Data centres have been one of the fastest growing investment sectors of recent years. Including corporate acquisitions, total transactions in this sector averaged $25 billion a year between 2017 and 2019, according to a report by global investment manager PGIM.

The covid-19 lockdowns across much of the developed world have further fuelled the sector as home working and shopping, e-commerce, remote entertainment have all added to demand. Naturally, returns are also attractive. PGIM estimates average global yields to be around 6 percent with total returns of around 11 percent. And real estate investment trusts specialising in data centres outperformed all other types of REIT in 2020.

At the same time as the digital economy is expanding, the future of certain traditional real estate assets is under question. How quickly, if at all, will demand for office or retail space return to pre-pandemic levels? Perhaps unsurprisingly, more real estate investment managers are taking an interest in data centres.

“Last year was a sea change – money started moving from office space and shopping malls to warehouses and data centres, and that sloshing of money is moving from those traditional assets to these emerging ones,” says Sandeep Kumar at digital consulting firm Synechron.

But digital assets, and data centres in particular, are looking increasingly like a contested space. Are these just another type of real estate? Or are they more like infrastructure investments?

“There’s a spectrum across real estate and infrastructure, and data centres could go in either direction,” says Greg Kuhl, portfolio manager, global property equities, at Janus Henderson Investors. “Some are just purely a building, but at the other end of the spectrum they could be offering a lot of services and can be very operationally intensive assets.”

What makes them similar to real estate is that they follow the same laws of supply and demand.

“If you build a toll road, you can’t just build another one. It’s infrastructure,” says Kuhl. “But you can always build another data centre.”

Meanwhile, Esther Peiner, managing director, private infrastructure Europe, at Partners Group, takes the opposite view. “From my perspective, data centres are digital infrastructure,” she says. “With a data centre, there is a location component to it, but there is also a connectivity component to it and there is also an energy component to it. I look at the fundamentals in the data centre space and the conclusion to me is obvious.”

The debate draws in a range of issues, from the financial analysis of cost of capital and risk to energy, connectivity and regulation.

Capital cost, risk and return

With yields and return on data centres running well ahead of the rest of real estate, the question naturally arises of whether they represent a different type of investment risk and merit different valuation metrics.

Crucial to this will be the cost of capital. Carl Beardsley, director at JLL Capital Markets, says that while data centres may start off looking like traditional real estate, they quickly evolve into something with quite different capital investment requirements.

“These start out as industrial shell buildings. However, we would categorise these more as infrastructure assets because of the amount of capital expenditure that’s required. That starts with the many sources of back-up power, generators and uninterruptable power supply equipment, batteries – everything that goes into these buildings is so capital intensive. They are not traditional assets and there is a mix that we would categorise as closer to infrastructure.”

Vivek Kulshrestha, at digital transformation consultancy Synechron, says: “Unlike other REITs, the metrics used to measure data centres are very different. It can be about square feet, it can be about the amount of power they have and use, the number of customers they cater to, or what variety of customers they cater to.”

Raul Saavedra, managing director at JLL Capital’s San Francisco office, specialises in data centre tenant representation and capital markets. He too believes the cost of capital and scale are the key issues that differentiate data centres from traditional real estate.

“The capital expenditure per foot or per kilowatt, or however you measure, is significant and this lends itself to a lower cost of capital which these infrastructure funds typically have,” says Saavedra. “As a consequence, if you want to be in this space, you need scale. The infrastructure funds already invest in fibre and cell towers, so it lends itself very well.”

Saavedra also highlights the need to understand the underlying drivers of the industries behind the demand for data centres. “Cloud service providers are driving everything at the moment. They are 80 percent of all the take up of data centres here in the US and in Europe. So, if for some reason that was to taper off there would be a real tapering in demand.”

Importantly, Saavedra is not predicting any such tapering off in the near future.

“I am really bullish on this space,” he says, but believes an awareness of the potential uncertainties is vital.

Kuhl does not regard this as a clinching argument and points out that traditional real estate investment managers are just as familiar with assessing the ebb and flow of demand from different industries.

The valuation methods still closely resemble real estate with a view on income capital expenditure and value and over the long term some infrastructure investors agree that the income profile of data centres can resemble that of real estate.

Peiner at Partners Group comments: “In the end, a yielding real estate asset brings stability, predictability and duration, and if you look at the underlying risk profile of a mature and fully operating data centre, if the contract is set up the right way, you get to a point where the income streams are very comparable. And there I would argue the skillsets converge again.”

But that is the long term. At the outset, Peiner believes data centres look much more like an exercise in building infrastructure and places particular emphasis on energy needs and the growing importance of ESG issues.

Energy, connectivity and ESG

Data centres are notoriously energy intensive and connectivity to data networks is critical. Peiner argues that in the early stages of data centre investment, these issues are overwhelmingly better understood from an infrastructure perspective. She compares it to the power connectivity that needs to be considered for renewable energy infrastructure.

“Right now, we see power and grid availability becoming an issue for some data centre markets and that’s a dimension you also have when you build renewable generating plants and we spend a lot of time understanding these issues,” she says. “So, for us, doing the same for a data centre is business as usual, whereas if you come from a world where you think power just comes out of a socket, then it’s a new challenge to master.”

Peiner describes her view as being one that looks at investing in the whole value chain and this is echoed by Saavedra at JLL. He cites global investment firm Digital Colony as a model. “That started as a business investing in cellular towers and then turned to the data centre space. It now has a portfolio of companies that are vertically integrated.”

Environmental concerns are also high on the agenda for such energy hungry operations as data centres. The source of that energy – fossil fuel or renewable – may be a key issue for assessing the environmental footprint of the asset, and so, with regulatory and investor eyes increasingly scrutinising investment managers on this issue, it becomes a consideration for the investability of a data centre.

Synechron’s Kumar agrees that these are not issues that can easily be added on. “It’s not like any fund can quickly move into this field and have that ESG skill. There are many layers of complexity before traditional investors can put an ESG lens on this.”

Kuhl, however, argues that real estate investment is not necessarily at a disadvantage to infrastructure investment when it comes to assessing ESG concerns. The issues, he insists, are not unique to data centres. “We definitely look at ESG. When I am looking at a real estate asset, I evaluate whether they will use a lot of power. It’s a real factor that we want to see with all new developments.”

But in one area, data centre investors may need skills to assess another aspect of regulation – the data itself.

Data regulation

Data regulation is a distinctly digital infrastructure issue. At one level the responsibility for meeting regulations on data storage and security will be a responsibility for the clients using data centres. However, there are elements that will relate to the security offered by the asset itself and crucially its location.

“There is a lot of data regulation in place now,” says Kumar. There is GDPR in Europe. California has a privacy act. Some of the US banks have their customer data stored in European data centres, but now regulation is insisting that they cannot hold their own citizens’ data overseas.

“So, those data centres that are housing data from other countries’ organisations are at risk when countries want to bring back the data to within their own borders.”

As long as the digitisation of the global economy marches on, the flow of investment into data centres is set to continue. Competition between investment managers from both infrastructure and real estate backgrounds to identify the most lucrative returns also shows little sign of abating.

And even choosing ‘infrastructure investment’ may only be a superficial guide, as data centres bring with them a range of issues that are distinct to the digital economy.

For investors and funds trying to assess who might be the best custodians of investment in data centres, it might be that they will need to look beyond the labels of real estate or infrastructure, and consider the full picture, the new skills and understanding required in what is still, in historic terms, a new and evolving class of asset.