Welcome to the latest edition of Inside Real Estate Today. My name is Rich Hill. I'm global head of real estate strategy and research at Principal Asset Management.

Today, we're diving into everyone's favorite topic-- data centers. Three points in particular-- number one, despite strong historical performance, we think many investors are unallocated to the sector. Number two, we see strong growth in the future driven by the emergence of a secular megatrend. And number three, what key themes should you be watching in the future?

So let's dig into returns. In the private market, according to NCREIF, data centers have delivered cumulative total returns since 2019 of around 75%, of which 50% is capital returns and 50% is income returns. In contrast, the overall private real estate market has delivered around 24% returns, including negative 4% capital returns.

What about the public markets? Well, since 2016, data centers have delivered 215% cumulative returns, making data centers the second-best sector of REITs. In contrast, listed REITs overall have delivered 77% cumulative total returns over the same period of time.

That said, listed REITs only make up 9% of listed REIT market cap. That's up from 0% in the early 2000s, but it's still relatively small compared to their performance. The private markets have even smaller allocations to data centers, at only 2% of the $25 trillion market in the United States.

So why are investors attracted to data centers? We think it's for three primary reasons. First of all, they have stable cash flows that are relatively insulated from economic cycles. Number two, they have a strong growth outlook driven by the emergence of a megatrend, such as cloud adoption and AI. And number three, their development yields of 8% to 9% are compelling relative to other commercial real estate sectors.

So how strong do we think growth is going to be over the next five years? According to Green Street, revenue per available facility is expected to be 5.4% in the U.S., compared to around 5.2% in Europe. Everyone talks about megatrends, but what does this really mean? Well, there's three things I would point out.

First, colo locations, which I'll talk about in a little bit, have doubled from 2020 to 2024. Second, digital data created may increase 2.6 times over the next five years. Then, finally, Dell predicts that data center needs will increase more than 100 times over the next 10 years.

Finally, what key themes are we watching in the future? First, location matters because you can't build a data center just anywhere. They need to be in low-cost markets with reliable power and low natural disaster risk. Ideally, they would have access to renewable energy.

Secondly, cost efficiencies matter and have been coming down. Power usage efficiency stood at around 2.5% in 2007, compared to around 1.5% today, and many properties are even lower. What's driving these efficiencies? It's things like liquid cooling and sustainability, both of which are in focus.

Third, data centers are evolving. In the past, we've talked about co-location and hyperscale. But now we're talking about cloud, inference, and generative AI. What are these three things?

Well, cloud is when you and I go on Amazon and shop for a good. AI inference is when you and I go on ChatGPT and prompt it. Generative AI is training models for future AI needs. We're really focused on cloud and AI inference because we think there's way more demand than there is in supply. We think generative AI is a bit more speculative. And while we might power land or even compile land together, we would be remiss to go vertical on it.

The final theme we're watching is what we call futureproofing.

We are already seeing some older data centers being redeveloped to take advantage of the new technology. And new data center development is making sure the space can be flexible to adapt to new technology over the next 5 to 10 years.