opportunities to invest in this property type.
Should you have questions regarding this Viewpoints or Chestnut Funds’ approach to middle market real estate investment, please feel free to contact Steen Watson at email@example.com or (423) 822-8761.
The information contained in this newsletter is intended for informational purposes only and is not intended to provide personalized investment advice or to constitute an offer or solicitation to buy or sell securities or interests in any investment. The charts, graphs, and other information contained herein should not serve as the sole determining factor for making investment decisions.
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