Data centers have migrated from being something of an “alternative” real estate asset class to a mainstream asset class in recent years. With the advent of 5G networks, data intensive technologies, and the continued digitization of our professional and personal lives, strong demand for data centers is expected to continue well into the future despite increases in supply. This seems all the more evident as companies large and small move employees into decentralized locations across the country, and, in some instances, around the world.
Data centers are increasingly attractive to investors because their yields are currently higher than yields realized for more traditional real estate assets. For example, the yields across Asian markets are currently 50-150 bps higher for data centers than prime modern logistics assets. There is a real risk that more traditional commercial real estate assets are on the demise because of the Covid-19 pandemic. Despite being a mainstream asset, data centers are different than the traditional office, retail, residential and logistics asset classes, and thus present different risks and challenges to investors. This blog provides readers with insights on a few of the potential legal pitfalls for those intending to acquire ownership of data centers.
Commercial Considerations
Before diving into the detail of what legal documentation may be required, it’s useful to outline some of the commercial considerations that are unique to data centers because managing the risks is the key to properly documenting data center transactions.
- Data centers require access to uninterrupted power, and a lot of it. It can take three to four years to arrange for the electric utility to upgrade the relevant power supplies. The power supply also needs to be regulated via a power distribution unit and a power panel so that a consistent level of power is available to the servers.
- Controlling the space’s climate, including temperature and humidity, is critical to the performance of the servers.
- The center’s data connectivity and data security is highly important to the operator.
- Given the importance of security there is typically greater concern over what persons have physical access to the space, and under what circumstances.
- The risk of natural disasters should be minimized by locating the building in a low risk area and properly designing the building itself.
Types of Leases
By definition, investors are not operators. So typically they will lease the entire data center – which may or may not comprise the entire building – to an operator. The operator may then choose one of several business models to use the data center, like self-use or letting space and power to co-location customers. It’s important to carefully prepare and review the proposed lease between the investor, who is the owner and landlord, and the operator, who is the tenant. There is a range of potential leases. At one end of the spectrum, the landlord provides few if any services to the tenant other than the right to occupy the physical space. This is commonly referred to as a triple-net lease. Continuing along the spectrum, the landlord may provide various levels of power and fiber connectivity and other services requested by the tenant for additional fees. At the far end of the spectrum, the landlord provides these types of services plus facility level maintenance services that are sometimes referred to as wholesale co-location services.
NNN Lease
In California the term “triple 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 center context, this refers to a lease where the tenant procures all fiber connections, utility services, and maintenance services for the building. These leases are the closest example to a normal industrial building lease with a few nuances. For example:
- If the tenant owns any of the facility infrastructure, the landlord will want 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. If the latter, the landlord should obviously be involved in ensuring the appropriate power is available. In some jurisdictions it may take several months, if not more than a year, to arrange appropriate power supply enhancements from the electric utility to properly power the data center.
Powered Core and Shell Lease
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, fiber connectivity, and un-conditioned power to the premises. This then requires a clearly defined demarcation point as to where the tenant takes responsibility for regulating the power supply in its portion of the building.
The facility’s infrastructure could be owned by either the landlord or the tenant, but typically the tenant would be responsible for its maintenance under this type of lease.
The tenant would typically install and maintain all power and networking, distribution, racks and IT gear in the facility. The landlord would provide limited services, and therefore no service level agreements would be needed. Rent can be based on square footage or power consumption or some combination of the two, or a combination of the space and services provided by the landlord.
Wholesale Co-Location Lease
Under a wholesale co-location lease the landlord will provide more services. Typically this would include fiber connectivity, conditioned power, cooling and humidity controls, and facility-level maintenance. In these cases, the Landlord would usually own and maintain the facility’s infrastructure.
The tenant would install and maintain all power distribution downstream from the point where power enters the facility or the tenant’s space. The tenant would also install and maintain networking, distribution, racks and IT gear in the space it leases. The environmental controls and facility maintenance services provided by the landlord would be governed by various service level agreements. Base rent is usually based upon power consumption as opposed to physical space.
Common Issues Among the Leases
Regardless of which type of lease is used there are some common issues that the transaction documents should address:
- Security and Access. The building or space should be highly secure. Each tenant or sub-tenant needs a secured rack for their equipment. Rights of access need to be much more tightly controlled than in a normal building. The landlord may not usually get rights of access, even in the case of emergency, unless they are appropriately escorted.
- Data Center Rules and Regulations. Data centers require detailed rules and regulations specified by the tenant/operator covering matters like security access policies, fire detection and suppression, maintenance routines, equipment delivery, cabling and outage notifications, and the like. 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.
- Service Level Agreements. In leases where there are service level agreements 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 of the centers.
Due Diligence
An investor looking to purchase a data center with an existing operator/tenant or looking at a new potential operator/tenant should do appropriate due diligence to ensure the following:
- The tenant is able to provide the services and has the appropriate contracts in place. For example, power purchase agreements, operation and maintenance contracts, and robust security contracts to protect against cyber-attacks.
- If relevant, the tenant should have appropriate sub-lease/licensing arrangements with the end users, the degree to which there is concentration risk in a few major sub-tenants, and the ease with which sub-tenants can terminate, if for example, there have been repeated breaches of SLAs in the past.
- The tenant has the appropriate licenses to operate the business and can comply with local privacy laws.
- The facility is sufficiently modern and in particular has sufficient power supplies to be attractive to the target market. Power supply is a measure of how much power is needed to run the servers when compared to the total amount of power to run the entire facility. That total is power for IT equipment power and 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 center 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 center. This is important because power consumption is often the major cost driver in data centers so a data center with a high PUE is likely to become non-competitive in the market. Any PUE figure given by the operator or a vendor should be independently checked.
Conclusion
As an asset class data centers are generating a lot of interest because they need for these types of real property facilities is on the rise with the advent of digitization of our professional and personal lives, and the decentralization of many corporate work forces. The commercial challenge is finding the right site at the right price. Beyond the geographic challenges, there are all of the legal issues and risks unique to this asset class that need to be appropriately managed through due diligence and thorough transaction documents.