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Data Center Investment Frenzy: Stalled or Just Beginning?



Executive Summary

  • America accounts for about 40% of global data center demand, which is expected to reach 35,000 MW in 2030, up from 17,000 MW in 2022, according to McKinsey.

  • 2022 was a record year for the industry with 2,500 GW worldwide absorbed by new and expanded data centers.

  • From 2015 to 2018, 42% of data center deals involved private equity buyers. This share increased to 65% from 2019 to 2021, and to more than 90% in the first half of 2022.

  • Brazil has the most data center capacity in the region with over a 33% market share.

  • Mexico grew at the fastest rate in the world in 2022 adding 20% to its data center capacity. Brazil and Mexico are expected to be the fastest growing data center markets in Latin America, over the next five years.

  • The investment thesis for data centers globally has come under pressure, with an increasing number of short investors circling and placing their bets.

Introduction


There are three ways for an enterprise to maintain data and they include: on site (i.e., enterprises), co-location, and in the cloud (i.e., hyperscalers). Enterprises maintain their data on their premises and have their own IT department, cyber security, software and servers which they maintain. Co-location data centers, on the other hand, allocate server space at their facility for multiple clients and maintains all the equipment and ensures the data center is properly cooled and has access to adequate levels of electricity. This is the category of data centers which investors and private equity primarily invest. Lastly, the hyperscalers are the large cloud platforms (e.g., Azure, AWS, Google Cloud, Salesforce) which host enterprises in the cloud and those servers are at a location owned and maintained by the hyperscaler. It should be noted that many hyperscalers opt to outsource some of their data needs to co-location data centers.


Capacity of data centers isn’t measured by the volume of data which go through its servers as one might expect. Instead, capacity is measured by the megawatts (“MW”) available and utilized by the servers operating within. America accounts for about 40% of global data center demand, which is expected to reach 35,000 MW in 2030, up from 17,000 MW in 2022, according to McKinsey. 2022 was a record year for the industry with 2,500 GW worldwide absorbed by new and expanded data centers.


Figure 1: American Data Center Demand is Forecast to Grow 10 Percent a Year Until 2030


Data Center Investment Theme


Investing into data centers has been a powerful investment theme over the past decade, with investments escalating rapidly during, and following, the global lockdowns. The lockdowns forced many to rely on the digital realm to make friends, work, and purchase goods and services. The result was an explosion in digital processing demand which many investors believed represented a paradigm shift and a sign that humanity was ready to more fully embrace lives lived within the confines of the screens of laptops, smartphones and smartwatches. Proliferation of AI, autonomous vehicles, 5g and streaming buoyed the optimism.


Figure 2: Internet Traffic and Data Center Energy Use (2010 – 2020

Internet traffic and data center energy use from 2010 to 2020

According to Synergy Research Group, In 2021, there were 209 data center deals worth more than $48 billion, up 40% from 2020. From 2015 to 2018, 42% of data center deals involved private equity buyers. This share increased to 65% from 2019 to 2021, and to more than 90% in the first half of 2022. The largest such deal in 2022 was the $15 billion acquisition of CyrusOne by KKR and Global Infrastructure partners.


Figure 3: Data center M&A and Private Equity Activity


Data center investments suited private equity investors, first and foremost, because they realized they could raise large pools of capital around the investment theme and generate fees. They believed they could achieve high returns from the growing demand of cloud and digital content users through acquiring, and investing into, data centers. They assumed demand for digital process would continue to grow. They liked that the leases were long-term in nature, and had low churn. The investors and their advisors saw additional upside in expanding internationally because so many countries had low rates of data center penetration.


Data Centers in Latin America


Brazil has the most data center capacity in the region with over a 33% market share. In Latin America, the telecoms are the primary holders of data centers, followed by private capital investors (e.g., REITs, private equity, LBO firms) and the hyperscalers. Mexico grew at the fastest rate in the world in 2022 adding 20% to its data center capacity. Brazil and Mexico are expected to be the fastest growing data centers markets in Latin America, over the next five years.


Ascenty is Latin America’s largest data center provider with 34 data centers in Brazil, Chile, Mexico and Colombia. These installations represent more than 5,000 MW of capacity, across 30 cities, and 3,000 properties. Most of the company’s development activity has occurred in the last five years. In 2019, it was purchased by Digital Realty Trust and Brookfield for $1.8 billion at cap rates estimated to be in the low- to mid- single digits. In 2021, Ascenty raised $925 million in credit to build five data centers in Sao Paulo. The debt syndication was led by Citibank, ING, Itau Natixis, and Scotia Bank.


Macquarie Group, through Aligned Data Centers, purchased ODATA from Patria Investments at the end of 2022 for an estimated $1.96 billion. The transaction paved the way for the institutional investor’s entry into the Latin America data center market. Macquarie plans to inject an additional $1 billion of capital to expand its presence in Brazil, Mexico, Colombia and Chile.


The Mexico Data Center Association expects $8.5 billion of investment in new power generation capacity, mostly in the Bajio region of Mexico, to serve new data centers in the pipeline. The expected investment translates into 600 MW to 800 MW of additional data center capacity. Expected investments to build data center properties is expected to top $905 million between 2022 and 2026. The region already has ten data centers and is expecting eighteen new projects. Microsoft is responsible for one of the new projects which will be the company’s first data center in Spanish-speaking Latin America, and the 62nd largest in the world.


Interestingly, Africa has had success attracting data center investment capital, and in January 2023 Convergence announced a fund closing of $296 million, and Teraco an additional $680 million. $1 billion in one month, into a single asset class, is huge news for Africa.


Cautionary Note


Latin American countries counting on further foreign direct investments in the data center space should do so with caution. The investment thesis for data centers globally has come under pressure, with an increasing number of short investors circling and placing their bets. Perhaps the most influential of these short sellers is Jim Chanos who is certain that American data center REITs are in for a bumpy ride.


Interest Rates. Like every asset category, dramatically higher interest rates are having adverse impacts on returns for holders of data centers. When interest rates go up, equity investors require higher returns to be persuaded to part with their money. Higher interest rates have the additional negative effect of increasing the cost of debt for the project, which reduces the amount of future cash flows available for distribution to investors and to fund operations. A saving grace for data center investors is that many raised capital when rates were lower, at fixed rates, and therefore are temporarily shielded from some of these adverse effects.


Low Valuations. During the data center investment frenzy there was more capital available than there were suitable deals. As such, cap rates compressed and towards the end of the cycle most deals were being concluded at valuations based on cap rates of between 5% and 7%. Many data center transactions closed in 2021 at valuations based on 20x-30x EBITDA. Data Bridge’s $11 billion purchase of Switch in 2022 was based on a valuation of 40x EBITDA. Some of these buyer are already sellers, and reports are that off-market listings are being marketed at cap rates of 9% or higher. Private equity activity in the space has slowed dramatically as the investors digest their purchases and come to terms with what they are actually holding.


More Competition. Valuations are also being driven down by more competition from the hyperscalers. For co-location data center owners, hyperscalers are a mixed blessing. On one hand hyperscalers are well-funded tenants with immense and growing data storage and processing needs. But hyperscalers are increasingly becoming competitors by building and owning their own data centers. It’s never a good position for a landlord to have its biggest tenants also be competitors. Even where hyperscalers remain in a co-location data center, the threat of building their own facilities provides leverage to negotiate better terms. These better terms usually mean shorter duration leases signed, and less net rent to the data center landlord.


Accounting Issues. Data centers is perhaps the most capital intensive category of real estate to maintain. The cooling systems and servers are expensive and must be replaced every couple of years. To not do so is to risk costly downtime caused by server failure or overheating. It is alleged that some of the private equity firm owners of data centers have categorized the expenses to replace the servers, cooling and other equipment as a growth capital expenditure. By so doing, the major and predictably recurring expenses are excluded from NOI calculations resulting in arguably artificially higher NOI-based valuations. Some sceptics say that this is one reason why the data center investment frenzy continued longer than seemed reasonable given all of the obvious headwinds for the asset category during the frenzy.


ESG Risk. An environmental public relations risk exists for owners of data centers given the amount of electricity and water they require to operate. One data center can use as much power as 80k households. The hyperscalers mask much of the electricity they consume through purchasing carbon offsets, but this PR strategy may not continue to be as effective as it is now. Datacenters are rarely hooked into renewable energy grids due to the unreliable and inconsistent nature of these power sources. When the wind isn’t blowing or sun shining, the data center still requires steady power to avoid costly outages. Diesel generators are often the stop gap measure employed.


Figure 4: Data Centers Use More Electricity than Many Countries


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