Chip Wars

How the real estate industry is reacting to the explosion of AI, which beckons opportunities in data centre investment?

• 2023 saw a record of $36bn invested in data centres
• Ongoing debate whether data centres should be classified as infrastructure or real estate
• Former FTSE 250 CEO of data centre operator called group “a glorified real estate operator”
• Data centres worldwide will likely consume 3-4% of overall power by the end of the decade

The entire digital world exists because engineers have mastered the art of controlling electrons across silicon slabs. This intricate dance underpins everything from smartphones to supercomputers. In "Chip War: The Fight For The World’s Most Critical Technology," Chris Miller explores the geopolitical battleground of semiconductors. He demonstrates how these chips define the technological landscape, international politics, the global economy, and military power dynamics. Geopolitically, the tension is most acute between the USA and China. AI systems are trained in vast data centres that are full of sophisticated chips like GPUs, which are the type of chips that are used to train AI systems. If you can’t mass manufacture cutting-edge chips, says Miller, then you can’t get the data centre capacity that you need to train AI systems. The US is ultimately trying to accomplish stopping China from developing advanced data centres. It’s using the machine tools as the choke point, preventing US firms, and also Japanese and Dutch firms, from transferring this equipment to China. Chips are integral to the growth of data centres due to their role in processing and managing vast amounts of data efficiently and at high speeds, a requirement that has been supercharged by the arrival of AI.?

Data centres are turning into a mainstream investment according to the Urban Land Institute and PwC 2024 Emerging Trends in Real Estate in Europe. True to form, $22bn has already been invested in data centres globally in 2024, on track to surpass 2023’s record of $36bn, according to Linklaters. The European market is growing quickly, with spending rising from 6% to 20% of the global total last year. So far this year, Europe comprises 29% of the market share, worth $7bn. RBC Capital Markets believes the European data centre market will be four times larger in the next decade and according to the CBRE Global Data Centre Survey, total transaction volume of European data centre asset sales in 2023 increased by 76% year-over-year.

This trend mirrors the rapid growth of mobile phone tower REITs. Mobile phone towers are now the largest sector of the US REIT universe, with data centres and healthcare REITs nearly as large as traditional office and retail sectors combined. The world's two largest REITs are American Tower, a cell tower giant, and Public Storage, a self-storage REIT. An investment manager in the ULI/PwC report said: “The alternative sectors that are supposed to be niche in the eyes of institutional investors are mainstream in the capital markets already.”

According to the CBRE survey, 97% of respondents, many of whom are the world’s largest institutional real estate investors, plan to increase their investments in the data centre sector this year. Currently, 38% have less than 5% of their assets in data centres, but only 8% expect to remain at that level in five years. Starwood, for example, has launched capital raising for its Starwood Distressed Opportunity Fund XIII, targeting $10bn in equity, PERE reported and the global fund intends to allocate 20% to 30% to data centres, translating to an investment of $2bn to $3bn in the sector, potentially more with the use of debt. This aligns with the Emerging Trends report above, which found that investor interest is strongest in higher-yielding opportunistic and value-add segments with solid market fundamentals. New energy infrastructure such as solar farms, electric vehicle charging units, and battery storage sites, along with data centres and healthcare assets, are now top priorities.

Rather than pursuing direct investment gains, other players, like CBRE, are looking to provide the ‘picks and shovels’ to the data centre industry. Recently, CBRE Group acquired Direct Line Global, a leader in mission-critical data centre infrastructure for top technology firms. The global market for data centre support services, estimated at around $30bn, is projected to grow annually by 16% through 2028. “This acquisition fits squarely with our strategy of enhancing our capabilities in asset classes that benefit from secular tailwinds – in this case, the increasing digitisation of the global economy,” said Vikram Kohli, chief operating officer of CBRE. “Direct Line Global perfectly complements our existing data centre management capabilities and provides us with best-in-class technical capabilities that differentiate our service offering.”

PIMCO outline, in a noted entitled “Powering the Future: The Strategic Role of Data Centres in the AI Evolution in Europe”, that AI-driven data centres serve two primary functions: AI training and AI inference, with the latter anticipated to demand significantly greater capacity as AI models become more sophisticated. AI training typically occurs in dense data centres, less sensitive to latency and situated in areas with ample land and affordable power. Conversely, AI inference facilities, crucial for delivering AI capabilities swiftly, are highly latency-sensitive and often located near cloud data centres. While recent focus has been on AI training facilities, the next 18-24 months are expected to witness substantial growth in hyperscalers’ AI inference capabilities.

Like the logistics sector requiring both expansive warehouses and nimble "last mile" delivery, the AI sector needs robust training facilities to develop powerful models and efficient low-latency inference capabilities for real-world applications.

As Principal Asset Management outline in 10 trends driving the global data centre market, meeting the staggering demand for data centre capacity will require massive capital investment. With data centres getting bigger, on average, they can now cost upwards of a billion dollars. While traditional models like self-funding and debt financing remain important, more data centre operators are turning to unique strategies to fund projects—including portfolio pruning, forward sales, joint ventures, and sale leasebacks. Private equity is increasingly active in funding this. From 2015 to 2018, private equity accounted for 42% of deal value, increasing to 65% from 2019 to 2021 and surpassing 90% by mid-2022.

There is ongoing debate about whether data centres should be classified as infrastructure or real estate. According to McKinsey, data centres are typically owned and operated either by large companies (such as cloud vendors, banks, or telcos) for their own use or by co-location companies that lease out space while providing network capacity, power, and cooling equipment. Tenants usually bring their own IT equipment. During construction, data centres resemble real estate investments. However, effective management demands specialised skills, particularly in engineering, which transforms them into infrastructure-like assets. Fund managers often invest in data centres through either infrastructure or real estate funds. Michael Tobin the buccaneering technology entrepreneur and former ‘maverick’ CEO of Telecity Group, the FTSE 250 data centre operator he took from ￡6 million to ￡3 billion before it was acquired by Equinix in January 2016, is renowned as the leader who created the data centre industry in Europe. He writes in his epic, and somewhat salacious biopic “Lifting The Floor; revealed the true stories hiding beneath the tiles of the data centre industry” that “…we were, in fact, a glorified real estate operator, a server ‘hotel’, which houses services for businesses that needed to store and share data.”?

The classification debate intensified when Barclays completed the first asset-backed securities issuance secured against a data centre earlier this year, as rating as asset-backed securities rather than CMBS may lead to different ratings outcomes. Benjamin Bouchet, a director at Scope Rating and quoted in React News, explained that the key attribute of data centres is providing uninterrupted power, which requires high-quality equipment and professional expertise. “To calibrate the assumptions of our cash flow analysis when rating such data centre financing transactions where the landlord is responsible for providing the infrastructure, we also take into account whether the management team has the necessary skills and capabilities. Further, we also consider the outlook on the sector based on our market research.”

This means that, while the existing commercial real estate methodology can be used to rate data centres, it often needs tweaking to take into account the operational side of the assets, adds Adam Plajner, associate director in the structured finance team at Scope Ratings: “Rating data centre backed debt is very similar to rating other types of commercial real estate (CRE) transactions. The properties – or in this case the power capacity and certain related services – are let out to the tenants who pay rent, which is the source of the interest payment on the issued debt.” React report on Europe's first asset-backed securities issuance secured against data centres, with Barclays and SMBC Nikko Capital Markets launching a ￡600m securitisation of two Cardiff data centre properties. This capital will refinance ￡480m in debt and expand the US-based Vantage Data Centres’ UK portfolio. According to DBRS Morningstar, the notes offer an indicative 6.7% coupon, highlighting the financial attractiveness of such investments.

The growth in data centres however is leading to issues with the availability of power. National Grid CEO John Pettigrew warned, “Future growth in foundational technologies like artificial intelligence and quantum computing will mean larger scale, energy-intensive computing infrastructure.” He expects UK data centre electricity demand to rise sixfold in 10 years. In 2022, the Greater London Authority told developers new housing projects in west London could be halted until 2035 because “major energy users” like data centres have taken all the electricity capacity.

S&P Global Market Intelligence reports on the ESG challenge to the data centre sector. In locations with carbon-neutral energy but limited supply, data centres may divert energy from other industries or require additional coal or gas-fired power. JLL’ notes in a report "The Data Center 2024 Global Outlook," that Europe’s ageing grid infrastructure, requires €584bn investments by 2030 for EU green goals. The US needs $2tn to achieve energy transition targets, enhancing grid capabilities and integrating renewable energy.

Computer scientist and futurologist Ray Kurzweil recently said AI is about to make the leap from revolutionising just the digital world to transforming the physical world as well. Indeed, SoftBank CEO Masayoshi Son recently said that the group's mission was to help in humanity's progress by realising artificial super intelligence, which he said would exceed human capabilities by a factor of 10,000. But Son's vision for AI robots would require “immense capital.” But also immense power. On average, a ChatGPT query needs nearly 10 times as much electricity to process as a Google search. Goldman Sachs Research estimates that data centre power demand will grow 160% by 2030, and this “increased demand will help drive the kind of electricity growth that hasn’t been seen in a generation.” At present, data centres worldwide consume 1-2% of overall power, but this percentage will likely rise to 3-4% by the end of the decade according to GS, and along the way, the carbon dioxide emissions of data centres may more than double between 2022 and 2030. The sector faces significant ESG challenges, with concerns about energy consumption, carbon footprint, and environmental impact. Despite these conflicts – and the lack of demonstrable track record or experience in the industry which is why it is still very much a “value add” play – the demand for data centres is expected to surge, driven by technological advancements and increasing data needs. This will make them a major component of modern investment portfolios.