Data Center REITs Are On Fire—Should You Invest?
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Data Center REITs Are On Fire—Should You Invest?

3 min read
Phil McAlister

Phil is the founder of The Macro Meets Real Estate Newsletter, a refreshing and entertaining take on real estate investing and financial markets.

A Chicago-area native and real estate investor, Phil’s career has spanned investment banking, commercial lending, and real estate, with extensive transaction experience from multiple sides of a deal.

Experience

Working for a large national sponsor, Phil has been in charge of the underwriting, financial modeling, and valuation of over $6 billion in commercial real estate, including multifamily, medical office, self-storage, hospitality, and senior housing assets. Phil leads a team in evaluating commercial real estate deals nationwide and across multiple strategies including core, core-plus, and value-add, with an occasional ground-up development sprinkled in.

Phil is also involved in evaluating and negotiating multi-million dollar joint ventures with various strategic partners. In addition, Phil has been tasked with evaluating projects in Qualified Opportunity Zones, a new and exciting frontier in commercial real estate.

Phil’s passions include family, football, American history, and real estate investing, in that order. Phil resides in Naperville, Ill., with his wife Kristin and three (sometimes) perfect children, Anna, Ryan and Charlie.

Phil holds a bachelor’s degree in finance and economics from Elmhurst College.

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If you’ve been on the right side of the grass over the past decade, you’ve probably noticed that nearly everything in the software and computing world has moved to the cloud.

Google, Amazon, Facebook, Apple, Microsoft—all the big boys run their platforms through the cloud. The sheer number of servers required for these operations is mind-boggling. In addition to these major companies, countless thousands of smaller operations are also using the cloud to run their software services. CRM companies, social media, podcasting, blogging, etc. all require space at server farms to operate.

On top of this already-expanding trend, the COVID-19 crisis and associated move from physical office space to digital work have greatly accelerated the need for more digital space to accommodate working and communicating from home.

Data center drivers

On the surface, data centers appear to be simply large boxes, similar to other industrial real estate investments like warehouses, that house these massive servers. However, unlike industrial real estate, where things like ceiling heights and loading bays are paramount, much of the capital in data centers is invested into the electrical, HVAC, and power distribution infrastructure to ensure that the servers have and maintain the energy and climate needed to operate.

There may be some interesting opportunities for real estate investors to own data centers and profit from the ever-increasing need for storage in our digital world.

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We can look to the major data center REITs for some insights into how the space operates. Hoya Capital did a nice recent rundown, where you can see that the data center REITs have been on fire, returning annual gains of 17-28% over the past five years.

In short, the data center space is driven mainly by location and whether or not the center is providing pure wholesale storage to clients or adding value through colocation and interconnection. The best-located centers can provide benefits to clients by collocating servers of companies that work together and charging premium rates over a more basic wholesale approach.

Do you need to understand the cloud to invest in data centers?

Owning a data center is like selling the picks and shovels to the gold miners during a gold rush. Instead of needing to know exactly how, when, or where the next technological innovations will occur, you can simply provide the critical real estate services that will be needed regardless of the changes that take place. Instead of needing to pick the right tech company or stock that will drive the demand for the data, we can simply align ourselves with this broader trend and profit from whichever horse wins the race.

As a potential landlord to tenants like Amazon, IBM, Intel, Oracle, Salesforce, or a number of other players, you won’t own the servers; those belong to the tenants. Landlords own the building and the infrastructure that allows the servers to operate. The tenants will typically own and manage the servers directly, so there isn’t the need to be an expert in cloud computing.

Data centers have the additional benefit of being resilient during economic downturns. Unlike some other forms of real estate like hotels, retail, industrial, and some types of apartments, the data center space is likely to be resilient in the face of a recession.

While it is true that companies can cut back on IT budgets when facing tough economic conditions, these data centers are critical to the backbone of the internet, which isn’t going anywhere. Are you going to stop using your smartphone because of a recession? People will continue to use social media, communicate, and conduct commerce over the internet even in a downturn. The internet of things and 5G connectivity will continue to serve as tailwinds for the sector for the next several years.

Looking forward

In terms of risks, one of the major potential downsides is simply the complexity and scale required to get into the space. Another is that the sector has experienced a lot of exciting growth, and therefore capital is flowing in. Newer, higher technology buildings are constantly coming online and there is a risk of oversupply as more operators enter the space.

It’s unlikely that a small, new investor could simply jump in. It may make the most sense to look into owning one of the publicly traded REITs or joining a syndication as a limited partner to gain exposure to this asset class.

If you’re interested in this asset class, this article is just the beginning. There is an entirely separate class of terminology and research you’ll need in order to understand the space. If it’s piqued your interest, the rest is up to you.