A Look at Digital Infrastructure Investments at Strategic Capital Fund Management
August 14, 2020 | James Sprow | Blue Vault
Blue Vault recently spoke with Brandon Hunt about Strategic Capital Fund Management’s (“SC”) strategies and investments in digital infrastructure, including data centers and wireless infrastructure such as cell towers, fiber optic networks, small cells, and distributed antennae systems. The demand growth for these types of assets has been phenomenal, with no sign of moderating, as the need for wireless connectivity to link the rapid growth of the “internet of things” and the compounded growth of data storage needs is expected to be at double-digit percentage growth for the foreseeable future.
We started by asking Brandon what the SC message to the marketplace is for alternative investments. A while back they were looking at a late-stage economy. They saw the long-term secular growth rates in the digital technology sector with a lot of innovation and the need for additional infrastructure. Tremendous growth in connected devices and cloud computing, supported by data centers and cell towers, as well as emerging technologies like small cells and expansion of fiber optic networks also entered into the equation. With the COVID-19 pandemic, the need for connectivity has been highlighted and we have become more aware of how necessary this critical infrastructure is. That was reinforced by the Department of Homeland Security designating the industry as “essential” during the pandemic.
With the transition to 5G, there will be even greater needs for more data storage and transmission. More devices will be generating more data and these types of assets will be critical in processing, storing, and delivering it all.
Strategic Capital Fund Management has built out their bench of expertise and experience in the telecommunications market as well as the data center real estate sector. On the data center side, their team has about $32 billion in transaction experience. On the telecommunications side, their team has over $135 billion in transaction experience. Digital infrastructure is often very technical and has higher barriers to entry. You really need the organizational expertise to build on your business case.
On the data center side, SC is primarily looking at existing facilities for investment. They are targeting both core, income-producing assets as well as opportunistic and value-add deals.
The cell tower side of the business is similar, where the company is generally targeting existing structures. However, SC has established partner relationships with several regional developers. These developers may have capital to permit and build three to ten or even 20 cell towers per year. The top carriers commission developers to build towers in a certain area and then the developer goes out and gets all the approvals to build. SC can then come in when the projects are shovel-ready and typically gets an exclusive right to acquire the assets at a pre-agreed upon price or cash flow multiple. This gives the developer an out so that they can recycle capital and move on to the next development project. In a scenario like this, SC acquires a new tower and new location with fresh leases with at least one of the top carriers as an anchor tenant. They also can potentially lease-up the tower to additional tenants such as other top tier carriers, regional and rural carriers, government and public safety entities, broadcasters, and others.
Cell towers support equipment for different uses (broadband networks, first responder networks, broadcasting, agriculture, etc.). As broadband technology advances and carriers continue to expand 5G networks across the U.S., signals from individual towers will likely have less range. Certain frequencies can carry data longer distances and some have more limited range. In general, 5G signals do not travel as far as the older technology, such as 4G signals. For the most part, 4G signals may travel up to several miles while the super-fast 5G signals we’ve heard about may only travel several thousand feet. There is currently a lot of marketing hype around 5G, but right now the coverage is pretty limited. Carriers are widely anticipated to be intensifying their 5G roll-outs over the next several years. It will take a lot more towers, fiber optic networks, and small cells (low-powered nodes that may only have 500 to 1,000 feet in range) to make 5G a reality. The implementation of 5G connectivity will require significant digital infrastructure expansion to get 5G coverage. On the data center side, 5G is expected to support many data-hungry applications (autonomous cars, artificial intelligence, virtual reality, smart city applications, etc.) that require immediate response with no lag time (i.e. ultra-low latency).
That’s where edge computing facilities are likely to be an integral component of the 5G buildout. Edge computing facilities are smaller, locally located data centers designed to store and compute data closer to end users to support data-heavy technologies, provide a better experience, and further reduce latency. Edge data centers can be located just about anywhere but tend to focus on markets where businesses need more local proximity, power, capacity, and connectivity to deliver a cost effective and optimal user experience to their customers. According to PWC, the global market for edge data centers is expected to nearly triple to $13.5 billion in 2024 from $4 billion in 2017.
Part of SC’s data center strategy is to invest in high quality assets with an eye toward secondary and/or tertiary markets. It’s in these markets where management believes there is less supply, less competition for assets, and more attractive yields relative to some of the major data center markets. Secondary and tertiary data center markets might include such high-profile cities as Austin, Houston, Seattle, Minneapolis, Portland, Charlotte, and others. The definition of primary markets is very different than what we would consider primary markets in other commercial real estate investments. There is a lot of new development in hyper-scale data centers in primary markets such as Northern Virginia, Silicon Valley, and Dallas. Also, there are large data center markets in NY-NJ, Chicago, Atlanta, and Phoenix. Interestingly, electricity cost is a major factor, generally making up 60-70% of the tenant’s cost of running a data center.
SC recently invested in a seven-tower project in Iowa, with the seller a community college, seeking to monetize its investment. During the due diligence process, SC’s acquisition team found a number of title deficiencies, missing easements, and inaccurate “rights-of-way” among other issues. The robust background and experience of SC’s team are what helped them through the due diligence process, agreeing to perfect the deficiencies, while still making them a condition to the closing. Performing the hard work that others weren’t willing to do (or weren’t capable of) helped the team to differentiate itself from other bidders and secure the transaction at what they believed to be a very favorable price.
Cell towers are primarily valued based on a multiple of tower cash flow. Tower cash flow is typically calculated as rental income less taxes, utilities, maintenance, insurance, and ground lease expense (if applicable). As such, maximizing tenancy on the tower and establishing long-term leases are critical factors that help determine the value of the tower. The majority of SC’s tower revenues (and many other tower owners) will often come from the top tier wireless carriers - ATT, Verizon, T-Mobile (which now includes Sprint), and U.S. Cellular. The T-Mobile / Sprint merger also saw the creation of DISH as a new competitor in the telecom space and then there are also 100s of local and regional operators that serve as cell tower tenants as well.
After maximizing tenants on towers via lease-up, one of the biggest opportunities for tower owners is to perform lease modifications as the tenants upgrade their equipment to 5G. When newer 5G equipment is added to a tower it is typically done in conjunction with a lease modification where a new, typically higher, monthly lease rate is established. The length of the lease term is usually reestablished and often includes an initial period of 5-10 years with multiple 5-year renewal periods. Like certain types of commercial real estate, annual rent escalators are also generally part of the lease terms. On SC’s Iowa tower portfolio certain tenants have upgraded their 4G equipment to 5G. The cost in doing so is borne by the tenant, similar to a net lease property, where the tenant is responsible for the upgrades. The tenant is also responsible for managing the equipment sheds and the fiber optic connectivity. The maintenance of towers is extremely low. Operational expenses, tenant improvements, and capital expenditures are relatively negligible. The towers are accentuated by very stable consistent cash flows from long-term leases and high-quality tenants with strong credit. Lease renewal rates are extremely high with the broadband carriers, as moving equipment can be very costly, disrupt their wireless networks, and affect coverage for their customers. As such, tower tenants tend to be very sticky.
Did the recent mergers of T-Mobile and Sprint result in some redundancy on some of the towers? For the most part, SC doesn’t expect much consolidation in the near term, as the new T-Mobile seeks to densify 4G coverage while simultaneously rolling out and expanding 5G networks. Full consolidation and the decommissioning of redundant towers can take years. That being said, only about 4% of SC’s wireless infrastructure rental revenues were attributable to Sprint as of June 30, 2020.
In their data center investments, SC is typically responsible for the structure and the tenants are responsible for the equipment in the facility. Responsibility for the structure generally includes the physical building as well as oversight for power, connectivity, and cooling. Tenants on the other hand are usually responsible for the cost and maintenance of equipment inside the data center. This can include servers, racks, networking equipment, routers, cabinets, cabling, remote power panels, back-up systems, and more. Because of these large initial and ongoing expenses, data center tenants (much like cell tower tenants) tend to be very sticky. Unraveling or moving a data center is a very risky, costly, and time-consuming initiative. SC currently has investments in data centers in Hartford, Connecticut, and St. Louis, Missouri, that are leased to one of the largest wireless carriers in the U.S. As of mid-August, SC has another data center asset under contract located in northern Virginia, the largest and one of the fastest growing data center markets in the world. The company also expects to close on an acquisition line of credit shortly.
What has been the impact of COVID-19 on their deal flow? It has been different depending upon the asset type. Wireless infrastructure has been very active over the last six months. There has been some slowdown on the developer side as permitting has lagged due to government authorities’ reduced workforces. In general though, cell towers require very little maintenance and don’t require a person on-site to operate. As such they have stood resilient in the face of COVID-19. In the beginning of the year, deal flow was relatively light, yet in the last several months there has been more transaction volume, with a tremendous amount of leasing activity, perhaps at a three-year high. COVID-19 has really driven the demand for more data as people are telecommuting, distance learning, and conducting more activities in an online, virtual environment. There has been a surge in data demand putting networks and the carriers to the test and data centers have performed splendidly.
Is the infrastructure vulnerable to large-scale outages? SC views the technology as more localized and faster reacting with a smarter grid and artificial intelligence. While not impossible, most data centers and wireless networks have disaster protocols in place to help prevent large scale outages. 5G will also likely facilitate a greater ability to detect problems more quickly, almost simultaneously, and come to quick resolutions.
We asked about the latency that we will have to see when we have self-driving vehicles. There are so many technologies around transportation with vehicle-to-vehicle as well as vehicle-to-road and even vehicle-to-building communication. Think about an autonomous car driving down the street where someone or something gets in the way of the car. The car needs to have an immediate response that is much faster than human reaction. The latency or lag time it takes to send all the necessary information to the car’s computer and make the car stop must be taken down to close to zero. Cell towers, small cells, fiber, and data centers are all likely to be major components of 5G and will be critical in helping to facilitate autonomous vehicles, smart cities, and other low/no latency applications. Given the secular demand drivers and the utility-like importance of these real assets, SC is encouraged by what they believe to be a long growth runway for the sector as well as the potentially favorable risk-return attributes of these investments.
When we asked about the potential for satellite communication systems, Brandon stated that any space-based system will likely still work in conjunction with earth-based system infrastructure. It is also very expensive to launch large clusters of satellites into space vs putting up a tower or placing telecom equipment on a rooftop. On top of that, there would likely be latency issues with satellites given the distance from the user, as well as issues with cloud cover, orbital rotation, rain fade, and more. Today, we use a variety of infrastructure assets such as towers, small cells, fiber, and distributed antenna systems to create a heterogeneous network that keeps us connected. Satellites may very well become another piece of that overall network. But SC believes it’s highly unlikely they will replace all other types infrastructure and offer a single solution. Today, it appears that satellites may be a viable solution for very remote areas with little or no connectivity and a significant lack of telecom infrastructure.
Strategic Capital Fund Management has assembled two distinct investment teams (data center and wireless infrastructure), consisting of highly experienced and knowledgeable individuals to help take advantage of digital infrastructure investment opportunities. When we asked Brandon to summarize his overall position on digital infrastructure investing, here’s what he had to say:
“Strategic Capital Fund Management isn’t betting on who will win the 5G race or which technologies will reign supreme. Instead, we’re investing in the underlying infrastructure that supports technology and telecommunications. Digital infrastructure is an exceptionally dynamic and extremely resilient market sector. Cell towers, fiber networks, data centers and the like provide us with the connectivity and data that we rely on from day to day, so much so that it’s now widely considered a 4th utility. The relative inelastic demand for the services they support helps insulate digital infrastructure assets from economic volatility and, at the same time, helps to generate relatively steady rental revenues. Furthermore, we believe the secular growth trends and emerging technologies point to a long-growth runway and attractive investment opportunities for these assets into the foreseeable future.”
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