Owning a Data Centre – the Emergence of a New Real Estate Asset Class
Data centres have moved from being an "alternative" real estate asset class to the mainstream in recent years. With the advent of 5G and continued digitisation of work and home life, strong demand for data centres is expected to continue despite increases in supply. They are attractive to investors as yields are currently higher than for more traditional real estate assets; for example, the yields across Asian markets are currently 50-150bps higher for data centres than prime modern logistics assets. Despite being a mainstream asset, data centres are a different beast to the traditional office, retail, residential and logistics asset classes and so present different risks and challenges. This article guides readers around a few of the potential legal pitfalls for those intending to acquire ownership of data centre real estate.
Before diving into the detail of what documentation is required it is useful to outline some of the commercial considerations which are unique to data centres, as managing these risks and concerns is the key in documenting data centre arrangements:
- Data centres require access to uninterrupted power, and a lot of it. It can take three to four years to arrange for the power supplier to upgrade the relevant power supplies. The power supply also needs to be regulated (via a power distribution unit (or PDU) and a power panel (or RPP) so that a consistent level of power is made available to the servers.
- The control of the space’s temperature and humidity is critical to the performance of the servers.
- The space’s data connectivity and data security is highly important to the operator.
- Given the importance of security there will be greater concern over who, and in what circumstances, has physical access to the space.
- The risk of natural disasters needs to be minimised both by location of the building in a low risk area (including controlling other users in the building if applicable)and the design of the building itself.
What Type of Lease?
An investor, by definition, is not going to be an operator. So typically they will lease the entire data centre (which may or may not comprise the entire building) to an operator. And the operator may then choose one of various business models in using the data centre, e.g., self-use or letting space/power to co-location customers. What concerns us here is the lease between the investor (as Owner/Landlord) and the operator (as Tenant). There is a spectrum of such leases from where the Landlord provides no (or very limited) services in addition to the right to occupy the physical space (in the US, this is referred to as a net net net lease) to where the Landlord is providing various levels of power and fibre connectivity (powered core and shell) to where the Landlord provides these things plus facility-level maintenance (wholesale co-location).
Net Net Net Lease
In the US the term “net net net” (or NNN) describes a lease where the Tenant pays all property taxes, insurance and maintenance costs. Similar concepts apply in other jurisdictions. In the data centre context this refers to a lease where the Tenant procures all fibre connections, utilities services and maintenance services. These leases are closest to a “normal” industrial building lease. However, there are nuances. For example:
- If the Tenant owns any of the facility infrastructure the Landlord will need to ensure the Tenant follows an appropriate maintenance schedule
- The rent can be based on the square footage of the building or the power availability (and if the latter, the Landlord should obviously be involved in ensuring the appropriate power is available – in Hong Kong, for example, it takes three to four years to arrange appropriate power supply enhancements for modern data centres from the power companies).
Powered Core and Shell
A Landlord may provide a powered core and shell of an entire building or an autonomous sub-set of a building. Typically, the Landlord would provide a raised floor, fibre connectivity, unconditioned power to the premises (which then required a clearly defined demarcation point to where the Tenant takes responsibility for regulating the power supply, typically the PDU). The facility infrastructure could be owned by either the Landlord or the Tenant but typically the Tenant would be responsible for its maintenance.
The Tenant would typically install and maintain all power and networking distribution, racks and IT gear. The Landlord would provide limited services and therefore no service level agreements (SLAs). Rent can be based on square footage or power consumption.
Under a wholesale co-location lease the Landlord will provide more, typically fibre connectivity, conditioned power (demarcation at PDU or RPP), cooling and humidity controls and facility-level maintenance. The Landlord would usually own and maintain the facility infrastructure.
The Tenant would install and maintain all power distribution downstream from the PDU/RPP, networking distribution, racks and IT gear. The environmental controls and facility maintenance services provided by the Landlord would be governed by SLAs. Base rent is usually based upon power consumption as opposed to physical space.
Regardless of which type of lease is used there are some key common issues that the documents need to address:
Security and Access – the building or space needs to be highly secure. Each Tenant or sub-Tenant needs a secured cage or rack for their equipment. Rights of access need to be much more tightly controlled than in a normal building. The Landlord will not usually get rights of access, even in the case of emergency, unless they are appropriately escorted.
Data Centre Rules and Regulations – data centres require detailed rules and regulations specified by the Tenant/Operator covering matters such as security access policies, fire detection and suppression, maintenance routines, equipment delivery, cabling and outage notifications, etc. The Tenant/Operator will require flexibility to change these from time to time as circumstances require, the Landlord will want to restrict changes that can be made without its consent.
SLAs – in leases where there are SLAs these will need to be negotiated to cover guaranteed availability of services and pre-agreed trouble shooting times as well as detailed liquidated damages for failure to provide the service. All of these can affect cash flow and therefore valuations.
An investor looking to purchase a data centre with an existing operator Tenant or looking at a new potential operator Tenant will need to do appropriate due diligence to ensure the following:
- The Tenant is able to provide the service and has the appropriate contracts in place; for example, power purchase agreement and operation and maintenance contracts, and robust protection against cyber-attacks.
- If relevant, the Tenant has appropriate sub-lease/licensing arrangements with the end users and the degree to which there is concentration risk in a few major sub-tenants, and the ease with which sub-tenants can terminate (for example, if there have been repeated breaches of SLAs in the past).
- The Tenant has the appropriate licences to operate the business and are able to comply with local privacy laws.
- The facility is sufficiently modern and in particular has sufficient Power Usage Effectiveness (PUE) to be attractive to the target market. PUE is a measure of how much power is needed to run the servers when compared to the total amount to power the entire facility (which is the IT equipment power plus power for temperature and humidity control). The formula is total power divided by IT equipment power. So a PUE of 2.5 means the data centre requires two and a half times as much power to run than it needs to power the servers alone. The lower the PUE the more efficient the data centre. This is highly relevant as power consumption is often the major cost driver in data centres so a data centre with a high PUE is likely to become uncompetitive in the market. Any PUE figure given by the Operator or a vendor should be independently checked.
As an asset class data centres are generating a lot of interest. The commercial challenge is finding the right site at the right price. However, beyond that there are legal issues and risks unique to this asset class that need to be appropriately managed by due diligence and robust documentation.