Ji Zhang, CFA
Portfolio Manager, Global Real EstateMore by this author
Harrison Klein, CFA
Senior AnalystMore by this author
15 minute read
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Artificial Intelligence is a transformative technology that we believe will be a net positive for real estate, though it has the potential to create both winners and losers across the investing landscape.
- Artificial intelligence is a transformative technology that has the potential to create winners and losers across the real estate investing landscape.
- We expect data centers to be early winners and longer- term beneficiaries of AI; new workloads should increase power consumption amid limited supply, translating to elevated data center demand and pricing power.
- We believe AI could be a net positive for real estate, though scenarios range from accelerating drug discoveries, which could increase demand for life science, to displacement of jobs, which could lead to lower demand for office space.
Over the past few decades, we have witnessed several transformative technology cycles: the proliferation of personal computing, the growth of the internet, the rise of social media, and the mobile revolution. Artificial intelligence (AI) appears to be the next technology with this transformative potential.
While AI has been progressing for decades, OpenAI’s release of ChatGPT in late 2022 brought language-capable artificial intelligence into the mainstream, catalyzing a rapid acceleration in investment, with the potential for mass adoption of technology. We believe generative AI is likely to have wide-ranging applications across the economy, and this technology has the potential to transform sectors across markets, including real estate.
Though still early, we believe AI has strong potential to be a net positive for more than half the investable universe for REITs, improving operational efficiency for sectors such as healthcare and hotels, while leading to increased demand for data centers and towers. On the other hand, traditional office, which represents 3.1% of the investable universe for REITs, could see lower demand due to job displacement from AI.
AI revenue is expected to grow significantly over the next several years. Leading research firms estimate annual AI growth between 18% and nearly 30%.(1) Bank of America estimates the growth will culminate in a total addressable AI market of $900 billion by 2026 (Exhibit 1).
Global AI market expecting 19% annual revenue growth
AI market size ($billions)
At September 12, 2022. Source: BofA Global Research, International Data Corporation. There is no guarantee that any market forecast set forth in this presentation will be realized. The mention of specific sectors is not a recommendation or solicitation for any person to buy, sell or hold any particular security and should not be relied upon as investment advice.
(1) Source: International Data Corporation, Bank of America, Morgan Stanley, CBRE Research, JPMorgan Chase.
Cloud service providers at the leading edge of artificial intelligence have pointed to a growing revenue opportunity and corresponding acceleration in capital expenditures to capitalize on AI.
A large supplier of AI hardware and software reported it has seen a surge in AI-related demand, resulting in second quarter 2023 data center revenues up 141% from the first quarter. Most of that growth is being led by accelerated computing requirements from cloud service providers, social media platforms and corporate enterprises across the automotive, financial services, health care and telecom industries.
One of the top-10 cloud providers has identified next-generation AI as a potential $10 billion business line and has signaled higher data center investments to support AI adoption and continued cloud migration. To meet increasing AI revenue opportunities, Morgan Stanley expects capital expenditure growth among the largest cloud providers to accelerate from 7% in 2023 to 15% in 2024 (Exhibit 2).
AI driving higher capex from 10 largest cloud providers
(Capex YOY Growth)
At June 30, 2023. Source: Morgan Stanley. There is no guarantee that any market forecast set forth in this presentation will be realized. The mention of specific sectors is not a recommendation or solicitation for any person to buy, sell or hold any particular security and should not be relied upon as investment advice.
We believe that data centers should continue to benefit from strong secular demand for cloud computing and, increasingly, artificial intelligence. Our analysis shows that cloud service and internet providers now represent an average of 41% of data center REITs’ recurring revenue, up from 25% six years ago, highlighting how outsized capital expenditures at large technology companies have translated into data center demand.
We believe it is early days and that growing artificial intelligence spend points to a potentially bright future for data center REITs with runway for future growth.
The business cases driving data center demand are a combination of existing cloud workloads and novel AI applications.
While AI use cases driving data center demand are intriguing, further understanding is needed for how consumers and enterprises are going to leverage AI. However, it is already clear that AI is changing how many companies operate, which in turn is increasing their need for computing power, cloud-based data and ultimately, data center capacity.
A few notable AI examples:
- More than 27,000 organizations—including Airbnb, Dell and Scandinavian Airlines—are incorporating Microsoft Copilot, an AI platform, to increase the productivity of their software developers.
- Telecom providers are utilizing AI to improve fleet dispatch for field technicians.
- Pharmaceutical firms such as Amgen are using AI to help with drug discovery and protein engineering.
- Financial services firms, like J.P. Morgan, are adding AI to their IT workloads. Jamie Dimon, J.P. Morgan’s CEO, noted the firm already has 300 AI use cases and has already spent $2 billion on cloud migration but is still early in its digital transformation.
As AI’s use cases proliferate, many workloads will begin in the cloud. Annual cloud revenue contribution from AI and machine learning is expected to climb to $111 billion (representing 36% annualized growth) by 2030, according to estimates from Bank of America (Exhibit 3).
AI/machine learning cloud market expected to surge
Market size ($billions)
At June 30, 2023. Source: Bank of America, Grand View Research, Cohen & Steers. There is no guarantee that any market forecast set forth in this presentation will be realized.
Even before ChatGPT and the current excitement surrounding AI, data centers were experiencing positive trends given power and supply constraints in key data center markets. As a result, the sector has recently enjoyed its strongest rent growth in a decade amid surging demand and historically low vacancies— especially in Northern Virginia, the world’s largest data center market (Exhibit 4). As large technology companies and enterprises increase their AI-related data center spend, data centers could enjoy even stronger pricing power.
Strong demand + low supply = high rent growth for data centers
Data center vacancy rate
Acceleration in demand has led to record absorption and historically low vacancies, especially in Northern Virginia, the world’s largest data center market
Data center pricing is up 17% in the last year due to very healthy demand vs. supply
At December 31, 2022. Source: Cohen & Steers, CBRE.
There is no guarantee that any market forecast set forth in this presentation will be realized. The mention of specific sectors is not a recommendation or solicitation for any person to buy, sell or hold any particular security and should not be relied upon as investment advice.
We believe there is a clear bull case for data centers as AI could drive incremental new demand, while existing data centers could benefit from non- AI applications. AI workloads require significantly more computational power than non-AI applications (as much as 5x by some estimates), which could absorb a significant amount of available power across major data center markets. As a result, end users with traditional workloads might gravitate toward existing facilities, as enterprises will likely not require the same level of power density that new AI workloads will likely require. One risk for legacy data centers, however, is that older facilities could either face greater capital requirements to be upgraded or risk becoming obsolete.
Outsized cloud revenue growth and digital transformation have benefited data center REITs so far, and we expect AI to be an additional secular tailwind.
AI’s impact beyond data centers
AI has the potential to disrupt numerous real estate sectors beyond just data centers, though we view much of the current investor discussion as speculative. Ultimately, we believe that discerning winners and losers will require careful analysis, and that capitalizing on opportunities will require active management.
We are currently considering both positive and negative scenarios across most real estate sectors (Exhibit 5). AI and automation are likely to improve margins for operationally intensive businesses such as senior housing and hotels. AI is also likely to improve the success rate of new drug discovery, leading to increased research funding and demand for life science property.
In addition, further investment in wireless networks will be needed as mass adoption broadens to mobile applications, which should be a positive for cell towers. Within office, job displacement as a result of AI could lead to lower demand for space, putting further pressure on occupancy.
AI has the power to positively impact several REIT sectors
There is no guarantee that any market forecast set forth in this presentation will be realized. The mention of specific securities is not a recommendation or solicitation to buy or hold a particular security in a sector and should not be relied upon as investment advice.
The AI boom is already underway, and we believe it has the potential to transform many of the sectors in our universe. While it’s still early, data centers are already seeing some tailwinds, and we believe AI has the potential to benefit many sectors across real estate. Our outlook will no doubt evolve alongside the technology itself, but we believe it is clear that AI will reshape the real estate investment landscape.
Index definitions / important disclosures
Data quoted represents past performance, which is no guarantee of future results. The views and opinions presented in this document are as of the date of publication and are subject to change. There is no guarantee that any market forecast set forth in this document will be realized. Active management is not guaranteed to ensure a profit or protect against loss and actively managed strategies may underperform the broader market. This material represents an assessment of the market environment at a specific point in time and should not be relied upon as investment advice, does not constitute a recommendation to buy or sell a security or other investment and is not intended to predict or depict performance of any investment. As of 6/30/23, we are not investors in the securities mentioned above.
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