In our rapidly digitizing post-pandemic world, the surge in new technologies has intensified the demand for real estate for data centers. Data centers are crucial in supporting the expanding infrastructure of AI, the explosive growth of eCommerce, streaming services, and communication technologies like 5G. They are vital in helping entertainment, technology, and financial institutions achieve their growth targets.
However, the industry faces a significant challenge: the current supply and pace of development may not keep up with market demand. Additionally, numerous office properties continue to weaken as distressed or under performing assets within commercial real estate portfolios. These challenges suggest a promising opportunity for the future of commercial real estate.
The Evolution of Data Centers in the U.S.
Data centers house critical infrastructure that powers everything from social media to cloud-computing services. The emergence of data centers as essential big-tech infrastructure pieces has impacted the real estate industry. Traditionally, data centers have been characterized by large, low to mid-rise buildings with extensive square footage. However, this is starting to shift as multistory data centers become more common. This evolution could provide a much-needed boost to the office sector.
Many older data centers were constructed before the advent of AI, which relies on vast amounts of data for effectiveness. These facilities were often located in remote areas with affordable real estate, contributing to their Spartan design and extensive land usage. However, the growing data needs of Big Tech are compelling data center operators to evolve.
Data Centers and Commercial Real Estate
According to Moody's, data centers are some of the most valuable, if not the most valuable, properties in the investment-grade commercial real estate universe in 2024. Supply growth is lagging behind demand. The surge in demand for data centers, driven by the growth of AI and the rising volume of information exchanged between individuals, has paved the way for new market entrants and enabled existing operations to expand swiftly. Over the next four years, approximately 2,840 MW are anticipated to be developed across five of the ten largest data center markets in the US. To put this in perspective, this added capacity remains smaller than the current data center market in Northern Virginia, which, at about 3,000 MW, stands as the largest globally.
Today, data centers are being developed in the suburbs and exurbs of major metropolitan areas, where land costs more. These new facilities are also emerging in locations where sprawling, windowless buildings behind barbed wire don’t fit the local aesthetic. However, not all buildings can be converted to data centers, and there are fewer developable sites available in primary markets. Consequently, the future of data centers is increasingly represented by multistory structures resembling office towers.
Constructing vertically presents several benefits for data center operators. The primary advantage is maximizing return on investment by leasing additional space to data-intensive AI operations. Although building taller entails extra costs for plumbing and electrical work, the multistory data center trend is likely here to stay.
This shift is already influencing land prices in key data center markets. For example, land prices have tripled in Chicago, one of the hot spots for data center development, suburbs in just the last three years. Keep in mind that the initial cost only covers purchasing the land for the data center; powering it is an additional expense. Here lies a potential opportunity for some of America's distressed commercial real estate. Certain multistory office buildings in suburban areas, currently facing tenant shortages, could potentially be transformed into data centers. While this conversion isn't feasible for every property, spacious suburban office buildings in major markets might be ideal candidates for such a transition.
Can the Data Center Boom Rescue Commercial Real Estate?
Even with the Federal Reserve's recent rate cut, numerous office properties continue to languish as distressed or under performing assets within commercial portfolios. Transforming even a small fraction of these properties into multistory data centers could help office REIT's and banks holding their loans significantly reduce losses, potentially saving tens of millions of dollars. Additionally, it could also offer an exciting investment opportunity for real estate investors.
Moreover, the rise of multistory data centers on commercial properties can potentially revitalize suburban neighborhoods and bring jobs to areas that had previously been struggling economically. This shift could also attract new businesses and stimulate further development, creating a ripple effect throughout the local economy. In turn, this growth may lead to increased demand for other types of commercial real estate such as office space or retail properties.
Looking ahead, it's anticipated that the significant mismatch between demand and supply will continue. Projections of exponential data growth will fuel strong demand for data centers, while supply constraints remain. Consequently, vacancy rates are expected to stay low, resulting in stable, healthy rents. The robust fundamentals of the data center market are likely to continue offering opportunities for real estate and infrastructure investors seeking direct, development, and platform investments.
Assessing Risks for Data Centers and Commercial Real Estate
Against a strong fundamental backdrop driven by the significant demand and supply imbalance, we see two key considerations for investors that are likely to play a role in shaping the data center market going forward. First, the speed of technological innovation could impact the asset class in ways that are difficult to predict. For example, the conversion to hyperscale data centers is already making some older data centers less desirable. How easily and at what cost can today’s data centers be upgraded to the needs of the next decade is unclear.
Sustainability is a key concern for data centers. Currently, data centers and transmission networks contribute approximately 1% of energy-related greenhouse gas emissions, according to the International Energy Agency, and this share is expected to rise with ongoing data center expansion. As sustainable practices are adopted worldwide, data centers are under increasing pressure to transition to renewable energy sources and ensure carbon-free energy supplies.
The emphasis on sustainability and the shift to renewable energy sources could affect the market in several ways, ranging from development costs to the valuation of premium assets. Investors may also need to evaluate the reputational risks associated with investing in energy-intensive, AI-driven data centers.
The New Real Estate
As the real estate market continues to evolve, 2024 introduces significant shifts that are set to redefine commercial real estate industry dynamics and create a new real estate industry. Increasingly influenced by technological advancements, environmental considerations, and the AI boom, the landscape is transforming in unprecedented ways.
Much like real estate investments, the location and the underlying land—particularly access to power and the ability to secure necessary permits—are crucial determinants of asset performance and market attractiveness. Data centers often provide stable rental income, similar to real estate assets, as they are typically leased to third parties.
With shifting market dynamics and rising capital costs, data center real estate investors now rely on specialized real estate software. The right technology can enable them to source, manage, and execute deals with enhanced speed, transparency, and precision.
LandGate's comprehensive data solutions empower commercial real estate professionals to perform thorough due diligence on both commercial and residential properties with ease. By offering detailed information on electrical offtake capacity, proximity to electrical grid infrastructure, and comprehensive risk indexes, LandGate enables a quick assessment of environmental and financial risks that may affect property value and appeal.
Additionally, its value indexes provide insights into potential hidden revenue opportunities for renewable energy ventures, such as the implementation of rooftop solar panels. This enables users to identify properties with untapped potential for generating sustainable energy, making informed decisions that capitalize on renewable energy investments and collocation opportunities.
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