Data centres: Server space for rent

Data centres in Europe are booming and may be a sound target for investors. But as Pete Carvill discovers, the sector faces a number of challenges, including ESG.

When the world was sent home from work in 2020 and offices around the planet closed, one sector of the investment market saw a distinct boon: data centres. It is likely, as you read this, you are probably sat next to or close by multiple devices – phones, computers, laptops, tablets, televisions – that rely on data for their functionality.

Because of their reliance on data, all of these are in turn reliant on data centres. A useful definition for these was coined in February 2021 by PGIM Real Estate in its ‘Global Data Centres: European Excerpt’.

It wrote: “Data centres are best described as buildings designed specifically to house computer systems and network equipment. They differ from standard industrial buildings because of the more complex technical specifications for the physical building and the fit-out, which comprises large amounts of electrical and mechanical hardware.”

The growth in demand for these services throughout the pandemic was staggering. According to PGIM, there was a ninefold increase in unique user count on tools such as Microsoft Teams and Zoom, alongside a 40% annual rise in average broadband usage per household and a 35% jump in the average number of hours of mobile phone usage.

And these numbers, says the firm, belie the fact that they came in a several-year period of a strong upward trend in usage.

“The growth story started a long time before the pandemic,” says Paul Lewis, director of European data centres for Principal Real Estate. “What happened before was that there was this macro trend of everything becoming more digital. It was a bigger trend that was then topped up by the pandemic, rather than it all being pandemic demand.”

Data centres, says Luke Jackson, data centres capital markets director for Emea at real estate investment manager JLL, were seen before as something of a niche product by investors, a mindset that began to shift in increments before Covid-19. It was then, he says, that investors started to notice what he calls the “strong fundamentals of the digital economy”, referring to online shopping, cloud storage and the Internet of Things.

Additionally, he says: “The investors saw that data centre investments performed incredibly strongly during the period of market uncertainty. Suddenly, there was this incredibly resilient investment product, and that’s when and where the shift in thinking towards this sector became turbocharged.”

What is more, PGIM wrote last year that the global data centre market is set to grow significantly, based on current trends. And moves back to the office should have little effect. Lewis says that the receding of the pandemic will not cause a fall in demand; the world shifted to the cloud, he explains, and is going to stay there.

There are other things coming down the pipe. Paul Mortlock, head of data centres at CBRE, points to the increasing demand, complexity and ubiquity of data-reliant services.

He says: “One of the things that gives us comfort is the sheer number of applications that need these services. That’s AI, VR, driverless cars, and eventually 5G. That means a lot of centres in a lot more areas than we traditionally see. It has been reserved for industrial areas with great fibre connectivity, but for something like driverless cars to work, there will be a need for small data centres to be installed on lampposts, or the tops of buildings. We are enormously bullish about the future growth of the sector.”

Europe is a hotbed for these services. Dr Carsten Schulz and Dr Sabine Kaben, partners at Taylor Wessing, wrote recently in ‘Data Centres in Europe – An Investment Opportunity’ that around a quarter of the generated revenue from the market globally, roughly $316 billion (€299 billion), comes from Europe.

While advances have been most acutely felt across the continent, especially in the ‘FLAP’ territories of Frankfurt, London, Amsterdam and Paris, ‘Tier 2’ cities such as Milan, Berlin and Stockholm are beginning to catch on and catch up.

Estimates vary, but the consensus seems to be that the market is approaching a boon period. Eric Boonstra, vice president and general manager at Iron Mountain Data Centres Europe, wrote recently in the ‘State of the European Data Centre Market in 2022’ that the colocation market – colocation is the renting of server space at third-party premises – has been valued at $12.81 billion in 2020 and is expected to grow at a compound annual growth rate of 13.1% between 2021 and 2028 to reach $33.66 billion.

As Schulz and Kaben wrote: “Despite increasing interest also from an investment perspective, the data centre investment market in Europe is still in its early stages and appears to provide loads of opportunities for investors.”

Data centres should be attractive to investors. They tend to come with long-term leases, often a decade or more, with indexation or fixed uplift as built-in rental growth factors. There is also a resilient tenant base and little churn.

“It’s a long-term investment strategy with a stable, calculable turnover,” says Schulz, talking to Funds Europe from Hamburg. “That’s one of the reasons that these investments fit well within a portfolio. It’s not a short-term thing; real data centre investment is long-term, but it gives you steady and secure revenues.”

The most-common types of deals, says Mortlock, are done through mergers and acquisitions, or from investors buying a stake in an operator. That operator, in turn, will contract a firm like CBRE to maintain the centre. Mortlock estimates that CBRE manages around 900 data centres around the world for colocation providers and enterprise cloud companies.

“It’s a billion-dollar revenue stream for us,” he says.

Everything has its curves, though, and data centres are no exception. There has been a shortage of computer chips in Europe since the pandemic, and the EU has drafted legislation and provided funding through the European Chips Act to combat this. And Pedro Sánchez, the Spanish prime minister, said in April that his government was looking to expand Spain’s role in the global computer chip market.

“There are definitely supply chain issues,” says Principal Real Estate’s Lewis, “and it’s something that goes wider than just computer chips. That’s particularly so in a construction-heavy industry like the building of data centres in Europe. That’s impacted on the timescales for delivery of centres, along with the fitting out of additional capacity for existing ones. But those constraints highlight the intrinsic value of existing facilities.”

The environmental costs are also staggering. Closely linked to that is the drain these facilities put on power grids. Deutsche Welle reported last year that the International Energy Agency estimates that the burden runs to around 1% of global electricity use. The pressure that these centres place on existing infrastructure is also a growing issue.

Some municipalities, once welcome to their development, have started to push back. As the firm Turner & Townsend wrote: “Taking a similar approach to the one-year moratorium on data centre construction in Amsterdam, Frankfurt is also looking to regulate data centre construction.”

Lewis believes that there are going to be constraints on supply, particularly in the FLAP locations. He also cites EirGrid in the Republic of Ireland announcing in May that it was stopping plans to connect 30 new centres to its power grid. Official data there suggests that 14% of all electricity in the country was being used by centres. Lewis says Madrid, too, has come to realise the role of power, a resource that had once been plentiful.

And this is before ESG considerations are factored in. All investment firms have ESG strategies in 2022. Most like to talk consistently and loudly about them. But can those strategies align with investing in a resource that uses colossal amounts of energy?

Jackson at JLL looks back to how organisations once ran their IT infrastructure. He says: “Data centres are more efficient than the alternative, which was for every office to have their own mini data centre and their own dedicated servers.”

Lewis acknowledges the dichotomy. “It’s the biggest issue facing us,” he says. “But the good news is that the sector is really focused on it and understands the importance of communicating how they’re positively impacting in terms of ESG.”

He goes on: “There’s a carbon saving in doing things like meetings virtually that is huge. There is a data centre somewhere that’s running these Zoom and Teams calls, and no one is getting on a plane or driving a car to go to a remote meeting. The big picture is that a move towards an increasingly digital economy is very useful for most industries striving for net zero.”

© 2022 funds europe



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