Data Centers Race to Cope with Surging Power Needs from AI Boom
But is New York office space a better investment?
From crypto to artificial intelligence, analogies to the Gold Rush are apt.
In perhaps the most common takeaway, the real money in California back then was made selling “picks and shovels" rather than hunting for the yellow metal.
And as these new technologies place soaring demand on the world’s power supply (although there is some debate about crypto's impact on power usage), electric grids and data providers are struggling to keep up.
In a recent article, Bisnow highlights how the ongoing boom in AI is impacting a little known corner of the commercial real estate world: Data Centers.
As described by ChatGPT:
The data center business model involves offering secure, scalable infrastructure for data storage and processing, providing services like colocation, managed IT, and cloud solutions, with a focus on reliability, security, and energy efficiency, catering to businesses needing robust and flexible technology resources.
And all that tech has to be housed somewhere: Enter the data center REIT.
Again from Chat GPT:
Data center REITs like Equinix (NASDAQ: EQIX) combine real estate investment with technology services, leasing space and offering IT solutions in strategically located facilities. They generate steady income through long-term leases and distribute significant profits as dividends, focusing on growth through acquisitions and new developments.
But according to Bisnow, the data center services industry is struggling to keep up new demand because:
Rapid AI adoption and the scramble to secure compute capacity has caught the data center industry by surprise
Long lead times to bring new facilities and capacity online inhibits data centers from meeting customer needs and
Existing power grid systems impose limitations on capacity, transmission and location
Interestingly, the consensus seems to be that the United States currently generates sufficient power to meet even the increased demands of the industry, but some don't see those conditions lasting. Elon Musk said last year that he believes the U.S. will experience a power shortage within two years, which could stunt the development of AI.
The grid issues are particularly applicable to the implications that surging electrical demand is having on real estate, since even forward looking developers have limited options to add new capacity.
To improve performance, data centers tend to cluster together where demand is high: 35% of all hyperscale data centers are located in Northern Virginia near Washington DC, according to the Virginia Economic Development Agency.
So even if there is enough power in the grid, clusters place a tremendous demand on local power transport systems - especially relative to lower demand regions nearby.
These bottlenecks slow down transmission and limit the power these centers are able to pull in to meet their customer needs.
Reading all this, it would be easy to think that "pick and shovel" investors probably got rich over the past year as the AI boom fueled data center demand.
Not really. As a proxy, EQIX is up almost 11% in the past 12-months while the S&P 500 has returned double that at around 22%
Looking back a bit further, EQIX has indeed outperformed the S&P 500 over the last five years, returning 114% compared to the broad market 80%.
But given the hype around AI and huge gains from companies like NVIDIA (NASDAQ: NVDA), data centers weren’t a terribly effective way to play this trend.
REITs of course do not sell the technology itself, but rather provide space and services in exchange for rent and fees. They are still real estate companies aiming to generate cash flow streams they can leverage into attractive returns for investors.
As an EQIX investor (full disclosure), it has at times been frustrating to see the stock move more closely in line with interest rates than the fundamental demand for its business. So it's important to remember that in today's capital markets dominated investing landscape, value is not just about the fundamentals.
But performance is relative, and EQIX has outperformed most of its real estate peers over what has been turbulent past year across the CRE space.
Equity Residential (NYSE: EQR), a large owner of apartment communities around the U.S., is down over the past 12 months even as EQIX chalked up its 11% appreciation.
Notably however, Empire State Reality Trust (NYSE: ESRT), an owner of New York area office buildings like the Empire State Building, has leapt almost 30% in the past year.
Office property still faces tremendous headwinds, especially as companies continue to reduce headcount and shed office space, but forward-looking equity markets are maybe, just maybe, indicating that the floor in values may be in.
But if fundamentals matter, there are perhaps no two sectors in the commercial real estate world moving in more opposite directions than data centers and downtown office buildings.
Disclosure: position in EQIX