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Edited Transcript of COR earnings conference call or presentation 25-Oct-18 4:00pm GMT

Q3 2018 CoreSite Realty Corp Earnings Call

DENVER Oct 26, 2018 (Thomson StreetEvents) -- Edited Transcript of CoreSite Realty Corp earnings conference call or presentation Thursday, October 25, 2018 at 4:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Derek S. McCandless

CoreSite Realty Corporation - Senior VP of Legal, General Counsel & Secretary

* 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

* Aryeh Klein

BMO Capital Markets Equity Research - Associate

* Bora Lee

RBC Capital Markets, LLC, Research Division - Associate VP

* Colby Alexander Synesael

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

* David Bryan Rodgers

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Erik Peter Rasmussen

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

* Frank Garrett Louthan

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

* Jordan Sadler

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

* Lukas Michael Hartwich

Green Street Advisors, LLC, Research Division - Senior Analyst

* Michael Rollins

Citigroup Inc, Research Division - MD and U.S. Telecoms Analyst

* Michael J. Funk

BofA Merrill Lynch, Research Division - VP

* Nicholas Ralph Del Deo

MoffettNathanson LLC - Analyst

* Robert Ari Gutman

Guggenheim Securities, LLC, Research Division - Senior Analyst

* Yong 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 CoreSite Realty Corporation's Third Quarter 2018 Earnings Conference Call. (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.

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Derek S. McCandless, CoreSite Realty Corporation - Senior VP of Legal, General Counsel & Secretary [2]

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Thank you. Good morning, and welcome to CoreSite's Third 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 the 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. I'm 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 concerted efforts to focus on quality deployments and strong pricing has paid off in this area.

Scale colocation 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 2 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 online beginning in 2019; and the normal lumpiness in scale leasing, as to 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 a strong quarter in number and quality of new logo acquisitions. The annualized GAAP rents signed by the 27 new logos in Q3 increased 11.2% compared to the trailing 12-month average. The number of kilowatts licensed increased 15.4%, and the average lease length 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, 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 has declined in Northern Virginia over the last 12 to 18 months, which will likely impact our prelease economics for 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 prepared for the new capacity in our construction pipeline, and we have an excellent group of colleagues who drive our success. Demand for and stickiness of data center deployments 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.

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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 product, which accounted for approximately 84% of the GAAP rents 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 at an 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 of our top 3 markets in terms of annualized GAAP rents signed for the first time in several quarters.

We saw a good traction in attracting high-quality new logos to our portfolio, signing 27 this quarter, which accounted for 19% of net annualized GAAP rents signed. Our well-established campus model of cloud-enabled, network-dense data centers continues to be a magnet for enterprises, with this vertical representing 61% of the annualized GAAP rents signed for new logos.

Among our new enterprise logos are a global leader in financial technology and payment processing; a leading network security provider; a top-tier member of the education vertical; a global provider of online games; and an 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, a major public cloud provider expanded its on-ramps with us in both our Denver and Los Angeles markets; a global web conferencing provider expanded with us in the Bay Area; and a key cloud-hosting company expanded with us in 2 additional markets.

Turning to our vertical mix. Network and cloud customers accounted for 25% and 35% of annualized GAAP rent signed, respectively. The network vertical had a good quarter, with high overall transaction count and 7 new logos signed, including 3 international network nodes, which speaks to our continued appeal with the international audience. We also signed a subsea cable deployment, connecting the consortium with telcos and major content players between the Los Angeles and Asia Pacific markets.

The cloud vertical continued to perform well, adding 4 new logos, including an industry-leading digital certificate provider as well as the expansion of 2 public cloud on-ramps in Denver and Los Angeles that were discussed earlier.

Our enterprise vertical accounted for 40% of annualized GAAP rent signed, driven by a leading ERP as a service software provider, now available on our global public cloud that expanded with us within an existing site and into a new market. In addition, several other existing customers expanded, including a member of the Fortune 500, seeking direct access to 3 of the cloud on-ramps we provide in the Santa Clara market; and a home goods e-commerce company expansion in Boston.

From a geographic perspective, our strongest markets in terms of annualized GAAP rent signed in new and expansion leases were Boston, Los Angeles, Northern Virginia and Silicon Valley. Collectively, new and expansion leases in these 4 markets represented 86% of annualized GAAP rent signed.

Demand in Boston was elevated this quarter, as customers leased new capacity we brought to the market in the fourth quarter of 2017. A large e-commerce company chose to expand with us into this new capacity, providing flexibility and a clear path for its continued future growth and expansion in the market.

Demand in Los Angeles was solid, with strength in the network vertical, followed by enterprise and cloud deployments. New logo activity included 7 new customers, which were well distributed among the verticals.

Northern Virginia continues to be our most competitive market with substantial amounts of undifferentiated offerings. However, this product set typically does not impact our competitiveness relative to latency, network and cloud-oriented use cases. Hence, leasing in this market was led by enterprise customers with 7 new logos. With regard to large-scale leasing, we look forward to presenting to the market additional capacity becoming available in early 2019.

Finally, leasing volume was lower in the Bay Area as a result of our tightened supply in this market. The cloud vertical led all 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 deployments as additional capacity becomes available. We're 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 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 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. Interconnection 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 cost, which amounted to $0.03 per share; and second, primarily as a result of the renewal and expansion of our lease at LA1, rent expense increased by $800,000 or nearly $0.02 per share. Partially offsetting these items were 2 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 buildout 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 turn-key data center occupancy increased 490 basis points to 90.1% from 85.2% in the third quarter of 2017. Sequentially, same-store turn-key data center 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 was 2.5%, inclusive of 70 basis points of churn from the single customer we mentioned last quarter. We anticipate this same customer to churn up to 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 data center 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 include space for 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 Q3 annualized adjusted EBITDA was 3.6x, 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 updates 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 and our expectation for timing of commencements in our backlog, we are decreasing our 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 5 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 data center landscape, we are comfortable modestly increasing our targeted debt to adjusted EBITDA ratio to 4.5x.

As a result of all of the above and the 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 and unit growth of mid-single digits in 2019 and accelerating into low double digits in 2020. All of these estimates are dependent upon completing and 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?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Jordan Sadler with KeyBanc.

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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 take a stab at the pipeline. It sounds like you guys are encouraged by what you're seeing in the scale pipeline. But I think -- and you pointed out, this quarter was a little bit light there. Is that just a function still of your -- the availability I think you touched on, Paul, in your prepared remarks? But just maybe a little bit of color around what you're seeing and why you're encouraged.

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [3]

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Jordan, this is Steve. I'll take a stab at it. And I think that we did cover it a bit in our prepared remarks there. We do see the overall pipeline remaining healthy. And I think, as you look at the use cases in the marketplace, they continue to drive more opportunity for that. And as we mentioned, there's a couple of things. One is we'd like to do better in that space. I think we can do better and there's things that we're 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're looking forward to getting that capacity back online.

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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 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 of the customers?

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [5]

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Well, I think it's more the nature of our strategy and how we're aligned around key metros 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 marketplace, artificial intelligence, autonomous vehicles, all of those kind of things that drive to more and more edge computing and latency-sensitive type of applications. And I think you'll just continue to see more of that, which sits very well with us.

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

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Right. And then, Jeff, could you clarify -- I caught your guidance there in the end. Was that FFO that you gave, growth for '19 and '20, upper single then low double digits?

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

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Yes, Jordan. I gave revenue and adjusted EBITDA growth for both '19 and '20 as well as FFO, so let me just clarify and repeat it.

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Jordan Sadler, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [8]

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Okay. I did hear this. Okay.

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [9]

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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.

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Jordan Sadler, KeyBanc Capital Markets Inc., Research Division - MD and Equity Research Analyst [10]

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And then just lastly, the churn that you're forecasting into the first half of next year, any additional insight on what's driving that elevation?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [11]

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Yes, 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're seeing some of that being a little bit elevated in the first half of next year.

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Operator [12]

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Our next question comes from the line of Dave Rodgers with Robert W. Baird.

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David Bryan Rodgers, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [13]

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Yes, just wanted to follow up on your comments about CapEx this year. It seems like it's getting pushed a little bit into next year -- and thanks for the added color on 2019 CapEx. But was that an execution problem in terms of maybe not getting more money out this year? Because clearly, there's been a capacity issue for a while and you'd think you guys would be a little bit higher on that and push as hard as you could to get that number as high as possible.

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [14]

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Yes, no. I wouldn't call it an execution problem, Dave. I think Brian Warren and our construction team are pushing as 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 into Q1, just depending upon where they are in the construction cycle. And 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 Q and that we're expected to start on late this year, early next year.

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David Bryan Rodgers, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [15]

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Paul, in your comments, you talked about impacting the return at VA3. Can you just dive a little bit further into that? Was that more a function of maybe how you now 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 the VA3? But maybe some added color will be helpful.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [16]

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Yes. It's mostly just market and what pricing for scale leases has done in Northern Virginia. Our best guess -- and again, we don't have -- these markets don't have perfect transparency, is that it's about -- down about 10% to 15% over the last 12 to 18 months for scale leasing. We will still -- we believe we'll still hit our targeted underwriting hurdles that we talked about in the past. But it does give us less cushion and room to outperform them as we frequently have in the past.

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David Bryan Rodgers, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [17]

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Okay, that's helpful. Then I don't know, for Steve or maybe back to Jeff. In terms of, like, 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 that was in the quarter and then kind of how you anticipate that impacting same-store MRR going into 2019.

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

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Yes. Let me give you the 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.

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [19]

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Then the only other thing I would add there, Dave, as you look at the overall mix and health of the Interconnection business, you look at enterprises connecting to cloud. We've seen that growth significantly in the 30% range. So overall, connectivity continues to grow, and I think, really, what you're seeing there predominantly is this, largely, effect of just rationalization of telcos as they come through that M&A process.

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David Bryan Rodgers, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [20]

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And the 8.1%, that's gross or net?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [21]

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That is net.

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Operator [22]

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Our next question comes from the line of Jonathan Atkin with RBC.

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Bora Lee, RBC Capital Markets, LLC, Research Division - Associate VP [23]

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This is Bora Lee on for John. 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?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [24]

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Bora, I would say that, in general, if you're inquiring in terms of whether or not there's additional capital required upon those renewals, it's very minimal, if any. And so there's not a lot of capital intensity on our typical renewals.

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Operator [25]

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Our next question comes from the line of Nick Del Deo with MoffettNathanson.

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

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Back to the price in Northern Virginia, are the pricing pressures you talked about for scale deployments bleeding into pricing for smaller deployments as well? Are those sufficiently differentiated that they've been shielded from those pressures?

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [27]

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Yes, 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 along with size. But 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 relative to pricing on the marketplace.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [28]

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Just to add on what Steve said though, Nick, as you can see from our overall pricing levels, it's not affecting the pricing for our core retail colocation product.

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Nicholas Ralph Del Deo, MoffettNathanson LLC - Analyst [29]

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Okay, got it. And then maybe turning to the development pipeline, what plans do you have currently for the space held for development in LA1? And how long would it take to turn that up once you decide to push the button?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [30]

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It's primarily there to accommodate the growth needs of existing customers as well as additional customers we expect to 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.

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Operator [31]

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Our next question comes from the line of Colby Synesael with Cowen and Company.

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Colby Alexander Synesael, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [32]

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Great. Two, if I may. First off, on the $400 million to $415 million CapEx next year, I assume that, that goes beyond the projects which you have 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 that there's still enough demand, I should say, in those markets to get you to the growth expectations that you're citing for 2019, and I guess, even more so, 2020? And then secondly, on leverage, you noted that you're 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?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [33]

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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 -- 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.

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [34]

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And Colby, in terms of the second question on the leverage, 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.

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Colby Alexander Synesael, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [35]

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Great. And then just, Paul, if I could just go back to your -- 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 4 or 5 markets to which you would 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, the scale product? Or is there another aspect of the story here that needs to get augmented over time?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [36]

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I think as we've shown historically and as we 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, so long as we are focused on differentiated use cases that require that interconnected, cloud-enabled campus dynamic. And 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 it'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 far between and really hard to forecast or incorporate into a model in any way.

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Operator [37]

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Our next question comes from the line of Robert Gutman with Guggenheim.

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Robert Ari Gutman, Guggenheim Securities, LLC, Research Division - Senior Analyst [38]

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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 $400 million-plus CapEx guide, a little more tangible indication in terms of the amount of capacity in net rentable square feet that you expect to add.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [39]

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Yes, 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 have some level of churn, which we report on a rent perspective, you're 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 until we ultimately see which customers churn and the timing of that event.

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [40]

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And just to get back to your other -- your second question, we've got about 160,000 square feet that is under construction today, and that, complemented with what we've 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 '19, some in late '19 and then some of that will ultimately bleed into early 2020.

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Robert Ari Gutman, Guggenheim Securities, LLC, Research Division - Senior Analyst [41]

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And do you think that -- last thing is longer-term, beyond 2019? Or does -- you're saying high single-digit growth '19, beyond that -- and low double-digit in '20. Is that a -- would you expect -- is there a long-term rate beyond that? Do you expect it to plateau around there? What's -- just an even longer-term view.

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [42]

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Yes, I wish I could give you more color on that, Rob. But a lot of it, as you've seen for '18 and '19 -- and it's really going to be dependent on the incremental capacity that we add to the market as well as performance on the sales side. And so I think -- we wanted to give some insight into 2019 and to 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.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [43]

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Well, let me just add to what Jeff said. 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 core and shell of all these 4 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 the land that we own down the road -- could, if the sales and demand are there, continue to maintain double-digit growth beyond 2020. But that's going to be dependent upon sales execution and demand.

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Operator [44]

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Our next question is from the line of Michael Rollins with Citi.

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Michael Rollins, Citigroup Inc, Research Division - MD and U.S. Telecoms Analyst [45]

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A couple, if I could. First, is there a significance to the conversion from some of the operating units 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 '19 and '20, relative to what you've been delivering over the last few years?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [46]

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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 noncontrolling interest into additional paid-in capital inside our equity statement. So I think that's what you're referring to. Does that answer your question on that?

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Michael Rollins, Citigroup Inc, Research Division - MD and U.S. Telecoms Analyst [47]

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It does.

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [48]

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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 -- or is our cash flow that is distributable to our common equity shareholders, which, in a simplistic view from our perspective, is AFFO less nonrecurring 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.

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Michael Rollins, Citigroup Inc, Research Division - MD and U.S. Telecoms Analyst [49]

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And is there any thought to maybe holding back some dividend growth to use that as internally generated cash and maybe flatten it out for a period of time? Or any other alternatives, just as you're thinking about financing for the business?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [50]

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So given where we are, on a leveraged basis, we're low-levered. And as Jeff pointed out, we have the capacity to still be conservatively leveraged and fund our capital growth plans. So I don't think we need to view any changes to the dividend policy as necessary, in light of where we are in our leverage.

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Operator [51]

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Our next question comes from the line of Sami Badri with Credit Suisse.

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Ahmed Sami Badri, Crédit Suisse AG, Research Division - Senior Analyst [52]

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In regards to your transition year, in your comments in 2019 and then the revenue acceleration at 2020, when you're considering your vertical revenue mix across cloud networks and enterprises, which category 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 a -- and this is a step-up of about 200 basis points versus the prior quarter. This is also during a time when almost every single public cloud is scaling. So I just wanted to get an understanding on where you guys see the acceleration occurring by a vertical mix from 2019 into 2020.

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [53]

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Yes, this is Steve. I'll give you an answer to that as that relates to our overall mix. I think it really points back to our overall strategy, really keying around 3 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 the unique value that we have across our platform. So all 3 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 a little bit of oscillation here and there between quarters. This quarter, enterprise was a bit elevated, primarily based off of the scale being a little softer than we would like, and then, also, that the impact of available capacity to sell into that space. So overall, we see a fairly consistent balance as we go forward, but all 3 aspects are very important to us.

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Ahmed Sami Badri, Crédit Suisse AG, Research Division - Senior Analyst [54]

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Got it. And then my last question just has 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 just trying to get some color that, given the interest in increasing the leverage ratio to 4.5x EBITDA. So any color would be great.

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [55]

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You bet, Sami. Yes, 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 it is something that we clearly have an eye on. I think it'd be premature to think about that being in 2019, but we continue to operate in a 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 2 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, I think, an attractive source of capital for us.

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Operator [56]

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Our next question comes from the line of Frank Louthan with Raymond James.

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Frank Garrett Louthan, Raymond James & Associates, Inc., Research Division - MD of Equity Research [57]

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How should we think about the scale of deployments going forward? Sort of what percentage of your mix should we think about being deployed that way? And then, maybe I missed this, but talk just a little bit about the current the size of your sales force and how you're going to see that grow maybe over the next 12 months as the top line is ramping.

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [58]

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Sure. Well, this is Steve. As you think about the overall mix of our transactions, they've been pretty consistent, with about over 90% of our leases being less than 5,000 square feet. And I think that's really the meat and potatoes of our strategy. And you'll see that going forward, which is also one of the key attractions 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 transactions, I think you'll see that be fairly consistent. And as we've mentioned before, those scale and hyperscale opportunities are more opportunistic based off of those that value that same ecosystem, that can contribute to it and overall provide more value there. So they are important to us. 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 look to be very consistent to next year. We have done some things. We announced some organizational changes last quarter, and we are looking to drive better efficiencies that can better align to the markets as we add new capacity coming onboard and as we see just opportunities for improvement. So across our sales, sales engineering and product mix, as there's areas that we've already identified, where we feel like we can make improvements there and we continue to work there.

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Frank Garrett Louthan, Raymond James & Associates, Inc., Research Division - MD of Equity Research [59]

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And what percentage of your sales are coming from the channel partners right now? And where do you see that going, going forward?

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

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Yes, our channel business fluctuates a bit from quarter-to-quarter. It's anywhere from, I would 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. Those essential off-table resources that can get our brand out 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 so as we go forward.

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Operator [61]

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Our next question comes from the line of Michael Funk with Bank of America.

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Michael J. Funk, BofA Merrill Lynch, Research Division - VP [62]

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A couple, if I may. You already said that leasing can be lumpy any given quarter, based on supply constraints and then scale lumpiness as well. Where do you see leasing longer term, as capacity comes online and maybe, more of a normalized basis for the scale business?

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Steven J. Smith, CoreSite Realty Corporation - Chief Revenue Officer [63]

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Yes. I think you'll see -- 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 that 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 often drive a 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-latency 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 4 markets, we expect to see better performance there as it relates to kind of that scale and hyperscale opportunity.

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Michael J. Funk, BofA Merrill Lynch, Research Division - VP [64]

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And then one more, if I may. I mean, obviously, ability to bring capacity online is dictated by, obviously, the permitting process and available land. What's your view with regard to other strategic alternatives for expanding the business either geographically, product set or even just in terms of getting more reach and the scale in the business in general?

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

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So the 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 the returns there are higher because the difficulty and the ability of others to compete is -- rewards people who can do it and who pursue it and stick to it. So we believe that it'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 on that as our primary strategy, where we can differentiate ourselves, both to our customers and to the investment community.

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Operator [66]

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Our next question comes from the line of Richard Choe with JPMorgan.

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Yong Choe, JP Morgan Chase & Co, Research Division - VP in Equity Research [67]

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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 '19 and accelerating into 2020. And then, also, kind of an idea of what gives you the confidence about the low double digits in 2020 in terms of your pipeline, if we can get a sense there, that would be great.

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [68]

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Yes, Richard. Let me just comment a little bit on your questions, and then I'll have Steve add some color and commentary. But you're right in that -- as you point out, that in the second half of '19 is where you're going to see some additional capacity being added, and that's going to be in the Bay Area with the completion of the first phase of 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 it's preleased or not, if we don't have any preleasing, you will see some impact -- negative impact to our earnings as a result of absorbing some of those costs until we get that leased 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 -- beyond that, I'll just have Steve and/or Paul comment on that.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [69]

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So I think what you're 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 processes, the biggest unknowns are in the permitting process. There are just a lot of steps, a lot of opportunities for community input, special environmental reviews. And so, until you're 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're 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 a general contractor, those contracts have set target dates that are based on assumptions around field conditions and weather, to some extent. And sometimes, you'll exceed those assumptions. Sometimes, you won't. But typically, on average, you're 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 -- not completely eliminate it, but fewer that can impact your schedule and your delivery time lines.

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Yong Choe, JP Morgan Chase & Co, Research Division - VP in Equity Research [70]

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And a follow-up on that really quickly. When can you actually start selling that capacity and have it in bookings? Is that -- the second -- like, when the properties are actually made? Or is it -- can you do it ahead of schedule? Kind of just some idea of timing when you can actually do booking?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [71]

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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 preleasing can begin to take place generally 3 to 6 months before you have an expected certificate of occupancy. And so typically, we see some preleasing before we actually open up a facility. And we try to approach that opportunistically. We're trying to smooth out the J curve but still get the right applications that value the ecosystem and the best pricing that we can.

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Operator [72]

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And our next question comes from the line of Erik Rasmussen with Stifel.

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Erik Peter Rasmussen, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [73]

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A lot have been addressed, but just circling back, maybe some clarification on the churn. You talked about elevated churn levels in the first half of '19 then getting back to more normal levels, but is the 6% to 8% still a good range to consider with the context of the first half guidance?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [74]

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Yes, Erik. Yes, I think when we reference back to normal levels, we would consider our normal levels to be somewhere between 1% to 2% per quarter. So pick a midpoint of somewhere around 3% for the back end of the year, and if you add onto that 4.25%, you're going to be somewhere towards the higher end of that 6% to 8% range. We're 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 consider your models. And obviously, we're going to work to outperform, but that's our best visibility as we sit here today.

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Erik Peter Rasmussen, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [75]

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Great, and then the interconnection, your guide this year is 11% to 14%. Growth has been decelerating. Obviously, there's some churn, that I think, was 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're targeting is kind of a longer term, is 11% to 14% still appropriate? Or can that change based on some of the development that's happening in the pipeline that you have?

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Jeffrey S. Finnin, CoreSite Realty Corporation - CFO [76]

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Yes, great question, Erik. Let me address it. I think if you look at our year-to-date growth for our interconnect, we're right at about 12.3%. And I would expect us 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 you a lot of specificity, I think it's a reasonable range. But as we get better clarity into 2019, we'll give some specifics around it, probably in February.

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Erik Peter Rasmussen, Stifel, Nicolaus & Company, Incorporated, Research Division - Analyst [77]

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Great. Then one final one. Obviously, you categorized next year as a transition year and there's a lot of development happening. And you talked to in the past, and it seems like it's still very much 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 this land held for development into production now? Or is it difficult, based on the markets that you guys participate in?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [78]

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So in terms of upside opportunities, the 2 primary things that could drive that would be: a, if we lease up more quickly the computer rooms that are coming online and the new buildings that we're 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've described on this call.

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Operator [79]

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The next question comes from the line of Aryeh Klein with BMO.

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Aryeh Klein, BMO Capital Markets Equity Research - Associate [80]

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Just going back to Northern Virginia as it relates to the pricing declines 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 capacity -- lack of available capacity recently, has that, in any way, affected your customer relationships at all?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [81]

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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 2 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 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.

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Operator [82]

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Our next question comes from the line of Lukas Hartwich with Green Street Advisors.

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Lukas Michael Hartwich, Green Street Advisors, LLC, Research Division - Senior Analyst [83]

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Given the deceleration and interconnection revenue growth, do you think you're hitting some sort of saturation point there?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [84]

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I mean, I think the best that we can tell, Nickolas (sic) [Lukas], is that it is just a 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 to 100-gig, but that doesn't seem to have meaningfully changed. On the other hand, as you know from the history of this industry, these cycles tend to increase and decrease as new data products and new demand sources come up. So I don't think we're negative about interconnection trend growth. We think it's a solid component of the story, and the industry and consumer factors that drive it continue to be positive.

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Lukas Michael Hartwich, Green Street Advisors, LLC, Research Division - Senior Analyst [85]

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That's helpful. And then can you just remind us about the company stance on international expansion?

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [86]

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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're in, it's not the best way to provide value to either our customers or our shareholders.

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Operator [87]

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We've reached the end of our question-and-answer session. I'd like to turn the floor back to Paul Szurek for closing comments.

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Paul E. Szurek, CoreSite Realty Corporation - President, CEO & Director [88]

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Thank you all for being on the call and for your interest and those good questions. We'll be at NAREIT in a couple of weeks. I'm 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'm 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 them for it. Have a great day.

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Operator [89]

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Thank you. This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation.