Interest rate hikes can slow data centers, but not as much as other industries

Interest rate hikes are being felt in the capital markets for data centers, but ever-increasing investor interest is helping to cushion the blow.

After 24 months of record M&A volume, soaring valuations and plummeting cap rates, the rising cost of capital and broader economic headwinds this year could throw some cold water on the industry’s fiery capital markets.

A price correction may be underway, but experts say that with demand for data center space continuing to significantly outstrip supply, a growing stream of investors looking to enter the space data centers is supporting valuations and helping deals cross the finish line, although getting there is more difficult than it was a few months ago.

“There’s been industry acceptance as a preferred asset class, so you’re not going to see valuations plummet like you can see elsewhere,” said Anubhav Raj, chief financial officer of Data Centers Alignedspeaking earlier this month at Bisnow’s DICE National Capital Markets Summit.

“It’s really an interesting time,” added Raj. “We’re in a place with data centers where demand is higher than ever, creating a lot of capital needed for growth, and it’s an interesting time to figure out how you’re going to capitalize on all of these opportunities.”

Like nearly all areas of commercial real estate, rising interest rates, along with other cost increases, have created complications for a data center industry that has seen unprecedented growth for more than two years. .

Until earlier this year, asset valuations for individual data centers and operators had soared, with cap rates on some transactions tightening below 4% and valuation multiples at over thirty times. income. The high yields have attracted new investors – pension funds, insurance companies, endowments, large asset managers, sovereign wealth funds, private equity funds and real estate funds – eager to deploy capital in the space of data centers.

While investor interest remained robust, the rising cost of capital squeezed valuations, experts said. According to Robert Walters, principal at Avison Youngdata center practice. He said valuations would likely continue to fall, but to what extent remains to be seen.

“There must be a point here where there is a price review,” Walters said. this kind of things.”

Experts said rising interest rates had the biggest impact on individual stabilized assets. At the enterprise level, operators that have relied on debt for growth through development or mergers and acquisitions have also suffered relative to their private equity-backed counterparts. These companies have had to get creative with financing expansion, using debt vehicles like asset-backed securitizations, ESG funds and sale-leasebacks. But experts said even those markets had slowed significantly.

“It’s sort of a tale of two cities,” said Kanan Joshi, head of digital infrastructure at DIF Capital Partners. “What we’re seeing is that data centers that need debt have been broken up, whereas with a lot of the smaller rigs that would be largely equity funded in the early years, valuations are higher than ever.”

However, among the panelists of Bisnow’s DICE Capital Markets Summit, there was broad consensus that data centers, or at least major industry players, will not see the type of movement on valuations and cap rates or the reduction in the volume of transactions that will be observed in other sectors.

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Courtesy of Aligned Data Centers

The future Aligned Data Centers second building on its Dallas campus.

Experts have pointed to the fact that a growing wave of private capital, much of it from investors new to the industry, continues to seek opportunities in data centers, and this trend is expected to continue. According to Avison Young’s Walters, the percentage of total real estate investment devoted to data centers and other so-called alternative assets has increased from 4% to 8% since 2020, and this number is expected to increase by the end of the year. . It’s a trend Necklaces General manager Robert Kline said he also saw it.

“It’s become the most popular flavor in terms of where to invest money,” Kline said. “All the life insurance companies and other funds, their allocation for the first and second quarters of next year are bigger than they’ve ever been, so that should tell you something. They’re cutting into other spaces and move more capital here, which helps and should be reflected in the cap rate because there’s so much capital chasing it.

Valuations may also be buoyed by new entrants to the data center space who need to increase bids in order to purchase their first deal in what remains a fairly closed ecosystem, said Ben Mann, vice president of capital markets at Cushman and Wakefielddata center practice.

“I think we’re going to see a lot more of those institutions that haven’t made it into the business but are still pushing up bids to buy their first contract,” Mann said. “This will mitigate the increase in the cost of capital in the sector. It will continue to evolve with the rest of real estate, but it will be slower.

Beyond investor demand, experts said the industry as a whole has become more resilient to changing interest rates as industry growth has been bolstered by a limited number of large companies. , mainly backed by strong private equity investments, able to develop the kind of facilities for hyperscalers that are driving demand. While interest rates can alter individual asset numbers, investors will still be willing to accept high valuations for companies with the land assets and development know-how to grow.

“If we look at things at the enterprise level, especially at the global platform level, there are many other compensating factors other than the interest rate that go into the valuation,” Kline said. . “You have all these constraints right now like supply chain, power and land shortages, so the ability to execute becomes more scarce, and companies that can execute in markets at scale worldwide are very rare.”

Ramon J. Espinoza