August 6, 2020

Warehouses and Data Centers, Market Favorites, Have Downsides

These real estate investments are pandemic investor front-runners, with high returns. But Wall Street euphoria masks weaknesses that can make the long term more chancy.

Reported by Sarah Min

Investors looking for some stable real estate income can count on at least two investments that have been spared from the willful discretions of a pandemic: warehouses and data centers.

The two sectors have done well. Real estate investment trusts (REITs) overall have fallen 39% thus far in 2020. But data center trusts have jumped 52%, and industrial (mainly warehouses) ones climbed 27% over the same time period, according to data from the National Association of Real Estate Investment Trusts, or Nareit.

“It’s clear that people have a hunger for stable income and they’re willing to pay for that more now,” said Rich Kleinman, managing director of research and strategy at LaSalle Investment Management, the fourth largest global owner of office space, a sector that is having problems in the work-at-home era.

Still, enthusiasm for these two sectors can come back to disappoint investors if they’re too eager to push capital into properties they do not understand. While an appetite for e-commerce and cloud computing is driving demand, there is concern that the enthusiasm is overdone. And that their downsides are little appreciated.

“Not everything is great in these two sectors,” said Prashant Tewari, partner at the Townsend Group, a global real estate investment manager and adviser and an Aon company. “It’ll be a mixed story, not because the sectors themselves don’t have strong fundamentals, but because there’s so much rush for investment in this area,” Tewari added.

Bigger and Better Warehouses

Investors will always have to watch that supply does not outstrip demand on any property type, but no lack of demand or capital for warehouses exists any time soon, according to Jeff Giller, head of StepStone’s global real estate group. “I think that the issue with any product type when it’s attractive is it can get overbuilt. I haven’t really seen signs of that for industrial. I think one of the aspects of a downturn is construction financing tends to dry up, which makes development harder, so it wouldn’t be something I would be overly concerned about,” he said.

“Leasing for industrial space has been off the grid this year. It’s been extremely busy,” said Joe B. Thornton, president of capital markets at commercial real estate firm JLL. Thornton said enthusiasm for warehouses remains high and, despite COVID-19, he was able to bring 10 of the largest industrial operators in the country to come visit land sites for industrial development in Dallas during the pandemic.

Warehouses can thank a burgeoning trend in the US to onshore operations, as well as a trend away from just-in-time inventory and the rapid acceleration in e-commerce, meaning warehouses increasingly require more readily available stock closer to stores. That means investors can fund smaller, more regional distribution centers in addition to the big-box centers that attract Amazon and Walmart as tenants, Thornton said.

Investors thinking of warehouses should also keep an eye on other changes. Warehouses rapidly evolving to accommodate the growth of e-commerce are getting bigger to attract tenants. Ceiling height in modern centers has jumped to 40 feet from floor to ceiling inside the buildings, up from 28 feet.

Warehouses, known as fulfillment centers in e-commerce speak, are getting more rectangular in shape, versus the square designs for manufacturing warehouses in the past, because they require more cross-loading docks and doors to ensure the flow of goods in and out of the buildings. “That’s how you would organize a space efficiently,” La Salle’s Kleinman said.

Other changes also abound. Parking lots are increasingly valuable to tenants who require more workers to pack smaller packages to meet the demands of one-day or same-day shipments. Along those same lines, more trucking space is also needed. Thornton said he has found that warehouses increasingly require cold storage space to meet the rise of grocery deliveries.

But investors wanting ideal assets to add to their core real estate portfolios should be picky. They need to focus on choosing the right operator managing the properties. Some questions to consider: How long have the operators worked with the property types? Does the firm have its own in-house capabilities or does it have to rely on third parties to source assets, value add, lease, manage properties, and exit? Some large operators with vertically integrated systems include Exeter in the US or Gramercy, owned by Clarion, in the UK.

A big problem for investors is that they’re unlikely to see much benefit from warehouse assets that do not lie on primary logistics routes.

But some investors doubt the crowding into the investment will last. While warehouse investments have grown, they’re still not a dominant part of most diversified real estate portfolios. This means that transaction volume for the sector is going to fall to more normal levels after other real estate investments stabilize from the uncertainty of the pandemic. Which stores will remain open, which tenants will continue to pay rent, which centers are eventually going to rebound?

“If I think about what has come across our radar screen in acquisition opportunities, in the last couple months, it’s been so disproportionately skewed towards industrial in a way that it never has been before,” LaSalle’s Kleinman said. “And that’s simply not going to last.”

“It’s a good secure core income generating asset type and typically not a high-yield investment,” StepStone’s Giller said.

And how well various sectors are doing is sometimes not apparent for a while. Clarity on apartment buildings is expected to emerge in a matter of months, while the state of play on office and retail investments is expected to emerge in quarters, Kleinman said.

“The story almost comes down to the other property types a little bit more,” he said.

Data Centers: Not Just a Bunch of Computers

Data centers are a relatively new favorite investment for investors, according to Thomas Liu, head of Greater China and North Asia Real Estate at Actis, who noted that interest has grown in the real estate investment conferences he has attended. “Two years ago, very few people were talking about data centers,” Liu said. “You go to a conference this year, even with COVID and everything is done over Zoom, everyone is talking about data centers.”

Data centers count for a much smaller piece of the institutional investor’s portfolio, but technological gains in recent years in cloud computing that’s dominated by Amazon and Microsoft have led to a surge in interest. During the pandemic, consumers staying in to stream television have only fanned flames to that trend.

Singapore sovereign wealth fund GIC said in its 2020 annual report that data centers are one area that appeals to it during the pandemic. Last year, Google said it would invest $13 billion into data centers across 13 communities. Liu’s firm, Actis, is hoping to soon close a $300 million investment in a Seoul data center this month.

But not everybody understands the asset, which is very complicated operationally and remains in short supply. “The supply is in the mode of catching up, and that catching up has a long hurdle to go,” Liu said. “For investors that have an interest in this sector, they have to be careful about not rushing in.”

In fact, LaSalle’s Kleinman said the firm is not active in data center investments, despite being active in other special property types, such as medical offices and self-storage. “We’ve looked at it,” Kleinman said. “We’ve tried to understand the space. But we have not been able to establish the kinds of partnerships we’d want to have to be active in that space.”

“There are a lot of assets to be owned, but only a few good operators,” Townsend’s Tewari said.

Data centers seemingly don’t need much upkeep, given that they are a bunch of servers housed in a building. But the very complexity of them can lead to trouble for the unwary. Finding operators who understand the asset class is crucial.

Some considerations:

Latency: What sort of applications a data center can run reliably is a crucial element when considering data centers. A one-second lag in internet service may be fine for tenants running basic applications, such as checking for email, but the same lag is less acceptable for phone or video conferences over the internet. For Wall Street traders, for whom millisecond differences are crucial, or for companies livestreaming events such as the Super Bowl, that small lag can be catastrophic. To avoid this, the best data centers locate themselves near a broadband pipe.

Trouble is, broadband pipes aren’t everywhere, and the most desirable spots on the planet are already taken by tech giants and investment firms.

Uptime: Along the same lines, the best data centers are classified by the time they stay up and running, and even minute differences matter greatly here. In the digital world, the crown jewels of data centers are known as the Tier IV assets, offering five-nine reliability, or the ones with servers running 99.999% of the time, or those exchanging mission critical data across networks, according to Tewari. But that high standard is seldom met. Instead, most of the investor transaction activity occurs in assets offering three-nine reliability for servers that are up 99.9% of the time.

Redundancy: The amount of redundancy, or backup power or cooling infrastructure, needed to support servers in the event of an outage has come down in recent years. Modern data centers can easily shift traffic in a split second to other units elsewhere, meaning tenants require less redundancy per building and operators have a competitive edge when it comes to charging rent.

That new ability, however, could hurt operators of older data centers, which may have tenants leaving them to go searching for cheaper power rates in other locations. Some data centers in New Jersey, for example, lost tenants to Virginia, which has lower power rates.

Security: In addition to video surveillance and background checks, modern data centers hold strict security requirements to protect against the rise in cybercrime, including events where thieves can come in and steal data. Biometric scanners for retinas, fingerprints, or voice patterns are replacing card access for users. Secure access points also ensure only one person can enter a room at a time.

But those safeguards aren’t always available. Outside the US, investors can expect a lot of growth but will have to navigate different regulatory hurdles, said Actis’ Liu. In China, local governments are reluctant to convert state-owned land for private logistics uses, given that factories and other uses can create more jobs or generate more tax revenue for the government.

In all, short-term investors need not worry about the vast differences within asset classes, as data centers and warehouses are Wall Street darlings. Still, investors with longer time horizons should be more wary. “None of that risk is apparent today, because the demand significantly outstrips supply, so those cracks are not very visible,” Tewari said. “But over time, they will be.”