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Edited Transcript of COR earnings conference call or presentation 26-Jul-18 4:00pm GMT

Q2 2018 CoreSite Realty Corp Earnings Call

DENVER Aug 10, 2018 (Thomson StreetEvents) -- Edited Transcript of CoreSite Realty Corp earnings conference call or presentation Thursday, July 26, 2018 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Greer Aviv

CoreSite Realty Corporation - VP of IR & Corporate Communications

* Jeffrey S. Finnin

CoreSite Realty Corporation - CFO

* Paul E. Szurek

CoreSite Realty Corporation - President, CEO & Director

* Steven J. Smith

CoreSite Realty Corporation - Chief Revenue Officer

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Conference Call Participants

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* Ahmed Sami Badri

Crédit Suisse AG, Research Division - Senior Analyst

* Ari Klein

BMO Capital Markets Equity Research - Associate

* Colby Alexander Synesael

Cowen and Company, LLC, Research Division - MD and Senior Research Analyst

* Eric Thomas Luebchow

Wells Fargo Securities, LLC, Research Division - Associate Analyst

* Erik Peter Rasmussen

Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst

* Frank Garrett Louthan

Raymond James & Associates, Inc., Research Division - MD of Equity Research

* Jonathan Michael Petersen

Jefferies LLC, Research Division - Equity Analyst

* Jordan Sadler

KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst

* Lukas Michael Hartwich

Green Street Advisors, LLC, Research Division - Senior Analyst

* Nicholas Ralph Del Deo

MoffettNathanson LLC - Analyst

* Robert Ari Gutman

Guggenheim Securities, LLC, Research Division - Senior Analyst

* Richard Choe

JP Morgan Chase & Co, Research Division - VP in Equity Research

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Presentation

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Operator [1]

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Greetings, and welcome to the CoreSite Realty Second Quarter 2018 Earnings Call. (Operator Instructions) As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Greer Aviv. Please go ahead.

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Greer Aviv, CoreSite Realty Corporation - VP of IR & Corporate Communications [2]

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Thank you. Good morning, and welcome to CoreSite's second quarter 2018 earnings conference call. I'm 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 website at coresite.com. And now I'll turn the call over to Paul.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [3]

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Good morning, and thank you for joining us today. We continue to execute well, achieving another quarter of strong growth with revenue, adjusted EBITDA and FFO per share each increasing 16% year-over-year. Regarding our strong internal growth, we had solid performance on substantially all measurements, including solid cash rent growth on renewals, low churn and 8% year-over-year growth and same-store monthly recurring revenue per cabinet equivalent.

Our sales activity generated $10.4 million net of annualized GAAP rent signed in new and expansion leases. Our core retail colocation business was solid, and we had a good quarter and scaled colocation leasing. Healthy organic growth was represented by 90% of GAAP rents signed coming from the expansion of existing customers. New customers looking to optimize their IT architecture were embarked on a digital transformation drove the 28 new logos we signed in Q2.

More importantly, we believe we continue to see an increase in the quality of new logos. The annualized GAAP rents signed by them in Q2 increased 13% compared to the trailing 12-month average, while the number of kilowatts licensed increased 10%. Hybrid cloud architectures appear to be gaining traction because they permit scaling, expansion, cost efficiencies and adoption of new technology products, including the constantly growing menu of cloud-based applications. We believe most companies today can deploy valuable innovative applications, even globally, from a single well-connected data center, with the right customer ecosystem and to direct connect facilities.

Our network and cloud-connected data centers, together with our customer communities, can help businesses with this kind of rapid scaling and innovation, while also generally lowering their cost per data center capacity. Our facilities continue to benefit from businesses requiring low latency and robust performance to serve many consumers and enterprises in our very large edge markets. We remain optimistic about the demand trends we are seeing in these markets, and supply is generally in balance with demand. Our Q2 pricing realized reflects the relatively stable pricing in the markets and segments we compete in. We also continue to make solid progress on the building blocks for future growth.

In Los Angeles, we commenced construction on 28,000 square feet of data center capacity at LA2, which is 100% preleased. Following the expansion signed by one of our strategic customers of LA2, we have approximately 65,000 square feet of remaining capacity at this building. Overall, we believe demand remained steady in L.A. and continues to outpace supply in the downtown market. With these dynamics in mind, we recently renewed our existing space in LA1 and expanded it to an additional 17,000 square feet. Importantly, this renewal and expansion extended the term of our lease by 7 years to 2029, and extended our control over our space of One Wilshire to 2044. As it relates to LA3, we continue to progress through the permitting process and expect to break ground in the last quarter of 2018. Please bear in mind that the timing is almost entirely determined here and in Santa Clara and Chicago by the municipal permitting process.

In Reston, we remain on track with our current phase of development at VA3 Phase 1B, scheduled for Q1 2019 delivery. In Santa Clara, we commenced demolition of the existing building on the SV8 site earlier this month. We expect to deliver Phase 1, consisting of 58,000 square feet of data center capacity during the third quarter of 2019. In Denver, we delivered 15,600 square feet of capacity at DE1, where capacity in the downtown area remains constrained. We have seen good demand in Denver. Finally, we completed 18,000 square feet of additional capacity at NY2 in Secaucus.

In summary, we are pleased with the quarter, and we are grateful for the colleagues who drive our success. I remain optimistic about our future opportunity, reflecting our solid position in great markets, with large numbers of dynamic enterprises, large populations of consumers of content, numerous sophisticated customers of cloud, analytics and similar data products and a good pipeline of capacity growth for the intermediate term. With that, I will turn the call over to Steve.

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [4]

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Thanks, Paul. Our new and expansion leasing activity was again driven by our core retail colocation group, which accounted for approximately 95% of leases signed in the quarter. We also had a good quarter in the scale colocation category, including a sizable expansion of an existing enterprise customer. In total, we executed 143 new and expansion leases, totaling $10.4 million in net annualized GAAP rent, comprised of 65,000 net rentable square feet at an average GAAP rate of $178 per square foot, offset by near-term reduction for reservation fees.

As it relates to portfolio-wide pricing, on a per kilowatt basis, Q2 new and expansion pricing was approximately 3% above the trailing 12-month average with variations by market similar to what we saw in Q1. We continue to focus on attracting high-quality new logos to our portfolio, signing 28 this quarter, which accounted for 10% of net annualized GAAP rent signed. Our well-established campuses, our cloud-enabled network dense data centers continue to be a magnet for enterprises, with this vertical representing 65% of annualized GAAP rent signed from new logos.

Among our new enterprise logos are our next-generation networking technologies company and a leader in open SDN solutions. We also signed 2 large West-Coast-based health and social services agencies, LifeLong Medical and the Children's Institute.

In the education vertical, we signed St. John's University and Udemy, a leading online college-level learning platform. Further, we had 5 IT solutions and services companies join our ecosystem, including Leidos, a Fortune 500 information technology, engineering and science solutions provider. Our strong organic growth reflects the continued expansion of existing customers across our portfolio, which accounted for 90% of annualized GAAP rent signed in Q2, including the enterprise customer that expanded its footprint with us in Los Angeles, discussed earlier.

In Denver, we also signed an expansion with a large social media company who'll be deploying its peering exchange serving the Rocky Mountain region with us.

Turning now to our vertical mix. Network and cloud customers accounted for 17% and 19% of annualized GAAP rent signed, respectively. The network vertical had a very strong quarter, with a high overall transaction count, and 60 logos signed including Pilot Fiber, an Internet service provider that will deploy with us in 4 markets to support its growing footprint.

We signed 6 new deployments from international networks, reflecting their continued strength and value of our ecosystem, with 2 of those international providers deployed in our Reston campus. Additionally, one of the world's largest telecom companies selected CoreSite in Virginia and Denver for significant deployments of its corporate infrastructure directly linking it to our cloud on-ramps, improving its performance as it moves to a hybrid cloud architecture for its internal IT needs.

The cloud vertical continued to perform well, adding 4 new logos, including on cybersecurity and intelligence provider. Additionally, a large [database] cloud and content provider expanded its footprint in Santa Clara to support the growth of 1 of its existing customers. Our enterprise vertical accounted for 64% of annualized GAAP rents signed, driven by a Fortune 500 customer that exercised its expansion option in anticipation of demand for its cloud platform in Los Angeles.

In addition, several other existing customers expanded, including the new deployment with one of the fastest-growing demand-side platforms and digital advertising, which chose CoreSite for its production environment and data analytics platform due to the ability to achieve scalability, high density and performance at the edge.

From a geographic perspective, our strongest markets in terms of annualized GAAP rent signed in new and expansion leases were Los Angeles, Silicon Valley, Northern Virginia and New York, New Jersey collectively representing 89% of annualized GAAP rent signed. Leasing in the Bay Area was weighted towards expansion of existing customers. In terms of verticals, cloud customers led leasing activity, including a new logo in Prismo Systems, which is a local provider of software for enterprise digital security operations.

New enterprise deployments included the signing by [stance.com]. Demand in Los Angeles was solid, with strength in the enterprise vertical followed by network and cloud deployments. New logo activity was well distributed among the verticals and includes a network [pop] from LiveCom Limited, a Chinese provider of satellite-based VoIP services. In Northern Virginia, leasing was driven by the network vertical with deployments across all of our buildings in the market and 2 networks that [prompted] VA3 Phase 1A.

Lastly, in New York, New Jersey, demand continued to be led by enterprise customers, including 4 new logos. Health care and media/gaming remain the primary demand drivers in this market, along with financial services. In addition, a leading public cloud provider expanded its footprint at NY1.

In summary, we are pleased with Q2 sales. Going forward, we will continue to focus on generating profitable organic growth, attracting high-quality new logos to our portfolio and delivering incremental value to our customers as we grow our ecosystem and footprint. I will now turn the call over to Jeff.

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [5]

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Thanks, Steve, and hello, everyone. Our Q2 financial performance resulted in total operating revenues of $136.4 million, a 5.3% increase on a sequential quarter basis and a 15.7% increase year-over-year. Data center revenue, consisting of rental revenue, power revenue and tenant reimbursements, contributed $116.1 million to operating revenues, an increase of 5.6% on a sequential quarter basis and 16.6% year-over-year.

Interconnection services contributed $17.4 million to operating revenues, an increase of 5.2% on a sequential quarter basis and 13.7% year-over-year. Excluding U.S. colo Interconnection revenue, Q2 Interconnection revenue grew 3.5% sequentially and 11.8% year-over-year.

Turning to FFO. We've reported $1.28 per diluted share and unit, up 0.8% on a sequential quarter basis and 16.4% year-over-year. As you think about sequential FFO growth in Q3, there are a few moving pieces to keep in mind as it relates to your models. First, in Q3, we usually have seasonally higher power cost, amounting to approximately $0.01 to $0.02 per share. Second, as a result of the renewal and expansion of our lease at LA1, we expect an increase of approximately $0.01 per share in our rent expense. And third, we anticipate increases in our property taxes of about $0.01 per share.

AFFO declined 0.5% sequentially, primarily due to higher interest expense and capitalized leasing commissions, reflecting an increased mix of scale colocation leasing in Q2. On a year-over-year basis, AFFO increased 30.5%, reflecting the growth in the operating portfolio and lower levels of recurring capital expenditures. Adjusted EBITDA of $74.9 million increased 2.7% sequentially and 15.5% year-over-year.

Our adjusted EBITDA margin for the trailing 12 months ended Q2 2018 was 54.7%, and remains in line with our expectations and our guidance for the full year. Sales and marketing expenses totaled $5.4 million or 3.9% of total operating revenues, up 20 basis points year-over-year.

General and administrative expenses were $10.3 million or 7.5% of total operating revenues, down 60 basis points year-over-year. Both amounts are in line as a percent of revenue to our expectations for the full year. Q2 same-store turnkey data center occupancy increased 430 basis points to 89.9% from 85.6% in the second quarter of 2017. Sequentially, same-store turnkey data center occupancy increased 80 basis points. Additionally, same-store monthly recurring revenue per cabinet equivalent increased 1.7% sequentially and 8.3% year-over-year to $1,483.

We renewed approximately 143,000 total square feet at an annualized GAAP rate of $137 per square foot. Our renewal pricing reflects mark-to-market growth of 2.8% on a cash basis and 5.7% on a GAAP basis. Year-to-date, our cash mark-to-market growth of 4.2% is in line with our guidance for the full year.

Churn was 1.3%, and we continue to expect churn for the year to be in the 6% to 8% range. As you may recall, within our annual churn guidance, we expected a 200-basis point impact related to a specific customer move out in Q4. With increased visibility related to this specific customer, we now expect approximately 70 basis points of churn in Q3, with the remainder in Q4. We commenced 34,000 net rentable square feet of new and expansion leases at an annualized GAAP rent of $192 per square foot, which represents $6.5 million of annualized GAAP rent.

Turning to backlog. Projected annualized GAAP rent from signed, but not yet commenced leases, was $9.9 million at June 30, 2018. On a cash basis, our backlog was $20.9 million. We expect approximately 42% of the GAAP backlog to commence during the second half of 2018, with the remainder expected to commence during the first half of 2019.

We ended the quarter with our stabilized data center occupancy at 93%, a decrease of 40 basis points compared to the prior quarter, primarily due to 2 computer rooms moving from the pre-stabilized pool to the stabilized pool. We have a total of 161,000 square feet of data center capacity in various stages of development across the portfolio. As the end of the second quarter, we had invested $56.3 million of the estimated $274.4 million required to complete these projects. Those buildings also include space for quick future construction of an additional 167,000 square feet of data center capacity.

Turning to our balance sheet. Our ratio of net principal debt to Q2 annualized adjusted EBITDA was 3.5x, in line with the prior quarter. As of the end of the second quarter, we had $336 million of total liquidity, consisting of available cash and capacity on our revolving credit facility.

In closing, I would like to address our updated guidance for 2018. I would remind you that our guidance reflects our current view of supply and demand dynamics in our markets as well as the health of the broader economy. We do not factor in changes in our portfolio resulting from acquisitions, dispositions or capital markets activity, other than what we have discussed today. As detailed on Page 23 of our Q2 earnings supplemental, our guidance updated for 2018 is as follows.

Total operating revenue is now estimated to be $537 million to $547 million compared to the previous range of $535 million to $545 million. Based on our year-to-date commencements of $22.7 million and our expectation for timing of commencements in our backlog, we now expect commencements for the full year to be closer to $36 million to $38 million in annualized GAAP rent compared to our original guidance of $40 million.

As Paul mentioned, keep in mind that the timing of future construction deliveries and related leasing is driven in large part by each locality's permitting process. While the lower level of commencements should not have a material impact on 2018 earnings, realization of incremental revenue in 2019 will depend on the timing of permitting and subsequent completion dates for SV8, LA3 and CH2.

So far, the municipal approval processes are tracking at the slower end of our estimates. Adjusted EBITDA is now estimated to be $293 million to $298 million, an increase of $2 million based on the midpoint of current and previous guidance. FFO is estimated to be $5 to $5.08 per share and OP unit. This midpoint of $5.04 per share represents an increase of $0.06 per share or 1.2% from the previous guidance. The increase in our FFO guidance also reflects lower-than-expected interest expense as a result of better-than-anticipated execution on the debt financing transactions completed in April.

As it relates to our guidance for capital expenditures. We are increasing the total expected investment to a range of $280 million to $310 million from the previous range of $250 million to $300 million. The increase is related to our outlook for data center expansion, primarily related to commencement of construction of SV8 and LA2 which we now expect to be $258 million to $273 million compared to the prior range of $228 million to $253 million.

Now we'd like to open the call to questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Jordan Sadler with KeyBanc Capital Markets.

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Jordan Sadler, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [2]

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I wanted to, first, just clarify something, Jeff, if you could in the guidance. Can you help me understand, just the difference between the upward adjustment in the operating revenues in the context of the downward adjustment and the commencements?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [3]

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You bet. Really, Jordan, it's -- the increase in revenues is really attributable to 2 things. And that's really related to the timing of the commencements. And it's also related to the product mix, predominantly powered. So as you think about commencements, even though we've taken them down slightly for the full year, the first half, we experienced slightly higher than what we anticipated in terms of those commencements. So it led to higher revenue that we're expecting for the rest of the year.

And then in terms of the profitability of the dollars, our product mix also helped contribute to most of that increase in revenue, basically flowing down through adjusted EBITDA and to FFO. And then the other item that I mentioned in my prepared remarks really relates to just interest expense, which is we're doing better than what we anticipated in our original guidance. So those are really the 3 pieces that drive the $0.06 increase, but the revenue is really driven by timing and commencements and the product mix.

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Jordan Sadler, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [4]

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Okay. And then in terms of product mix, is it -- it sounds like you said -- mentioned power revenues. So a greater mix of breakered-amp type requirements? Or...

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [5]

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That's exactly right. A greater proportion of the breakered product model than what we had anticipated.

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Jordan Sadler, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [6]

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And can you expand on that a little bit? It was sort of an area of questioning I was curious about in terms of what you're seeing, maybe that's better for Steve, trend-wise in terms of customer requirements. Are they still -- it seems like they're still receptive obviously, to the breakered-amp product, but are you seeing more pushback and are more people looking for metered power solutions today? Or no?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [7]

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Let me just give you what the numbers are telling us historically, and then Steve can give you a little commentary in terms of what the customers are seeing and saying. But if you just look at our product mix of power revenue today, that composition equals about 55% is on our breakered model and about 45% on our metered model. And that's been fairly consistent over the past several quarters. And so to date, we haven't seen a significant degradation of that breakered power model. But Steve can give you some commentary related to the conversations with customers.

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [8]

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Yes, sure. Thanks, Jeff. Jordan, as it relates to the overall mix, and the, I guess, adoption of the breakered model, the core retail colocation space is a big focus for us, always has been and we talked about that in the prepared remarks as well. And the bulk of those customers are typically buying at the size level and in the markets and the buildings, where breakered is the predominant product that those customers are buying. It gives them better predictability around their costs and also gives us a better view into how we distribute power across the building.

So overall that's -- I think, just speaks to the health of our business and that core area of retail colocation in those hybrid type of deployments that we're seeing from those enterprise customers.

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Jordan Sadler, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [9]

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Okay. And then Steve lastly, while I have you, I was curious, Jeff talked about I guess the pace of permitting and entitling or maybe planning, moving a little bit slower on some of the builds. And I'm kind of curious if that is, at all, affecting your ability on the preleasing side? Or basically what you're seeing on that -- on the pipeline for people who are interested in the possible prelease for some of those developments?

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [10]

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Well, I mean, as far -- from a overall pipeline perspective, the pipeline continues to be healthy. And as you look at just the overall data growth and the market in general and just technology adoption, the pipeline does remain healthy. I think that the preleasing window is probably shorter than it's been historically, because there's more inventory that's available on the market. But at the same time, still you see a healthy amount of pipeline that we feel like can time out well with when those commencements happen. So overall, it doesn't seem to be impacting us overall.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [11]

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Jordan, I just would add. This is Paul. We are still in the window of expectations for receiving permits that we've signaled previously, just at the slower end of that and that's 100% a reflection of the fact that we're building in infill markets, much stricter permitting processes, generally understaffed government agencies. In the long term, that creates a lot of the value in these markets. But it does make the short-term permitting harder to predict.

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Operator [12]

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Our next question comes from Robert Gutman with Guggenheim Securities.

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Robert Ari Gutman, Guggenheim Securities, LLC, Research Division - Senior Analyst [13]

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So it seems like the smaller footprint leasing was -- under 1,000 was accelerated a bit last quarter. Just wondering if you're seeing any -- what's underlying that in terms of market demand last quarter versus this quarter in that category. And was the scale stuff, did you say it was driven by 1 customer in particular? The rise there to $4.6 million from like $2.6 million last quarter?

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [14]

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I'll just speak to the overall demand aspects of the less than 1,000 square feet there, first I guess. I wouldn't say I've seen any major shifts in that space -- in that market. As I mentioned earlier, it's a continued focus for the company, our marketing team and our overall sales team to try to bring in those customers, the majority of which are enterprises that are looking to deploy and take advantage of the many networks and cloud on-ramps that we have in our data centers. So overall, I'd say the trend is positive as more enterprises continue to adopt colocation and hybrid type of environments. But I wouldn't point to anything that says that anything dramatic has changed.

As it relates to the larger scale leases, Jeff has probably more detail on the numbers there. But...

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [15]

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Yes. Rob, it was driven by -- really there's a handful of customers in that second bucket. And obviously, one was a little bit on the larger side, but without going into any specifics around customer -- individual customer needs, that's about what we can tell you today.

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Operator [16]

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Our next question comes from Colby Synesael with Cowen.

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Colby Alexander Synesael, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [17]

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The revenue per cabinet up -- I think, it was up 8%, pretty strong growth there. Just wondering if there's anything worth calling out in the sustainability of that going forward? And then also, just more broadly, Paul, just curious if you can give us your current thinking on the importance of market expansion, having a global footprint? How that may or may not have changed in terms of your thinking over the last, I guess, since the beginning of the year?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [18]

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Colby, let me address your first question. Really, when you look at that MRR per Cab E growth, what we saw this quarter is very consistent with what we've seen in the past several quarters, which is the Interconnection revenue and the power revenue are really driving the majority of that increase. So for instance, Interconnection revenue in our same-store on a per Cab E basis was up 10% and power was up 13%. Overall, contributing to the 8.3% increase we saw year-over-year.

As we look at the second half of the year, I would tell you that we would anticipate that MRR per Cab E growth to be at the mid- to higher single digits, consistent with what we saw the first 2 quarters of 2018, to give you some idea of what we expect.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [19]

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Colby, expanding to new markets would be a nice to have, not a need to have. We have plenty of opportunity in the markets where we are. And frankly, building out the campuses and the scale and the customer ecosystems is a really good way to drive value, both for customers and for shareholders. We do continue to look at other markets. If we -- where we can enter and follow our existing business model.

Internationally, our views have not changed on that over the course of the year. We continue to have very good traction with non-U. S. customers attracted to our campus communities. And an increasing amount of our customers, both new and old, who are able to go international via other mechanisms than establishing their own data centers in other places, cloud, content delivery and things like that.

So I think we provide a very good service to those customers by making it easier for them to do that within our data centers that have all the companies and the utilities they need in order to do that.

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Operator [20]

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Our next question comes from Frank Louthan with Raymond James.

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Frank Garrett Louthan, Raymond James & Associates, Inc., Research Division - MD of Equity Research [21]

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Great. I want to dig into what factors inflation may be having and its potential impact on development yields. What are you seeing in both sort of raw materials and labor and your outlook and the ability to kind of pass that along? Did any of that play into the increased CapEx for SV8 and LA2?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [22]

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Not really LA2, a little bit in SV8 labor costs in the Northern California market are -- have increased. Materials costs have increased a bit. I'm sure you all know what's going in the background there. But with all that, and as Steve mentioned in his prepared comments, pricing continues to be pretty strong. We were actually 3% above our trailing 12 months average on a per kilowatt basis. And so we still expect to achieve or exceed our targeted returns on investment that we previously talked about.

So yes, you got to be -- you got to pay more attention to your development planning and design and cost. Brian Warren and his team are doing a good job with that. And we think everything will work out pretty well.

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Operator [23]

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Our next question comes from Nick Del Deo with MoffettNathanson.

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Nicholas Ralph Del Deo, MoffettNathanson LLC - Analyst [24]

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First, a guidance clarification for Jeff. You mentioned the timing of commencements and product mix for the revenue guidance change. How much did the U.S. colo acquisition play into that? If I remember correctly, last quarter you didn't include it and it was going to be worth a couple of million bucks this year.

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [25]

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Yes. Nick, what we're seeing from U.S. colo is, obviously, it's contributing some to our revenues. And has played in part to some of what we're seeing with the results and ultimately guidance. To date, U.S. colo contributed about, for the second quarter, it contributed about $1 million of revenue in the quarter. That gives you some idea in terms of its contribution.

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Nicholas Ralph Del Deo, MoffettNathanson LLC - Analyst [26]

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Okay. And maybe 1 bigger picture question. Do you guys have any interest in developing your own SDN offering the way Equinix is? Or is that not something that makes sense for you?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [27]

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So there's a lot of different flavors of how companies can service customer desire for more nimbleness and how they provision aspects of their network. We recently pushed through and upgraded to our Open Cloud Exchange, which provides a lot of that functionality, more options for customers, a broader range of choices they can make, greater API integration to other platforms. And that's a utility that we can continue to evolve to give customers more control and flexibility about how they provision both cloud and network.

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Operator [28]

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Our next question comes from Sami Badri with Credit Suisse.

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Ahmed Sami Badri, Crédit Suisse AG, Research Division - Senior Analyst [29]

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Jeff, you made a comment earlier about 3Q, 2018, realizing higher power costs. And I just wanted to understand, what is driving that across your customer workloads and installed bases? Like what is fundamentally happening around that time in the seasonality?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [30]

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It's really not attributable to our customer workloads, Sami, it's really attributable to the rates that we receive from our power providers. That's -- it's something that happens every year due to the increased volumes of power consumption throughout the markets, not just from data centers. Obviously, just from the U.S. consumption in general. And that's just very common, and we see it every year, and it's about $0.01 to $0.02 per share in the third quarter, is what we would typically see.

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Ahmed Sami Badri, Crédit Suisse AG, Research Division - Senior Analyst [31]

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Got it. And then the next question is more to do with how we should be thinking about modeling in the dividend and dividend growth rate over time. And you've increased it now a couple times in the last 2 years, probably a little bit faster than what some people are already modeling. Should we think about modeling an adjustment with like the payout ratio against the dividend like maybe close -- maybe you could just give us an idea on how we should be doing this? How should we think about this in the next 2 years as far as total dividend?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [32]

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Yes. I think the best way to look at that, Sami, is if you look at our payout ratio and just take the second quarter of '18 and this is provided on Page 9 of our supplemental, you can see that our payout is about 82% of our trailing 12 months FFO and it's about 91% of our trailing 12 months AFFO. I don't anticipate those increasing meaningfully. They're already at the -- fairly at the high level. If they move, it would be (inaudible) at the margin at best. So what really is going to drive that growth is really growth in our cash flow, which, as we've talked in the past, is really driven by what we defined as cash flow that is distributable to our common equity holders, which is AFFO less nonrecurring capital. All of that's disclosed in a way in our supplemental, but that's really the way we manage around our dividend increases, is to monitor increases in [CFDCE]today. And what we think it will do prospectively.

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Operator [33]

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Our next question comes from Erik Rasmussen with Stifel.

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Erik Peter Rasmussen, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [34]

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So circling back with the permitting. The pace seems to be slowing down, but it's still kind of within the range. But what has fundamentally changed? Is it really just more of a supply and more deals kind of trying to be put through the system? And then do you continue to see this as a headwind and -- or do you think, at some point, things can free up a little bit? And I have a follow-up.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [35]

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So honestly, I don't think there's any new news here. It's within the ranges of what we've said before. And it's pretty typical for these types of permitting environments. In fact again, I want to give credit to our development and construction team for being very proactive and getting us within the ranges that we've originally set. Just to give you some historical perspective, if you go back to VA2, which we built on land that we already owned before we started the special exception, design and construction process, we started that in early 2011. We're not able to bring new capacity on until the first quarter of 2015, so about 4 years. Every project that we've got going on right now is tracking to about 50% of that time line. So again, not a -- not an unusual situation in any of these markets. It just is what it is, and it makes the asset more valuable going forward.

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [36]

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Erik, one thing I will point out to just because I think it's important as you and others think about models for 2019. Because obviously, we've had 3 ground-up developments that have -- that we are working on, as Paul alluded to. The only thing I would add is that you saw we put SV8 under construction this quarter and so we have better visibility into the timing we've disclosed that at this point as being sometime in Q3 2019, is when we think we will be completed with that first phase.

As you think about the other 2 construction projects that we're working on, LA3 and CH2, we've always said that -- we always thought LA3 would be expected to be completed by sometime in the back half of 2019. And we still expect it to be in late 2019, but as Paul alluded to, subject to what happens on the permitting process.

As it relates to CH2, we've always been saying it's sometime probably in late '19, early 2020. As we sit here today, I think it's probably leaning towards more early 2020 before that would get completed, again tracking towards the latter part of our original estimates. So just think about that and factor that in as you guys model 2019.

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Erik Peter Rasmussen, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [37]

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That's helpful. And then just around -- there seems to be a lot of variability on your larger colo deals. The prior 2 quarters' numbers were down -- or lower, but then you've seen a meaningful improvement this quarter. Speak to maybe that. Is that just the nature of this business? Can you explain the variances and maybe your expectations for these larger deals?

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [38]

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Yes. Erik, this is Steve. I'll answer that for you. It is lumpy, as you've seen in our results. And I think that we've kind of called that out as the expectation, both in prior calls as well as going forward. We do look to really be disciplined on how we approach that marketplace and make sure that those leases that we're signing on that larger scale are additive and complement our ecosystem. So there's a lot of hyperscale deals that are going on out there that are probably not a great fit for us, given the economics that are associated with it and whether or not they value the ecosystem of our customers as well as networks and other on-ramps. And so making sure that we get those right customers and right deployments doesn't happen every day, but there is still a good pipeline of those types of deployments that are out there.

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Operator [39]

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Next question comes from Jon Petersen with Jefferies & Company.

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Jonathan Michael Petersen, Jefferies LLC, Research Division - Equity Analyst [40]

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So the pricing on new leases this quarter was a little below average from recent quarters. But obviously, you guys had a 1 or 2 large-scale deals. So I'm just kind of curious if you could maybe break out the different product types, smaller leases, scale-sized leases. I mean, how are rents trending? And then maybe even a little more specifically on the scale side, are you seeing rents trend down like we're seeing with some of these really huge hyperscale deals, which I know you guys don't usually play in?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [41]

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So Jon, let me take a stab at that and Steve and Jeff can jump in if they -- if I omit anything. We try to give both space and power pricing, because both components play into our business. And with higher density stuff, the power side of it actually tends to be more meaningful. And as you saw from Steve's comments, on a per kilowatt basis, our pricing was 3% above the trailing 12 months. We don't break out pricing by market and by product because, quite honestly, that just gives away too much competitive information. But we do look at that internally, and we feel good about where the trends are.

As Steve said, it's up in some markets, down in some others. But overall, it's up. And as it relates to scale leasing, we tend to focus on those scale leasing opportunities that need the retail colocation ecosystem or the network ecosystem. There's more value to those types of scale opportunities in our data centers. And so far, we're seeing that pricing hold up pretty well, although that does vary by market.

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Jonathan Michael Petersen, Jefferies LLC, Research Division - Equity Analyst [42]

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Okay. And then maybe a question for Jeff on the balance sheet. I mean, just thinking about your capital needs between now and the end of the year, and maybe into 2019. I guess, what sort of financing needs do you have? I guess, how does the preferred market look today versus maybe some unsecured debt? And then also, with the permitting process, I guess, slowing down some of these developments in L.A., Santa Clara and Chicago, does that kind of push out, I guess, your capital needs a little bit? Just trying to think about how we should be modeling from that perspective?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [43]

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Sure. Yes, Jon, I think when you look at the guidance we updated related to our CapEx spend, you can see the midpoint went up by about $20 million, so call it $295 million is what we're currently guiding to in terms of total CapEx spend. We spent $120 million in the first half, which means you'll see some accelerated spend in the second half of the year, upwards around $175 million. Just given where our total liquidity is, I don't think we need to do anything from a financing perspective through the end of this year. And so there's no need to do it.

Having said that, it is something we watch closely to see whether or not there is any type of movements or changes in the markets that we might want to take advantage of. But as we sit here today, if I had to bet, I would say I can't imagine us doing something by the end of the year. It'd probably be more of a first quarter, maybe early Q2 2019 type of event, unless something changes significantly from a pricing perspective that we might want to capture before the end of the year.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [44]

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I would only add that given our low leverage, I don't think we would tap the preferred market.

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Operator [45]

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Our next question comes from Richard Choe with JPMorgan.

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Richard Choe, JP Morgan Chase & Co, Research Division - VP in Equity Research [46]

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I wanted to ask about the churn event in 4Q? So far, rental revenue has been growing on a dollar basis at a very nice rate. How should we think about the impact of that churn event, and then going into '19, what the quarterly impact will be?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [47]

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Richard, let me see if I can address that and add any additional commentary. So we updated our guidance this quarter related to that particular churn event. And just given some incremental visibility we have, we know that, that particular customer is going to churn about 70 basis points of their deployment in the third quarter. And we're estimating the remaining 130 basis points of churn in the fourth quarter. So I'm not sure I could add any more commentary associated with it beyond that, other than to say that it's obviously a customer we continue to have conversations with. And we'll see ultimately what they end up doing in the fourth quarter. But at this point, we're modeling as if they churned, but we don't have perfect visibility into that as we sit here today.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [48]

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And Richard that -- even with that, it just puts our churn in our normal historical range year by year.

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [49]

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Yes. I appreciate that, Paul. I think we typically expect -- I'd say we're continuing to expect 6% to 8% churn for the full year of 2018.

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [50]

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Well, I guess -- this is Steve. Just some added color, I guess, there relative to the churn of that customer. The churn that we do expect is in our stronger markets. So as far as the backfill and more customers in there, we're bullish on that and optimistic.

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Richard Choe, JP Morgan Chase & Co, Research Division - VP in Equity Research [51]

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So can I take away from that, that if this customer didn't churn, churn would probably be lower and it's probably going to be quickly backfilled?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [52]

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I think that's a good way to look at it, yes.

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Operator [53]

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Our next question comes from Ari Klein with BMO Capital Markets.

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Ari Klein, BMO Capital Markets Equity Research - Associate [54]

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Maybe just following up on that last question. What kind of Interconnection footprint does that customer that's churning have? And then maybe turning to the scale leasing opportunities. How does that compare to -- how does the pipeline for that compare to maybe a year ago? And do you expect that to continue to grow?

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [55]

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As far as the Interconnection footprint, typically, on those larger leases, the intensity of Interconnection is less than you would see on kind of our smaller deployments when you look at it on a either per square footage basis or on a per kilowatt basis. I don't have the specifics in front of me as to that individual customer. And I'm not sure we would disclose that anyway. But not a material amount, I guess, is probably the easiest way to put it in the great scheme of things as it relates to our Interconnection landscape.

As you think about scale leasing, as I mentioned before, it is lumpy as far as the deals that we write. The overall pipeline is still very healthy, as I mentioned earlier. And the forecast, as we look towards it, is optimistic. It's just a matter of aligning those key deployments that also, again, value our ecosystem, are looking to take advantage of it. But also, are willing to essentially pay for it. There are some lower-cost providers out there that don't offer that same value and if they're looking for just space, power and cooling, and don't value that, it's probably not a great fit for us. So there's a lot of kilowatts that are being sold out there that probably aren't a great fit for us, and how we align that and be disciplined around our pricing and how it fits in our ecosystem is the game we play. So overall, we're optimistic and it looks positive.

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Ari Klein, BMO Capital Markets Equity Research - Associate [56]

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And regarding the extended development time lines, how should we think about CapEx into next year? Can it be higher than 2018?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [57]

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Yes. Ari, I think as you think about it, typically, when we have ground-up development starts like what we would expect to see with LA3 in 2019, that's typically going to drive CapEx at the higher level than what we would normally see. Without giving you some specific numbers, I would just anticipate it. I wouldn't see it decreasing meaningfully from what we expect for this year, let's just say that. I would expect it to be a little bit elevated like what we saw again this year.

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Operator [58]

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Next question comes from Lukas Hartwich with Green Street Advisors.

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Lukas Michael Hartwich, Green Street Advisors, LLC, Research Division - Senior Analyst [59]

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Just 1 for me. Edge computing seems to kind of continue its positive momentum. What sort of opportunity do you think that presents for CoreSite?

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [60]

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I'll dive in on that one. This is Steve. I think it's a great opportunity for us, and it continues to -- you continue to see innovation in the marketplace that is turning new businesses into global players. Traditional brick-and-mortar type of businesses are being put on their head and now being done in more electronic ways that require low latency. And all of those are being deployed at the edge. A lot around artificial intelligence as well as the emergence of 5G on the mobile front. All of that leads to the critical need to improve speed to the end user, which means edge computing.

So we feel like we're well positioned for that because that requires Interconnection and networks to make that happen. And we feel like we have a great model in terms of both the Interconnection footprint that we have as well as the ability to support some of those kind of, I would call it, kind of midscale type of deployments that are typically come along with those edge type of environments.

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Operator [61]

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Our next question comes from Eric Luebchow with Wells Fargo.

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Eric Thomas Luebchow, Wells Fargo Securities, LLC, Research Division - Associate Analyst [62]

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I'll just ask 1. I know you said last quarter you're operating at a slightly lower level of sellable inventory than you had historically. If you could just update us on where you sit today on your inventory levels as we look out toward the second half of 2018? And whether any potential capacity constraints could impact your ability to do -- continue your momentum with scale leasing over the course of the year?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [63]

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So the good news is that we've restored our sellable inventory to more normal levels. I think we ended the quarter with about 265,000 square feet of sellable inventory. We actually have under -- we completed so far this year 147,000 square feet. We actually have a 161,000 square feet of the initial phases of development in various stages of construction or development. And in those buildings, we could very quickly add another 167,000 square feet of capacity. And we still have some capacity in other markets for expansion.

So we feel like we're in good shape. When you look back over the last 2 years, we were -- we had 1 building under construction in July of 2016, and no new land for development. And now we've got 4 projects under construction or in development on new land. And all of them are proceeding apace. So we feel like we've rebuilt the pipeline, and although the timing related to permitting is not greatly predictable, it's a matter of short timing. And once we get through that, the new capacity will come on into very regular pace.

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Operator [64]

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I would like to turn the floor over to Paul Szurek for closing comments.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [65]

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Thank you for joining us today. I do want to thank my colleagues for another solid quarter. We're all very fortunate to work with a talented group of people here at CoreSite. I also want to congratulate Steve and Maile Kaiser on their new roles of Chief Revenue Officer and Senior Vice President of Sales, respectively. And thank them for taking on those larger roles. I look forward to seeing how Steve and Maile can both further drive growth with their broader responsibilities.

It is great that this exciting industry and our organizational ethos combined to enable us to provide these kind of growth opportunities for our team. We look forward to the future. Hope you all have a great day.