Profit-on-cost’s rising popularity and what this means for data centre developers

Despite the significant capital injections that they require, purpose-built (or build-to-suit) data centres offer significant advantages over colocation, particularly for businesses that plan to expand computing capabilities into more power-intensive workloads, such as AI, cloud computing, or inference.

In addition to providing a facility that has been designed and built with the needs of one specific business in mind, build-to-suit data centres allow for greater flexibility in approaches to power sources and cooling methods, both of which are particularly important considerations given the gargantuan amounts of water and energy that a data centre requires.

For developers, build-to-suit data centres also provide greater security than speculative builds because there will be a guaranteed tenant once the facility is built.

These kinds of developments are also proving popular with investors. According to CBRE’s 2024 Global Data Center Investor Intentions Survey, 31% of respondents believed that hyperscale build-to-suit data centres would provide the best opportunities over the next one to two years. In 2021, just 17 percent of investors thought the same.

Read our insight here for a more comprehensive comparison of colocation and purpose-built data centres.

In previous build-to-suit arrangements, the developer has been responsible for acquiring the land and promoting it as a suitable site for a development to potential hyperscalers customers for colocation services.

The hyperscaler has then worked with the developer to specify a facility that meets their exact specifications, with the developer constructing the data centre and fitting it out with the basic essential infrastructures.

Recently, however, demand has begun to outstrip supply, exacerbated further by issues with security of power supply, rising energy costs, water conservation, heat generation and objections from local residents to planned data centre sites.

This is causing the costs of existing data centre projects to spiral into the hundreds of billions, whilst leaving many businesses on the waiting list for a suitable opportunity.

In response, some of the largest hyperscalers are becoming more proactive in their approach, sourcing and purchasing the land that they need and procuring a developer to complete the build-to-suit project under a negotiated yield-on-cost agreement.

Prior to commencing a build-to-suit development, the developer and operator will agree a total, fixed cost for completion of the project covering, not only land and power connection costs, but also agreed hard and soft costs.

This covers all the necessary expenses that will accumulate throughout the duration of the project, including costs for materials, labour, and any additional construction required for connections to power, fibre and water supplies.

The developer and operator will then agree the developer’s yield (or profit), which is taken as a percentage of this cost. For example, where a project’s total cost is fixed at £100m, and a 5% yield is agreed, the developer will receive £5m in profit once the project is completed.

Whilst common in the housing development sector, the yield-on-cost approach is still a relatively new one in data centre development and may not satisfy all of the developer’s returns profile.

Large, multinational hyperscalers, however, are using it more frequently, not least because it allows them to source a suitable site for a data centre facility without waiting for an opportunity to become available in the marketplace. 

Fixing profit and cost from the outset also substantially de-risks data centre development; a particularly appealing prospect at the moment given soaring costs of energy, power connections, key long led items such as generators, and materials such as steel.

For developers, however, such agreements need to be approached with caution. Whilst there is an opportunity to agree a sensible yield on cost, the developer also shoulders most of the project’s risks, particularly regarding construction costs and delays.

This is because a cost is fixed from the outset, meaning that it may not account for cost fluctuations or project delays that occur over the project’s two-to-three-year lifespan.

Both events are increasingly likely at present, with tariffs, supply chain disruptions and global conflicts all causing the prices for raw materials to rise significantly. Delivery times are also being impacted. In some markets, such as the Gulf Cooperation Council (GCC), contractors and suppliers are applying a war surcharge due to shipping lines in the Strait of Hormuz being blocked. 

Projects are also delayed due to problems with power supply and local infrastructure, both major issues for data centre developments around the world. Dublin, for example, has a moratorium at the time of writing on building new data centres due to the strain current facilities have placed on Ireland’s national electricity provider.

Where a fixed price and profit are not properly calculated, developers risk losing significant amounts of money. Indeed, there are already many examples of developers that have gone insolvent because project timelines and/ or costs have overrun initial projections.

Where power supply is the key issue, it is often recommended that the operator take a step agreement with the local energy supplier. This allows the project to go ahead using the existing infrastructure, with the option to increase supply once new power generation capabilities are developed. Given the timelines involved in constructing energy infrastructure, developers would be advised to ensure these step agreements are in place before a price for the data centre’s construction is agreed.

The increasing popularity of the profit-on-cost model will not necessarily place data centre developers at a disadvantage. Provided they can take a comprehensive and long-term view on the costs involved, it is possible to agree a fixed cost, and subsequent profit on this cost, that will benefit both developer and operator.

With economic uncertainty and the complexity of data centre development ever increasing, however, having specialist legal and commercial advice from the outset of such negotiations has arguably never been more crucial.