Data centres – here today, here tomorrow: Financing data centres in Spain’s booming market

Ismael:

Hi, everyone, this is Ismael Fernández. I am responsible of the real estate practise in Spain, and today we're going to talk about data centres, about how this asset class is being tackled by investors here in Spain, in the Spanish market. We have with us today my partner Jose Christian.

Jose Christian:

Hi, Ismael. So I am heading the banking team in Madrid, and I will cover the financing aspects of data centres in Spain.

Ismael:

So which we has been involved in a few presentations in the market so far, just to give a brief of introduction about the market, this is a booming market right now. Spain has gained a lot of interest recently and this is due to several reasons. The main one is linked to the fact that is expected than 70% of the data which are supposed to cross Europe, should be passing through Spain because we have those tables which come from the US arriving to our coasts. And it seems that they are going to manage a lot of information, a lot of data.

The main element we are seeing in the market is that it's not just for investors or investment funds, those who are coming to our market. Is that we are seeing companies which have a track record or knowledge linked to some part of the value chain of data centres, which are also trying to create their own companies in this subsector, this is the case for example of ACS, which is a construction company, and they have created a company called Iridium, which is their brands as regards to data centres. And this is also the case with Ferrovial, which has created its own data centres company and in fact they have hired a CEO coming from the US. Same happens with all the companies, which activity is for example, energy or electricity such as Iberdrola. Many of them are trying this just to expand through the value chain of the data centres and not just focus in one of the elements they are doing already. Jose, if you want to add something to what I said, how do you see market?

Jose Christian:

Well, I think from our perspective, market is booming and we are seeing lenders being more and more involved and trying to bridge the learning curve to get up to speed with technical developments, et cetera, and see how they tackle financing and data centres.

Ismael:

So because of this situation where the market is just starting for us, there's a lack of knowledge in the market and that's why we have been lucky enough to carry out some transactions, some of the few transactions which have already happened in our market. And that's why we are attending seminars and doing presentations, not only to clients but also to other agents such as students at university. And this is one of the elements we want to talk about today is about the seminar we organised at Universidad Autónoma de Madrid last week, where we were talking about data centres with representation on the concept of data centres. First thing we have to say is that as it happens, and this is one of the topics we covered during the presentation, is that data centre, which in the end is the combination of three main elements, which is the physical element is the continent, this is the real estate element. Plus equipment, industrial equipment which is required for the data centres to operate, is mainly what is called the MEP, which is mechanical electricity and plumbing.

And finally the third element which composes a data centre is the digital infrastructure, which is basically software and hardware. So we presented this because obviously the kind of audience we had that day, they had no idea about what the data centre is, but obviously they know what data is because this is the kind of people who heavily uses data through the social apps. And after that we described each of these three elements trying to explain and trying to show how difficult it is for clients these days, for investors, how difficult it is to find opportunities in our market because you require from just legal perspective, the first element you need is a plot of land suitable from a zoning perspective. So that's where we cover this zoning element, where the main issue we are seeing is that the Spanish zoning system varies from one region to the other and its town hall, it has its own, what's called the zoning plan, which sets out what uses can be developed in each of the plots of land.

So the concern here is that in some cases they are not up-to-date in the sense of they are not including this new type of uses like a data centre one. So they are trying to accommodate in many, many occasions to already assisting recognised uses within the zoning plans. For example, industrial use. They are saying industrial is the category where the data centre could fit well.

And the other element, apart from the land, is power connection, which is, as it happens with many other jurisdictions, is one of the difficulties linked to the fact that the electric grid has not enough capacity to attain the booming and the day-to-day increasing demand on public capacity. So once you have a land and you have a public connection, it's like having gold in our market right now. A few months ago, we closed a transaction selling a plot of land which had this power connection attached and this was about 60 megawatts on the price, it was 75 million euros, which is a huge, huge price. I'm not saying that it's not worth it, but this is the kind of magnitude we're talking in this market.

Then after talking about the element of the plot, plus the power connection, then we talk about the process to make those elements converted into a real data centre, which in the end is again talking about zoning and licencing, is getting the authorizations. But we have here two kind of authorizations. One has to do with the right to build, to develop the building. Plus the right to use it and open it, plus the right to materialise the power capacity, electricity which was attributed or given to the plot of land. After that, we cover a bit about how these investors make money, which in the end is how they commercialise the asset one is already in place. And this is basically linked to the idea of lease agreements entered into with operators who in the end are those who are going to paid the rent. And we explain a bit about the different type of lease agreements though, mainly three of them, which is the triple net lease agreement where all economy risks are with the tenant, which assumes obviously the CapEx also pays the rent which is linked to the space they are using, plus what is called the essential low cost and the critical low cost.

These are the concepts linked to the consumption of the equipment which is installed in the data centre, plus the electricity consumption linked to the cooling of this equipment. The proportion of the ratio between one and the other is what is called the PUE, power usage effectiveness, which is one of the key metrics used to evaluate the capacity of a data centre. In fact, for example, if we say that the data centre has a PUE of 1.5, means that for one unit of power required for the equipment to operate, you need half a unit to keep it at the right temperature. And after that, Jose, you were describing a bit about the issues linked to the financing of these projects.

Jose Christian:

Yeah, exactly. Thank you. Thank you, Ismael. So again, this was a talk given to students at university, but there's some conclusions that are useful generally. So going back to basics, financing of data centres will always be a non-recourse or limited-recourse financing, i.e., the asset as such and the revenues of the asset should be enough to repay the financing. It will typically be a secured financing and we'll get into that in a minute. Well in the current world we're in, there's a push for it to be green financing as well. And with this in mind and generally regarding data centres, the EU has issued some rules regarding KPIs that data centres need to meet from an ESG perspective and that includes, as Ismael was saying, power usage effectiveness, but not only in terms of sustainability, but also water usage and cooling efficiency and data centres undertake to report on that regularly and lenders will of course keep an eye on that and impose certain other takings linked to that in the financing.

Now how do banks or lenders generally look at financing of data centres? The different ways to look into it. So we can be looking at greenfield data centres, so financing the construction from scratch. And in that case, emphasis will be put on the construction itself. And there are certain measures like loan to cost that will be relevant. And generally the discussion is whether you look at data centre financings as real estate financings or project financing. Different banks look at it from different perspectives and some of them source it from the real estate teams and others source it from their projects teams. So if you look at it as a real estate financing, the emphasis will be heavily put on the assets and the data centre itself. And in terms of security, what that means is a lot of weight will be put on the ability to have a mortgage over the data centres.

This brings with it costs since mortgages are registered securities in Spain and they bring with it stamp duty, the percentage of the stamp duty depending on the region in Spain where the data centre is located. If you look at this from a product finance perspective, the emphasis is put on the off takers on the hyperscalers. If the data centre just leads to hyperscalers or on the co-locators, if it's a colocation data centre with multiple tenants, in inverted commas. And so emphasis will be put on them and on the cash flows and the ability to generate cash flows and possible penalties you might have in the lease agreements in case connectivity doesn't work properly, for example. And that will entail that the facilities agreements are designed slightly different depending on where you put the weight. And there's another type of financing that we're already starting to see, since in some cases we are already seeing data centres that are being sold to new investors who either purchase a single data centre, or a company owning different data centres.

And obviously, in that case, the financing takes more of a shape of an acquisition financing where the emphasis is put A, on cash generation, but also B, also on the leverage of the transaction as a whole. One important feature that we found needs a lot of explaining and hand-holding is a feature of data centres called NDAs, non-disturbance agreements. Basically, when you have a data centre with significant tenants, they will want to ensure that regardless of who provides the financing to the owner of the data centre, if things go south and security ends up being enforced and the data centre ends up in the hands of somebody else, that new owner of the data centre cannot disturb the lease agreement the relevant hyperscalers has with the servers in the data centre. So that is a bit opposite to what we see in other sectors and it puts a lot of power on the hyperscalers with lenders having to adapt to the requirements of the hyperscalers. I think that's a summary of what we discussed. Ismael, I don't know if you have anything to add to that.

Ismael:

Yes, it might be interesting to understand how do you see the banks in the sense that, do they understand the product? I guess there's a long way to go yet. Do you see a difference between Spanish banks or French banks?

Jose Christian:

I think a lot of effort has been done and they are gaining a lot of traction and knowledge in the last year or so. I don't see a huge difference between Spanish and non-Spanish banks probably because the deals we've looked into with non-Spanish banks have been managed out of the teams here. So probably the knowledge of the market is more or less the same, but there's still a lot to be done in terms of understanding all the intricacies and the underlying drivers and the technology developments that can make data centres more efficient, and where you need to put the emphasis in the facilities agreements. Just to give you an example, in the last deal we did, there was significant handholding required in terms of NDAs. Obviously all the fundamentals of the facilities agreements, I mean they know them better than we do, but in terms of NDAs, there was this need for explanation and see how far we could go and what was a no-go for hyperscalers.

Ismael:

Yeah, thank you. I asked because from my perspective on this already happening in the past, you see real estate investors moving to the next asset class and while this was obvious when they started doing logistics a few years ago, logistics is not that sophisticated. I mean in the end it's just a box and it's not difficult to develop a logistic platform if at least you have already developed other asset classes. But in the case of data centres, we are talking about different beast. And this is something we are seeing in the sense that although many of them are interested data centres are looking to do data centres, you need credibility, the operators have to trust you, need to trust you, otherwise they are not going to enter into an agreement with you on the basis of a future data centre. And this is the kind of situation we're seeing in our market where many real estate investors are struggling, because they are not known by operators and in the end it will be difficult for them to really get a data centre running, to be honest.

Great. Thank you so much for joining us, Jose. It has been fascinating to hear your thoughts. Obviously I think we will be interested to hear what our colleagues report following further events as José is hosting in the coming weeks because this is a very hot topic for us as well. And thank you very much to our listeners for joining the podcast today. As always, we are really keen to hear from you to get your own views on the issues we have discussed. So please do get in contact. Thank you very much indeed. And do visit our data centre hub on Ashurst.com.