Data centres – here today, here tomorrow: German landscape ripe for growth

Ruth Harris:

Hello and welcome to Ashurst podcast series on data centres, here today, here tomorrow. I'm Ruth Harris, a finance partner specialising in data centre financing. And I'm joined today by Rebecca Clarke, a partner in our digital economy team. This is part of a series of podcasts where we connect with our global data centre teams and explore the data centre market in different jurisdictions across the globe. In previous podcasts we've covered the UK, India, Middle East, France, amongst others.

Rebecca Clarke:

It's great to be joined by Stefan Bruder, Derk Opitz, and Marina Arntzen, welcome everyone.

Marina Arntzen:

Thanks, Rebecca. Great to be here.

Stefan Bruder:

Indeed. Great to be here, Rebecca and Ruth.

Derk Opitz:

We are excited.

Rebecca Clarke:

We're very much looking forward to exploring the recent activity in the German data centre market with you. I think Germany is sometimes stated as the largest data centre market in Europe with over 500 operational data centres, but it's not the number of data centres that matters. It's the size and it's the type, whether it's an AI factory or an edge data centre or something else. It's all about the fit out and flexibility, which is key. But whichever way you look at it. Most sources agree that the data centre market in Germany, just like in the UK, is on a growth path and expected to grow by about 13% year-on-year between now and 2030.

Ruth Harris:

That's right, Rebecca. That's what we hear. And I expect that the drivers of demand in Germany are the same as in the UK and across the world, so driven by a politically supported AI arms race, also general demand for cloud adoption, expansion of AI, machine learning, and the broader digital transformation of German industry, and of course, sovereignty of data. So in this podcast, we're going to be asking Stefan and his team about the data centre market in Germany. I'm going to ask them what type of funding and investment structures are being used, who's active in the market right now? Where's the capital coming from? And other things. Rebecca, what else shall we cover?

Rebecca Clarke:

We'll also cover some of the challenges such as connectivity and what is being done by way of a regulatory framework to support speed to market, but in a responsible and a sustainable way.

Ruth Harris:

Okay, great. So Derk, let's start with you. Could you give us an overview of the data centre market in Germany right now? And we'll take it from there.

Derk Opitz:

Sure. The market is still hot and we do see continued demand for data centre exposures across all asset classes. Frankfurt is still the centre of the market, why? The D-E-C-I-X is located in Frankfurt. D-E-C-I-X stands for Deutsche Commercial Internet Exchange, and it's one of the largest internet exchanges in the world. And so naturally, well, the market started here and most data centres are located here. By the way, I'm based in Frankfurt, but the market starts to get saturated. And at the moment, if you want to plan a data centre in Frankfurt now, you won't get a site allocated before 2030. So we do see clients doincreasingly shifting to other locations. And I would say Munich and Hamburg are probably now the next, well, core locations for data centre.

Rebecca Clarke:

That's great to hear, Derk. Do you have a feel for the size of the market? I know it's sometimes difficult to decipher between reality and aspiration about what's being built, what is under-planning, and what is just, as I said, pure aspiration.

Derk Opitz:

I think as you said on the outset, well, depending on who you ask, Germany is the fourth or fifth-biggest market for data centres in the world, depending on if we want to put us ahead or behind the UK, but for sure it's a big market. So if we look at investment volume, we currently stand at roughly a €9.1 billion, and we are expecting that to grow or to double in the next five years. What does that mean in IT load capacity? We currently stand at 3.4,000 megawatts and expected to grow to 6.2,000 megawatts. What's aspiration? What's reality? It's really difficult to say. We come onto that. Generally, and you said it at the outset, we are expecting a growth rate of 13 to 15% per annum. However, we do face practical problems, and I think we come onto that later on.

Ruth Harris:

That's great, Derk. And you know very well that I'm very competitive with the market in the UK. So let's say we are slightly bigger than. Though I was surprised you weren't giga bragging then because you were using the thousands of megawatts and I'm going to use gigawatts. I think we're about the same, about three gigawatts now in the UK, but it sounds like we're more aspirational. We predict growth to 12 gigawatts by the end of 2030. So let's see. And we've got 15 billion, it says invested, or I have read, is invested in the UK right now and going to double that by 2030. So let's track that across the next five years and see who wins. Over to you, Marina. We've talked in other podcasts about the need for collaboration to enable speed to the market and then consolidation, I should say, of the market. What are you seeing in Germany by way of collaboration, either with domestic participants or internationally? But let's maybe start with the M&A activity that you're seeing.

Marina Arntzen:

Sure and let's do that. So the M&A market for data centre remains highly active. It's driven by a strong investor appetite for digital infrastructure and limited high quality supply. And despite the higher interest rates, the valuation level remains resilient and particularly for platforms with secured grid connections and late state development assets.

Ruth Harris:

Okay. And is it easy to get this secured good connection or are you experiencing constraints like most other jurisdictions?

Derk Opitz:

Well, maybe I pick that up and this will be a common theme today. We have the legal world and the reality. From a legal perspective, it should be easy to get grid connection because the four big TSOs are under a statutory obligation to grant non-discriminatory access. The problem is that the TSOs, they don't really have a pre-qualification scheme. So they treat every filing for grid connection with the same priority. And so it is not assessed. A filing is not pre-assessed for feasibility and reliability of the proposal. So the TSOs are overwhelmed with speculative filings. There are shady investors out there who try to get grid connection and then do something with it. So grid connection is doable, but it's not as easy as it should be.

And to look ahead, we do expect that the legislator at some point to step in because grid connection is becoming a problem for other asset classes as well. We are facing the same issues for battery storage. And so on the long run, things should improve, but at the moment, this is a practical bottleneck.

Ruth Harris:

Well, that sounds very similar with the UK. And actually we've started now seeing movements of the government and the grid operators to look at those lists of people waiting for connection and to actually assess whether they're real needs and actually reorganise that queuing to prioritise those with real needs and a proper plan put together.

Rebecca Clarke:

And just bringing Marina back in now, what kinds of data centre assets or platforms are attracting investor retention in Germany?

Marina Arntzen:

Thanks, Rebecca. Competitive tension remains strong in processes, especially involving platforms with proven delivery teams, not just land permits. And the execution capability is becoming the key valuation driver. And I can tell you maybe some example. We have recently advised MEAG on a significant investment in a data centre platform, and it was a consortium consisting of MEAG and GIC, and they acquired these data centres from Vantage Data Centres, and the acquisition includes four state-of-the-art data centres. So two were located in Frankfurt and two in Zurich. And these facilities have an IT capacity of 72 megawatts. And this transaction builds on the first successful investment partnership between, on the one hand Vantage and on the other hand, MEAG. And it includes six data centres in the UK and in Germany with an IT capacity of 177 megawatts.

Ruth Harris:

That's the first of many of those investments. Stefan, you've also been watching this market, who are you seeing investing in the German market?

Stefan Bruder:

Well, actually the MEAG example Marina just gave gives already a flavour of the kind of not only deals, but also the investors coming to Germany. Obviously, there are strategic operators that themselves also try to consolidate the market to a certain extent. So they really also seek sometimes to invest into smaller operators, into smaller data centre platforms just in order to achieve a certain amount of consolidation. The real push, however, now from the equity side comes from the private equity sponsors and from the infrastructure funds. They in a way invest a little bit differently themselves. So the way we see it in Germany and to a certain extent, continental Europe, is that the PE sponsors like to invest in real platforms, including maybe also development and operating capacity in order to hold them to a certain extent and grow them and maybe then sell them off.

Stefan Bruder:

As opposed to infrastructure funds and for that matter, also certain sovereign wealth funds from all over the world that may be more invested in the underlying assets, more interested in the underlying data centres that may come in then at a later stage of a data centre development, or trying to invest in certain sub parts of bigger clusters in yield cost and so on in order to then hold them for a longer run. And then increasingly, we see also corporate buyers coming in, like energy utilities, telecom companies, fibre operators who simply try to achieve a certain consolidation with their investments or their own operations in adjacent markets to the data centres. And that's certainly a trend to watch, would be interesting to see how much materialises and their competition to the other investors I've mentioned.

Ruth Harris:

Well, that's great. Obviously lots of interest from lots of different areas and lots of different investors, so no wonder it's such a booming market. I wonder who's financing all of this? So I'm going to turn to Derk now to ask who's providing the leverage. I haven't seen traditional German banks so much, but maybe that's just I haven't seen them in our market. Derk, over to you. What's it looking like?

Derk Opitz:

Ruth, you're right. The financing market is dominated by the international banks and we don't see the traditional German banks on the market yet. And the main problem is that the German banks, most of them are mortgage lending banks and in their rating tools, they cannot assess a data centre because the ground, just looking at the ground, it's not worth much. And so the valuation is on a pure cashflow basis. And the mortgage lending banks simply cannot appropriate that just on the basis of cash flows. So, traditionally we see in the German market, we see the international banks, we see the debt funds and the German mortgage lending banks. So the mortgage lending banks are not active yet, and the same goes for the debt funds. In other asset classes, they became really an important funding source.

Derk Opitz:

Here, they struggle with the flexibility requirements in the construction phase. You know that, and it's the same in UK deals, sponsors are asking a lot of flexibility from their lenders in the construction phase, and some debt funds, they just don't have the organisational structures for that. So it's a market for international banks, and that leads to that the pricing, from the perspective of the banks is not that much under pressure as other asset classes. And we do still see higher debt margins than in other comparable asset classes.

Ruth Harris:

I'd agree with all of that Derk. But what I would add is that what we're seeing is that the debt funds are now looking to move up that risk curve and understand the asset before construction is starting, even before perhaps a customer contract has been signed and then pushing it to before even power has properly been secured, maybe a grid offer achieved, but not actually connected. So this is a really interesting space and it's really interesting to work with debt funds and other lenders on that journey to get involved with an earlier part of the risk curve. But I wonder if I could just move on in Germany then to any licencing requirements that listeners may need to know about if they're looking to lend, or let's take it broader, perhaps let's say if anyone's looking to invest in Germany in data centres, what would they need to be aware of, Derk?

Derk Opitz:

Let's start with lending requirements. Generally inbound lending into Germany requires a licence. And so if you want to advance commercial loans into Germany, you have to have a licence in Germany or European passport, i.e., a licence in a country of the European Union. So there are certain exceptions, and the most important exception of that is the so called non-solicitation or rule of a passive freedom to provide services rule. So you are free if an international lender doesn't target the German market and it's not solicitating its activities, but is approached by the sponsor to lend, then that party would be exempt from the licence requirement, but it's something to be very cautious which has to be looked at very carefully because breaching the licencing requirement is a felony in Germany and our financial regulator does look at it every once in a while.

Derk Opitz:

And obviously, we don't want to be on the transaction one out of 20, which is actually scrutinised by the regulator. One other thing which has to, when lenders like project finance lenders or let's say non-real estate lenders come into Germany and finance data centres, it has to be, there will be a withholding tax issues because data centre are located in real estate and every direct or indirect income from real estate is taxable in Germany. And so this is something to look at that there's no withholding tax applies. Then moving away from just pure financing and looking at inbound investment more broadly, data centres are critical infrastructure, and so they are subject to German FDI rules.

Derk Opitz:

And that means when the investment has a certain size, the starting point would be 3.5 megawatt of contracted capacity, then any acquirer or any financier who's a non-EU or a non-EEA entity will have to file its investments and it needs to be approved by the federal government. So we didn't have many, many problems recently. Usually the federal government does approve and they have a certain time period. They have to approve within two months, so it's nothing that's going to hold up the process dramatically, but it's something in particular for non-European investors to keep in mind. And the government is becoming more cautious on investment and critical infrastructure.

Ruth Harris:

That's interesting. Not the same, but similar to our National Securities and Investment Act, which has been in the UK since January 2022, but I don't think ours is as broad reaching as yours. So maybe that's something to watch this space on in the UK. Thank you for that. That's really interesting.

Rebecca Clarke:

It just goes to show that governments around the world are really recognising data centres as critical, and I think this is reflected in the FDI rules and regulations. So just moving on a little bit, Marina, are there any particular kinds of investment models which are being favoured by investors in Germany?

Marina Arntzen:

Yes, Rebecca, we continue to see at least five kinds of investment models being favoured by the investors, which are preferred investment models. And we start with a structured equity and a preferred equity model. That means investors take a preferred return with downside protection, often sitting between pure equity on the one hand and debt on the other hand. Then we have a mezzanine capital model that is frequently used when traditional lenders remain conservative, provides higher flexibility, and especially during development phases. Then we see, as I've mentioned, for example, in our MEAG transaction and in the Aquila Capital transaction, we have seen joint venture and development joint venture structures that's increasingly popular for capital intensive projects.

Marina Arntzen:

And then we see real equity investments. They are very common and typically structured on a portfolio basis rather than the single asset deals. So we see it often for larger developers like Vantage on edge scale. Then we see a fifth structure, which is preferred. When you look at the investor structures, these are yield cost structures and they are emerging where subsets of development assets are carved out for financial sponsors to invest. That's often targeting higher yields and early stage projects.

Ruth Harris:

Thanks, Marina. And Stefan, I know you were lead counsel for Aquila on the investment by Bain. I think it was the AQ Compute subsidiary. And also were involved in the MEAG transaction that Marina mentioned earlier on. Are these typical transactions we expect to see now in Germany? And maybe tell us a little bit about the drivers behind those investments.

Stefan Bruder:

Yes, of course. In a way they are typical, but in a very, very different way, honestly. The Aquila Bain joint venture, which is now known as hscale actually, is really the example of a private equity investor coming in, really investing in a development operating platform and really to build scale. So yes, this is a typical example. At the same time, I think there are limits in how many of these platforms actually can be established, but we see it that other PE investors also are doing the same or like to do the same. Again, I would say this is also not typical for Germany only, but I think these platforms have to be seen more in an international context, maybe in continental Europe, maybe including UK, maybe also including the Middle East, for example. In that sense, maybe the other type of structure, which is more yield cost structure, is more typical in terms of numbers.

Stefan Bruder:

And I would predict that we see them much more frequently now for the following reason. They provide a structure where other type of investors, as mentioned before, like Infra investors, like Sovereign Workforce can invest in. They can invest in certain subset of assets they like for whatever reason, depending on the size, the location, the development stage. And we've also seen a lot of discussion when we have larger transactions maybe involving, again, various jurisdictions, that as a subset of these transactions, we see yield cost structures being carved out in order to enable other type of investors coming in from various jurisdictions. They provide the beauty that, again, they can be shaped in the type of location, the type of development, but also in the type of size and also the returns honestly, and maybe then pose less of a threat for some investors of taking too much of a development risk.

Ruth Harris:

Okay, that's really interesting. And Marina, you mentioned mezzanine financing. I'm just going to ask Derk about the evolution of funding models. We've spoken a lot about this recently, for funding models across Europe. Shall we maybe talk a little bit about how these models have evolved in Germany?

Derk Opitz:

Sure. Generally, when you look at. When we have new asset classes in Germany, Germany pretty much follows the UK market. I think on the financing side, to us, it feels we are two or three years behind UK in terms of structures. So I think, and as you mentioned earlier, debt funds are more active already in the UK and I assume that we are always a bit slower, but I assume this is going to be the same development. So there's no uniform standard on debt financing. It's somewhere between project real estate and leverage finance, and it really depends on the type of sponsor and the type of project. So there are two maybe trends. So as a rule of thumb, when we have strong sponsors, they tend to simply impose their international financing standards. We acted on the financing for the Mainova Webhouse platform, which has BlackRock as sponsor, and they are using what they're using in the UK.

Derk Opitz:

And so it's a more leverage type of documentation. So that's one trend. But moving away from the parties in terms of types of transactions, the platform financings, they're usually more leveraged styles. Here a business is financed and it looks a bit like a leveraged financing with real estate security. On the other hand, the standalone hyperscalers are sometimes just really financed as similar to a real estate financing. And obviously background is to make use of real estate rates. And so that's the scale. We start with flexible leverage financing structures on the one hand and on the other spectrum with really real estate type of transactions, very restricted covenants, limited purpose.

Ruth Harris:

And also driven by which desk within the bank is actually driving the transaction. That sounds all very familiar. Thanks, Derk.

Rebecca Clarke:

Before we come to a close, I just wanted to ask about the regulatory framework in Germany. We sometimes hear that investors can be put off because of the regulatory frameworks within Europe, and that's not just in respect of data centres. How would you respond to that?

Derk Opitz:

Well, a German lawyer answers every question with, "It depends." And it's similar to what I said to grid connection earlier. If I look at the laws itself, on the regulatory framework, then it's very light touched. You need just one permit for the operation and the construction of a data centre, which is the building permit. And that permit has what we call concentration effect, i.e. it includes any other permits, any other laws which have to be applied, for instance, environmental laws. So in theory, an investor just has to go and get one permit. There's only one other permit which is relevant, but that's not for the data centre itself, it's for the backup power. If the backup power is a diesel generator, then there might be another permit for the noise emissions, but that's it. The problem is, Germany, this is all federal law, but federal law is applied at a local level.

Derk Opitz:

So what we do see is investors are facing practical problems. The competent authority who's deciding over data centre is the local building office at the municipality. And so the speed of execution depends on the priority set in that office and the staffing. And so Frankfurt tends to be quite good because there's lots of experience, but we are doing a portfolio of edge data centres in what I would call B locations, smaller cities. And it's very, very different throughout. There are cities, you get your permit straight away and there are cities, it appears they're sitting on their hands for six months. So to sum it up, it's the same with grid connection. In theory, the legal framework, on the paper, it's very investor friendly, but in reality, you do have practical problems with the bureaucracy.

Rebecca Clarke:

I don't think that's just limited to Germany, to be fair.

Derk Opitz:

That's good.

Rebecca Clarke:

And I think we experience that in many jurisdictions. Just another quick question around the Energy Efficiency Act and the obligations to report on power usage effectiveness for data centres over 500 kilowatts. What has been the response from operators in Germany? And is this information published? Is it available?

Derk Opitz:

To be honest, from our side, it's not available. And from our perspective, I'm not sure whether it already hit the equity side, so then it's something for Marina and Stefan, but on the debt side, I can only say this is something yet to be seen.

Ruth Harris:

That's interesting. And same on water usage effectiveness as well?

Derk Opitz:

Correct. But something will happen because we recently had some surprised calls from our clients whether this is already built into the documentation. And then the answer was no, currently from the financing side, there's not yet a focus on it.

Ruth Harris:

Okay. So we're seeing that sneaking into our documentation have done for a while actually, at least a requirement to report. I think some of the issues are whether or not that information is available, but we're definitely seeing a movement in that direction.

Derk Opitz:

On the financing side, you have to give us the two years to catch up, so maybe we can talk about it in a year's time.

Ruth Harris:

Will do. I know you said, Rebecca, that we're running out of time. I wonder if we have time for one more question. Derk or whoever wants to answer this, We have a certain level of government support for investment in data centres in the UK, and we just had the budget yesterday where for the budget announcements in favour of the compute ecosystem in the UK and AI research, et cetera, has just been announced. What's being done by the government to encourage investments in data centres? Anything by way of designated growth zones or special tax treatments or anything like that? I noted as well, Brazil's really pushing on this with very favourable import tax now. They've dropped their rates considerably. Is there anything or any news of anything or any rumours something's going to happen in Germany?

Derk Opitz:

I can start and maybe the others chip in. From my perspective, there is no digital strategy in Germany. And for fibre rollout and data centre, there was a little bit decision made that it's left to the market and there's no central support scheme as you, for instance, see it in France where there's public support in areas or where there's market failure. And that's not the case here. And so generally, as mentioned, the regulatory framework is investor-friendly, but it's lacking implementation, but there's no speeding up processes or no priorities and so forth. And if we just look from beyond data centre to other digital infrastructure assets, the support for the rollout of fibre networks really depends. It's different from municipality to municipality.

Derk Opitz:

Some put priority on it and some don't. And so generally, maybe to take the optimistic view, something ... It can only get better. And now for the first time, we do have a ministry for digital affairs, so maybe things will improve, but at this stage, the national digitalization plan or something is just not there yet.

Stefan Bruder:

Exactly. And maybe to sum it up in a slightly different way, so of the two previous questions. I guess there's a lot of talk from the political side, what to do about the digital infrastructure. And I think there's also willingness to do it. At the same time, at least from my perspective, the focus is a little bit different in the sense of that an asset class like data centre is seen to be important, but I think in a way also sufficiently be equipped by all the investors coming in, as mentioned, from various shapes. I guess it's less a question of will there be incentives, but will there be more streamlining on the questions of licencing, grid connection, and so on, in order to give it a better framework, a faster framework. And I think there we do see indeed a political willingness to make all of these regulatory, statutory framework questions more investor investment friendly than it is currently.

Ruth Harris:

Okay. So Marina, Derk, Stefan, I'm afraid that's all we've got time for today. Thank you so much for your interesting insights into data centre investment activity in Germany. And thank you to our listeners for joining us.

Rebecca Clarke:

To learn more about Ashurst data centre experience across our global network, please contact us or visit our data centre hub at www.ashurst.com, where you'll find lots of interesting resources, including our Jargon Buster. Data centre projects are often multidisciplinary, so there's lots of room for collaboration. Please get in touch if you'd like to speak to any of our specialists across the globe in relation to any aspect of your data centre project.

Ruth Harris:

Thanks, Rebecca, and thanks everyone. Our next episode of Data Centres, here today, here tomorrow is going to be from Madrid, where we'll be joined by Ismael and Irian amongst others, to bring us up to date with what's happening in the data centre sector in Spain. So looking forward to connecting again then, but for now, goodbye.