The data center industry has been one of the few sectors to navigate the high interest rate environment and related market disruption during the past few years with little to no disruption.
Indeed, by almost any measure, the industry is thriving. According to global real estate services company JLL, the market for US colocation data centers (large facilities that rent out server rack space to third parties) has doubled in size in just four years. Since 2020, occupancy has increased at a compound annual growth rate of 30% and year-on-year rents have climbed between 13%-37%, depending on the lease size.
The expansion rate of hyperscale data centers (significantly larger facilities that are often owned by third-party operators but leased to major technology companies with massive computing and storage needs) has been similarly impressive. Globally, the total capacity of hyperscale data centers has also doubled in the past four years, with more than 1,000 centers currently operating. The US accounts for more than half of that capacity, driven by domestic technology giants Amazon, Microsoft and Google.
Several key trends have fueled the data center industry’s rapid expansion. The adoption of cloud computing has driven consistent demand for scalable and dependable data infrastructure, which enables businesses to transition from traditional IT systems to cloud-based platforms, which is increasingly reliant on technology as traditional IT infrastructures migrate to cloud-based platforms. Simultaneously, the boom in artificial intelligence (AI) tools has increased the demand for advanced computing power, with hyperscale centers increasingly designed to support AI-driven applications like machine learning and generative AI.
These upward trends are expected to continue fueling a surge in construction, with Boston Consulting Group estimating that data center capacity is likely to triple from 2022 to 2030 to meet the expected demand.
Financing continues to gain momentum
Robust data center construction activity has generated strong demand from developers and infrastructure investors for project financing. The capital available for data center projects has set them apart from other adjacent asset classes, such as office real estate, where vacancy rates continue to rise, and retail space projects where leasing activity has been flat.
But while there is abundant liquidity available for data center projects, financing packages that meet the specific requirements of data center developers demand specialized, multi-disciplinary expertise. The financing structure and terms are often driven by whether the loan originates from a specific deal team within the lender’s project finance or commercial real estate division.
Typically, data center loan documents include construction advance provisions addressing capital costs to construct the core and shell of the building as well as long lead-time equipment procurement. The documents will also often include real estate terms related to subdivisions and site plan approvals for the property and the granting of easements to connect the property to utilities. As a result, some sections of the documents will be familiar to real estate lawyers, while other parts of the loan agreements (particularly those covering covenants and financial tests) will require project and leveraged finance expertise.
The hybrid nature of data center financings has led debt finance lawyers to collaborate with lawyers from other legal areas to build data center-specific practices. Traditional debt finance teams typically require support from real estate finance lawyers to handle specific issues, such as technical advisor reports and ongoing project reporting requirements.
Gridlock
In addition to blending real estate finance and leveraged finance terms, loan document terms and maturities must also factor in the possibility of delays before new projects can come online and start generating cashflow from leaseholders.
Data centers consume a substantial amount of power. McKinsey estimates that the amount of electricity required to power US data centers will more than triple to over 600 terawatt-hours per year by 2030.
This is already putting a strain on power generation networks and leading to bottlenecks in providing grid connections to new data center sites. Some power companies expect that wait times for grid connections for large projects could extend to as long as seven years as power grids struggle to keep pace with the rising demand. Even where power companies have committed to a certain power delivery timeframe, those dates may be delayed.
Zoning is another area that must be considered. If a site is not pre-approved for a data center development, a considerable amount of work has to be done to secure planning and zoning approval. With some municipalities capping the amount of land available for data center construction, this may impact the valuations on projects that are still in the process of securing zoning clearance.
Looking ahead
Data center developers with approved planning, grid connections and a signed lease with a hyperscale tenant are likely to attract lenders offering favorable financing terms, as banks view these projects as financing investments with an investment-grade tenant. With forecasters pointing to sustained long-term growth in the sector, data center operators and developers are well positioned to continue securing financing on attractive terms. Further, since hyperscale leases are generally long-term, often spanning 10 to 15 years with multiple extension options, these leases are especially attractive to lenders and garner considerable support in the securitization market.
Initially, the option to securitize was limited to developers contracting exclusively with big, blue-chip cloud and technology companies. But as the sector has matured, data center groups have also been able to move into the securitization market. The growth of data center securitization financings allows issuers to refinance bank loans with lower-cost securitization financing packages. This market is attractive not only from a cost-of-capital perspective, but also because it enables data center operators to recycle bank capital. Securitization proceeds are used to refinance loans previously provided by banks once the assets have been stabilized and are no longer in the development phase, allowing lenders to reallocate capital to new projects.
The appetite for data center securitizations has been so robust that Infrastructure Investor reports that despite elevated base rates, the spreads on data securitizations have been narrowing.
As more financing providers—from banks and private debt funds to fixed income investors—move into the data center market in large numbers, and as the range of financing options for data center developers continues to expand, the outlook for available financing in the sector is brighter than ever.