Powering Progress Episode 5 – The Space Behind the Servers: Real Estate Structures for AI Infrastructure

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.

Data centers may be powered by energy and technology, but their success also depends on the real estate structures that support long-term operations and expansion.

In this episode, we’re joined by Courtney Hammond, who advises clients on data center leasing, build-to-suit developments, sale leaseback transactions, and the evolving real estate frameworks supporting digital infrastructure.

We’ll explore how lease structures are evolving to accommodate increasing power demands, long development timelines, and the operational needs of hyperscale and enterprise users.

Welcome, Courtney.

Courtney Hammond [00:01:16]

Hi, Aubrey.

Aubrey Bishai [00:01:19]

Let’s get into it. What lease structure best aligns with power and infrastructure commitments?

Courtney Hammond [00:01:26]

So data center leases present unique structuring challenges because power, not just square footage, is often one of the most critical components of the tenant’s operations. So the leases carefully allocate power-related risks and costs and responsibilities between the landlord and the tenant, from construction through energization and through their ongoing operation over a really long period of time here. We’re talking sometimes 10, 20 years from the beginning. So I can’t really say there’s a best structure. That’s going to depend on a lot of different factors like tenant sophistication, the power source, whether the lease is a build-to-suit or a powered shell, co-location lease — I could keep throwing out terms. But I think we can focus in on a few general items here.

So with respect to rent structure, I’m going to focus in on kind of hyperscaler, large leases. And we are seeing two different structures, mostly a triple net and a yield on cost. And there are different cost risk allocations here, but we’re seeing both of these in the market. For the triple net, we’re seeing a per-kilowatt pricing model for base rent rather than a traditional lease, which would be on a per-square-foot pricing model. And looking at it on a per-kilowatt function, it more accurately reflects what’s driving the deal, which is the power. It doesn’t really matter how much space is in the data center — I mean, you have to have adequate space, but it matters how much power the landlord has made available to the tenant within that space. So that per-kilowatt is just the base rent.

And so sticking with the triple net structure here, the landlord will make the critical load power available to the tenant, and the tenant pays for that whether it is used or not. And then the tenant pays for the power that it actually consumes through an additional rent mechanism. That’s where there are also other pass-throughs like taxes and insurance and operating costs.

The other rent structure I mentioned is a yield on cost. I’ll just touch on it briefly, but instead of a per-kilowatt base rent, base rent is constructed on an agreed contracted yield and multiplied by the eligible project costs. And there are agreed caps and agreed budgeted ceilings within this pricing model as well.

And then one thing we’re seeing too is for term, the initial term of these are long. It’s going to be 15, 20 years. And we’re seeing a big focus on limiting tenant termination rights. And this protects the landlord, and more importantly, it allows the landlord to go out and get financing necessary to construct these large projects. So instead of termination rights, tenants are given tiered, escalating per-day credits for delivery delays. And there are caps on those, but the lenders are focused on these caps and force majeure carve-outs.

And then I’ll also touch on two different construction structures. The two different structures I’m going to touch on for data centers — they differ in how the power obligations are handled and the level of landlord completion and the required capital investment from the landlord. So the powered shell is one, and the other is a build-to-suit. We see both in the market.

So on a build-to-suit, the landlord builds everything, including the infrastructure and the power to the rack level within the data center. The tenant just turns the key and walks in. Here, the landlord and the tenant really focus in on the basis of design before they get to building. And once the basis of design is agreed, that’s kind of the demarcation line for when change order costs that are driven by the tenant shift to a tenant cost. There’s risk on the landlord here because they’re taking more time to build out all of the infrastructure. So they really focus on these cutoff dates for approving designs and focus in on what constitutes a tenant delay.

The other one I’ll touch on is a powered shell. In this case, the landlord just builds pretty much the shell of the building and brings power and other utilities to a certain delivery point. And then the tenant takes over from there and builds out all of their internal fit-out — so their racks and their generators and their special cooling. Here, the landlord has less responsibility, and so it’s less risk, right? They’re focused just on getting the primary feeds and the substations and the transformers, just like they were under a build-to-suit, but their obligation stops at a point outside the building or leading into the building.

Aubrey Bishai [00:06:27]

How are expansion rights and future capacity addressed?

Courtney Hammond [00:06:32]

So because power is a driving factor here, the parties have to think about when and how much power will be available to the site and if and when the tenant will actually want the power. So getting square footage without the necessary power and cooling mechanisms isn’t great for the tenant. So the lease usually specifies how the tenant can scale the megawatts and space over time and when the landlord must make certain infrastructure available to the tenant. I’ll hit on a few core mechanisms that we see.

So one expansion right is a tenant-initiated expansion option. And so the landlord and the tenant pre-negotiate this right. One of the main expansion rights that we see is a tenant expansion option. And it’s a pre-negotiated right to lease additional power. And that can be within a data hall or for the next building that’s coming online. The landlord’s willing to do this if it’s tied to a campus or tranches of power that they have already contracted to be delivered to the site. So if the landlord knows that the power is going to be delivered in phases, they can offer that up to the tenant, and the tenant can exercise their right to take that power.

Kind of similar there, there’s a must-take obligation. This is more favorable for the landlord because, you know, if they’ve contracted for power to be delivered to their site — in these cases with a must-take obligation, when that power comes and is actually delivered to the site, the tenant must take it whether they need it or not.

And then a hybrid is a right of first offer, where a landlord is obligated to notify a tenant when additional capacity comes up, whether that’s an additional suite or a data hall or a new building — that will all be negotiated in the lease. But anytime that becomes available, before they market it to a third party, they have to go offer it to the tenant and give the tenant the opportunity to have first go at this capacity.

There’s a similar concept called a right of first refusal, and this actually requires the landlord to go out to third parties and see what the market is willing to pay for that capacity, and then take it to the tenant and allow them to match it. You know, while this provides the tenant with really strong protection, landlords are really hesitant to agree to right of first refusals, because it can turn off otherwise interested third parties from negotiating with them.

Aubrey Bishai [00:09:04]

So who bears responsibility for upgrades or additional power requirements?

Courtney Hammond [00:09:09]

This is going to depend on a handful of factors, similar to the first question that we talked about here — the tenant sophistication, the power source, the rent structure, if the lease was a powered shell or a build-to-suit — but I’ll give some general thoughts.

So the landlord is generally responsible for providing and maintaining the agreed power capacity and redundancy to a certain demarcation point, and that’s going to be defined in the lease. You know, there’s a certain handoff location, maybe a main switchgear or maybe distribution to certain halls. And then any additional capacity that’s beyond this contracted capacity that the landlord agreed to provide in the lease usually falls to the tenant. You know, the landlord agreed to provide X. Once they do that, anything over and above becomes a tenant cost and a tenant maintenance obligation.

But with respect to maintenance responsibilities, kind of sticking there, an overall view that there are capital improvements to these buildings, and landlords in both build-to-suit leases and powered shell models commonly retain the obligation to maintain the site structure and the shell — you know, the roof, the utilities and substation and generators and fuel systems. And they have a lot of maintenance obligations that relate to the building and the structure of the building. But that’s just the obligation to maintain it.

But then there’s also this cost component, right? And the landlord will have to come out of pocket to do those capital improvements. But in a lot of these leases, we’re seeing that we can pass on at least a portion of that capital cost to the tenant. You know, they’ll amortize the cost over the useful life of the capital improvement or the remaining term of the lease. And, you know, there’s maybe a six or eight percent carry cost associated with that. And a piece of that cost will be passed through to the tenant for the rest of the term.

But, you know, that’s all saying that everything’s negotiable. And so focusing in on what the operating costs are and what can be passed through is a big component of all these leases and heavily negotiated. And they’re going to be carve-outs for items and matters that the tenant does not see as capital improvements and that can’t be passed on to them, and that will remain a landlord obligation.

Aubrey Bishai [00:11:37]

Thanks, Courtney, and thank you for listening to Powering Progress. For more conversations and insights on the infrastructure powering the AI economy, visit us at velaw.com.