Fed Uncertainty Is Keeping Data Center Sellers On The Sidelines
Data centers have been one of the most highly sought-after asset classes for commercial real estate investors, but the lack of clarity on interest rates has prevented owners from putting properties on the market.
The Federal Reserve announced a new round of interest rate hikes Wednesday, the ninth set of rate increases in the past year. For the data center industry, the continued interest rate uncertainty, along with the accompanying volatility of debt markets, has meant lower valuations of data center assets and significantly fewer data centers hitting the market.
While strong demand, rising rents and growing investor interest place data centers on strong footing compared with other commercial real estate sectors, experts say it will remain tough to get deals done so long as the cost of capital remains in flux.
“It has caused a lot of pencils to just go down — maybe things are starting to come back into alignment, but definitely for the past six months or so, it has been really tough to underwrite anything,” said Bobby Little II, the director of digital infrastructure for Landmark Dividend. “All the underpinning economic factors for the industry are extremely positive. The uncertainty is really tied to those sellers wanting to re-engage those sales processes.”
Overall sales volume for data center assets dropped more than 20% in 2022, according to CBRE, largely due to sellers bringing fewer properties to the market.
Higher interest rates have led to lower valuations for data centers, with buyers seeking lower acquisition costs to maintain margins as it becomes more expensive to borrow. Experts said many data center owners who may have been looking to unload parts of their portfolios have slammed on the brakes as cap rates climb and potential returns diminish.
“The shift is really that there’s just less product becoming available,” Little said. “A lot of those sellers are saying, 'Maybe I just wait it out for things to regress and for cap rates to compress again.'”
Sellers have been more hesitant to put certain types of assets on the market than others, experts said.
Transactions involving fully leased data centers — so-called core assets — have seen the most significant decline. While these properties represent stable, low-risk investments, they have low margins that higher lending costs can negate entirely. And with tenants signed to long-term leases, there is no lever an owner can pull to get more revenue out of the property. This has caused valuations on these properties to plummet and sellers to flee the market.
A higher percentage of data center deals involve what investors would categorize as value-add assets: data centers that are only partially leased. This allows buyers to take advantage of rising rents and other strong industry fundamentals to boost operating income and offset higher borrowing costs.
“If you have a value-add transaction where it’s 50% leased, you’re reaping the benefit of all that rental growth and how groups will underwrite for what the potential operating income might be,” said Kristina Metzger, executive vice president and leader of CBRE's data center capital markets group. “Value-add product is less impacted in the current environment, which is why we are seeing more value-add investment opportunities come to market than we are on the core side.”
Beyond interest rates simply being higher, industry insiders said the uncertainty around capital costs and the resulting volatility in debt markets have been the primary factors limiting data center deals. Even if rates stay high, Metzger said, stability and greater certainty about what the borrowing environment will look like just weeks into the future will help potential sellers get a better read on how to realistically price properties and will get them off the sidelines.
This volatility has also made it difficult to execute deals even when properties do come on the market, with the fundamental math underpinning negotiations shifting significantly with the cost of capital over the course of a negotiation.
“It’s similar to crypto in a sense: With all this movement in a relatively short period of time, it’s difficult to ascertain what the true asset value is and what the normal curve will be,” Little said. “I’ve seen a few processes where we were not the winning bidder, and we came to find out that a good portion of those deals fell apart with the financing.”
Transactions may be down, but industry insiders emphasized that sellers are by no means retreating from the market entirely. In some cases, higher interest rates and general economic headwinds are actually incentivizing certain data center owners to sell fully leased assets to help fund development amid high borrowing costs and lagging stock prices.
Experts expect many of these deals to occur as partial-interest trades, in which an operator sells a partial share in a data center asset or portfolio through a joint venture or similar mechanism.
This type of transaction is particularly important in the data center space, where new investors want entry into the sector but need the operational expertise of longtime industry players. For the seller, maintaining a share and operational control over a property allows it to not risk its relationships with hyperscalers and other key tenants, which could be damaged if control over the building housing their crucial digital infrastructure is just handed over to another party.
“With data centers, where it's really operationally intensive, a lot of the investors want the operators to stay in,” Metzger said. “The operators want to maintain these relationships. So you see this kind of thing versus an outright sale that you might see in other product types.”
Some of the largest data center operators have indicated their intention to pursue this kind of deal in the months ahead. Data center REIT Digital Realty is looking to raise around $2B over the coming year through the sale of core assets and joint ventures, with a significant percentage going toward funding new development.
“Looking at the stabilized JVs and the development JVs, clearly we're seeing strong demand for those assets,” Digital Realty Chief Investment Officer Greg Wright said on a February call with investors. “The private markets have a strong bid for those assets given the quality of the assets, the stability of the income stream and the creditworthiness of the customer base.”
Even as a significant percentage of sellers retreat from the market, investors said the current environment may end up presenting meaningful opportunities. Landmark Dividend’s Little said investors have their eyes peeled for owners forced to bring properties to the market due to a combination of maturing debt and an expiring lease at a facility too outdated to attract new tenants.
“In times like this, typically there’s going to be blood in the market,” Little said. “We’re hoping to see some of that materialize.”
