Filtering Out the Noise: Capturing Near-Term Investment Opportunity in a Data Center Boom

The data center sector has become a pivotal real estate asset class, attracting significant interest from institutional and private investors due to its robust fundamentals and expansive growth prospects. However, this market’s unique challenges and complex market dynamics often leave investors uncertain about how to effectively deploy capital into the space. To effectively evaluate prospective data center investments and maximize investor returns, it is essential to develop an understanding of current market dynamics, recognize emerging opportunities and navigate challenges alongside strategic partners within the sector.

Data Center Market Dynamics: Unprecedented Demand Driven by AI and Cloud Computing

The data center sector is experiencing a tremendous demand surge, primarily driven by the proliferation of artificial intelligence (AI) and continued growth of cloud computing technologies. AI’s computational intensity and the explosive growth of machine-learning applications are significantly driving up power requirements, resulting in both supply shortages and utility infrastructure constraints across the country. According to a recent report by McKinsey & Co., by 2023, U.S. data center demand is projected to more than triple, reaching 606 Terawatt-hours (TWh) of electricity demand and accounting for nearly 12% of total U.S. power demand, up from approximately 4% as of 2024. McKinseyReport2024

The unprecedented surge in electricity demand for data centers has created widespread challenges for utility providers, particularly in the primary data center markets. In Northern Virginia, the world’s largest data center market, utility provider Dominion Energy has been grappling with challenges associated with transmission infrastructure upgrades required to support accelerating data center load requests since 2022. Despite its recent progress to resolve transmission bottlenecks, Dominion is still challenged with solving for an unprecedented volume of new load requests, stretching delivery timeline estimates for new grid connections, to 4 to 5 years, in most cases. In its 2023 forecast submitted to regional transmission authority, PJM Interconnection, Dominion projected over 4 gigawatts (or 4,000MW) of load would be consumed in 2024 by data centers in its territory alone, representing over a 20% increase in actual data center load served by Dominion in 2023. Going forward, Dominion projected data center demand growth at a ~10% CAGR until 2030, when it estimates roughly 7 gigawatts of demand will be required to support its data center load. Given the recent acceleration of AI requirements, however, projections for further data center growth in the region are anticipated.

This dilemma of utility infrastructure and delivery constraints is one that is mirrored in other primary data center markets, including Silicon Valley, where power delivery timelines are now being projected beyond 2030. In other core markets, like Dallas and Atlanta, utilities have recently issued moratoriums on new large load requests, to engineer solutions for the unprecedented volume of large load requests already in the queue.

Data Center Demand Fueling Power Surge, Shortages

Exponential increase in power consumption associated with growing data center demand from AI and broader data proliferation threatens short-term power supply.

Continued Growth in Traditional Workloads

While AI and emerging technologies have been the driving force behind the recent acceleration in data center demand, it is important to note that more traditional data center workloads, including cloud computing and data storage, continue to thrive. In Q2 2024, AWS, Google, and Microsoft all reported record earnings, driven primarily by cloud revenue growth, with all three groups recording double-digit year-over-year growth for their cloud services. AWS alone generated $26.3 billion in cloud sales in Q2 2024, yielding a $105.2 billion annual run rate for the cloud services behemoth. Emphasizing the need for further growth to accommodate sustained demand, AWS VP of Investor Relations, David Fildes, revealed in the Q2 earnings call that the company has a backlog for AWS cloud services totaling $157.0 billion, or nearly 1.5x greater than the company’s current annual run rate.

Commitment by the largest cloud giants to satisfying growing demand for cloud and AI services is reinforced by their budgeted capital expenditures for new investment, which total a combined $195.0 billion in 2024 between AWS, Microsoft, Google and Meta.

The combined capital expenditures of the tech giants reflect the need for near-relentless pursuit of new data center capacity to satisfy their escalating needs, particularly as near-term supply diminishes across both primary and secondary markets.

Data Center Sector Tailwinds

The proliferation of data and growing demand for AI and emerging technologies have resulted in unprecedented demand for data center space.

Data Center Leasing Momentum

Quarterly new leasing volume across the top eight U.S. data center markets reached another sector record of 1,500 MW in Q1 2024; Amazon, Meta and Microsoft accounted for the bulk of the new leasing.

Data Center Leasing Momentum: Supply Effect

As leasing volume reaches record heights, data center supply compresses near record lows in most primary markets, despite unprecedented pace of new construction.

Supply-Demand Imbalance and Record Low Vacancy Rates

The current supply-demand imbalance in the data center market is stark, with demand consistently outpacing supply, as evidenced by CBRE’s H1 2024 North America Data Center Trends report, reporting record-low vacancy rates across major U.S. markets (at 2.8% as of Q2 2024). As users (both hyperscale and enterprise) look to solve for near-term requirements of their businesses, leases are being executed for capacity that cannot be delivered until 2027 or 2028. According to CBRE, of the record 3,872MW actively under construction by third-party developers, nearly 80% was pre-leased as of Q2 2024.

With a market landscape marked by fierce competition, urgent requirements, and prolonged utility constraints, amplifies the push for alternative energy to sustain anticipated demand growth.

Utility Procurement and Capacity Challenges Boost Secondary Markets

The combination of heightened demand for scalable power and existing supply shortages has led to a run on power in data center markets nationwide. As a result of the recent utility constraints in most primary markets, developers and users have begun to pursue opportunities in secondary and tertiary data center markets with more immediate access to power. Further, in a trend that is becoming more common amongst the hyperscalers, some groups have pursued new development in totally unproven data center markets such as West Des Moines, Iowa; and Madison County, Mississippi, as noted below, for their access to scalable power, abundant land, and favorable tax incentives.

Notable Examples:

• Microsoft announced its 6th data center on its West Des Moines, Iowa, campus – bringing the company’s total investment there to more than $6 billion.
• In acquiring a site in Mississippi (Madison County) for a new hyperscale campus, AWS made a $10 billion investment in the area, the largest capital investment in Mississippi history.

Off-Grid Solutions to Power Challenges

In reaction to utility challenges which have overwhelmed utilities across the U.S., many data center developers have begun to explore off-grid or behind-the-meter power generation solutions, primarily via natural gas. The approach to alternative generation aims to mitigate the barriers to power procurement and reduce dependency on overburdened utility grids. While alternative generation methods like natural gas can present a viable solution to energy procurement for data center use, these solutions require significant capital investment and present unique challenges which may may not be feasible to overcome for all markets/sites.

In what is likely an indicator of the future of energy for the data center sector, AWS’ acquisition of Talen Energy’s Susquehanna nuclear plant in early 2024 represents the largest use case for alternative generation as a means to energize data centers to date. Following the acquisition, which included land and power infrastructure, AWS will secure carbon-free power directly from the Susquehanna nuclear plant to support a 960MW development. In a similar vein, Microsoft has struck a deal to reactivate the Three Mile Island nuclear plant, which is set to provide dedicated power for its data centers. This initiative underscores a revival in interest, as nuclear power offers a consistent and clean energy solution amidst rising power needs driven by tech infrastructure demands.

Powered Land Strategies for Entry into Data Center Sector

Despite challenges, powered land strategies present a new pathway into data center investing, attracting traditional real estate investors due to manageable equity requirements and (typically) minimal downside risks. While powered land opportunities can generate attractive investor returns, they have become increasingly challenging to uncover due to speculation by unsophisticated and under-capitalized groups, in addition to the growing complexity associated with large-scale power procurement.

For inexperienced data center investors to properly evaluate viable powered land opportunities, it is important to align with reputable partners who have experience in data center site selection, leasing and development.

Key Elements of a Successful Investment Strategy (Powered Land / Development)

Effective Site Selection

• Understanding of user requirements and potential market limitations
• Knowledge and technical understanding of required infrastructure (utilities, fiber, etc.)

Development Expertise

• Proficiency in developing powered shells and turnkey data centers tailored to modern hyperscale specifications

Operational Experience

• Proven data center management and operational capabilities

Strategic Relationships

• Robust, established relationships with key partners, including end users, operators, utility companies and investors

Significant Pre-Development Capital

• Willingness to invest in pre-development activities to exhibit intent to develop to utility companies
• Ability to place large cash deposits for utility engineering/studies, “take or pay” guarantees and long-lead equipment procurement

Utility companies are beginning to sort through many gigawatts in load requests within their queues and place priority on operators with historical utility usage and a development track record, real intent to develop, actual ownership and cash available for deposit… a welcome change in their standard first-come-first-served operating procedures that have been taken advantage of during this race to large scale sites.

Recent insights from a McKinsey article highlight the challenges in meeting the growing demand for AI. Investors and developers face issues beyond power shortages and supply chain constraints. Developers are designing high density solutions for rapidly changing AI workloads during delivery in some cases. To accomplish this, collaboration with end users is crucial to address electrical and mechanical advancements and supply chain bottlenecks. This environment requires unprecedented levels of investment, potentially exceeding a trillion dollars across the sector. The focus has shifted from merely securing land with power potential to procuring comprehensive power infrastructure and electrical/mechanical equipment supply, to support future AI-ready data centers. This shift implies a more capital-intensive approach than previously anticipated.

Uncovering Existing Investment Opportunities: Value-Add Strategy

When it comes to investing in data centers, traditional real estate investors are often sidelined due to cost barriers associated with the increasing scale of capital investment required for today’s data center facilities. For modern hyperscale data centers, capital investment often nears $1 billion for a single development, driven by investment in MEP infrastructure, which comprises up to ~80% of a data center’s value. Given the capital limitations for most investors in pursuit of a data center mandate, an enterprise-focused, value-add strategy can present a viable entry point for investment.

Purpose-built, underutilized enterprise data centers (less than 20MW, in some cases) may offer investors a more accessible entry point, due to the smaller equity check requirements and downside protection of existing capacity. Typically, these data centers present an attractive opportunity to acquire the facility well below replacement cost and to generate value-add returns via the modernization/power densification of the asset. Specifically, most enterprise-built facilities were built to satisfy strict redundancy requirements (i.e., 2N) and at much lower densities than today’s user specifications. These overbuilt facilities present an opportunity to procure additional, leasable power capacity by unlocking redundant configurations in favor of the N+1 electrical configuration generally accepted by modern data center users, including enterprise. Further, given the dearth of available capacity across the country, these assets present an attractive upside opportunity to lease excess and/or expanded capacity to a broad spectrum of users with <20MW requirements (including hyperscale, AI and enterprise users), securing attractive rental rates reflective of the ongoing supply-demand imbalance.

In most cases, these facilities already have power and network delivered, so capacity can be accessed and offered for lease well before a new greenfield project can come out of the ground.  Additionally, these sites are often located at infill locations within core data center markets, while much newly delivered capacity is being developed in more remote locations due to availability of power. The field of potential tenants is much broader here, often catering to enterprise, collocation, the established data center operator segment, and even smaller hyperscale and AI deployments.

Leveraging Strategic Partnerships to Yield Optimal Results

For new investors looking to initiate a long-term data center strategy, reliance on strategic partnerships with proven data center experience is essential to successful execution. Forming strategic partnerships is critical for accessing local insights and mitigating risks associated with the intrinsic challenges of investing in the data center market. By aligning with experienced groups, new investors can access existing relationships with utility providers, end users, local governance and more, to facilitate successful project executions.

As a proven partner to new capital groups entering the data center sector, Lincoln Property Company (“Lincoln”) has the expertise required to execute on successful data center investments, from identification of the opportunity through optimal realization of the investment.

The Lincoln Advantage

In a sector characterized by constant evolution and complex challenges, Lincoln offers a comprehensive understanding of market dynamics, infrastructure requirements, and operational expertise. Our proven ability to navigate the complexities of data center investments, across the risk spectrum, offers distinct advantages for investors seeking to capitalize on opportunities in the sector.

At Lincoln, we leverage our track record, longstanding relationships with key stakeholders, and practical knowledge of hyperscale specifications to deliver successful outcomes for investors.

To learn more about how we can help you identify and execute actionable data center opportunities, contact us today and explore the future of data center investments.