Interest Rate Hikes May Slow Data Centers, Just Not As Much As Other Sectors

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

Following 24 months of record merger and acquisition volume, skyrocketing valuations and plummeting cap rates, the rising cost of capital and broader economic headwinds this year may be throwing a bit of cold water on the sector’s heated capital markets.

A price correction may be underway, but experts say that with demand for data center space continuing to significantly outpace supply, a growing flood of investors looking to enter the data center space is propping up valuations and helping deals continue to get over the finish line, even if getting there is more challenging than just a few months ago. 

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

“It's definitely interesting times," Raj added. "We’re in a place with data centers where the demand backdrop is as strong as ever, which is creating a lot of capital needed for growth, and it's an interesting time to figure out how you're going to capitalize all those opportunities."

Like nearly every sector within commercial real estate, rising interest rates, along with other cost increases, have created complications for a data center industry that has been in unprecedented growth mode for more than two years.

Until early this year, valuations of both individual data center assets and operators had soared, with cap rates on some transactions tightening below 4% and valuation multiples at more than thirty times revenues. High yields attracted new investors — pension funds, insurance companies, endowments, large asset managers, sovereign wealth funds, private equity funds and real estate funds — that were eager to deploy capital in the data center space.  

While investor interest has remained robust, the increased cost of capital has compressed valuations, experts said. Cap rates have climbed around 200 basis points in recent months as valuations declined slightly, according to Robert Walters, principal at Avison Young’s data center practice. He said valuations will likely continue to decline, although by how much remains to be seen.

"There's got to be a point here where there’s a repricing,” Walters said. "It’s been an amazing run-up from a pricing perspective, but we may be in it given the headwinds: inflation, rising rates, supply chain constraints, all those types of things."

Experts said that rising interest rates have had the most impact on individual stabilized assets. At the company level, operators that have relied on debt for growth through development or M&A have also suffered compared to their counterparts funded through private equity. These companies have had to get creative when it comes to financing expansion, using debt vehicles like asset-backed securitizations, ESG funds and sale-leasebacks. But experts said even those markets have slowed considerably. 

“It’s sort of a tale of two cities,” said Kanan Joshi, head of digital infrastructure at DIF Capital Partners. “What we are finding is that data centers that need debt have been dislocated, whereas with a lot of the smaller platforms which would largely get funded by equity in the first few years, valuations are as high as ever.”

Yet among panelists at Bisnow’s DICE Capital Markets Summit, there was a broad consensus that data centers, or at least the major industry players, won't see the kind of movement on valuations and cap rates or the reduction in deal volume that will be seen in other sectors.

Experts pointed to the fact that a growing wave of private capital, much of it from investors new to the sector, continues to look for opportunities in data centers, and that trend is expected to continue. According to Avison Young’s Walters, the percentage of total real estate investment spent on data centers and other so-called alternative assets grew from 4% to 8% since 2020, with that number expected to increase by year’s end. It is a trend Colliers Managing Director Robert Kline said he has seen as well. 

“This has become the most favored flavor in terms of sectors to put money into,” Kline said. “All the life insurance companies and other funds, their allocation for the first and second quarter of next year are greater than they’ve ever been, so that should tell you something. They’re reducing in other spaces and shifting more capital here, so that helps and should be reflected in the cap rate because there’s so much capital chasing it.” 

Valuations may also be supported by new entrants to the data center space who have to push up bids in order to buy into their first deal in what remains a fairly closed ecosystem, said Ben Mann, vice president in charge of capital markets at Cushman & Wakefield’s data center practice. 

“I think we're going to see a lot more of these institutions that haven't managed to get into the sector yet pushing up bids to buy their first deal,” Mann said. “That's going to soften the increase in cost of capital within the sector. It will still move along with the rest of real estate, but it will be slower.”

Beyond demand from investors, experts said the industry as a whole has become more resilient to changing interest rates as the industry’s growth has been consolidated by a limited number of large firms, mostly backed by robust private equity investments, which are capable of developing the kind of facilities for hyperscalers that are driving demand. While interest rates may move the numbers on individual assets, investors are still going to be willing to agree to high valuations for companies with the land assets and development know-how to deliver growth. 

“If we look at things on the company level, especially to the global platform level, there are many more offsetting 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 rarer, and the companies that can execute across markets on a global basis are very scarce.”