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Annual Best Ideas

Data Center Demand Growth Likely a Long-Term StoryDataCenterDemandGrowthLikelyaLong-TermStory

Jan 19, 2023

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Data center demand has grown significantly in recent years, underpinned by a host of factors. When it comes to real estate, the information, communication and technology (ICT) sector is the underlying driver of demand for data centers—buildings designed specifically to house computer systems and network equipment to support digital information processing. Based on current structural trends and the latest available data, this sector will continue to grow significantly in the coming years.

Demand for data globally is likely only going to grow, and as we create more data, we’ll need more processing power to meet this demand. To do this cost efficiently and in a more environmentally friendly manner, development of more modern hyperscale data center capacity is inevitable. And strong tenant demand forecasts for data centers comes from the vital role they play in a technology-driven world, and as such they are firmly entrenched as an integral part of corporate IT architecture.

In particular, as more businesses embrace the public cloud to streamline this architecture and improve efficiency and security, they have gradually been migrating or integrating their IT infrastructures to incorporate the public cloud. As a result, the public cloud services market is forecast to grow globally by approximately 20% to reach almost $600 billion in 2023, and cloud data centers are expected to remain the main growth driver in data center IP traffic.

Estimating the Growth in Demand for Data Centers

Sources: Oxford Economics, Cisco, Statista, PGIM Real Estate. As of November 2022.

This demand for cloud data center capacity will be further increased by various underlying drivers as upstream IT demand broadens across industries, particularly among native technology companies. Despite the sharp declines in share prices of technology companies in recent months amid falling stock markets, many of these drivers—including e-commerce, artificial intelligence, and the metaverse—are expected to remain in place, driven by long-term needs.

One consequence of this growth in demand is the rise in the need for hyperscale data centers—generally very large facilities that have the ability to scale up further as demand grows. The number of facilities tracked by Synergy Research has grown at an average rate of 12% per year since 2018 and is expected to hit 1,000 globally by the end of 2024. The growth in hyperscale data centers also aligns well with PGIM’s environmental, social and governance (ESG) stance. Hyperscale tenants and operators have voiced a strong commitment to a zero-carbon footprint and using renewable energy in the facilities in which they operate.

Carbon emission in data processing is driven by the number of servers running and the total energy required to power and cool the servers.  Customers would use fewer servers and less power by using cloud computing instead of operating their own enterprise solutions, so a shift from enterprise to cloud dramatically reduces carbon emissions. Data centers will have a crucial role to play in the most optimal utilization of resources and what is the most energy efficient way to meet future digital demands.

The number of hyperscale data centers tracked by Synergy Research has grown at an average rate of 12% per year since 2018 and is expected to hit 1,000 globally by Q4 2024.

A Growing Global Need

Strong structural demand has been met with significant investment activity in the sector, in turn rapidly driving new supply. Data center supply rose 20% per year between 2016 and 2021, led by the APAC region, which saw supply grow 30% per year over the same period. Growth was particularly strong during 2018 and 2019, when development rose sharply as the region played catch-up to the more mature US market.

Looking ahead, global supply growth is expected to moderate to 13% per year over the next three years. The supply pipeline in APAC is also expected to moderate, though certain markets such as Sydney and Tokyo will remain focal points of capacity growth. Growth in Europe is expected to remain relatively stable at 15% per year. Recent development trends have seen strong activity in secondary markets outside the traditional four to five major data center markets in each region. These tend to be high population density markets, with less-developed data center infrastructure but better land and power availability, where cloud operators set up facilities to complement those in major metros nearby.

The global data center sector enjoyed a record year in 2021, with an average return of 15%, driven mainly by yield compression. This was in line with our expectations of tightening yields as risk premiums between data centers and other traditional commercial real estate sectors declined. Going forward, the returns outlook across the three major markets (US, Europe and APAC) tells a similar story—a softer near-term outlook to yields as the economic environment weakens before recovering ahead of expected improving economic fundamentals in 2024.

The similarities across the regions speak to the globally shared critical need for digital infrastructure. Globally, as an unweighted average of the three markets, we see returns bouncing back in 2023 off an expected pickup in economic and transactions activity, hitting an unlevered return of around 7.5%. In terms of risks with construction costs, including those associated with environmental goals, potentially limiting supply by more than expected, global rental growth is likely to pick up by more than expected, driving returns higher.

Investor surveys tell us alternative real estate sectors, such as data centers, healthcare, cold storage and student living, have gradually become more mainstream. Today, almost a third of all investors are seeking investment exposure to the data center sector, compared to only 5% of institutional investors surveyed in 2018. Key drivers for this have been the attractive returns for new entrants alongside compressed yields in the more established commercial real estate sectors. But demand is also being driven by strong underlying structural needs. As with technology, data centers are “a need to have,” and we expect demand to be resilient amid the current challenging economic conditions.

While the sector does face some challenges, it is hard to ignore the sheer speed at which technology and the need for data centers is being adopted. With data centers increasingly becoming critical infrastructure to keep economies working, we see investment returns rebounding in 2023 on a global basis—reflecting the global need and demonstrating the sector’s resilience to short-term market forces.

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This material is for informational and educational purposes only and should not be construed as investment advice or an offer or solicitation in respect of any products or services to any persons who are prohibited from receiving such information under the laws applicable to their place of citizenship, domicile or residence. PGIM is the principal asset management business of Prudential Financial, Inc. and a trading name of PGIM, Inc. and its global subsidiaries. PGIM, Inc. is a registered investment adviser with the U.S. Securities and Exchange Commission (“SEC”). Registration with the SEC does not imply a certain level of skill or training.

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