Data Centers Are the New Target for Commercial Real Estate Investors

Your head may not be in the clouds, but all of your stuff probably is. 

The cloud has easily become the most ubiquitous way to store data. Individuals and businesses of all sizes use cloud computing to do everything from stash photos, media and important documents to support paperless offices and file-sharing servers, electronic payments and cryptocurrency exchanges, personal apps, and anything else the internet touches. And while it may seem like a virtual space floating above our heads, the cloud actually has a physical address. 

Cloud computing systems are stored on very real servers in data centers, and these spaces are quickly becoming the most valuable asset in commercial real estate. They are hitting all of the right fundamentals: strong and growing demand, superior returns that outpace traditional assets and a dearth of functional supply. Here is a look inside the newest asset class that has investors and developers buzzing. 

Breaking Records

Over the last several years, data centers have been among the top-performing commercial real estate asset classes. In 2021, US data center absorption totaled a record-breaking 885.7 megawatts (the measurement used in place of square footage to express the capacity of a data center). The absorption rate was described by JLL as “a mammoth total,” and it represented an increase of 44% year-over-year. Last year wasn’t an anomaly, either. In 2020, data center absorption was also record-breaking at 614 MW, up 70% from 2019. 

This is a global trend. In Europe, data center absorption grew 9% in 2021, and in India, absorption increased 49%. Much of the demand is led by key data center markets. Paris and Frankfurt in Europe and Mumbai in India were responsible for the vast majority of demand. In the US, the absorption activity was contained to 14 data center hubs—Northern Virginia, the largest data center market in the country, followed by Phoenix, the Pacific Northwest, Dallas-Fort Worth, Chicago, North Carolina, Northern California, Houston, Salt Lake City, New Jersey, Los Angeles, Atlanta and, finally, Boston, San Antonio and New York, which each had less than 5 MW of absorption activity. 

The sheer increase in technology usage alone has been enough to drive this impressive global demand for data storage space, but the pandemic certainly energized an already hot market. Remote work has largely driven the need for more data storage capacity, along with increased online shopping and content consumption, like streaming, and as such, large cloud and technology expansions were behind much of the absorption in 2021. 

The demand has been a windfall for investors. From 2019 to 2020, data center REITs were  the top-performing sector of the REIT market, and looking over the five-year period from 2015 to 2020 data center REITs delivered the strongest returns at 15.5%. Comparatively, the broad-based REIT index had only 8.5% returns over the same period. 

With data center usage expected to grow at a compound annual rate of 24% through 2025, data center returns are likely to hold up, and as the Motley Fool notes, the asset class tends to be recession-proof. However, it’s important to note that in 2021 REIT performance slipped, recording 25% annual returns for the year. This was due to a combination of volatility in tech stocks, supply chain issues that limited the availability of semiconductors needed to operate these facilities, and the reopening of economies. 

This year, data center returns have continued to underperform for similar reasons, but this hasn’t deterred investors, who largely believe these are temporary setbacks. As a report from JLL noted, “There continues to be an influx of cash in the sector, with investors targeting increased tenant demand,” adding that data center consolidations have increased buying power.  

Breaking Ground

Developers are holding a similar theory. Returns may be soft at the moment amid some broader economic challenges, but demand for data centers will ultimately deliver long-term growth and, more expressly for developers, demand for new supply. 

The construction pipeline has already swelled to new records. There is currently 727 MW of data center space under construction in the US, an 18.9% year-over-year increase and the highest number on record, and 70% is already preleased. Northern California and Northern Virginia are leading this activity with a combined 400 MW of construction in the two markets alone. The growth has come quickly. Just five years ago, only 177 MW of space  was under construction in the US.

Perhaps more importantly than the construction pipeline itself is the individual demand for larger space. Users are now looking for 36-plus MW facilities when the former standard was typically less than 20 MW. Now, there seems to be more demand for large 20 MW facilities than 1 MW facilities, according to research from JLL. These hyperscale data centers, as they are called, will ultimately drive the construction of larger capacity facilities and new construction styles, like vertical data centers. 

While strong demand warrants this voracious construction activity, developers are facing emerging headwinds. In addition to the construction delays and supply chain disruptions plaguing all commercial real estate asset classes, land prices in key data center hubs like Northern Virginia are at historic highs, and labor shortages for data center operations could limit expansion. 

These changing market conditions along with other economic challenges complicate ongoing and prospective construction projects in the data center market—but the opportunity is too valuable to miss. It’s imperative that developers lean on predictive data and analytics and automated budgeting tools through commercial real estate technology companies like Northspyre to mitigate these headwinds and better understand the future outcome of a project. This technology not only reduces cost exposures but provides valuable data-driven insights to support the ultimate success of a development. In the data center space, the potential is big. 

Commercial real estate technology is reshaping the industry, from driving more efficient operations to creating investment opportunities. Data centers are already proving to deliver strong returns, and increased technology adoption will only drive more potential in this maturing asset class.