The global pandemic may have accelerated demand for data infrastructure, but the underlying drivers behind the growth of data centre markets go far beyond short-term factors, explains Laurence Monnier.
The world’s appetite for data is voracious, driving the need for new infrastructure to transport and store it. Driven by new applications, this trend is likely to continue, with Cisco forecasting annual growth in data traffic of 27 per cent between 2017 and 2022.
The COVID-19 crisis has further accelerated this transition: data traffic exploded during the initial lockdowns, but far from abating when restrictions were lifted, it has continued to grow. This is illustrated in Figure 2 by the evolution of traffic on the Japan Internet Exchange network from 1999 to June 2021.1
Figure 1: Growth in data (exabytes per month)
Source: Cisco VNI, 2019
Figure 2: Daily traffic volume, Japan Internet Exchange network (bits per second)
Source: Japan Internet Exchange Co., Ltd., data as of June 4, 2021
The digital transition is both enabling and providing impetus for big societal changes, from online shopping to remote working, automated vehicles and social networking. These changes are in turn generating increasing demand for new infrastructure to distribute, process and store data.
Data infrastructure has been gaining significant investor attention
Against this supportive background, data infrastructure has been gaining significant investor attention. Yet, infrastructure networks are more intricate and interconnected than more traditional utilities, with multiple ways to deliver data though both fixed and mobile networks. With rapid technology change, fast-changing user needs, multiple networks and evolving regulation, assessing the long-term viability of data infrastructure projects can be complex.
Figure 3: Multiple ways of delivering data
Source: Aviva Investors, June 2021
Data centres: At the frontier of infrastructure and real estate
Data centres provide the essential storage and processing capability needed to support the digital transition. Additionally, the sector benefits from a low risk of technology disruption over the foreseeable future – until today’s computers are replaced by more advanced technology such as quantum computing, which could be well over a decade away.
After mobile towers and broadband networks, investors are increasingly attracted to this segment of telecom infrastructure. In a 2019 survey of European infrastructure investors by global law firm DLA Piper, debt and equity investors expected to increase their exposure to data centres by 33 and 18 per cent respectively.2 This is also reflected in the increased number of transactions in recent years.
Figure 4: Data centre transactions closed
Source: Inframation, data as of April 2021
Data centres are technically simple buildings containing technically complex installations. The IT equipment housed within is usually the responsibility of the tenants. Data centres are designed to anticipate and prevent any incident that could interrupt live operations through, among other things:
- Connection to typically more than one fibre network
- Batteries and back-up generators on site to ensure uninterrupted power
- A design that incorporates a significant number of redundancies
- Strong onsite security
Some data centres seek a quality accreditation from the Uptime Institute (ranked Tier 1 to 4) to attest to their degree of operational efficacy and reliability.
Figure 5: Uptime Institute tiers
Source: Aviva Investors, June 2021
Obsolescence risk still exists at an individual asset level
Energy efficiency is another key factor for investors to consider. This is measured by the power usage efficiency (PUE) – the electricity consumed by the whole facility divided by the electricity consumed by the IT equipment within. A low PUE is important from both an environmental and a financial perspective. Power is usually a tenant cost, but leases often contain a maximum PUE clause, beyond which power costs are paid by the owner.
The average PUE in the UK is about 1.3, but older data centres have much higher figures, making them less desirable. So, while the sector has low technology risk, obsolescence risk still exists at an individual asset level.
As explained earlier, data storage and processing capacity must continue to expand massively to support social networking, the Internet of Things (including automated vehicles), online gaming and streaming, as well as business needs.
In the corporate world, data centres fit into a broader trend to outsource IT. A first outsourcing step was for companies to either rent a space (co-location) or a full (enterprise) data centre to house their servers, with location and proximity to the businesses they serve a critical factor. This may explain why this sector has for a long time attracted both private equity and real estate investors, including specialist real estate investment trusts.
More recently, there has been a tendency to transfer core data and computing to the cloud. For example, Netflix originally operated from its own enterprise data centres, but moved its operations to the cloud over ten years ago. In 2018, public cloud accounted for about six percent of data centre spending; this is forecast to increase to 60 per cent over the long term.3
Cloud storage and processing has triggered the growth of hyperscale data centres
Cloud storage and processing has triggered the growth of hyperscale data centres (HDCs), which have a much larger capacity and are leased to or owned by large providers of cloud services, such as Amazon, Google, or Microsoft – although other companies may also use some of the space.
Most HDCs are developed on the edge of large cities, were they have access to sufficient power capacity and dense fibre networks. In Europe, Frankfurt, London, Amsterdam, Paris and Dublin are tier one markets, but we see increasing development in other markets, including Madrid, Warsaw and Prague.
Sites outside of large cities may also be suitable if they have favourable grid and fibre access. For example, Vantage Data Centre acquired last year the largest data centre in the UK, in Newport, South Wales. With large single asset investments and high-quality tenants, the HDC market has proven particularly attractive for project financiers.
The data centre market will continue to evolve
The data centre market will continue to evolve. Many new applications need “edge computing” – the capacity to receive, process and transmit data with very low latency. Automated vehicles and online gaming are typical examples of such applications. A denser network of smaller, powerful and well-connected edge data centres are needed to support these developments.
As the sector matures, the pace of M&A activity will continue. New platforms will emerge as more companies, including telecoms companies, outsource. This will bring opportunities to finance more diverse portfolios rather than individual assets.
Figure 6 shows the lease tenor available for different sectors, and highlights the importance of understanding the local corporate market, as well as the size of individual assets.
Figure 6: Lease tenor versus location
Source: Aviva Investors, June 2021
Sector opportunities and risks
We completed our first financing of a data centre for an infrastructure debt mandate in 2016, and subsequently financed facilities with more than 190 MW of capacity, with a focus on hyperscale data centres in Europe.
From a pure real estate perspective, investments into this sector were initially viewed with scepticism
From a pure real estate perspective, investments into this sector were initially viewed with scepticism, given the high valuations attached to a simple building with no alternative use in a semi-rural or industrial location. This was in contrast to the infrastructure position, where the sector has been viewed favourably for providing stable, recurring cashflows that investors are looking for.
The majority of debt transactions we have seen were structured with a tenor of five to seven years and a bullet or balloon repayment at maturity. This type of structure has the widest appeal for banks, but this sector would lend itself well to longer-term, fixed-rate institutional finance, particularly when long leases are in place. Given the refinancing risk inherent in bullet structures, the analysis of the term structure of leases is critical.
Lease structure and stickiness
Hyperscale data centres often have a highly rated anchor tenant taking a large proportion of the space, and they may also have smaller tenants. Anchor leases tend to be longer term (ten years or more, often with extension options).
Moving IT equipment from one data centre can be very time consuming and expensive for tenants
Critically, moving IT equipment from one data centre can be very time consuming and expensive for tenants4, not to mention the risk of downtime. In this context, leases are considered “sticky”, particularly against the backdrop of exponential storage growth.
Nevertheless, for debt providers, the level of risk must be assessed against the reliance placed on new, or extension of existing, leases to repay the debt. The type of new tenants depends to some extent on the location of the data centre, with remote locations less attractive for enterprise users. However, HDC anchor tenants, due to their size, rating and market dominance, can generally dictate favourable terms, and the space let to other tenants can generate significant revenue upside.
Data centres are valued by independent surveyors, and the loan-to value (LTV) varies significantly between transactions. Documentation may include traditional infrastructure (debt service coverage ratio, interest coverage ratio) and real estate (LTV, debt yield) covenants.
Bringing the expertise of our in-house real estate surveyor was of great benefit
These covenants may trigger a lock up, and the ability to sweep cash to repay debt if breached. Other cash sweep mechanisms may be in place for transactions with more lease renewal risk. Given the mixed nature of these transactions, we found that bringing the expertise of our in-house real estate surveyor was of great benefit to assess risk and provide sensitivity analysis around asset value.
From a credit standpoint, understanding the basis on which a valuation is conducted, including its reliance on assumptions around future events (lease renewal, expansions, etc), is critical to assess the level of protection provided by the covenants.
The owner of a data centre is exposed to performance risk, in as much as lease terms often include penalties and, in extreme cases, termination rights if the owner fails to deliver the specifications required (power, temperature, humidity) and core services (security, fire protection, etc).
A key protection against performance risk is the degree of redundancy built into the design
A key protection against performance risk is the degree of redundancy built into the design. Higher quality data centres (Tier III or IV) are built with redundant components, meaning they don’t need to be shut down when equipment needs maintenance or replacing. The other important factor to consider is the track record and expertise of the operator and, where relevant, their sub-contractors.
Another potential risk is related to energy efficiency. Data centres are power hungry: a single 50MW hyperscale data centre consumes as much energy as 140,000 households5. While power costs are generally paid by the tenant, some leases specify electricity usage above a certain PUE ratio is payable by the owner. Apart from the cost impact, poor power energy efficiency has negative environmental impacts and could become less desirable for tenants. Again, the quality of design and experience of the operator will be key factors to consider.
Faster and more secure data supports economic growth by helping businesses and consumers connect more efficiently. In terms of environmental impact, however, the picture is mixed.
Data can play a positive role for the energy transition, and digital technologies are a critical enabler for the Green Deal, the EU's new growth strategy to become the world's first climate-neutral continent by 2050. Yet data storage in hardware-filled data centres in temperature-controlled buildings requires vast amount of energy, as well as water for cooling.
Data centres were responsible for three per cent of energy consumption in 2017, and this is growing fast. Illustrating the point, Figure 7 compares the trajectory of Google energy consumption with that of the US.
Figure 7: Energy consumption – Google
Source: Statista, data as of 2018
Concerns about demands on the power grid led Amsterdam to temporarily suspend the construction of new data centres. It is therefore important for investors to understand not only the financial viability, but also the environmental impact of assets they are looking to finance, and their integration in the local area.
Storing data inevitably requires a high level of energy
With the current state of technology, storing data inevitably requires a high level of energy. Higher quality assets with a low PUE ratio are better placed to minimise the impact. Having access to clean energy and an abundant water supply, without having a detrimental impact on the local community, will also ensure the asset not only enables social development, but also minimises its environmental impact.
Conclusion and outlook
The market for data centres is not new, but infrastructure investors have come to it more recently, attracted by the growing scale of capital required to support cloud migration and the stable revenue structure.
The HDC market is set to expand exponentially
With more companies, including cloud operators, looking to outsource their infrastructure, the HDC market is set to expand exponentially. While data centres carry limited operational and technical complexity, investments in the sector are not without risk. When analysing opportunities, bringing real estate and ESG expertise into the due diligence process can reap huge benefits. Data centres are not for everyone but, with the right expertise, the prospects for investors in the sector look bright.
This article originally appeared in Project Finance International.