Digital Infrastructure in the Post-COVID Environment
July 22, 2021 | James Sprow | Blue Vault
A Blue Vault Webinar presented by the team from Strategic Capital Fund Management on July 15, 2021, featuring:
• Brandon Hunt – Portfolio Manager, Strategic Capital Fund Management
• Bryan Marsh – Chief Executive Officer, Strategic Data Center
• Todd Rowley – Chief Investment Officer and Chief Financial Officer, Strategic Wireless Infrastructure Funds Management
Host: Stacy Chitty – Managing Partner, Blue Vault Partners
Brandon: Digital connectivity can be thought of as a fourth utility, providing a critical role that we use on a daily basis. As a firm, we are focused on that digital infrastructure ecosystem. The pandemic highlighted the importance of digital connectivity. The SCFM team is spread out across the country. We’ve become a lot more comfortable with digital connectivity during the pandemic. It has accelerated the adoption of the new technology, increasing the pace of change in digitization at a faster pace than we have ever seen, making it more important now than it has ever been. From an investment perspective, these assets are very resilient. We’ve become a lot more comfortable with a digitized economy. The pace of change is accelerating so fast. The backbone, the digital infrastructure that supports that is more critical today than it ever has been in the past, and I don’t think that’s going to slow down post-COVID.
Bryan: Data centers are the foundation of our digital economy. That’s where all the computers and networking gear reside and all the data we are relying on in the digital age resides. They are very sophisticated and complex and the overall supply of data centers has doubled in the U.S. in the six years. We measure the capacity of data centers in megawatts of supply, and over the last six years we’ve added about 1,000 MW in supply in the U.S. to about 4,000 MW of capacity.
In commercial real estate, you want to see demand outpacing supply and the vacancy rates are going lower, with very high occupancy rates running 93% to 94% across the U.S. The construction of new data centers has slowed due to the pandemic. We were seeing a need for about 200 megawatts of new capacity quarterly in the U.S. but we are seeing only about 100 megawatts of new supply and now we are seeing rental rates beginning to escalate. Supply is tightening up. The cost of construction of data centers has been going down. The main tenants of the data centers are the cloud service providers and the hyper-scale companies and they have a lot of leverage in leasing this space. We’ve seen leasing rates hit bottom and begin to rise.
All this has led to higher values for these types of properties and we’ve seen a lot of new capital coming into the market, more and more institutional investors, private equity and foreign investors, sovereign wealth funds. They are seeing this as an ideal place to be investing money, with excellent, sticky tenants who pay their bills on time and have low risks of default.
We’ve seen compressing capital rates. The data center market is here to stay and it’s a great place to be investing right now. We’ve seen about a 50 bps cap rate compression between 2019 and 2020 on the sale prices. In the first half of ‘21 we’ve seen another 50 to 100 bps cap rate compression fueled by this strong demand. The data center asset class is here to stay and it’s a great place to be investing right now. 
Brandon: CBRE says 95% of their survey respondents expect to increase allocations to data center assets in 2021. We have seen a tremendous uptick in our deal activity. The asset class has continued to perform throughout the pandemic. Those trends were well on their way before the pandemic. The outsourced infrastructure, cloud computing, AI, augmented reality, virtual reality, autonomous vehicles, internet of things, all of these data-intensive applications will continue to grow.
Bryan: We’ve seen annual growth rates of 30 to 40% in mobile data traffic, virtual reality, and these things that are generating more data. It’s easy to see that is only going to multiply more and more. We think the stars are aligned right now. Data centers can’t just be built anywhere. They demand a lot of electricity and there are high barriers to entry to the sector. Not everybody knows how to do it the right way.
Stacy: What about geographical concentrations?
Bryan: The top ten markets are Virginia, around Washington D.C. Access to the trans-Atlantic cables to Europe and Africa. New York, New Jersey, serving Wall Street and Manhattan. Dallas and Chicago are big logistics hubs where a lot of companies have headquarters. Silicon Valley for all the tech firms. Atlanta has been a hot market, and Phoenix seeing a lot of companies escaping California. There are a ton of other secondary markets, places like Columbus, Ohio, San Antonio, Minneapolis, Seattle. Because there is less competition in these secondary markets, we actually see higher rents in the secondary markets. Data centers are popping up all over the place.
Todd: The key assets that they are investing in are the underlying backbone assets that connect the wireless network that covers our country today. A sister asset to the data centers are the towers. You’ll see a rooftop with a lot of wireless antennas and that’s a rooftop easement. There’s the ground underneath towers called ground easements. Then there’s small cell installations. Then there are antenna systems that are in large convention centers or large office areas or stadiums or places like that. These are the pieces that support all of this. Then you have the fiber networks that connect all of these and get you to the data centers.
Our customers are very high creditworthy clients. The tenants are incredibly sticky. Once they are tenants they are not likely to move because it’s very complicated to change.
We’re now into the fourth industrial revolution. Because all of these new technologies are traveling across these networks like AI and autonomous vehicles and the internet of things, etc. The volume of data is doubling every two years or so. New investments in these networks are going up about 40% per year. Carriers recently spent about $81 billion to buy new spectrums in a C-band auction. How does that translate into growth for our cell networks? When a carrier wants to convert to 5G they have to put in new equipment at the cell site. They have to put in new equipment and capacity on the towers and small cells and rooftop easements and that translates into more revenue for us. T-Mobile (Sprint) got a head start on 5G and now Verizon and AT&T are right behind them after spending billions on this auction. What we’re going to be seeing in the coming year is going out to these cell sites and upgrading them to 5G. Because the range of these 5G networks are not as great, we’re going to see new carriers getting on our towers because they need to densify. There’s going to be a lot of growth from that over the next three to five years. There are also some new entrants, like Dish Networks who are building out their new network called an Internet of Things network. We’re about to sign new leases on our towers with them. The cable companies have all launched wireless products. They are now cumulatively the fourth or fifth wireless operators in the country. There are also companies that want to bring wireless to the home to replace the cable. That’s why we are so excited because of the trends we see with 5G and 6G coming eventually.
We do not have any non-competes on who we lease to. When the carriers were building out their own towers they were the only carriers on the towers. They can do it more cost efficiently by leasing from tower owners because they can have more tenants on a tower. The incremental operating costs that they have when they add a new tenant are virtually zero, which means the additional leases go straight to the bottom line.
Stacy: Who owns the equipment?
Todd: We generally own the tower and the land around the tower. All of the equipment on the tower and the maintenance and the technology is on the tenant. We are insulated from the technology risk. It’s the simple asset in a very complicated business.
We work with developers to build the towers. It can take two or three years. They get the zoning and permitting and lock down the real estate. We get a deal with the developer that says “Ok, when you reach these milestones we will pay you these fees and then once it’s built and on the air and the carrier is paying you these revenues, we will buy it.” When it’s a single-tenant tower, we have a lot of opportunities to add tenants.
Stacy: What does it cost to build a cell tower? 
Todd: You have to buy the land. It depends on where it’s located. How big is the tower, can it handle five tenants or lighter like two or three tenants? It can be around half a million. A half-million tower can trade for two million if you have more tenants.
Stacy: Are there any public REITs that are concentrated on these types of assets?
Bryan: I came from one of the largest REITs, Digital Realty. The major data center companies have been focused on greenfield developments and more internationally. They are actually off-loading some of their stabilized properties. They are supplying potential inventory for SCFM. There has also been some consolidation and you will continue to see that. Blackstone recently acquired 2TS paying about a 20% premium over their June share price. Digital Realty is continuing to recycle their capital with a large portfolio coming out this year or early next year. SCFM is currently tracking about $3.5 billion in buying opportunities. They are looking at stabilized assets in secondary and tertiary markets and they don’t see that much competition.
Todd: There are a handful of publicly traded companies in the tower business. The smaller deals don’t move the needle for the large tower businesses. SCFM is looking at $5 million to $10 million deals which don’t really attract the larger REITs. The operators want SCFM to be their landlord. We are viewed as friendly to these carriers. We are buying in at good values and we have a lot of growth that we are expecting to have in the future. The big publicly traded REITs already have their future growth built into their stock valuations.
Stacy: Is digital infrastructure considered infrastructure or real estate?
Brandon: There’s a lot of similarity to real estate but there are differences also. It really straddles the line of both. Data centers are more clearly on the real estate side.
Thank you.
