Burning REITs in Data Centers – Should You Invest?

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

Google, Amazon, Facebook, Apple, Microsoft – all the big boys run their platforms via the cloud. The sheer number of servers required to perform these operations is overwhelming. In addition to these large companies, countless thousands of smaller companies also use the cloud to run their software services. CRM companies, social media, podcasting, blogging, etc. all need server farm space to function.

In addition to this already expanding trend, the COVID-19 crisis and the associated shift from physical office space to digital work have greatly accelerated the need for more digital space for working and communicating from home.

Data center drivers

On the surface, data centers just seem like big boxes, much like other industrial real estate investments like warehouses that house those huge 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 in the electrical, HVAC and power distribution infrastructure to ensure that the servers have the energy and climate they need and maintained to use.

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

We can look at the big data center REITs for some insight into how the room works. Hoya Capital recently did a nice rundown where you can see that the data center REITs are on fire, making 17-28% annual profits over the past five years.

In short, the data center space is mainly determined by the location and whether the center provides pure wholesale storage to customers or creates value through colocation and interconnection. The most conveniently located centers can benefit customers by putting together servers from companies that work together and charge premium rates over a simpler wholesale approach.

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

Owning a data center is like selling picks and shovels to the gold diggers during a gold rush. Instead of having to know exactly how, when or where the next technological innovations will take place, you can simply deliver the critical real estate services that are needed regardless of the changes taking place. Rather than having to pick the right tech company or stock to drive demand for the data, we can simply align ourselves with this broader trend and take advantage of every horse that wins the race.

As a potential landlord to tenants such as Amazon, IBM, Intel, Oracle, Salesforce, or a number of other providers, you will not own the servers; these belong to the tenants. Landlords own the building and the infrastructure that enables the servers to operate. The tenants usually own and manage the servers directly, so no cloud computing expert is required.

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

While it’s true that companies can cut IT budgets in difficult economic conditions, these data centers are critical to the backbone of the Internet, which goes nowhere. Are you going to stop using your smartphone because of a recession? People will continue to use social media, communicate, and do business online even during a downturn. The Internet of Things and 5G connectivity will continue to give the industry a tailwind in the years to come.

I’m looking forward to

In terms of risk, one of the biggest potential downsides is simply the complexity and scale that it takes to get into the area. Another reason is that the sector has seen a lot of exciting growth and hence capital is flowing. Newer, more highly technical buildings are constantly going online and there is a risk of oversupply if more operators enter the area.

It’s unlikely that a small, new investor could just step in. It may make most sense to own one of the listed REITs or join a syndication as a limited partner in order to get 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 that you need to understand the space. If it piques your interest, the rest is up to you.

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