Unpacking the key elements of modern data center real estate

The data center boom is upon us

There is no denying that artificial intelligence (AI) has become one of the most talked about innovations of the last few years – perhaps even the last decade. It should come as no surprise, then, that the data center industry – one of the key components of the “digital economy” in which we now live – is experiencing rapid growth. In fact, in January 2023, McKinsey & Company projected the industry would grow 10% a year through 2030, with global spending on the construction of new facilities hitting $49 billion.

According to CBRE, North American data center inventory grew by 24.4% year-over-year in Q1 2024, adding 807.5 MW across Northern Virginia, Chicago, Dallas, and Silicon Valley. These centers serve a critical purpose in the modern world, helping to prop up the world’s information and telecom infrastructure by providing governments, industry, and individuals access to the power, security, and connectivity needed to support the systems that keep our digital world running.

Of course, like any piece of real estate, not all data centers are created equal. Data centers have certain features that contribute to operational efficiencies and improved end-user performance, such as access to power and fiber optics, a receptive local government, and cost and environmental considerations, to name a few. Perhaps more importantly, a data center, whether mobile or fixed, owned or leased, enterprise or colocation, must evolve as quickly as the systems it serves.

However, with great growth, can come great disconnect. The rapid evolution of – and demand for – data centers can be disorienting for real estate professionals who are well-versed in more conventional classes of real estate.

Altus Group’s Nicholas W. Carter addresses these challenges and delves into the key elements of data center real estate that add the most value to the enterprise in the Appraisal Journal’s peer-reviewed report, ‘Where’s the Real Estate? Redundancies, Servers, Edge Sites, and the Search for Real Property’s Role in the Modern Data Center’. This week, we sat down with Carter to discuss the key takeaways from the report.

If you were to sum up this article in a few short sentences, how would you?

Data centers are multiplying at a rapid pace to support the demands of the nation's high-technology infrastructure. These facilities are meticulously designed to support the IT systems housed within them, and understanding the role that real estate plays within these systems is critical for all who wish to perform competent real estate appraisal services.

Why did you think this was such an important topic to write about?

There has been a surprising lack of guidance in the body of knowledge around this property type, likely due to the pace of its growth. The rate of technological innovation is only accelerating, and as data centers emerge as a coveted asset class, the industry must play catch-up as it relates to unpacking – and accounting for – the complexities of this sub-sector. This is especially concerning in the real property tax space where assessors are mandated to provide annual market value estimates without the support of professionals who have gained a baseline understanding of the systems and economics within the sector.

Unfortunately, this can be an intimidating endeavor and, to make things worse, this is one of the areas of commercial real estate that is currently attracting the most capital. With this in mind, practitioners need to be prepared to learn about the characteristics that drive value for these unique properties.

Why are data centers so challenging to value?

Traditionally, appraisers have always been taught to “mimic the market” when developing an opinion of value. Unfortunately, the market for these assets is controlled by individuals with graduate degrees in engineering – not real estate. On top of that, these facilities are so sensitive that any information on the property, let alone any transaction, is held very closely, which impedes the transparency required to complete a credible valuation.

Are data centers more or less complex than other asset types and why?

Data centers are, without a doubt, very different than other asset types. While traditional real estate values are largely influenced by location, building design, or proximity to amenities, these factors hold less significance in the case of data centers. Instead, data center valuations focus heavily on the technical infrastructure, power capacity, and the facility’s ability to ensure uptime and security.

Moreover, data centers often require specialized equipment and layouts, and their income-generating potential is tied more to how well they can serve as mission-critical assets, unlike other types of real estate. This makes the valuation of a data center more dependent on the facility’s functional performance than aesthetic or geographical factors.

There’s been a great allocation debate over what is real estate and what is personal property when it comes to data centers. Are there other complex properties where there is similar debate?

The allocation debate is not new or unique to data centers; however, it is more complicated, nuanced, and notably consequential to taxpayers operating in this space. Complex properties (where real estate assets become intertwined with other personal property assets) all require an interpretation of a fairly vague and limited framework to guide an allocation verdict.

As a result, several real estate asset classes fall victim to a muddled distinction between real estate and personal property, from manufacturing to hotels and hospitals. Whenever real estate is componential to a larger business (or system), allocation is an important step in the appraisal process. Appraisers of just the real estate components of hotels or hospitals know that sales observed in the market rarely involve the transfer of the same rights that are being appraised in the assignment.

What are the critical elements of a data center that help an appraiser determine what a successful data center facility looks like, and how do you assess these?

The key elements of a successful data center include, but are not limited to: uptime, operational efficiency, and the ability to deliver acceptable end-user performance.

Uptime

Uptime represents reliability; security is the top priority for most of these facilities and increments of downtime for the systems – no matter how small – are increments of downtime for the internet. In some cases, such as data centers that power systems and networks that help ensure public safety, this is a huge concern. Choices in location, construction and system redundancy are the tools that determine a facilities ability to guarantee uptime.

Operational efficiency

Many data centers are located strategically in areas for the sole purpose of reducing operating expenses – especially power. Power inputs (and other expenses including property taxes) have a significant impact on how a data center performs as an investment and thus how the market establishes its value.

Delivers acceptable end-user performance

End-user performance is the most interesting element of the data center value. This element addresses all user experience failures due to a source system being misplaced on a network. Location, which is a real estate attribute, is also a key consideration here.

The strategy of “edge” data center deployment involves placing (oftentimes small) data centers near a population base on a network line with minimal junctions. The goal is simply to minimize latency, or the dreaded “loading circle” as some call it.

Conclusion

The valuation of data centers is undeniably complex and presents unique challenges for real estate professionals, especially when compared to traditional asset types. As technological innovation continues to drive demand, understanding the nuances of data center real estate valuation – from uptime to operational efficiency and location's role in minimizing latency – becomes critical. As data centers increasingly attract capital, appraisers and investors alike must ensure that they have gained a basic competency in this evolving landscape to fully grasp the factors that contribute to their value.

In the realm of real property taxation, the allocation determinations (real vs. personal) become incredibly consequential to the tax burdens placed upon owners, and directly impact taxpayers' ability to deploy capital and invest in their futures.

To read ‘Where’s the Real Estate? For redundancies, servers, edge sites, and the search for real property’s role in the modern data center’.

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