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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Greetings and welcome to the CoreSite Realty Corporation's Third Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the presentation. [Operator Instructions] As a reminder, this conference is being recorded.
I would now like to turn the conference over to Derek McCandless, General Counsel. Thank you. Please go ahead.
Thank you. Good morning, and welcome to CoreSite's third quarter 2018 earnings conference call. I am joined here today by Paul Szurek, President and CEO; Steve Smith, Chief Revenue Officer; and Jeff Finnin, Chief Financial Officer.
Before we begin, I would like to remind everyone that our remarks on today's call may include forward-looking statements as defined by Federal Securities Laws, including statements addressing projections, plans or future expectations. These statements are subject to a number of risks and uncertainties that could cause actual results or facts to differ materially from such statements for a variety of reasons. We assume no obligation to update these forward-looking statements and can give no assurance that the expectations will be obtained. Detailed information about these risks is included in our filings with the SEC.
Also, on this conference call, we refer to certain non-GAAP financial measures, such as funds from operations. Reconciliations of these non-GAAP financial measures are available in the supplemental information that is part of the full earnings release, which can be accessed on the Investor Relations pages of our web site at CoreSite.com.
And now, I'll turn the call over to Paul.
Good morning and thank you for joining us today. I am glad to share our third quarter financial and operating results, as well as to update you on our markets and development activity. Financial results for the third quarter reflect revenue, adjusted EBITDA, and FFO per share each increasing 13% year-over-year.
Regarding our internal growth, we had good performance across substantially all measurements, including solid cash rent growth on renewals and 7% year-over-year growth in same-store monthly recurring revenue per cabinet equivalent. Sales performance was mixed in the third quarter. Our core retail colocation sales were $5.1 million of annualized GAAP rent, consistent with our trailing 12-month average. Pricing overall for the quarter was up approximately 5% above average on a per kilowatt basis. Our consorted efforts to focus on quality deployments and strong pricing has paid off in this area.
Scale coloation leasing was on the low end, resulting in total sales of retail and scale of $6.1 million. We believe scale leasing this quarter was primarily influenced by two factors we have mentioned before; smaller than normal inventory of contiguous space in our major markets, which is being remedied by the new buildings, we expect to bring on line beginning in 2019 and the normal lumpiness and scale leasing after which we are encouraged based on current pipeline and utilization trends we see in our data centers.
During the quarter, we had a healthy balance of organic capacity expansions by existing customers coupled with our strong quarter in number and quality of new logo acquisitions. The annualized GAAP rent signed by the 27 new logos in Q3 increased 11.2% compared to the trailing 12-month average. The number of kilowatts licensed increase 15.4% and the average lease rent increased by 25.3%. We are optimistic about the demand trends we are seeing in our markets and believe supply is generally in balance with demand. We view Santa Clara as the most supply constrained and Northern Virginia as the least supply constrained. We still like the Northern Virginia market due to the overall high demand of our network and cloud dense campus, and the diversity we provide in Reston as compared to our peers in Ashburn. However, we believe pricing on undifferentiated or marginally differentiated large scale deployments have declined in Northern Virginia over the last 12 to 18 months, which will likely impact our pre-release economics to our new building at VA3
We continue to make good progress on construction of our new VA3 building and are likely to deliver an additional 6 megawatts of capacity in Q1 2019. In Santa Clara, construction on SV8 is progressing and we expect to deliver the 6 megawatts of Phase 1 during the third quarter of 2019. CH2 and LA3 are progressing through the permitting phases as expected consistent with our comments from last quarter we expect LA3 Phase 1 will be complete around year end 2019 and CH2 Phase 1 in early 2020, subject to the uncertain timing of the permitting process in these markets.
Please keep in mind, all our projects are ground-up developments, which take longer to deploy the first phase of supply but allow us to build subsequent phases more quickly. As we've discussed on previous calls, we expect 2019 to be a transition year for us. We expect to enter the year with leasable capacity at a low level compared to our historical norms, and to end the year with leasable capacity, plus quickly developable incremental capacity consistent with the higher levels available to us at the end of 2015. This new capacity should enable us to reaccelerate growth moving from 2019 to 2020 and beyond.
In summary, it was a solid transition quarter as we prepare for the new capacity in our construction pipeline, and we have an excellent group of colleagues to drive our success. Demand for and stickiness of data center requirements that are network and cloud-enabled in large metro edge markets continues to be strong. I remain optimistic about our future opportunities, reflecting our solid position in great markets with large numbers of dynamic enterprises, consumers of content and sophisticated customers of cloud, analytics and similar data products.
With that, I will turn the call over to Steve.
Thanks Paul. Our new and expansion leasing activity was again driven by our core retail colocation product, which accounted for approximately 84% of GAAP rent signed in the quarter. In total, we executed 120 new and expansion leases totaling $6.1 million in net annualized GAAP rent, comprised of 31,000 net rentable square feet and average GAAP rate of $193 per square foot.
As Paul mentioned, portfolio-wide pricing on a per kilowatt basis was 5% above our trailing 12-month average. This is noteworthy considering Boston was among our top three markets in terms of annualized GAAP rent signed for the first time in several quarters. We saw good traction in attracting high quality new logos for our portfolio, signing 27 this quarter, which accounted for 19% of net annualized GAAP rent signed.
Our well-established campuses or cloud enabled networked dense datacenters continues to be a magnet for enterprises, with this vertical representing 61% of the annualized GAAP rents signed from new logos. Among our new enterprise logos, our global leader in financial technology and payment processing, our leading network security provider, our top-tier member of the education vertical, a global provider of online games, and as American luxury retailer.
In addition to new logo growth, we again experienced organic growth from our expansion of existing customers across our portfolio, which accounted for 81% of annualized GAAP rent signed in Q3. During the quarter, our major public cloud providers expanded it on-rents with us in both our Denver and Los Angeles markets. A global web conferencing provider expanded with us in the Bay area a [indiscernible] company expanded with us in two additional markets.
Turning to our vertical mix, networking cloud customers accounted for 25% and 35% of annualized GAAP rents signed respectively. The network vertical had a very good quarter with high overall transaction count and seven new logos signed, including three international network nodes, which speaks to our continued appeal with the international environment. We also signed a subsea cable deployment, connecting the consortium of telecos and major content players between Los Angeles and Asia Pacific markets. The cloud vertical continued to perform well, adding four new logos, including an industry leading digital certificate provider, as well as the expansion of two public cloud-on rents in Denver and Los Angeles that were discussed earlier.
Our enterprise vertical accounted for 40% of annualized GAAP rents signed, driven by a leading ERP as a service software provider, [indiscernible] on a global public cloud that expanded with us an existing site and into new market. In addition, several other existing customers expanded, including the member of the Fortune 500 seeking direct access to three other cloud on-rents we provide in the San Clara market and a bunch of ecommerce companies expansion in Boston.
From a geographic perspective, our strongest markets in terms of annualized GAAP rents signed in new and expansion leases were Boston, Los Angeles, Northern Virginia, and Silicon Valley. Collectively new and expansion leases in these four markets represented 86% of annualized GAAP rents signed. Demand in Boston was elevated this quarter as couple of lease new capacity we brought to the market in the fourth quarter of 2017. A large ecommerce company chose to expand with us into this new capacity, provided flexibility and a clear path for us continued future growth and expansion in market.
Demand in Los Angeles was solid, with strength in the network vertical, followed by enterprise and cloud deployments. New logo activity included seven new customers which are well distributed among the verticals. Northern Virginia continues to be our most competitive market with substantial amounts of undifferentiated offerings. However, this product typically does not impact our competitiveness relative to latency, network and cloud-oriented used cases. Hence lease in this market was led by enterprise customers with seven new logos.
With regard to large scale leasing, we look forward to presenting to the market additional capacity become available in early 2019. Finally, leasing volume was low in the Bay Area as a result of our tense supply in this market. The cloud vertical led our other verticals with 81% of new and expansion GAAP rent signed in the market.
In summary, we are encouraged by the execution of sales in our core retail colocation product during the third quarter. However, we look to improve our leasing of scale deployment as additional capacity becomes available. We are also pleased with the incremental changes we continue to make in our sales execution and product features as a result of the sales and revenue leadership changes we announced last quarter.
Going forward, we will continue to focus on generating profitable organic growth, attracting high quality new logos for portfolio and delivering incremental value to our customers as we grow our ecosystem and footprint.
I will now turn the call over to Jeff.
Thanks, Steve, and hello everyone. Our Q3 financial performance resulted in total operating revenues of $139.2 million, a 2% increase on a sequential quarter basis and a 13.1% increase year-over-year. Our rent, power and related revenue contributed $118.6 million to operating revenues, an increase of 2.1% on a sequential quarter basis and 14.1% year-over-year. And our connection services contributed $17.7 million to operating revenues, an increase of 1.6% on a sequential quarter basis and 9.3% year-over-year.
Turning to FFO, we reported $1.25 per diluted share and unit, down 2.3% on a sequential quarter basis and up 13.6% year-over-year. As a reminder, last quarter we highlighted a couple items that would impact our sequential FFO growth in Q3. First was seasonally higher power costs, which amounted to $0.03 per share, and seconds primarily as a result of the renewal and expansion of our lease at LA1, rent expense increased by $800,000 or nearly $0.02. Partially offsetting these items were two items that provided a benefit of approximately $0.02 per share. The first being a lease termination fee and the second being incremental revenue related to the build out of a customer's deployment.
AFFO increased 1.6% sequentially and 19.4% on a year-over-year basis, reflecting the growth in the operating portfolio. Adjusted EBITDA of $73.8 million decreased 1.4% sequentially and increased 13.1% year-over-year. Our adjusted EBITDA margin for the trailing 12 months ended Q3 2018 was 54.7% and remains in line with our expectations and our guidance for the full year.
Sales and marketing expenses totaled $5.2 million or 3.7% of total operating revenues in line year-over-year. General and administrative expenses were $10.1 million or 7.2% of total operating revenues, down 70 basis points year-over-year. Both amounts are in line as a percentage of revenue with our expectations for the full year.
Q3 same-store turnkey datacenter occupancy increased 490 basis points to 90.1% from 85.2% in the third quarter of 2017. Sequentially, same-store turnkey datacenter occupancy increased 20 basis points. Additionally, same-store monthly recurring revenue per cabinet equivalent increased 2% sequentially and 7% year-over-year to $1,513.
We renewed approximately 98,000 total square feet at an annualized GAAP rate of $166 per square foot. Our renewal pricing reflects mark-to-market growth of 3.2% on a cash basis and 5.8% on a GAAP basis. Year-to-date, our cash mark-to-market growth of 3.9% is in line with our guidance for the full year. Churn with 2.5%, inclusive of 70 basis points of churn from the single customer we mentioned last quarter. We anticipate the same customer to churn up to a 100 basis points of additional capacity in Q4 2018, including churn from this specific customer and our year-to-date churn of 5.7%. We expect churn for the year to be at the higher end of the 6% to 8% guidance range.
We commenced 37,000 net rentable square feet of new and expansion leases at an annualized GAAP rent of $160 per square foot, which represents $5.9 million of annualized GAAP rent.
Turning to backlog, projected annualized GAAP rent from signed but not yet commenced leases was $10.2 million at September 30, 2018. On a cash basis, our backlog was $17.5 million. We expect approximately 35% of the GAAP backlog to commence in the fourth quarter, with the remainder expected to commence during the first half of 2019.
We continue to have a total of 161,000 square feet of datacenter capacity in various stages of development across the portfolio. As of the end of the third quarter, we had invested $100.7 million of the estimated $281.8 million required to complete these projects, those buildings also includes space for future construction of an additional 167,000 square feet of datacenter capacity.
Turning to our balance sheet, a ratio of net principal debt to Q3 annualized adjusted EBITDA was 3.6 times in line with the prior quarter. As of the end of the third quarter, we had $295.9 million of total liquidity, consisting of available cash and capacity on our revolving credit facility.
I would now like to address update to 2018 guidance and growth drivers heading into 2019. We are maintaining 2018 guidance related to operating revenue, adjusted EBITDA and FFO per share and unit. However, we have updated our expectations together with some visibility into 2019 for the following items.
Based on our 2018 year-to-date commencements of $28.6 million, in our expectation for timing of commencements in our backlog we are decreasing are expected commencements for the full year to a range of $33 million to $35 million in annualized GAAP rent compared to our most recent guidance of $36 million to $38 million. As you will recall, we expect Q4 2018 churn to be elevated in the range of 2% to 2.3% depending upon the resolution with our customer I mentioned earlier.
Looking ahead into 2019, we also expect elevated churn in the first half of 2019 in the range of 2% to 2.5% in each quarter before returning to more normal levels. We expect 2019 cash rent growth on renewals to be in the range of 2% to 4%. As it relates to our capital expenditures, we expect to finish 2018 towards the low end of our guidance range. In addition, we anticipate an increase in 2019 capital expenditures to $400 million to $450 million depending upon the timing of final permits and approvals.
Importantly and further to Paul's comments related to leasable capacity, we anticipate growth capacity in our five largest markets equal to approximately 15% of our total portfolio entering 2019 as compared to 19% when we entered 2018, and our longer term average of approximately 30%. The anticipated development in 2019 should increase this percentage of growth capacity to mid 20% by the beginning of 2020, depending upon future absorption.
Due to our elevated capital expenditures in 2019, we anticipate accessing the debt markets for $350 million to $400 million to term out the balance on our credit facility. Given our history with the business and the leverage metrics across the datacenter landscape, we are comfortable modestly increasing our targeted debt to adjusted EBITDA ratio to 4.5 times.
As a result of all of the above and a related timing, we anticipate directional financial results in 2019 and 2020 as follows; revenue and adjusted EBITDA growth in the upper single digits for 2019 and low double digits for 2020; FFO per share in unit growth of mid-single digits in 2019 and accelerating into low double digits in 2020. All of these estimates are dependent upon completing in leasing our growth capacity and related capital financing, and our team will continue to work to achieve these growth estimates. We will provide our typical annual guidance related to 2019 in connection with our Q4 call in February.
Now, we'd like to open the call to questions. Operator?
[Operator Instructions] Our first question comes from a line of Jordan Sadler with KeyBanc
Thank you, and good morning. I wanted to first take a stab at the pipeline, it sounds like you guys are encouraged by what you are seeing in scale pipeline, but I think you pointed out this quarter was a little bit light there. Is it just a function still of the availability, I think you touched on Paul in your prepared remarks. But just maybe a little bit of color around what you are seeing and why are encouraged?
Hi, Jordan, this is Steve. I think we did covered better enough in our prepared remarks there. We do see the overall pipeline remaining healthy, and I think if you look at the use cases in the marketplace that continue to drive more opportunity for that. And as we mentioned, there is a couple of things. One is, we like to do better in that space. I think we can do better on this thing that we are working on to just operate better there and sell better with the capacity that we do have, but we are a bit capacity constrained at this point and we are looking forward to bring that capacity back in line.
Okay. And then is there any color around what you're seeing in terms of that pipeline that you talked about being encouraged about, anything either by market or nature and customers?
Well, I think it's more the nature of our strategy and how we are aligned around key metros or across the U.S. and the makeup of our overall strategy really focusing on those latency sensitive network dense type of applications that seem to be more and more prevalent regardless of the line of business, so you think about things like 5G that's rolling out in the market place, artificial intelligence, autonomous vehicles, all of those kind of things drive to more and more edge computing and latency sensitive type of applications and I think we'll just continue to see more of that which fits very well with us.
Then, Jeff, could you clarify. I caught your guidance there in the end, was that FFO that you gave growth for 2019 and 2020, upper single and low double digits?
Good morning, Jordan. I gave revenue and adjusted EBITDA growth for both 2019 and 2020 as well, so let me just clarify and repeat it.
Okay, I did hear this. Okay.
So, revenue and adjusted EBITDA for 2019 to be upper-single digits and for 2020 to be the low-double digits. For FFO per share and unit, for 2019 mid-single digits and low-double digits in 2020.
Thank you for clarifying that and then just lastly, the churn that you are forecasting into the first half of next year, any additional insight on what's driving that elevation?
Yeah, Jordan, primarily it's some of the – what we typically see related to some of the M&A or end of life type of events you are seeing, some of that being a little bit elevated in the first half of next year.
Thank you.
Our next question comes from the line of David Rodgers with Robert W. Baird.
Jeff wanted to follow-up on your comments about CapEx this year, it seems like it's getting pushed a little bit in the next year and thanks for the added color on 2019 CapEx, but without an execution problem in term of maybe not getting more money out this year, because clearly there has been a capacity issue for a while. You think you guys have been a little bit higher on that and pushed as hard you could to get that number as high as possible?
No, I wouldn't call it an execution problem Dave. I think Brian Warren in our construction team are pushing this hard as they can and our estimates obviously are dependent upon a lot of things going perfect on the construction side. And so, it's not uncommon to see as you get towards the end of the year, some of that capital spend ultimately moving from Q4 in Q1 just depending upon where they are in the construction cycle. So, that we do see that periodically and then obviously we provided some additional commentary around what we expect for 2019 again to be elevated largely due to the ground up development that we have in the queue and that we'll expect it to beached out on light this year or early next year.
Thanks for that. Paul, in your comments you talked about impacting a return at VA3, can you just dive a little bit further into that? Was that more a function of maybe how you know anticipate leasing that asset? Is that purely just a function of the market with no change in your view on what you want to do with VA3, but maybe some added color will be helpful.
Yes, mostly just market and you know what pricing for scale leases has done is Northern Virginia, our best guess and again we don't have you know as markets don't have perfect transparency, is that it's about 10% to 15% over the last 12 to 18 months for scale leasing. You know we will still – we believe will still hit our targeted underwriting hurdles that we've – you know talked about in the past, but it does give us less cushion and room to outperform them as we frequently have in the past.
Okay, that's helpful. Then, I don't know for Steve or maybe like Jeff, in terms of kind of cross connect pricing and volume, you may have discussed this in the prepared comments and I just missed it, but can you kind of talk about that and then maybe what was in the quarter and then kind of how do you anticipate that impacting same store MRR going into 2019.
Yeah, let me give you a volume growth on our fiber product Dave. Year-over-year that was up about 8.1%, so that gives you some idea on volume. What we also saw which is consistent with what we saw in the earlier parts of 2018 is some continued consolidation of customer deployments predominantly from some previous telecom and telco M&A activity where they are consolidating some of their pops which is leading to some increase in some of those disconnections.
And the other thing I would add there, Dave is, as you look at the overall mix and health of the interconnection business, you look at enterprises, connecting to clouds, we've seen that grow significantly in the 30% range, so overall connectivity continues to grow and I think really what you are seeing there predominantly is largely effect of just rationalization of telcos as they have gone through that M&A process.
And the 8.1% that's gross or net?
That is net.
Okay. Great. Thank you.
Our next question comes from the line of Jonathan Atkin with RBC.
Hi, this is Bora Lee on for Jon. Thanks for taking the question. On the renewal spreads which were positive again on both a cash and GAAP basis, can you talk about the capital intensity associated with those renewal spreads?
I would say that in general if you are enquiring in terms of whether or not there is additional capital required upon those renewals, it's very minimal if any. And so there is not a lot of capital intensity on our typical renewals.
Got it. Thank you very much.
You bet.
Our next question comes from the line of Nick Deo with MoffettNathanson.
Hi, thanks for taking my question. You are back to price in Virginia. Are the pricing pressures you talked about for scale deployments leading to pricing for small deployment as well? Are those sufficiently differentiated if they've been surely from those pressures?
Nick, this is Steve. I would say that it's not necessarily size, it's really the application that goes along with it and sometimes that can go alone with size. But you know it's really the use case that goes behind the actual application and how they tie back to either a hybrid multi-cloud type of environment or other network type of deployments that value that low latency connectivity. So, we feel like that gives us a competitive advantage and also gives us a bit more staying power on relative to pricing on the market place.
Just to add to what Steve said Nick, as you can see from our overall pricing levels it's not affecting the pricing for our core relation colocation product.
Got it. Then maybe turning to development pipeline, what plans do you have currently for the space ultra-development in LA1 and how long would it take to turn that up once you decide to push the button?
It's primarily there to accommodate the growth need of existing customers as well as additional customers we expect want to come into that ecosystem, and then as you know that's a very special facility. It is not an easy construction building something new in one of these old office building, telecom, hotels, but I believe we expect to be able to bring that online in the second half of next year possibly as early as late Q2.
Our next question comes from the line of Colby Synesael with Cowen and Company.
Great. Thank you. Two if I may. First off, on the $400 million to $450 million CapEx next year, I assume that goes beyond the project which you – as you've discussed thus far. In terms of other projects which you have yet to announce, I'm just wondering are you intending to go outside your current markets, or do you think if there is still enough demand I should say in those markets to get you to the growth expectations that you are citing for 2019 and I guess even more so 2020?
Then secondly, on leverage, you noted that you are comfortable taking that up to 4.5, would you be expecting to maintain that leverage on a go-forward basis, or if given the opportunity, you would look to potentially do an equity raise to get that back down or simply just deleverage back to your current levels over time? Thank you.
Let me take the first half of your question Colby. All of the capital that's in our forecast is in our existing markets and projects. VA3, SV8, LA3 and CH2 as well as you know we from time to time we build additional computer rooms in our existing buildings that are already out there. None of that capital is targeted for any additional markets.
And Colby in terms of the second question, on the leverage, you know our leverage is something that we look at and have discussions with both internally and with our board, and I can't and I don't anticipate we'll continue to have those discussions, but I do not anticipate bringing that back down to our typical 4.0 level and it's something we'll continue to just monitor as we work through 2019 and 2020.
Great. And then just, Paul, if I could just go back to the response to that question, when you think about getting back to double digit growth in your model which has historically been call it 50% retail oriented and 50% more scale oriented, when you look at the four or five markets to which you see majority of your growth coming from, is there enough growth in those markets the way that you guys build the way that your business is structured to achieve those or do you have to kind of get more aggressive and for example a scale product or is there another aspect of the story here that needs to get augmented over time?
I think as we've shown historically and as we've forecast out demand trends, we could achieve those levels of growth we believe in our existing markets. And as you know, we've always been flexible around the scale versus retail dynamics along as we are focused on differentiated use cases that require that interconnected cloud-enabled campus dynamic and you know we try to make sure that we can accommodate higher density as well as low density applications within the same campus. That's really what makes the community of customers thrive. And again, most of the growth in edge use cases the vast majority of it is going to take place in the major metros of the type that we're in. And so, we do believe that's possible. Now, we always look to evaluate and enter different markets with the business model that we have, but those opportunities are few and fall between and really hard to forecast or incorporate into a model in anyway.
Great. Thank you.
Our next question comes from the line of Robert Gutman with Guggenheim.
Hi. Thanks for taking the questions. I was wondering, looking at next year's interconnection growth year-over-year, if that will be impacted by the churn occurring in the second half of this year. And I was also wondering if in terms of the $40 million plus CapEx guide little more tangible indication in terms of the amount of capacity, net rentable square feet that you expect to add?
Rob, let me comment on the interconnection and we'll see if we can get you a number for the $400 million to $450 million. I would just say in general any time you some level of churn which we report on a rent perspective, you are going to get some additional churn associated with the interconnections, that's just very common just given the types of deployments. What we don't always know is the level of churn in the interconnection side of it and it's going to vary just depending on the cross connect density in each of those deployments. So, it will impact it to some extent, to what extent is uncertain and so we ultimately see which customer's churn and the timing of that event.
And just to get back to your other – your second question, we've got about 160,000 square feet, it is under construction today and that complemented with what we have talked about related to LA3 and some of which is CH2 is going to be about 280,000 square feet that in total you would see under construction, some of which will be completed in 2019 – some – in late 2019 and then some of that will ultimately bleed into early 2020.
Do you think that, let say is longer term beyond 2019 or is it – you are saying high-single digit growth 2019 beyond that and low-double digit in 2020, is that a – would you expect – is that long-term rate beyond that? Do you expect it to plateau around there? What's – just a longer-term view.
Yeah, I wish I could give you more color on that Rob, but you know lot of it as you've seen for 2018 and 2019 is really going to be dependent on the incremental capacity that we add to the market as well as performance on the sell-side. And so, I think we wanted to give some insight into 2019 into 2020, because we are going through this low from a capacity perspective, just to give better visibility into that. Beyond that, I'm hesitant to comment at this point in time.
Well, let me just add to what Jeff said, you know ultimately it's dependent on sales which is primarily dependent upon demand, but bear in mind what I said in my comments that what we're building in this first phase are the corn shell of all these four new buildings out of which we're initially building only the first phase of capacity. So, we do in these buildings in our current footprint, plus what we can add in – you know in the land that we own down the road could – if the sales and demand are there, you know continue to maintain double digit growth beyond 2020. But that's going to be dependent upon sales execution and demand.
Our next question comes from the line of Michael Rollins with Citi.
Thanks for taking my question. A couple if I could. First, is there a significance to the conversion from some of the operating unit into the common shares into the quarter? And second, can you talk about how your guidance may affect the dividend policy going forward in terms of what kind of growth investors should expect in 2019 and 2020 relative to what you've been delivering over the last few years?
Good morning Mike. Let me try to address your first question related to the conversion, so you probably saw in early August Carlyle chose to monetize some portion of their OP units and when that does occur, you just literally get a rotation out of what we refer to as our non-controlling interest into additional capital inside our equity statement. So, I think that's what you are referring to, does that answer your question on that?
It does.
Okay and then secondly, the dividend policy, I think as you've seen historically and when you look at our dividend today as compared to AFFO, we have about a 90% payout and it's something we obviously address on a quarterly basis with our Board to evaluate what that dividend needs to be, but as we've said historically, those increases are largely going to be tied to our increases in cash flow. And we define that most relevant is common – is our cash flow that is distributable to our common equity shareholders which in a simplistic view from our perspective is AFFO less non-recurring capital that we spend inside our portfolio. So, I think that's the measurement you have to watch and that would largely give you some indication in terms of what that dividend increase could be relative to the growth in that cash flow number.
And is there any thought to maybe holding back some dividend growth to use that internally generated cash, maybe flatten it out for a period of time, or any other alternatives just as you are thinking about financing for the business?
So, given where we are on a leverage basis, you know we're low levered and as Jeff pointed out, we have the capacity to still be conservatively leveraged and fund our capital growth plans. Don't think we need to view any changes to the dividend policy as necessary in light of where we are leveraged.
Our next question comes from the line of Sami Badri with Credit Suisse.
Hi, thank you. In regards to your transition year and your comments in 2019 and then the revenue acceleration into 2020, when considering your vertical revenue mix across cloud networks and enterprises, which tenant do you think is going to be driving the majority of the acceleration from 2019 to 2020 and the reason why I bring this up is, this quarter you reported 49.4% of annualized revenues from enterprises and this is coming during – this is a step-up for about 200 basis points versus the prior quarter, it is also during a time where almost every single public cloud is scaling. So, just want to get an understanding on where you guys see the acceleration occurring by vertical mix from 2019 into 2020.
Hi, this is Steve. I'll give you an answer to that. As this relates to our overall mix, I think it really points back to our overall strategy really keen around three aspects of the market, one being network, the other being cloud and the other being enterprise and how those are mutually attracted to one another and really ultimately drive their unique value that we have across our platform. So, all three are very important to us and if you look at the overall mix of our ecosystem about 50% of that is enterprise and then the other 50% is evenly divided between cloud and network. So, we see little bit of oscillation here and there between quarters. This quarter, enterprises was a bit elevated, primarily based off of the scale of the old socket than we would like, also the impact for the available capacity to sell that space, so overall we see a fairly consistent balance as we go forward. But all three aspects are very important to us.
Thank you. And then my last question is have to do with a potential investment grade rating and whether the company is deciding to pursue that after some of your peers have already achieved an investment grade rating and wanted to get some color on that given the interest in increasing the leverage ratio to 4.5 times EBITDA, so any color would be great?
You bet Sami. It is clearly something we watch and monitor closely not only what our peers are doing and what those rating agencies are doing, but also we have those conversations with the rating agencies that we meet with on a periodic basis and so, we obviously operate the business with that in mind and is something that we clearly have an eye on. I think it'd be premature to think about being in 2019, but we continue to operate in manner that ultimately we could do that in the public markets. Having said that, I would just comment on one of the areas of financing, we've tapped as you've seen is that private placement and those two issuances are rated what's referred to as NAIC 2 which is a surrogate for investment grade in the private market. And so – and we've been able to access that at the investment grade level, which continues to be a – I think an attractive source of capital for us.
Our next question comes from the line of Frank Louthan with Raymond James.
Great. Thank you. How should we think about the scale of deployments going forward? So, what percentage of your mix should we think about being deployed that way. And then, maybe I missed this, but talk a little bit about the current size of your sales force and how you are going to see that grow maybe over the next 12 months as the top-line is ramping? Thanks.
Sure. Well, this is Steve. As you think about the overall mix of our transactions have been pretty consistent with about – over 90% of our lease has been less than 5,000 square feet and I think that's really the meat and potatoes of our strategy and you will see that going forward, which is also one of the key attraction for why a lot of the cloud and content companies want to do business with us as well on the scale level. So, as far as number of transaction, I think you'll see that be fairly consistent. And as we've mentioned before, there is scale and hyperscale opportunities are more opportunistic they thought from those that – by that same ecosystem that can contribute to it and overall provide more value there.
So, they are important to us and as I mentioned before, we do want to improve there and we feel like the additional capacity that we're bringing online will give us the opportunity to do that. And you'll probably see as you've seen in other quarters where when those events do happen and those leases do occur, that that will outweigh some of the smaller deployments in terms of just square feet and overall revenue, so again opportunistic, needs to provide value to the ecosystem as well as through returns that our shareholders are looking for.
As far as the sales team is concerned, the overall expense structure we looked at – be very consistent to next year. We have done some things, we have some organizational changes last quarter and we are looking to drive better efficiencies that can better align to the markets as we have new capacity coming onboard and as we see just opportunities for improvement. So, across our sales, sales engineering and product mix, there is areas that we've already identified where we feel like we can make improvement there and we continue work there.
And what percent of your sales are coming from the channel partners right now and where do you see that going forward?
Our channel business fluctuates a bit from quarter to quarter. It's anywhere from I'd say 8% to 15% depending upon the quarter. It is an important part of our business and will continue to be an important part for us as we go forward. There's essentially off tables resources that can get our brand up in the marketplace and really not only carry our value but other components that are important to customers as they evolve their IT strategies is key to us. So, we continue to focus there and expand that and I expect our focus to be even more strong as we go forward.
Our next question comes from the line of Michael Funk with Bank of America.
Yeah, thank you for taking the question. A couple if I may. I understood that leasing can be lumpy any given quarter based on supply constraints and then I mean scale lumpiness as well. You know where do you see leasing longer-term, as capacity comes online and maybe more on a normalized basis for the scale business.
I think you'll continue to see it be lumpy. There is – and the use cases that go into that scale leasing, again I think you need to look at what the deployment is within those larger scale leases and how they either value or don't value. The ecosystem and the network connectivity that we offer within our campus model, because some don't. And those that are – that don't value that up and drive much lower price points that frankly is an additive to our ecosystem or our shareholders and the return that we expect. So, again, it will be opportunistic, but we do see good opportunity and the opportunity actually improving as those low lengths of use cases continue to evolve and we see more and more of those every day, across every industry for that matter. So, as you see capacity come on, especially within our top four markets, we expect to see better performance there as it relates to scale and hyperscale opportunity.
One more if I may, I mean obviously you know ability to bring capacity online is dictated by obviously the permitting process and you know available land. What's your view with regard to you know other strategic alternatives for expanding the business either geographically you know product set or event just in terms of getting more reach and scale in the business in general?
So, great opportunity in our development program is that we are really meeting the needs of our customers where they have the highest need. People like us we're not developing these in-fill urban campuses that have these great connected communities. Somebody else would have to do it and you know the returns there are higher, because the difficulty and the ability of others to compete is you know rewards people who can do it and who pursue it and stick to it. So, we believe that's very strategically important to meet our customers' needs where they express the greatest desire for them and so that's I think for the foreseeable future that's going to be the highest and best use of capital. It has been since our IPO and I think we're going to continue to focus that as our primary strategy where we can differentiate ourselves both to our customers and to the investment community.
Our next question comes from the line of Richard Choe with JPMorgan.
I just wanted to ask a little bit about how we should think about the pacing of churn, the development and revenue growth. It seems like growth will be more back-end loaded in 2019 and accelerating into 2020. And then also can I have an idea of what gives you the confidence about the low double digits in 2020 in terms of your pipeline, if you can give a sense there that would be great? Thank you.
Hey good morning Richard, let me just comment a little bit on any questions and I'll ask Steve add some color and commentary. But you are right in that as you point out that in the second half of 2019 is where you are going to see some additional capacity being added and that's going to be the Bay Area with the completion of the first phase SV8. And so, I think what is important and we've tried to get as – be as transparent on this as possible which is getting to when capacity will be coming online on a quarterly basis and by market. Keep in mind that as we do bring some of that capacity online, depending upon whether some of its pre-leased or not. If we don't have any pre-leasing, you will see some impact – negative impact to our earnings as a result of absorbing some of costs until we get that list up to a certain level. So just keep that in mind as you look at your quarterly models. And in terms of what's driving that or our confidence around – you know beyond that, I'll just have Steven or Paul comment on that.
So I think what you are really asking Richard is, our confidence levels around the timing of delivering capacity, I hope this isn't too much detail, but as we go through our process is the biggest unknowns are in the permitting process. They are just a lot of steps, a lot of opportunities for community input, special environmental reviews. And so, until you are basically at the end of that, it's a lot harder to predict what the timing of development will be. We feel pretty good because we are pretty far along in the properties that have not been permitted yet, and so we've got a few hurdles behind us. Once we have a property under contract with the general contractor, those contracts have set target dates that are based on assumptions you know around field conditions and weather to some extent. And you know sometimes you'll exceed those exceptions, sometimes you won't, but typically on average you are going to be right around those contracted dates with your general contractor. So, once we start coming out of the ground with vertical construction, there are a lot fewer variables that can, you know not completely eliminated but fewer that can impact your schedule and your delivery time lines.
And to follow-up on that really quickly, when can you actually starts selling that capacity and have it in bookings? Is that a second that or like when these properties are actually made or is it – can you do it ahead of scheduled kind of just some idea of timing? When we can actually do booking?
So as we said in the past, it really does somewhat depend upon market and somewhat on buyer, but a good rule of thumb is that some pre-leasing can begin to take place, you know generally three to six months before you have an expected certificate of occupancy. And so, typically we see some preleasing before we actually opened up a facility and we try to approach that opportunistic. We are trying to smooth out the J-curve but still get to right applications that value the ecosystem, and the best pricing that we can.
Right. Thank you.
And our next question comes from line of Erik Rasmussen with Stifel.
Thanks for taking the questions. A lot has been addressed, but just circling back maybe some clarification on the churn. You guys talked about elevated churn levels in the first half of the 2019 and getting back to more normal levels. But is that 6% to 8% still a good range to consider with the context of the first half guidance?
Good morning, Eric. I think when we referenced back to normal levels, we would consider our normal levels to be somewhere between 1% to 2% per quarter, so take a midpoint of some more around 3% from the backend of the year, and if you add on to that 4.25%, you're going to be somewhere towards the higher end of that 6% to 8% range. We are a ways out from some of that, but based on the visibility at least that we have in the first half, we wanted to at least make sure people were aware of it as you considering your models and obviously we are going to work to outperform, but that's our best visibility as we sit here today.
Great, thanks. And then the interconnection, your guide this year is 11% to 14% growth has been decelerating, obviously there is some churn as I think was it talked a little bit earlier that kind of leaks into the equation here. But what is an appropriate growth rate next year or what you are targeting is kind of a longer term, is it 11% to 14% still appropriate? Or can that change based on some of the development that's happening in the pipeline that you have?
A great question, Eric. Let me address that. I think if you look at year-to-date growth for our interconnect, we're right at about 12.3%, and I would expect this to end up somewhere in our guidance range of 11% to 14%. If I had to guess maybe towards the lower end, but we'll see how Q4 ultimately produces. In terms of beyond that, we'll obviously plan to give some specific guidance as we typically do on our February call. I think the things to consider is that volume growth really generally is going to drive that revenue growth, absent any increases in pricing or migrating certain customers to different products. So I without giving a lot of specificity, I think it's a reasonable range, but as we get better clarity into 2019 will give some specifics around it probably in February.
Great, thanks. And one final one, obviously, you categorize next year as the transition year and there is a lot of development happening, and you know you talked in the past and it seems like it's still very much in an issue now or consideration is the local permitting. But what could potentially pull that or drive that growth rate up next year? I mean is there potential to pull some of these – from this land held for development into production now or is it difficult based on the market that you guys participate in?
So in terms of upside opportunities, the two primary things that could drive that would be; A, if we lease up more quickly the computer rooms that are coming on line in the new buildings that were constructing. B, if we have to start sooner constructing new computer rooms in those buildings or for example in the VA3 campus, where we actually have some shelf where we can add some additional computer rooms more quickly than doing ground up development. So if it is a big year for scale leasing that would be the sort of thing that would drive upside to what we described on this call.
Great, that helpful. Thanks so much.
The next question comes from the line of Ari Klein with BMO.
Thanks. Just going back to Northern Virginia, as early to the pricing decline you've noted over the last 12 to 18 months. Have you seen that accelerate at all recently? And then just as far as the lack of available capacity recently. Has that in any way affected your customer relationship at all?
So, on the first question, I don't think we can pinpoint exactly when that pricing drop occurred over. That's why I said over the last 12 to 18 months, but it doesn't seem to have changed much in the last quarter or two as far as we can tell. On the second point to be honest, I think we've actually been fortunate in that we haven't had to – and part of this is holding some stuff back, so that we make sure we can take care of the existing customers, but we haven't had to disappoint any existing customers and their need or ability to expand in our current markets yet. Although, we do see them ramping up and using up space that was acquired previously, so we do need to stay on top of our development.
Thank.
The next questions come from line of Lukas Hartwich with Green Street Advisors.
Hi guys. Given the deceleration in interconnection revenue growth, do you think you're hitting some sort of saturation point there?
I mean I think the best that we can tell Lukas is that it is just – this part of the cycle related to telecom and carrier, M&A and subsequent pruning. There has been this longer term slow grind of the 10-gig or 100-gig, but that doesn't seem to have meaningfully changed. On the other hand as you know from the history of this industry, the cycles tend to increase and decrease as a new data products and new demand sources come up. So, I don't think we are negative about interconnection trend growth. We think it's a solid component of the story and the industry and consumer factors that drive it continued to be positive.
That's helpful. And then can you just remind us about the company stance on international expansion?
We just haven't seen it as necessary to fulfill our business plan or meet our customer needs. And so far compared to developing in the markets that we are in is not the best way to provide value to either our customers or shareholders.
Great, thank you.
Thank you. We reached at the end of our question-and-answer session. I'll like to turn the floor back to Paul Szurek for closing comments.
Thank you all for being on the call and for your interest in those good questions. We'll be at NAREIT in a couple of weeks. I am sure many of you will be there as well, and we look forward to seeing you. I'd like to just close by thanking my colleagues at CoreSite, as you can tell from the information we provide to you we have a lot of good things happening that require a really capable team, building out new capacity, bringing in all these high quality new customers into our ecosystem, continuing to drive a good product mix of customers within our ecosystem and great diversity there. These are not easy things to accomplish and I am really proud of how well all the members of our team prosecute their jobs day in and day out, and I'd like to thank the board. Have a great day.
Thank you. This concludes today's teleconference. You may disconnect your lines at this time. And thank you for your participation.