Powering Progress Episode 13 – Power Is the Product: Negotiating Data Center Leases

Transcript

Aubrey Bishai [00:00:09]

Welcome back to Powering Progress, a podcast series exploring the infrastructure, energy, and market dynamics shaping the next generation of data centers and AI development.

I’m your host, Aubrey Bishai, Chief Innovation Officer at Vinson & Elkins.

As demand for data center capacity continues to accelerate, the real estate agreements behind these projects are changing with it.

A data center lease today isn’t simply about securing space.

Power availability, cooling requirements, construction and equipment timelines, permitting, financing, and even the ability to adapt or exit as technology and business needs change can all affect how these agreements are structured.

Joining me today is Peter Bergan, a partner in our real estate practice who works with clients on data center leasing and development.

Peter recently identified five strategies for navigating today’s data center leasing market, and we’re going to use those as a starting point for our conversation.

We’ll talk about what developers, owners, and tenants should be thinking about before they commit to a site, how AI is changing traditional leasing assumptions, and where some of the biggest risks and opportunities are emerging as this market continues to evolve.

Peter, welcome to the podcast.

Peter Bergan [00:01:45]

Yeah, it’s great to be here.

Aubrey Bishai [00:01:47]

So pre-leasing has become the norm with tenants signing years before a building exists. How are landlords and tenants splitting the risk when delivery dates slip?

Peter Bergan [00:01:59]

Great question. Pre-leasing has really turned the lease into a construction contract with a lease attached, frankly. Delivery date provisions are perhaps the most heavily negotiated points in the actual lease document. The reason this matters is just because the hyperscaler and AI company tenants need capacity on a relatively fixed timeline and landlords need a signed lease to raise the required construction financing. So we’re talking about signing leases two to three years ahead of when projects are actually up and running. This means everyone is pricing construction, supply chain, and utility risk well in advance of the actual rent commencement.

So the way we see most deals, obviously, is they set some sort of target delivery date. That’s the best guess estimate of whether the project is going to be ready, and an outside delivery date, sort of the far outside worst case scenario as to when the project can be completed. Often this is set up on a phase-by-phase basis so that a single building has multiple data halls, and each data hall can have its own separate target delivery date and outside delivery date.

As far as what happens if the project timing slips, scope of the tenant’s remedies come in a number of different layers. Usually there’s a small grace period after the target date during which the tenant really doesn’t have any remedy — talking 60, 90 days, nothing really happens. Then if the project continues to slip, that’s where rent credits or some other liquidated damages start kicking in. So these are often a day-for-day or multiple-day rent abatement, and these escalate as the project gets more and more delayed. And then at the end of it, if the project is still not done by some far outside date, that starts seeing more drastic remedies kick in. This means things like the tenant stepping in and doing the construction themselves, or the worst possible situation, the tenant having just a full termination right if the project is not completed by the outside delivery date.

Where we see our landlord developer clients protect themselves is relatively straightforward things like caps on the delay credits, so that it’s not just unlimited and they’re occurring forever — typically set to some number of months of rent, three months of rent, up to maybe one year’s worth of rent. And then having the credits themselves really be the tenant’s sole and exclusive remedy before they step in or ultimately terminate the lease, that’s a right that they have. This sort of ensures that the landlord knows the full scope of potential remedies that there might be incurring.

And then just making sure that whatever broad tenant delay and force majeure definitions are put in the lease, to make sure that the developer landlord is capturing the things that may delay the project — things that aren’t their fault — that push all those dates out. So you may have a two-year outside completion date, but force majeure is going to extend that date for some period of time. And right now, where we’re seeing sort of the fights, call them, are things like whether supply chain shortages count as force majeure. Things like transformers, switchgear, generators have lead times well in excess of a year at this point. Similarly, whether permitting and utility delays extend the outside date, because that’s a little bit of a concept that’s outside of the control of either the tenant or landlord.

Tenants are increasingly insisting that force majeure cannot extend that outside, hard stop date, but that continues to be a fight amongst both parties on these deals. And I guess at the end of the day, just because there’s a lot of unknowns, people are trying to mitigate risk as much as possible. The trend in the data center leases themselves is really just to provide as much detail as possible, really drilling down into exactly what’s going to happen if certain things happen — like there’s a supply chain disruption, or if there’s a regulatory event, something happens which prevents the project from being built. So we’re certainly seeing more detail rather than less in these data center leases.

Aubrey Bishai [00:05:57]

A consistent theme that’s coming up across all of these interviews is how power has become the scarcest input in the industry. How is power availability handled in the lease? And who bears the risk if the utility doesn’t deliver?

Peter Bergan [00:06:16]

So this is definitely one of the main arguments, slash points of discussion, in the lease negotiations. Perhaps power is the product in the data center lease. The tenants here aren’t really leasing square footage in a building. They’re leasing the power that’s available at the site. And the hardest risk really to allocate is that power, that utility, because usually neither party controlled it.

So a lot of times the way we see this set up is you have the deals starting to separate the delivery of the building itself versus the delivery of the power — two distinct things. So the rent often does not start, or maybe only starts in part, once the building is fully built, and all of the contracted power capacity is fully energized and fully commissioned. At least in a data center, a constructed building with no power isn’t of much use.

As far as who bears that utility risk, you know, sort of speak to both sides. The landlords can argue that the utility delay is fully outside of control, should count as a force majeure event, maybe it extends whatever completion dates are set up in the lease. The tenants often respond by saying, hey, look, landlord, you chose the site, you kick-started utility arrangements or negotiations, so you, landlord, should bear that risk either entirely or partly.

And often where we see it play out is some sort of middle ground, where perhaps a utility delay extends certain dates, maybe it suspends rent, but the outside termination date would still apply, or outside step-in right date, and again, what rights the tenant has in a lease. But at the end of the day, practically speaking, the tenant can’t be held to a building that has no power indefinitely — meaning at some point there needs to be a path forward if there clearly is not going to be power available to the site.

The way that tenants can really protect themselves is just pushing for covenants as early as possible, whether in a lease or some sort of term sheet, that the landlord’s going to just pursue the utility diligently, keep the deposits current, they’re going to share whatever load letters or electric service agreements with the tenant. They’re going to tell the tenant promptly when it’s clear timelines are going to change, following the tenant in that process as much as possible.

And once the facility is operating, it comes much easier. The lease is really going to dictate what sort of service level agreements are in place, the primary one being power availability — what happens if the power goes down for a certain period of time. That’s dealt with by way of service credits, meaning some credit against base rent, and potentially termination rights if we’re talking about chronic failures or sustained failures — things like it’s happening every day over the course of a week, or power is not available for an extended period of time.

But at the end of the day, a data center lease that does not have power isn’t really worth much of anything. So it’s in both parties’ interest to really diligence the utility plan or story as much as they possibly can, as far up front as they can, because that’s really more important than the underlying real estate.

Aubrey Bishai [00:09:26]

Before a lease is even signed, developers are often spending tens of millions on long lead equipment and design. Talk our listeners through what a cost reimbursement agreement is and why it has become such an important part of these deals.

Peter Bergan [00:09:43]

It’s something that’s more and more involved in our deals. The cost reimbursement agreement really lets the developer landlord start spending well before the lease is signed, without taking the full risk if the deal entirely falls apart. This long lead equipment, as you can imagine, has to be ordered well before a lease is executed. Transformers, generators, switchgear, chillers, UPS systems all require variable, long lead time orders. Some of the things covered by cost reimbursement as well are things like design work, utility deposits, even early site work — all of which has to happen well before the actual lease is executed.

And because, as you mentioned, these commitments can reach tens of millions of dollars, if not hundreds of millions of dollars, a landlord’s not going to simply just take that risk on speculation that a lease is ultimately going to be signed. There just needs to be something in place well before the lease is executed. So the CRA is really a pre-lease contract under which the prospective tenant agrees to reimburse the developer landlord with respect to specified costs if the lease ultimately is not signed. Some versions have the tenant funding costs as they’re incurred.

And the things that a typical CRA is going to include are what types of categories of costs are approved by the tenant — things that the landlord can spend the money on, often with budgets specified, certain line item caps on specific expenses, whether the tenant has sign-off on purchase orders above certain dollar thresholds, as mentioned, often a cap on a line item basis, or what the maximum reimbursement obligation of the tenant is.

The CRA will also mention who owns the equipment as it’s delivered to the site. The tenant is paying for it, but the landlord is often ordering it on their behalf. But once it actually arrives at the site, whose is it? And it matters on the back end if the deal falls apart.

The CRA will also specify what happens if the lease negotiations break down and the transaction is ultimately terminated. Often the developer is going to have some obligation to cancel orders, to the extent they can, to mitigate damages or mitigate costs as much as possible, so that the tenant is reimbursing the landlord for as little as possible.

Why we’ve just seen this more and more, perhaps obviously, is just because the supply chain lead item lead times have just made early procurement unavoidable. It has to be done well in advance of lease signing, otherwise the timing of the lease completion deadlines is just not going to make sense. Everyone wants speed to market and to move as quickly as possible. And unfortunately, lease negotiations take a long time, and you can’t simply wait until the lease is fully executed.

On top of that, the developers and the lenders really want this early spending de-risked. It’s a lot of money, and no one’s going to spend it with this idea that a lease may not ultimately be signed. There needs to be some sort of obligation there. And it really shows that the tenant is committed to the project beyond execution of a term sheet. The term sheet is generally a necessary step, but again, no one wants to move forward without knowing the project is actually real.

So the cost reimbursement agreement, at a high level, is really this bridge that makes all these often aggressive delivery schedules within the lease possible. Without it, those dates just don’t happen.

Aubrey Bishai [00:13:02]

The CRA really does sound so critical. How do cost reimbursement agreements interact with the lease once the deal signs? And what happens if it never does?

Peter Bergan [00:13:15]

So ideally, the CRA is signed and the lease is subsequently signed and everything works out. Often that’s not the case, and that’s what the CRA is there to address.

So in the good situation of the lease being signed, often the CRA just sort of goes away, and a lot of the concepts are folded into the lease itself. The costs incurred under the CRA are often credited against the tenant’s obligations under the lease. They’re rolled into the project budget that ultimately sets what the base rent is, maybe treated as some sort of tenant improvement contribution. And the lease itself is really going to talk about, with respect to the equipment actually procured under the CRA, things like warranties, title, risk of loss — all of which is just going to line up with the general landlord work construction provisions. So that all sort of gets buttoned up nicely. But again, the CRA generally goes away and the lease is going to govern.

The tricky part, right, is if the lease is never signed and the transaction just breaks down. So this is where, obviously, the CRA becomes of utmost importance. The tenant in that situation is still going to pay the reimbursable amount up to, if there’s a cap — there’s often time periods upon which that needs to be paid.

Where we see disputes potentially arising in this scenario are: look, were the costs that were incurred by the landlord under the CRA properly incurred and approved by the tenant? Did the developer landlord mitigate costs appropriately, trying to avoid costs that it could when it found out that the lease was not going to be signed? And even whether costs incurred, especially for equipment, are for things that the developer landlord can use on another project, right? If they can use it for a subsequent tenant, then the tenant makes the argument — look, why are we paying for this when your subsequent tenant can pay for it?

And that ties into just really how the treatment of equipment is handled in the CRA. So because the CRA is often covering paying for equipment that may be delivered to the site, if the transaction falls apart, that’s what the CRA needs to address. Okay, what happens to all this equipment that’s now at the site? It may be that the tenant just takes title to the equipment and delivers it to another project site. It could be that the landlord or developer keeps the equipment to use it for a subsequent tenant at that site, and the CRA tenant will receive a credit against that, just given that the landlord’s going to use it for another tenant. Or the equipment may just be sold or otherwise returned to the provider, and the tenant would be credited with the sales price or whatever refund is able to be obtained from the equipment provider.

Some of the things we often see missed in CRAs, but it’s certainly important to consider, is really who caused the lease transaction to be terminated. Does the tenant still pay these costs if the landlord walked away for any or no reason, right? Nobody did anything wrong, if just for whatever reason the transaction breaks down, or if it becomes clear that power is not going to be delivered to the site anytime soon. Really not a landlord default, but still a reason the tenant may want to get out of the transaction.

And then the other one is really credit support for the reimbursement obligation itself. These are very large numbers and real dollars being spent. So as a landlord developer, or that landlord’s lender, you want to make sure that the tenant has an entity that has the financial wherewithal standing behind it to satisfy whatever reimbursement obligations exist.

And the way we think about it, these cost reimbursement agreements are really like a mini lease, or even a pre-development agreement, for this pre-development period of time that exists before the lease is signed. And the same attention and importance that a lease has, that should be given to the CRA itself. It’s a very important document. It should be given a lot of thought, to make sure that people are giving it the same attention to detail that they’re giving the lease itself.

Aubrey Bishai [00:17:08]

Peter, one of the things that we’re seeing is that many data center tenants sign through special purpose entities or newer AI-focused companies. What credit support are landlords asking for, and how is that changing?

Peter Bergan [00:17:25]

Perhaps the tenant base in data centers has broadened well beyond your investment grade hyperscalers. And because of that, landlords and their lenders are really adjusting the scope of the credit support package to match those changes. Why this matters, really, is these leases are 10, 15, 20, up to 30 years, and supporting extremely large construction loans. So lenders are underwriting to the tenant’s credit, and they need a credit support package that you can really stand behind, that the lenders are lending on.

The easy one, really, is hyperscalers, just given their credit ratings. The hyperscalers are signing through usually a wholly owned subsidiary. So because of that, usually the easy ask is really to offer up some sort of parent guarantee. Sometimes that’s a full guarantee, sometimes it’s capped. Perhaps it burns down over time as the lease goes on in years. There’s often just covenants restricting assignments to weaker affiliate entities, but often, as long as the guarantee stays in place, it’s not as much of an issue. And then even on the financial reporting covenant side, it’s usually an ask, but not a hugely important one, because many of the investment grade hyperscaler parents are publicly traded companies. So the financial reporting is done through just their own public filings.

The trickier issue is really the newer AI-focused tenants. These entities may be very well capitalized, but really have a very short operating history, where they depend on some sort of venture or debt financing. So their credit is just not what investment grade hyperscalers have. And because of that, landlord developers are asking for things like very large letters of credit covering multiple years of rent. These may step down over time as the tenant hits certain milestones, maybe related to some sort of credit rating. In addition, or alternatively, things like just cash security deposits — a pretty vanilla concept that’s used in just pieces generally, but an easy one.

And then guarantees from investors or strategic partners — really anybody who has credit that’s higher than this AI-focused tenant, NeoCloud tenant that’s at the data center. Sometimes we see support tied to certain chip and cloud partnerships. So if an AI, NeoCloud tenant has a relationship with AMD or Nvidia or another chip provider, it could be that they’re getting their credit support that way.

And then we often see cross-default to other agreements with the tenant, perhaps with rights tied to the tenant’s equipment — meaning the landlord will access the tenant’s equipment in the event of a lease default. But really, repossessing GPUs, TPUs, whatever’s at the site, is very complicated, just given that the GPUs are financed often separately. So there could be lenders that have superior rights there.

But really the credit support universe is getting bigger and more structured, and a little bit more complicated — although maybe it’s coming more simplified too, as people think through these more and more. But often it’s including things like step-downs, ratings triggers, and replenishment obligations, just because so many of the credit support providers are asking the counterparties to look to the newer AI-focused tenant, cloud tenants directly, and saying, look, the credit quality of these entities is getting better. And now that it’s better, you no longer need this big credit support entity sitting behind it.

As mentioned, credit support is really now required for cost reimbursement agreements on top of the lease itself. So thankfully, some of the credit support discussions are happening much earlier. You’re not really necessarily waiting just to have a connection with the lease. You’re having it really upfront, as soon as you’re having those CRA discussions.

A lot of this is driven really by lenders, as the investor parties are providing financing. They are the ones who have a lot of say in negotiations and what they’re going to accept by way of the scope of these guarantors and just the credit support package generally. But at the end of the day, really the quality of the credit support determines whether a deal gets done and the transaction closes. This is probably the number one issue, along with power availability, that’s driving a lot of these deals, when we spend this much time really on the scope of these guarantees and backstop guarantees as we do on anything else — just because it’s so hugely important to the transaction.

Aubrey Bishai [00:21:48]

This was an absolute masterclass in data center leasing. Thank you so much, Peter. And thank you all for joining us for Powering Progress. If you’d like to learn more about insights on AI infrastructure and the legal frameworks behind it, visit velaw.com.