Up view in financial district, Manhattan, New York
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Commercial real estate owners and managers are under more pressure than ever to show creativity and uncover new sources of revenue as office occupancy continues to underperform its pre-pandemic levels. Few options are off the table, from community-oriented flex space to rooftop restaurants and party venues. Add to this mix data centers, which are increasingly seen as a potential path to office building profitability.
There is a growing need for digital infrastructure, driven by near-universal internet access, mobile phone subscriptions, smartphone-based applications and even adoption of artificial intelligence, according to recent research. While hyper scalers, over-the-top media companies and edge data centers meet the majority of today’s demand, more data space is needed across all regions. The global colocation data center market is projected to grow at a five-year compound annual growth rate (CAGR) of 11.3% from 2021-2026, while the hyperscale market is expected to grow even faster, at approximately a 20% CAGR.
Even with this growth, demand is outpacing supply. Components required to build and operate data centers have been delayed and finding adequate data center space is a challenge in all regions. A large portion of the new supply pipeline is also preleased, with most of the new construction projects not inhabitable until late-2023 or 2024. But could the vacancies in the office market pose a possible solution?
With continued pressure on the office market to adapt, data center conversions offer a real opportunity to make office space more useful and profitable, but they require specific infrastructure that poses an immediate upfront cost.
Data center basics determine feasibility
Particularly in U.S. hubs, office buildings share much of the needed infrastructure to make data center conversion feasible, including uninterrupted power supply, cooling systems and high-speed connectivity. Location is also a critical factor to make a conversion viable.
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Established regional data center hub markets such as Northern Virginia, Dallas and the San Francisco Bay area will persist in their growth trajectory despite escalating land and utility costs. These markets offer low risk and stability, and their enterprise ecosystems, network connectivity infrastructure and service provider capabilities are difficult to replicate elsewhere in the U.S., making them a highly attractive option.
Office space located in an established hub offers the best opportunity to explore conversion possibilities. There are also some value-add investors who are looking to secondary U.S. markets, like the Pacific Northwest and Atlanta, where there is less competition for data center development, but still increased demand.
Determining the ideal operating revenue model
With the right location and infrastructure in place, the next critical step is to determine the operating revenue model. Building owners have to decide if they will undertake the conversion independently, invite someone to partner with them or pursue a hybrid joint venture.
An owner-driven conversion can be a challenging but rewarding endeavor. Establishing the necessary infrastructure could cost $15 million and take approximately 18 months to complete. Once the data center is operational, a leasing group can help fill the space and manage the tenants, while the owner reaps all rewards. But both the time and expense of a conversion make this approach risky.
Office building owners can also partner with a third-party group to lease space and assume the expense of building and operating the data center. Under this model, the owner receives rent and potentially a portion of generated revenue, similar to how a landlord might receive a percentage of sales if a restaurant operating in their building exceeds certain targets. This type of arrangement can be mutually beneficial, as the owner benefits from steady rent payments, while the third-party group can operate in a strategic location. It is important to negotiate the terms of the agreement carefully to ensure a fair and profitable partnership for both parties.
The third model is a hybrid joint venture, where the owner of the building and the third-party group collaborate to build and operate the data center. In this model, the owner contributes some portion of the capital expenditure required for construction and the revenue stream is negotiated between both parties. For example, if the owner invested $8 million of the estimated $15 million to make the necessary infrastructure improvements for the project, they might request to receive half of the revenue generated by the data center throughout its life cycle. This hybrid model provides a balance between other options, as it enables the owner to share in the revenue generated by the data center while also mitigating some of the financial risk for the third-party group.
Analyzing other costs
It’s necessary to determine how much office space will be allocated to the data center after conducting a feasibility study and analyzing the costs and time required for conversion. Factors such as cabling, switching, engineering, and power requirements, which are critical in data centers, must also be taken into consideration. Additionally, there is a heating, ventilation, and air conditioning aspect to consider since adequate cooling is essential, and integration with a technological partner is required to connect the market with the center’s capabilities.
Overall, converting vacant office spaces into data centers offers property owners the potential to generate additional income, since data center operators are often willing to pay a premium for the specialized infrastructure and location provided by office buildings. While it may not be an ideal solution for every underutilized office, data centers are among many emerging revenue-generating opportunities for buildings that cannot rely on long-term office leases.