Investing in data centers? Here is what to consider

With the boom in artificial intelligence data centers have become a hot topic not only among tech executives but also among real estate investors.

They have emerged as mission-critical infrastructure that supports everything from cloud computing to artificial intelligence and a profitable real estate business.

For real estate investors interested in learning more about the data center market and how to invest in data centers, this article explores the key factors to consider before investing in these specialized facilities. We’ll provide a high-level overview of the benefits, risks, investment models, and market outlook that together can help your decision-making.

An introduction to data centers

In simple terms, a data center operator, data centers are centralized facilities that organizations use to house computer systems and associated components. This includes servers, storage systems, networking equipment, backup power supplies, and environmental controls like cooling systems.

Within their secure physical infrastructure, data centers provide a controlled environment for the continuous operation of an organization’s critical IT infrastructure and applications. Major types of data centers include:

• Enterprise data centers – Owned and operated internally by large companies to support their own computing and data storage needs.
• Colocation data centers – Multi-tenant, rental facilities where organizations can lease space to house their IT infrastructure.
• Cloud data centers – Massive facilities operated by hyperscale cloud providers like AWS, Microsoft Azure, and Google Cloud Platform.
• Edge data centers – Smaller facilities located closer to end-users to enable low-latency data processing.

Demand drivers and growth forecasts

Understanding the underlying trends fueling data center growth is crucial to gauging the market’s investment potential. The robust demand for data centers is driven by several key technological and business shifts:

• The rise of big data analytics: Organizations are accumulating vast datasets and relying on data centers for storage, processing, and AI/ML applications.
• Cloud adoption: As enterprise workloads migrate to the cloud, hyperscale cloud providers like AWS and Azure are expanding their massive global data center footprints.
• Proliferation of IoT: Billions of connected devices, sensors, and wearables are generating zettabytes of data that must be stored and analyzed.
• 5G networks: New low-latency 5G networks will further accelerate data volumes and demand for edge computing infrastructure.
• Remote work and digital transformation: COVID-19 accelerated enterprises’ digital transition, increasing needs for data center capacity.

According to Statista, the global data center market is projected to grow at around 6% CAGR between 2024 and 2028, reaching revenues of $438 billion by 2028.

Key benefits of investing in the data center market

There are several compelling reasons why data centers are attracting increased investment, both from specialized REITs (real estate investment trusts) as well as institutional investors like private equity firms and sovereign wealth funds

1. Strong and resilient demand drivers

Data center demand is estimated to grow at a 6% CAGR through 2030, driven by high demand and by exponential data growth and digital transformation across sectors.These facilities are also recession-resilient, operating as mission-critical infrastructure even during economic downturns.

2. Long-term, predictable revenues

Data centers can secure long-term leases with major tenants, typically 3-5 years or longer. For example, a hyperscale cloud provider may sign a 10-year lease for data center capacity. These long contract periods lock in stable rental income streams over an extended timeframe.

Additionally, data center facilities tend to maintain high occupancy and renewal rates because transferring servers and data to an entirely new facility is extremely challenging logistically for tenants. The hassle of relocating to store data makes tenants less likely to leave at lease expiration, providing cash flow visibility.

Between long initial contract lengths and high renewal rates, most data center owners and operators can reliably forecast revenue from their tenant base years into the future. The essential nature of their facilities also makes this revenue resilient, as tenants are unlikely to vacate even during economic downturns. This enables reliable financial planning and helps justify major capital outlays required to develop and operate data centers.

3. Growth opportunities

The rapid growth in data volumes and emerging technologies is creating a major demand for new data center capacity. For example, AI and machine learning workloads require massive processing power supported by new data centers, with high-performance computing capabilities.

To keep pace with surging capacity needs, existing operators are expanding their facilities while new entrants are developing large-scale data centers. For instance, Equinix is investing over $8 billion to build out its data center portfolio.

4. Portfolio diversification

Data centers represent a distinct asset class that behaves differently than traditional securities like stocks and bonds. Their performance is tied to demand for digital infrastructure rather than macroeconomic cycles or interest rates. For example, data center revenue stayed resilient during the COVID-19 downturn as online activity surged, while many other assets declined.

This differentiated risk-return profile makes data centers an effective way to diversify an investment portfolio. Adding exposure to data center real estate or equities can help manage overall risk because these assets follow a separate set of demand drivers.

Key risks and challenges

While data centers represent a sizeable opportunity, they also come with investment risks and operational challenges:

High upfront capital costs

Constructing and launching a data center facility requires extensive upfront investment well before the property can start generating revenue. Key capital costs include:

• Land acquisition – Data centers require large plots of land, especially for expansion. Prime locations come at a premium cost.
• Construction – Developing specialized data center buildings with raised floors, fire suppression, and security features has high construction costs per square foot.
• Power infrastructure – Installing utility transformers, backup generators, UPS systems, and distribution wiring is expensive.
• Cooling systems – Data centers utilize complex HVAC and refrigeration systems for heat removal that require major capital.

IT equipment – Outfitting facilities with racks, servers, and networking gear prior to opening carries a hefty price tag.

Ongoing operating costs

In addition to major upfront capex, operating a data center incurs significant recurring opex to maintain 24/7 operations. Key operating expenses include:

• Utilities – Powering and cooling data center equipment consumes massive electricity. Facilities spend heavily on utility costs.
• Maintenance – Critical electrical and mechanical infrastructure requires constant upkeep and monitoring by teams of technicians.
• Staffing – Data centers need on-site staff for security, operations, cleaning, and technical roles. Labor is a major OPEX component.
• Security – Physical security and cybersecurity services are vital and carry frequent fees for systems, guards, and monitoring.
• Capacity expansions – Growing data needs require building additional data halls and infrastructure over time at added cost.

Technology risk

While demand for data center capacity is currently growing rapidly, future innovations could potentially disrupt the outlook of the data center industry and reduce this demand over time. For example:

• Advances in computing power and miniaturization may enable companies to operate smaller, modular “micro” data centers on-premise rather than relying on third-party facilities.
• New chip designs and photonic computing could significantly reduce power consumption needs, lowering barriers to self-managed data centers.
• Breakthroughs in quantum computing could revolutionize data processing/storage and change infrastructure requirements.
• Decentralized blockchain computing and storage models could reduce reliance on today’s centralized data centers long-term.

If technologies emerge enabling enterprises to effectively shrink and self-manage their own data centers at lower costs, they may lease less capacity from dedicated providers.

Regulatory changes

Data centers need to keep pace with evolving government regulations which can significantly impact how facilities are designed and operated. For example:

• Data privacy laws may require new access controls, encryption, or data handling processes that increase security costs.
• Stricter environmental regulations around carbon emissions and energy efficiency could require expensive retrofits to make facilities greener.
• Changing security mandates could force upgrades to physical barriers, surveillance systems, on-site guards, and cybersecurity standards.
• Shifts in local tax incentives or zoning could reduce the feasibility of expansion in certain regions.

Many major data center markets like the European Union are considering tightening regulations in these areas. If passed, existing facilities may need retrofits to comply, while new development costs could rise.

Specialized expertise

Operating data centers efficiently requires expertise across several technical domains that differ from traditional real estate or IT management.. Key areas requiring specialized personnel include:

• Electrical engineering to manage backup power supplies, redundancy, and capacity planning for power distribution systems.
• Mechanical engineering focused on data center cooling load calculations, HVAC configurations, and thermal management.
• Connectivity specialists to oversee fiber optic routes, bandwidth provisioning, and low-latency network architectures.

Without in-house personnel or trusted partners in these domains, data centers face greater risks of downtime. 

Investment models and market outlook

For investors interested in the data center market, there are several potential approaches to data center deals:

• Invest in data center REITs for steady income and diversification. Data center REITs like Digital Realty Trust allow investors to gain exposure to data center assets while earning steady rental income, and adding diversification to their portfolios.
• Acquire shares in public data center operators like Equinix. Investors can buy stock in public companies like Equinix that own and operate global data center campuses to gain exposure to the industry.

• Pursue direct ownership of facilities through partnerships with experienced developers. Investors could partner with established data center developers like DuPont Fabros Technology to build new facilities and share in the ownership and revenue.
• Provide financing via data center debt products. Lenders can provide construction loans, mortgages, or other debt products to data center operators to finance development and earn interest income on the debt.

The market is projected to continue its strong growth trajectory as global IP traffic surges, further elevating the strategic importance of data centers. However, rising competition and saturation in top markets could potentially moderate returns over the long term.

Key location factors

When evaluating data center markets, investors should assess local infrastructure advantages and risks:

 

• Power costs and reliability of energy supply: Data centers require massive amounts of consistent, uninterrupted power, so locations with affordable and stable energy sources are ideal.
• Network connectivity and proximity to fiber optic routes: Proximity to major fiber optic networks and internet exchanges ensures low latency connectivity vital for data center customers.
• Climate and ability to utilize free cooling: Locations with cool climates allow data centers to use fresh air or chilled water for free cooling, reducing HVAC costs.
• Availability of tax incentives and government policies: Areas with government tax breaks and preferential data center policies can improve cost dynamics.
• Exposure to natural disasters and geopolitical risks: Data centers are sensitive to natural disasters and conflicts, so locations with low risk help prevent disruptions.
• Access to qualified technical talent: A skilled local workforce with expertise in areas like data center design and operations helps staff and support facilities.

 

Top existing markets like Northern Virginia benefit from connectivity, affordable power, and skilled labor pools. However, saturation could limit growth, opening opportunities for emerging hubs.

Business models and revenue streams

The two primary investment approaches involve:

1. Developing and operating owned data centers

In this model, investors finance and develop facilities and then earn direct revenue streams including:

• Rental income from leasing colocation space and power: Data center operators earn revenues by leasing space for customers to house their servers and IT equipment, along with charging for power required to operate them.

• Managed services like cloud solutions, security, and technical support: In addition to space and power, data centers can generate revenues by offering managed IT services like cloud hosting, storage, backup, cybersecurity monitoring, and technical support/maintenance to customers.

2. Investing in data center REITs

Real estate investment trusts allow exposure to data center assets without direct ownership. REITs earn income from:

• Leasing data center space and power: Data center REITs generate revenues by leasing white space and power capacity to tenants who want to locate their IT infrastructure in the REIT’s facilities.
• Providing value-added services: REITs can offer additional services like cloud solutions, security, and technical support to tenants and charge fees to generate incremental revenues.
• Acquiring and developing facilities: REITs grow by acquiring existing data centers or developing new facilities, expanding their leasable capacity and tenant base.
• Selling assets at a profit: REITs may strategically sell facilities at a profit after developing or appreciating them, realizing gains from the sale.

Top data center REITs include Equinix (EQIX), Digital Realty (DLR), and CyrusOne (CONE).

Evaluating potential investments

When assessing potential data center acquisitions or data center development projects, investors should consider several factors. In order to outline how to evaluate a data center investment and how financial modelling for data centers work, we showcase a fictional case study with hypothetical numbers:

Market analysis

• Assess size and growth rate of local data center market to gain insight into potential demand and revenue opportunities. For example a market growing at 10% annually signals strong potential.
• Analyze competitor landscape including pricing, market share, and vacant capacity to gauge the competitive environment and future risks, such as aggressive pricing eroding margins.
• Constraints like power availability and fiber connectivity could hamper growth prospects despite overall market demand.
• Entry barriers like zoning and tax incentives can impact market accessibility and profitability, for example tax breaks can provide a 10-15% boost to returns.

Financial modeling

• Projected capital expenditures and operating expenses: A financial model may estimate $200 million in upfront capex and $15 million in ongoing annual opex for a new 40MW data center facility.
• Expected occupancy rates based on absorption trends: Forecasting a 70% occupancy rate in year 1 growing to 95% by year 3 based on a historical 20MW annual absorption rate in the local market.
• Forecasted rental income at market lease rates: Projecting colocation revenue starting at $10 million in year 1 and reaching $20 million by year 5 based on full occupancy with an average $800/kW lease rate.
• Estimated ROI using discounted cash flow analysis: Calculating a 9% levered IRR over 10 years after discounting capex investments, operating expenses, and forecasted rental revenue at a 7% discount rate.

Infrastructure evaluation

• Building physical security and compliance with standards: Assess perimeter fencing, video surveillance, biometric access controls, and intrusion detection systems to ensure compliance with physical security standards.
• Power capacity and reliability of energy supply: Audit utility feed redundancy, backup generators, UPS systems, and power distribution paths to ensure sufficient capacity and uptime reliability.

• Cooling equipment efficiency and capacity: Review HVAC system tonnage, COP ratings, containment strategies, and ability to add capacity to match projected rack densities.

• Network connectivity and bandwidth options: Analyze presence of diverse fiber entry paths, proximity to carriers/IXPs, and bandwidth scalability to 10G/100G port availability to enable tenant needs.

• Robust infrastructure is vital for providing tenant services: A deficient assessment of any major infrastructure factor could restrict capacity sold or hinder service commitments, directly impacting revenue.

Operations assessment

• In-house vs outsourced data center management: Assess whether the operator uses internal staff or outsources facility management. Verify the expertise of those teams running day-to-day operations.
• Expertise in key technical areas like data center design. Examine experience of engineering teams in core specialties like power distribution, cooling optimization, and data hall layout for efficient service delivery.
• Track record meeting SLAs like power uptime: Verify the operating history meeting reliability KPIs like 99.999% power uptime to confirm the provider’s ability to maintain continuous operations.
• Scaling capabilities to support future growth: Review vacant land, modular data hall designs, and construction partnerships. Ensure the provider can expand capacity as needed to meet growing tenant demand.

Conclusion and key takeaways

In summary, data centers offer enticing attributes like stable cash flows, growth tailwinds, and diversification that make them an appealing investment within a technology-focused portfolio. However, managing the risks requires thorough diligence across financial, infrastructure, operational, and market factors to confirm an asset’s suitability.

With prudent due diligence and risk assessment, data centers stand out as a unique digital infrastructure investment that can enhance portfolio returns and diversification. Yet, careful upfront analysis is required to maximize rewards while minimizing pitfalls.