Data Center Transparency, Operating Concerns Raise Alarms In Ballooning CMBS Market

Data centers are swiftly becoming a massive pillar of the CMBS market. But as the assets enter the mainstream, special servicers — those charged with working out problem loans on behalf of bondholders — are beginning to question how to evaluate the highly complex and at times opaque developments.

Few loans have reached maturity, and the need for special servicing hasn’t yet been great. But rapidly evolving technology, a lack of transparency and surging supply are raising red flags for the industry.

“If I were investing in the credit for some of these deals right now, I would consider myself woefully underinformed and ill-prepared,” Trepp Head of Applied Research and Analytics Stephen Buschbom said. “It might take something breaking before somebody like me learns the lesson.”

“Sometimes we don't know that the train is going to hit us,” he added.

Prior to 2020, annual securitized loan issuance for data centers rarely exceeded half a billion dollars. In 2021, volumes shot up to approximately $10B, according to JLL. Activity reached all-time highs last year, with asset-backed security and single-asset, single-borrower transactions totaling approximately $30B. 

This year, global originations are expected to reach $50B, according to JLL. 

Data centers typically don’t tap into the CMBS market until after construction. Once they are stable, including being powered and leased, developers shift to bondholder-backed debt.

Developers are funneled to the CMBS market largely because other sources of funding don’t have enough capital to support the growth. Blackstone's QTS Data Centers refinanced three data center campuses in the Northern Virginia, Chicago and Atlanta markets with more than $2B in CMBS debt.

Unlike a typical lender-borrower relationship, the large number of CMBS investors have little control over the asset. As a result, there are more reporting requirements for securities. That can be a problem for data centers. 

Security concerns have made nondisclosure agreements common in the space. Though some so-called hyperscale companies like Microsoft have opted to end their use of NDAs to build trust with communities, others have no choice but to continue the practice. 

Software companies like Palantir and Anthropic, which work with the U.S. military, are beholden to government contracts. NDAs are used to prevent leaks and other national security concerns. 

That can be an issue for special servicers, which rely on tenant and lease information for loan workouts. 

“The value is not necessarily in the real estate,” Duane Morris partner Robert Montejo said. “Most of the value in a data center is in the energy contracts, in the personal property that's inside the data center, in very concentrated tenant risk because of the number of hyperscalers and the amount of the market that they control.”

Data center contracts also include terms that are unusual in other sectors of the industry, said Montejo, who represents data center clients and special servicers.

That can include termination clauses if a developer is unable to deliver enough power to the facility — something that could become more of an issue as artificial intelligence capabilities expand and loans mature.

“Some of these data centers might not be future-proof,” Buschbom said. “Our needs, say five, seven — heaven forbid we even talk about 10 years — in the future will mean that some of these facilities could end up being obsolete.”

To address such fears, hyperscaler leases are getting shorter, with newer leases spanning just four to six years before the first renewal, according to Moody's. Some landlords are negotiating guarantees for tenants to either renew their leases or pay up if they decide to vacate the premises. 

Shorter leases look better on tech giants' balance sheets, and due to accounting standards, renewal or backstop payment agreements don't have to be included in financial disclosures. Moody's estimates that, of the nearly $1T in future lease commitments from the five major hyperscalers, more than two-thirds are unreported on their balance sheets.

That means that without access, special servicers may be left in the dark about the true prospects for a property. 

Mount Street is among the special servicers that have begun building a team dedicated to the sector, leaning on its experience in the infrastructure space. Still, Rawle Howard, who leads the firm’s U.S. platform, called data centers “a totally different beast.”

Underwriting the real estate can already be complicated, but the biggest issues may arise if and when defaults start rolling in.

“You can't just grab a bunch of property managers and go in and take over the property, because you need specialized resources,” Howard said. “You need engineers who understand power, cooling, all the equipment.”

That equipment is only becoming more complex as data center developers find ways to create energy themselves, as opposed to plugging into the grid. 

To power its data centers, Google is investing in geothermal technology. Switch operates five exascale campuses, supported by thousands of acres of utility-scale renewable energy projects. Nearly half of Oklo’s microreactor project pipeline is dedicated to data centers.

Intense operating needs could give borrowers an advantage over inexperienced lenders or servicers in reporting and negotiations, Howard said.

“Do you really want to give a servicer or a lender the keys to a nuclear power plant?” he said.