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DuPont Fabros Technology, Inc. (NYSE:DFT)

Q2 2010 Earnings Call Transcript

August 4, 2010 10:00 am ET

Executives

Chris Warnke – IR Manager

Hossein Fateh – President and CEO

Mark Wetzel – EVP, CFO and Treasurer

Analysts

Brendan Maiorana – Wells Fargo

Jordan Sadler – KeyBanc Capital Markets

Ross Nussbaum – UBS

Chris Lucas – Robert Baird

Bill Crow – Raymond James

Sri Anantha – Oppenheimer

Srikanth Nagarajan – FBR Capital Markets

Rob Stevenson – Macquarie

Dave Rodgers – RBC Capital Markets

John Stewart – Green Street Advisors

Jonathan Schildkraut – Evercore

Romeo Reyes – Jefferies & Company

Mark Montana – Citi

Michael Bilerman – Citi

Jonathan Atkin – RBC Capital Markets

Operator

Good day, ladies and gentlemen, and welcome to the DuPont Fabros Technology second quarter 2010 earnings conference call. One note, that today's call is being recorded.

At this time, I would like to turn the conference over to Chris Warnke, Investor Relations Manager of DuPont Fabros. Please go ahead, sir.

Chris Warnke

Thank you. Good morning, everyone, and thank you for joining us for DuPont Fabros Technology's second quarter 2010 results conference call. Our speakers today are Hossein Fateh, the company's President and Chief Executive Officer, and Mark Wetzel, the company's Chief Financial Officer and Treasurer.

Certain matters discussed during this conference call may constitute forward-looking statements within the meaning of federal securities laws. These forward-looking statements are subject to certain risks and uncertainties. The company assumes no obligation to update or supplement these statements that become untrue because of subsequent events.

Additionally, this call contains non-GAAP financial information, of which explanations and reconciliations to net income are contained in the company's earnings release issued last night, which is available in PDF format in the Investor Relations section of the company's corporate website at www.dft.com.

To manage the call in a timely manner, questions will be limited to two per caller. If you have additional questions, please feel free to return to the queue.

I will now turn the call over to Hossein.

Hossein Fateh

Thank you, Chris, and good morning everyone. Thank you for joining us on our second quarter earnings call. As noted, in last night's press release, we again delivered a solid quarter of operating results. These results exceeded the midpoint of our second quarter guidance by $0.025 cents of FFO per share. For this quarter, our FFO was $0.33 per share as compared to $0.28 per share a year ago. We are raising our 2010 full-year FFO guidance range.

Mark will walk you through the details later in the call.

In the second quarter of 2010, we signed eight new leases and renewed one lease. The eight new leases included four Internet tenants, two enterprise tenants, and two reseller tenants. As always, all the leases are triple net. The weighted average lease term of these leases are 9.2 years. Three of the leases are with new tenants and five are with existing tenants. Five of the leases commenced in the second quarter of this year.

None are expected to commence in the third quarter. Two are expected to commence in the fourth quarter and one in the first quarter of 2011. These commencements can begin earlier if tenants request early access, which occurred with three of the leases that commenced in the second quarter. So far in the third quarter we have signed one new lease and one lease renewal. The new lease is our first pre-lease in New Jersey, representing 6.25% of the building. This lease is with an existing tenant from our Virginia market and is a financial reporting tenant. Lease commencement is expected in the fourth quarter of 2010, within a 10 year – with a 10-year lease term.

The additional incremental revenue expected on all executed and commenced leases will be 1 million in the third quarter and 6 million in the fourth quarter, as compared to our second quarter results. We will have approximately 40 million of additional incremental revenue on already executed leases with the full year 2011, as compared to 2010. As a reminder, we have no leases expiring in 2010. We have one lease with a government tenant Systems Integrator that has an early termination option at the end of third quarter 2011. This lease has a rolling six-month termination notice starting in the third quarter of 2011.

Our top three tenants, Microsoft, Yahoo, and Facebook now represent 59% of our annualized base rent as of the end of the quarter. At the end of second quarter 2010, Microsoft and Yahoo represented 44% of our annualized base rent compared to 86% at the IPO. We expect to deliver and open both ACC5 Phase II development in Ashburn, Virginia, and New Jersey Phase I development in Piscataway, New Jersey, in the fourth quarter of this year. Both will be on time and on budget.

ACC5 Phase II is 88% pre-leased as of today. We expect to be 100% leased by the end – by year end. Based on our cost to complete and anticipated rents, we expect to exceed a 15% unlevered return on both phases of ACC5. NJ1 is 6.25% pre-leased as of today, and we continue to expect to be fully leased within 24 months of opening.

Our pro forma assumption is 12% unlevered return. Traffic and tours remains solid and we continue to be optimistic on leasing. During the second quarter, we raised sufficient capital to fund the next stage of our growth. The secondary common stock offering completed in May raised just over 305 million. During the same months, we also closed on an $85 million line of credit, which was discussed in Q1 call. With these – with these available funds, we have restarted the Santa Clara project and started Phase I of ACC6 in Ashburn, Virginia. We are fully funded to complete these projects. These two data centers will add another 26% to our current per megawatt operating portfolio. We expect construction for each of these projects to be completed in the third quarter of 2011. We have our construction teams onsite at both locations.

The majority of our hard costs contracts have been executed and any long due items have been ordered. We firmly believe the traffic and the demand for our high-quality wholesale data centers remains promising in all our markets.

Now I will turn over the call to Mark, who will take you through our financial results.

Mark Wetzel

Thank you, Hossein. Good morning, everyone, and thank you for joining us today. I want to cover four key topics today – our second quarter results, our Q3 and full year 2010 guidance, capital markets update, and an update on our 2010 dividend.

For the second quarter of 2010, the company's FFO was $0.33 per share, compared to $0.28 per share in the second quarter of '09, 18% increase. Revenues were up 21% in the same period. Specific to our second quarter results as compared to Q2 '09, the $0.05 per share FFO increase represents $0.10 of increase to operating income, partially offset by $0.05 of higher interest expense. Total interest cost expense to the P&L Q2 2010 amounted to 64% of overall interest incurred, compared to 74% last year.

Sequentially to Q1 2010, the $0.03 per increase in FFO is primarily increased operating income and lower interest expense, partially diluted by the issuance of the 13.8 million shares of common stock in May. You may also notice a reduction in tenant recoveries and property operating cost sequentially. This included an approximate $2 million base rate refund from our local utility in Virginia. Due to the triple net lease structure, there is minimal impact to our bottom line results.

As Hossein mentioned, FFO for the second quarter of 2010 exceeded the high-end of our published guidance range. Primary reasons cover several areas, including the eight leases signed in Q2, which was an expansion pod at CH1 for an existing customer started immediately in June. Two tenants scheduled for a Q3 lease commencement requested early access in June and the leases, therefore, commence in Q2. And one-time other income projects were finalized in late Q2. The time we released the updated Q2 and 2010 guidance range on June 3rd, we did not anticipate this activity and, therefore, it was not included.

AFFO was $0.21 per share for both quarterly reporting periods. Cash rents increased enough quarter-over-quarter to offset the increased interest expense incurred and the dilution from the issuance of equity. Our Q3 FFO guidance range is projected at $0.33 to $0.36 per share. We are raising our previously provided annual 2010 FFO guidance range of $1.25 to $1.35 per share, to $1.30 to $1.40 per share. The primary driver for this increases are the early lease commencements.

Since December 2009, we have been very active in the capital markets raising approximately 1.1 billion of capital which includes 400 million since our last call. Our follow-on common stock offering of 13.8 million shares in May at a price of $23 per share raised approximately $305 million net proceeds. We also finalized an 85 million unsecured line of credit during the second quarter. Although we continued to talk to new lenders about the remaining available 15 million porting [ph] feature on the line, we are very comfortable the existing amount of 85 million is sufficient for current needs.

As a reminder, we have less than 8 million of secured loan principal amortization through the end of 2011, assuming the extension of the ACC4 secured loan. Assuming this extension, we have no debt maturities until October of 2012. Most importantly, we are fully funded to finish four new developments which add 57% of megawatt inventory to our portfolio. As of June 30th, we had approximately 405 million of cash and short-term securities on hand, and all 85 million of the line available. We will incur approximately 430 million to fully fund and complete all four developments to the end of the third quarter of 2011.

Finally, we plan to continue to pay a quarterly 2010 cash dividend of $0.12 per fully diluted share and our policy of distributing a 100% of taxable income remains in place. We expect future dividend increases will be based on such policy subject to our Board of Directors' approval.

With that, let me turn it back over to Hossein.

Hossein Fateh

Thanks, Mark. Our top priorities at this time are to complete the development in the fourth quarter of this year and continue to pre-lease Phase I of New Jersey and Phase II of ACC5 in Ashburn, Virginia, to complete the development and open Phase I of Santa Clara, ACC6 in Ashburn in the third quarter of 2011, to maximize property operations by taking great care of our tenants and, thereby, providing organic growth.

We believe we are best-in-class for ground-up developments in the wholesale data center market. We will continue to provide our current tenants with current – our current and new tenants at competitive advantage within the marketplace due to our higher quality data centers and lower overall cost to operate.

With that, we will be happy to turn the call up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Additionally, we ask that all participants ask two questions at this time, and with time remaining at the end, you may place yourself back into the question queue for any additional follow-up questions. (Operator Instructions) and we'll go first to Brendan Maiorana with Wells Fargo.

Brendan Maiorana – Wells Fargo

Thanks. Good morning. First question I think is for Mark. As I look at your stabilized operating pool of assets, all of which are 100% leased, are all of – are you recognizing GAAP rental revenue on all of the tenants and all of those buildings at 100% today? And how much, on average, are your annual contractual in-place rent bumps?

Mark Wetzel

Contractual rent bumps typically are 3%. We have one of the commencements in the Chicago building which doesn't start until this fall. So it's one of the lease commence – commencements that will start in the fourth quarter.

The rest of the commencements that Hossein spoke of are in the ACC5 Phase I, which we open this fall. So there's one lease at Chicago that has not started yet.

Brendan Maiorana – Wells Fargo

Okay. Great. So just that one in Chicago. Okay. Good.

Mark Wetzel

Correct.

Brendan Maiorana – Wells Fargo

And then just second question is on the development pipeline and specifically kind of the future development projects where you're capitalizing some base building costs today and there will be some capitalization of those costs as you kind of build out the Phase I of the project, some of the Phase II costs will be capitalized. As you look out and think about developing the Phase II of those projects, do you think that the cost per megawatt will be inline or lower on the Phase II projects relative to the Phase I costs?

Mark Wetzel

Well, history has taught us that the Phase II tends to be a little less expensive than the Phase Is because the shell is built. We can turn it faster. So it tends to be at or below where the Phase I would be.

Brendan Maiorana – Wells Fargo

Okay. And then just to clarify. Once you stop development on the Phase I portion, you begin to expense all of the carry costs as it relates to the cost spent for the Phase II to that point?

Mark Wetzel

That is correct. Yeah, that's a conservative approach. But yes, when Phase I opens, Phase II is finished as well at that point. It's sort of in a holding pattern until we go to restart that development.

Brendan Maiorana – Wells Fargo

Okay. Thank you.

Operator

And next we'll hear from Jordan Sadler with KeyBanc Capital Markets.

Jordan Sadler – KeyBanc Capital Markets

Hi.

Mark Wetzel

Hi, Jordan.

Jordan Sadler – KeyBanc Capital Markets

Good morning. Question regarding New Jersey and Santa Clara specifically, these being the new markets. And I think you broadly stated in your prepared remarks that you feel good about traffic and tours. But I'm just a little bit more curious about digging in on what you're seeing in terms of the demand pipeline in New Jersey and Santa Clara now that you're under construction there. And also what the competitive landscape looks like in terms of wholesale data center supply in those two markets.

Hossein Fateh

Sure. In New Jersey, we're seeing the tenants are a little bit smaller in size. Like in Virginia we'll probably have 12 tenants or 13 tenants occupy 36 megawatts. I believe in New Jersey that figure will be close to 20 to 24 tenants in one center. The tenants are better credit tenants but they are more financial-related and enterprise. So they'll take a little bit longer to negotiate leases with.

We feel very good about our competitive landscape. We believe we've got the best product in the market. We have two leasing guys who are very well qualified hitting the ground, and we're seeing decent traffic. However, I wouldn't expect lease ups to be sooner than two years from opening in Jersey. It is kind of a similar model, you know it takes – these buildings are extremely large. So with the size that we're building it'll take the full two years. But once leased our operating costs are so low that we are extremely competitive for our terms.

In Santa Clara, I would say it's somewhat in between Jersey and Virginia. We do have a lot of the similar profile tenants that we have in Virginia also in Santa Clara. So – and but Santa Clara's also a little bit further out, in that we're delivering in the third quarter of '11. So third quarter of '11 for an in tenant-type company, and those companies will be in tenant that have – that have existed only for five years, it is tough to do much pre-leasing at this stage of the construction just because it's so far out for an in tenant company. So we don't have a salesperson actively leasing that market yet, but we do intend to hire someone in the next few months. But because many of our tenants are the same as our Virginia tenants, we feel that somewhere in between Jersey and Virginia.

Jordan Sadler – KeyBanc Capital Markets

Okay. And then just sort of switching gears back to northern Virginia, your sort of home field. Do you think – is the activity's such that the rest of ACC5 Phase II and ACC6 get done pretty quickly, similarly to what ACC5 –?

Hossein Fateh

Well, the rest of ACC5, I think it's pretty quick. I think in my prepared remarks I said by the end of the year, and we're seeing some very good activity. We are being a little choosier with our tenants because we have such little space left. And we want to get the – kind of the very, very good quality credit tenants. And ACC6, we feel very good about it. In fact, I wish we had space sooner because we're not delivering until the third quarter. But I wish we had inventory in the first quarter.

But I think as a – to be extremely conservative – Mark, what's our party line –??

Mark Wetzel

(inaudible)

Hossein Fateh

– within 18-month – lease-up. But, yes, so that's what we're saying, 18 months.

Jordan Sadler – KeyBanc Capital Markets

Okay. The demand there coming from the existing tenants in the park?

Hossein Fateh

Both. We've got many of the existing tenants asking for additional space, and we're negotiating with some new tenants. I would say maybe 60% existing, 40% new tenants.

Jordan Sadler – KeyBanc Capital Markets

Okay. Thank you.

Hossein Fateh

Thank you, Jordan.

Operator

And next we'll move on to Ross Nussbaum with UBS.

Ross Nussbaum – UBS

Hi, everyone. It's Ross –

Hossein Fateh

Hi, Ross.

Ross Nussbaum – UBS

– here with Rob Salisbury. Can you talk a little bit on New Jersey in terms of showings and traffic levels? Can you actually sort of quote us how many showings have occurred there in the last three months and how that may compare to your other developments over the past couple years?

Mark Wetzel

Ross, we do track that. I mean, it's a couple of visits a week on average. But I don't know if I have – we don't have in front of us the exact traffic.

Hossein Fateh

Yes, I would agree. It's about a couple of times a week traffic coming in to see the space. And then we've got two guys that are pursuing tenants. But everyone knows about the space. Anyone who needs the space is seeing it. It's – and if you ever want to visit it in New York, I'll be happy to let you go and visit the site in Piscataway and take a look at it. It's an extremely high-quality center, and we feel good about the traffic.

Ross Nussbaum – UBS

Okay. And then just I think following up on Jordan's question on Santa Clara, so you're for the time being confident enough that without a DFT leasing rep on the ground there, that the demand is strong enough that you don't need to spend the dollars right now on the added personnel?

Hossein Fateh

Well, I mean, let me point out, at the moment we have four salespeople. Everyone in the company, including me, is in sales. So it's not that we don't have an active person to talk to. Our Chicago person has been talking to people on the west coast. We've made several visits. We have a sales engineer who's been there a number of times visiting. He's very good at what he does. It's not that, hey, we're not taking calls. We are.

But with the current dedicated G&A, we feel very good about it. And when time comes a little bit closer, we'll again hire one additional person.

Ross Nussbaum – UBS

Okay. And then lastly, Hossein, can you talk a little bit about the 8-K that the company filed at the end of last week? I did speak to Mark briefly. I guess the question really is I understand economically the change in your employment contract has no impact on the company. I get that. But if that's the case, why bother doing it at all?

Hossein Fateh

There are two issues. Actually three issue – two major issues. One is, frankly, it's a huge tax benefit for me. Secondly, the company wanted to get rid of the gross-up provision in my employment contract itself that that wasn’t there and it was a trade off with that. And if there are any excess funds, it remains within the company.

Ross Nussbaum – UBS

I guess one way to – that I was thinking about it was, you're receiving a tax benefit from this, but the company doesn't really get anything. So all else being equal, if it was a zero sum game, shouldn't the company have shared in some of that tax benefit – i.e., a lower airplane allowance? Now that way the company comes ahead and you come out ahead as well?

Hossein Fateh

Well, I think if there's any money left it goes to the company. And also it could be thought of as look down the road of more modest increases.

Ross Nussbaum – UBS

Thank you.

Operator

And from Robert Baird, we'll move on to Chris Lucas.

Chris Lucas – Robert Baird

Good morning, guys.

Mark Wetzel

Good Morning, Chris.

Chris Lucas – Robert Baird

Hey, Hossein, can you just maybe talk a little bit about what you're seeing in terms of the sales cycle and maybe compare it to what you were seeing earlier in the year as – just in terms of the process by which tenants are making decisions and the length of time. Is that getting better? Worse? And then maybe if you could provide some color in each of the markets.

Hossein Fateh

It's tough to say. Generally, like always, the Internet companies have been quicker. It's tough to say right now in Chicago because we're 100% leased. I felt like if we had another two, three megawatts right now, we would have done well with it. We had to turn down people because we don't have any space left. In Virginia, I think we may have lost one five megawatt deal because we just didn't have five megawatts immediately to deliver.

But in New Jersey, I think the sales cycle is more enterprise than financial. I would say that's a longer term deal. But with us, it's so each deal we do is so large we're doing four deals a quarter or three deals a quarter. So it's tough to say it depends on the personnel involved. It's not like we're doing 100 deals like a retail tenant to track sales cycles very closely.

It almost depends on who the person is we're negotiating against or how much they want the space. But, in general, Internet, which is Virginia, and later will be Santa Clara, is faster. Enterprise, which was Chicago and New Jersey, the sales cycle is slower. And that continues to be the case.

Chris Lucas – Robert Baird

Okay. And then can you maybe talk a little bit about any shifting dynamics that you're seeing in the marketplace as it relates to some of your – some of the users maybe going to think about more building their own facilities versus the outsourcing model?

Hossein Fateh

To be honest, I, to be very straightforward, I don't see that very often. Users that go to build their own and what makes financial sense, and we're seeing it more and more, is 10, 15 megawatts or so it makes financial sense. We're seeing more and more – and those are guys that have been, for example, declared Facebook’s building a big size in Oregon. That's public information. Well, they are a 15 megawatt-plus user, and, yes, that starts to make sense.

Our niche market is 500 kilowatts to kind of in the teens megawatts per user. So for that user, financially it doesn't make sense. So it's – we're seeing more and more one or two megawatt kind of say, "Oh, my gosh, what were we even thinking trying to build our own when we see that your space is available."

Chris Lucas – Robert Baird

Very good. Thanks, guys.

Operator

Moving on to Bill Crow from Raymond James.

Bill Crow – Raymond James

Good morning, guys.

Mark Wetzel

Hey, Bill.

Hossein Fateh

Hi, Bill.

Mark Wetzel

How are you?

Bill Crow – Raymond James

Good, thanks. Hossein, can you just give us an update on what you're seeing in construction cost trends, equipment cost trends?

Hossein Fateh

Sure. The equipment hasn't changed that much, because much of the equipment is custom build or semi-custom build. If we don't order it, they don't build it. The issue on some construction, it depends on the material. If you look at the sand and gravel operation, the sand and gravel operation, when the – there's not demand, which there's not much demand right now, out of three plants, they close two of them. So prices don't change that much. What – prices where we see huge change, maybe 10 or 15% decline is in pre-cast orders. At pre-cast plants they can't shut it, so we see 10 or 15% decline in the pre-casts, which is good.

The other issue which is helpful is 50% cost of constructing your data center is labor. The labor is unionized so the hourly labor rate doesn't change, but there is more available labor so that we work less overtime.

So all-in-all, I would say, rough numbers, we're keeping our costs approximately current with inflation, and we're not seeing much of an inflation. But I wouldn't model due to the recession big construction declines; at least we're not seeing it.

Bill Crow – Raymond James

Yes. Okay. That's helpful. Thanks, guys.

Operator

And from Oppenheimer, Sri Anantha.

Sri Anantha – Oppenheimer

Yes. Good morning. Thank you. Hey, Mark –

Mark Wetzel

Hi, Sri.

Hossein Fateh

Hi, there.

Sri Anantha – Oppenheimer

Hi there Hossein. Hossein, couple of questions. One, if I'm looking at the leasing activity this quarter, it looks like the majority of the leases were signed in the first month. But in the subsequent months there haven't been a whole lot. Is this – like is this pretty normal? Because some of your peers have talked about a little bit of a longer sales cycle, especially this quarter. Has that had any impact on your new lease signings?

Hossein Fateh

No, not really. I mean, what I'm – what we've always said is our business is lumpy, in that our leasing is not a straight line in Excel that you could exactly model. And sometimes it's better. Some quarters is lower. We have zero space left, so it's tough to – it's tough to have an answer to that when we have no space available. We have no current space available. So it's really hard to answer that, Sri.

Sri Anantha – Oppenheimer

Got it. Mark, the 6 million of incremental revenue that's going to come in 4Q, is that all tied to new leases or is – does that include any additional contribution from one of the lease that was extended from 2014 to 2017?

Mark Wetzel

No, no, no. It's all – it's all the – the opening of ACC5 Phase II, the 88% pre-lease and the 6% in New Jersey.

Sri Anantha – Oppenheimer

Okay. Is –

Mark Wetzel

And, obviously, that third one that I mentioned earlier, the Chicago lease starts.

Sri Anantha – Oppenheimer

Is it possible to disclose what he lease rates on these new leases are? And how do they compare to your base rates or the lease rates on your current portfolio?

Hossein Fateh

No, Sri, we don't disclose individual lease rates. It's just a bad business for us to do that, comparing one tenant to the other.

Sri Anantha – Oppenheimer

No, not individual leases, Hossein. What I'm saying is just an average for all the leases that were signed because if you look at some of your peers they do that, just give you a ballpark number so that it allows us to compare what your rate of –

Hossein Fateh

We have the leases – we have such few leases it still continues to be a bad business plan. We have such few leases that get signed every quarter. We just quote overall returns and we're very comfortable with our overall return that we will hit and – in – just like we did in Chicago. We've told everyone 12%, we hit 12. ACC5, we're going to hit 15 very comfortably. And New Jersey we're – we believe will hit the 12% unlevered return.

Sri Anantha – Oppenheimer

Great. Okay. Thank you.

Operator

(Operator Instructions) we’ll move on to Srikanth Nagarajan from FBR Capital Markets.

Srikanth Nagarajan – FBR Capital Markets

Hi. Thanks and good morning. A couple of questions. As the economy recovers, I know you answered a previous question that there are not a lot of – whole lot of do-it-yourselves in the 500 to one megawatt range. But if you look at local developers, are they coming back to the market to complete their unfinished projects? And are they competing with you here? What are you seeing on the ground that gives you more comfort or pause here?

Hossein Fateh

Well, we're not seeing that. There's – we're not seeing much at all. A lot – we see – we hear a lot of talk. But let's face it, the assets to debt [ph] is unavailable for a data center developer. Even for us, the reasons – it's not a magic secret why we got a loan on ACC5. If you look at that, it's the same banks who were in our bond deal. And right now our bonds are trading below how we can get long-term debt, below the price of our long-term debt. The last time I looked they were trading at 7.2%.

Srikanth Nagarajan – FBR Capital Markets

I see.

Hossein Fateh

So it is for private developers long-term money at those rates is totally un – I mean, it's not even there at that price. But I would say it's unavailable. So it's a – although the credit markets seem to be opening up for other asset classes, we haven't seen it yet for this asset class.

So we haven't seen one or two megawatt developments. But more importantly even if you did get the one or two megawatt developments, the operating cost to the tune of several X cannot meet the operating cost of a 36 megawatt data center.

So we're very comfortable and going through the numbers with anyone who wants to prove us wrong on that. And we very often show tenants what our operating cost historically can be, and it is – and once – okay. Once in a while you're going to get a head of IT for a company that no matter what he wants to build an empire and you're not going to get every deal. But financially, we can show that it's significantly more economical.

Srikanth Nagarajan – FBR Capital Markets

How much – I mean, how much more – I mean, could you give some numbers on this, throw some numbers on how much more significantly economical it is to share the 36 megawatts –

Hossein Fateh

Sure. I'm happy to. I'm happy to do that, Sri. Like, for example, our operating cost in ACC5 is approximately 24 to $25 per month per kilowatt to operate. Now, on a two megawatt data center, that cost could be easily 60 to $70 per kilowatt.

Srikanth Nagarajan – FBR Capital Markets

And what is necessarily driving that increase?

Hossein Fateh

Well, labor. I mean, I'll give you one example. The – we operate ACC5 and ACC4 with six to seven people per kilowatt per month – per – sorry – six or seven people. That is our in-house staff. Cost of six or seven, that does not include security and doesn't include outsourced labor that six or seven, if you look at it, is 1.6 million a year.

Srikanth Nagarajan – FBR Capital Markets

Right.

Hossein Fateh

1.6 million divided by 36 is approximately 44,000 a year for the in-house labor.

Srikanth Nagarajan – FBR Capital Markets

Right.

Hossein Fateh

I know an insurance company in the Chicago area who has a two megawatt data center. Their labor – they operate that same building. Their labor is approximately five people to run that. But that's electrical and mechanical.

And a third – two electrical, two mechanical, and a help for both of those. The cost of those is 700,000. 700 divided by two is 350. So it's 350 versus 44. Meanwhile, we buy all our – we're buying and maintaining 36 UPS systems. They're maintaining three or four UPS systems. We're maintaining 36 generators. They're maintaining three or four generators. So I mean, the math is easy to understand.

Srikanth Nagarajan – FBR Capital Markets

Fair enough. The second question that I had was, while you guys are not active participants, what is your view of the consolidation of the data center space, how you see Equinix buying a switch and data there, as well as other public REITs that have been acquiring data centers, how is it changing your landscape as you look at development?

Hossein Fateh

Well, Equinix doesn't really affect us. I think it's a good deal for them and I'm very happy for them. And, frankly, the digital deal with 365 Main, I'm ecstatic for that because it takes another player out of the market. So we're happy to continue to compete and build our high quality data centers. We believe our data centers are the highest quality and would like to stick to what we're doing. We're never going to say no if a fantastic deal comes along. But right now we like our strategy.

Srikanth Nagarajan – FBR Capital Markets

All right. Thanks.

Operator

And from Macquarie, we'll move on to Rob Stevenson.

Rob Stevenson – Macquarie

Thanks, guys. Can you talk a little bit, not in terms of your portfolio, but inter terms of what you see in the overall data center market in terms of the trend on pricing over the last six months to the last year?

Hossein Fateh

We've managed to lease up everything we had with our returns. Could we have got a little bit higher rents, I think we probably could have, but we just wanted to lease our space up quickly. It's tough to say lately, because we're 100% leased and we're building a lot more.

Typically, I'll tell you, the Internet continues to grow and the Internet continues to surprise us at – twice a year with a new business model that didn't exist that generates income for that tenant. Whether it's the Apple iPad applications, whether it's healthcare, whether it's video games on demand, we see data center demand going up significantly. I'm not sure if that answers your question.

Rob Stevenson – Macquarie

Yes. I mean, I guess a sort of secondary question would wind up being, for the guys that come in and kick the tires on one of your facilities, what's the main reason why they elect to go with somebody else? Is it – is it basically price? Is some of the people out there undercutting on price? Or is it something else?

Hossein Fateh

I think sometimes it's price. Sometimes is existing relationships. And sometimes is because we don't have any space left.

Rob Stevenson – Macquarie

Okay. Thanks, guys.

Hossein Fateh

Thank you, Rob.

Operator

Now we'll move on to Dave Rodgers with RBC Capital Markets.

Dave Rodgers – RBC Capital Markets

Yes. Good morning. Hossein, on New Jersey you've had a fairly low, I guess conversion rate to this point in New Jersey, but obviously did sign that lease.

I'm curious about what the pushback you might be getting in that market is, as well as how many of those maybe showings have gone elsewhere and actually signed deals and how many of those might still be in the market.

Hossein Fateh

I think, like I said, the enterprise deals, just like in Chicago, take longer to execute. We're confident on our plan. And the deals are smaller, so it's going to be smaller increments because the size of the tenants are non-Internet.

And I believe that – I mean, I don't track deals that we've lost. But I think that we're happy where we are and it is not – some people may choose to go retail, in that environment. I think that's a possibility and that they may just want to pay more and sign shorter term commitments. But I think we're comfortable. We haven't even opened it yet.

Dave Rodgers – RBC Capital Markets

Okay. Fair enough. And then, Mark, what rate are you going to capitalize the interest for the developments?

Mark Wetzel

Well, it's sort of on a weighted average basis. But we have, obviously, on ACC5 we have a secured loan in place. But the weighted average is around 7%.

Dave Rodgers – RBC Capital Markets

Okay. Great. Thank you.

Operator

John Stewart from Green Street Advisors has our next question.

John Stewart – Green Street Advisors

Thank you. Hossein, I just wanted to follow-up on the do-it-yourself versus outsource model. And as you pointed out in your opening remarks, obviously you've diversified away from Microsoft and Yahoo by half since the IPO. But even so, 60% of the rent roll is arguably still a 15 megawatt user. So how should we think about that exposure?

Is that basically a 10-year bond and we deal with it when it comes up and you continue to diversify away? Or is there a particular reason to think that those guys will stay put?

Hossein Fateh

It is very expensive for anyone to leave a data center, extremely expensive. Network-wise it's extremely expensive. They continue to be very, very happy with our service.

And meanwhile, don't forget every data center even within the data center, if a tenant has six rooms, they may have four different lease expirations over a four-year period. So, and each time they may want to leave, they may – they have to give us, in every case, one year notice.

Even within the single tenants buildings, we have three to four year, in one case five year exits with one year notices on each room that comes up, with a high likelihood, with a good likelihood, or a high likelihood that they'll continue to stay because it's so expensive.

So if they – it's tough to say a few years from now what will be the mode. Also, some of these companies actually change their mind, saying, yes, we do actually like to outsource now while we didn't before. So it's tough to think about it and read what they're going to do.

But if they do decide to leave, we have the one year notice, and on each data center a – on each tenant, a multiple-year lease expiration.

John Stewart – Green Street Advisors

Okay. That's helpful. Thank you. I understand there was clearly Santa Clara, in particular, is kind of a unique situation. But if we look at the total expected investment for your development pipeline from last quarter to this, is you've basically brought new projects back into the pipeline. How should we think about a run rate in terms of development starts going forward?

Mark Wetzel

Well, the way we've laid out these four that we're actively working on, two this fall, two late, we said Q3, we hope to be ready early Q3 or late Q3 on one or two of those. And then as we think about beyond those two and these four phases that we have Phase IIs on, it's really a function of where the leasing hits.

If we have somebody interested in Chicago Phase II, that could be next on the list. So ideally, one or two a year is where we've been kind of talking about. But it depends on how this leasing goes as well and how we would finance that.

John Stewart – Green Street Advisors

Okay. Lastly, I just wanted to come back to the 8-K on the compensation arrangement. And I guess there's a couple of points that I'm just still not clear on. And particularly, it references indirect tax benefits. So I guess, number one, Hossein, it sounds like, is there a make-up of a gross-up provision related to this new arrangement?

And I guess maybe if you could help us understand why the tax treatment would be different for you personally. Why would – why would this not be taxable income as well?

Hossein Fateh

I don't want to get into tax issues. There are other – there is a tax benefit for me. On the call I don't want to get into trying to explain IRS tax laws. Just trust me; I have a tax benefit that is beneficial to me. The – on the gross-up provision was actually deleted out of my employment agreement.

John Stewart – Green Street Advisors

Okay. Thank you.

Operator

And Jonathan Schildkraut from Evercore.

Jonathan Schildkraut – Evercore

Good morning, Hossein, Mark. Nice to be –

Hossein Fateh

Good morning, Jonathan. How are you?

Mark Wetzel

Welcome back.

Jonathan Schildkraut – Evercore

I'm doing great. Thank you for fitting me in on the questions here. Hossein, some of the retail guys who have been sort of inching their way into the suites-based business indicated in some conversations that the market where retail and wholesale meets, call it half a megawatt, is becoming more competitive.

And I know that you guys are currently sold out. But I was wondering what your view is in terms of offering smaller spaces.

Secondly, if you could talk a little bit about the Chicago market. What we're getting from our local reads are that there's been a big turnaround in that market. Obviously you've had phenomenal lease-up there this year. But in general what we're hearing is that there's not that much construction going on and we may end up in a position where there's a dearth of wholesale space available, and what your view on that market is.

Hossein Fateh

Sure. Thanks, Jonathan. Yes, and welcome back. The half – I think the reason that market is becoming more competitive for the retail players is because us and some of the wholesale players have decided to compete in the half a megawatt market and make it wholesale. So that's why the retail players are feeling it. I think when we did our ACC4 deal, we didn't really have much. I think we only did two half a megawatt deals.

Now we would easily do half a megawatt deals because I think it's helpful, it diversifies tenant space, and I'd like to have more tenants per building. But that's I think how – why they're feeling it. In us, we've – we're still getting our rents and we're still getting the returns.

So I wouldn't necessarily say for us is necessarily becoming more competitive. The wholesale – a person who needs half a megawatt, the reason they would go to a wholesale player is they would prefer to sign a license agreement.

Also, these days, a half a megawatt player can also just go to a cloud computing platform and not even have their own data center. And then those cloud guys would absolutely be with the wholesale player, if you see what I mean.

Jonathan Schildkraut – Evercore

Absolutely. And I think that –

Hossein Fateh

Good.

Jonathan Schildkraut – Evercore

What we're seeing is for some of the smaller co-lo, traditional co-lo buyers that the cloud platforms have become increasingly attractive. And I think that you house a couple of those cloud providers.

Hossein Fateh

Exactly. And that makes sense for everyone. So on the second part of your question, in Chicago, like I said earlier, I wish we had another – currently – I think we've missed out on like about three megawatts of deals. And so we are actively showing the second phase of Chicago.

And at the appropriate time I will decide to build that. But you're right, the market is becoming tighter and tighter. We're seeing interest from a few players, anywhere between, I think right after we were 100% leased we lost one, 1.3 megawatt deal and a couple of others have said, look, is there anyone – is there any way we could get in? And we're like, we're fully leased.

And they said, when can you get the space up. And we're kind of talking to them about Phase II and kind of feeling our way as to when to build Phase II. But you're right; the market is becoming very tight there right now.

Jonathan Schildkraut – Evercore

All right. Thank you for taking the questions.

Hossein Fateh

Thank you, Jonathan.

Operator

Romeo Reyes from Jefferies & Company. Please go ahead.

Romeo Reyes – Jefferies & Company

Hi. Good morning. Two – can you hear me? Two quick questions; First, can you give us just a general characterization –

Hossein Fateh

Can you speak up? Sorry. You're away from the speaker.

Romeo Reyes – Jefferies & Company

Just two quick questions. I'm trying to figure out if you could, perhaps, give us a characterization of the – some of the customers or potential customers in your New Jersey data center, specifically with respect to kind of existing customers.

I know you've talked about enterprise being a focus there. But can you give us a sense of whether or not your existing customers in some other data centers are following you there or if you have had any meaningful discussions there for additional contracts?

Hossein Fateh

I think in New Jersey, I think we said in our prepared remarks that the current customer is also the customer that signed is an existing customer with us in Virginia.

Romeo Reyes – Jefferies & Company

But I was thinking more in terms of kind of the prospective customer base.

Hossein Fateh

Oh. I think a lot of the prospective customer base will be new. They're not – the Internet-type companies won't necessarily go to New Jersey.

Romeo Reyes – Jefferies & Company

Okay. And then a second quick question here with respect to kind of the past investment grade on your debt here. Are you – do you have any sort of parameters or have the rating agencies given you any sense as to what kind of credit metrics you need to achieve in order to get an investment grade rating?

Mark Wetzel

Well, I think we still have some wood to chop at this point. We have to take care of business with leasing New Jersey, geographically diversified was one of the t here main things we talked about when we got the initial rating. So we're doing that with New Jersey and with Santa Clara. Obviously we need to lease those buildings.

Second, we need to diversify our tenant base, which we're doing that as well. Hossein in his prepared remarks said eight – the top two were 86% at the IPO, today they're 44%. So that –

Hossein Fateh

They wanted us to lease Chicago, and we did.

Mark Wetzel

Yes. And then thirdly, we just – we're a 2.5-year-old public company. We just need to be around a little longer. So we're doing everything that we've talking about. And so it's – it's not around the corner, but it's within the next two years or three years, we'd hope.

Romeo Reyes – Jefferies & Company

Have they given you any guidance in terms of kind of what – that's EBITDA or interest coverage it should be for them to upgrade you?

Hossein Fateh

No. I mean, they haven't. But I think if you look at some other people, debt to EBITDA of the low – if you look at some of the other players in the market, they haven't said – they never say exactly one thing. But if you look at some other players in the market around the low 5 or 4.5 is where other people are that are investment grade.

Romeo Reyes – Jefferies & Company

Great. Thanks much.

Operator

Next we'll here from Michael Bilerman with Citi.

Mark Montana – Citi

Hi. It's Mark Montana in here with Michael and Quinton.

Hossein Fateh

Hi, Mark. How are you?

Mark Montana – Citi

Doing well. How are you?

Hossein Fateh

Good.

Mark Montana – Citi

Regarding Santa Clara, I've seen substantial competition in this market, especially as of late and expected over the next year or two, and it's had the effect of pressuring rents. I'm just wondering how we should think about unlevered yields in this market for the –

Hossein Fateh

We're comfortable with a 12% unlevered return. I think our – the market is tight. A lot of the tenants look at our building as possibly one of the best buildings built out there.

We're excited about that building, and I wish we were – I wish we had the liberty of being able to deliver it earlier. But I think for – from our guidance, you should look at a 12% unlevered return.

Mark Montana – Citi

And is that what it had been pro forma prior to shifting the equipment over to New Jersey? Or is that – has that come down a bit?

Hossein Fateh

Oh, no. The – Mark, why don't you –

Mark Wetzel

No. No. It was still in the same ballpark in terms of where we expected. I mean, it was, in that 12 to 15 is what we typically said.

And so Santa Clara's obviously going to cost a little bit more. We'll get higher rents in Virginia, but it won't be materially different. But the 12 is probably where we're at right now.

Mark Montana – Citi

Okay. Great. And I think Mike –

Michael Bilerman – Citi

Yes. Hossein, I just wanted to come back to the aircraft and dollar salary. I think you've been pretty open that it was clearly driven by a substantial tax benefit for you.

And I'm just curious how you, and especially the Board, thought about the ethical issues of a public company sort of starting to mix personal and business and trying to effectively decrease tax revenues to the government and what that sort of implicates.

Hossein Fateh

(inaudible) I think it's every American's duty to optimize their taxes. That's how the Board thinks of it as well. It is every American's duty to optimize their taxes, and no one thinks about – you must be joking if you think people are trying not to optimize their taxes. So I think the Board looked at it. We had compromises, and the Board approved it.

Michael Bilerman – Citi

Well, I'm just – you look across a lot around corporate America and especially in the REIT space, there's not one company that has done this. And I know that there's a certain benefit, and, clearly, the Board could have just said, we'll just pay you more, and, obviously, that's damaging to FFO per share. But there's certainly the other side of it as well.

Hossein Fateh

I don't see the other side. I think the fact that no one's done it before, no one builds 36 megawatt data centers either. I think it's – if you look at it optically, you put on some glasses and read the print [ph], if the company is a little bit better off and I'm better off, so why not?

Michael Bilerman – Citi

Mark, just a clarification question in terms of the in-place revenue stream. So you have 157 million of base rents the next 12 months, 132 of cash. Can you just break out the differential between those two numbers of how much of that's straight-line rent and how much of that is just where the cash rent hasn't begun and – but it will be – it will have some pro forma effect?

Mark Wetzel

Well, obviously it's a mix of both. I don't – I don't have that number handy, but it is – contractually there's 3% bumps on all leases. We have all different staggered lease terms so they kick in at different times over that 12-month window.

But that spread difference, obviously with the mature buildings, it's all contractual. For ACC5 in Chicago, it's probably more step up with regards to the leases. So I can –

Michael Bilerman – Citi

I mean, it's just a big – it's a big differential. I'm just trying to get a sense of how we should think about what's effectively contractual in-place cash versus – versus straight-line over the 10-year life of the leases.

Mark Wetzel

It's – I mean, the differential is very comparable to our straight line that we give on – in our 2010 guidance, roughly $30 to $36 million. So it's comparable to that on a rolling 12 is all I was trying to accomplish with providing that info.

So I – again, it is a mix. And I'll look at that mix and maybe we socialize that internally of whether we disclose that going forward.

Michael Bilerman – Citi

Okay. Thank you.

Hossein Fateh

Thank you.

Operator

(Operator Instructions) we'll go to Jonathan Atkin with RBC Capital Markets.

Jonathan Atkin – RBC Capital Markets

Yes. Good morning. I apologize if these were asked already, my phone cutoff midway through. But I wondered first of all if you might be able to provide a perspective on pricing that you're seeing among some of the one-off private players in the wholesale space, as well as any multi-region wholesale players, again on the private side. And then on prior calls you've given some perspective on international. You may have sniffed around in some of those markets in the past. And if there's any kind of updated read that you have there to share with us.

Hossein Fateh

On the private players, we – I mean, I guess the only perspective I should shed on right now is in Virginia. And there's one or two private players. And we continue to be very, very competitive, especially on our operating costs.

There is once in a while, for example, a tenant that says they want to be in a data center with no one else around, and sometimes they go to one of those private players. But price-wise, we're extremely competitive. And it's tough for a one-off player to be able to compete with a 36 megawatt data center.

To answer your second question on internationally. We continue to look internationally and in other markets in the US with no immediate plans. Currently we are looking at various markets. We don't want to say which markets. But we – there are some very interesting markets. And some of our US tenants are actually asking us about it.

They're saying we really don't want to do anything. We'd like to go to a player that we like. Would you do something with us in Europe and Asia? And so we're tentative. We're looking. But please don't pro forma anything.

Jonathan Atkin – RBC Capital Markets

Great. Thank you very much.

Operator

And we'll go back to Jordan Sadler.

Jordan Sadler – KeyBanc Capital Markets

Thanks. Just a quick follow-up. In the prepare remarks there was a mention of a termination option that begins in 1Q '11. Mark, could you just go through that again?

Mark Wetzel

Yes. Just it's an existing lease with a government system integrator who has a contract with the Federal Government. And they have the right to give six months notice starting at the end of the third year, which is in late September of '11. So if the government contract gets canceled, then they can give us six months notice. It's a small lease.

Jordan Sadler – KeyBanc Capital Markets

Okay.

Mark Wetzel

It's a half a –

Jordan Sadler – KeyBanc Capital Markets

It's a half a – so it's about a megawatt?

Mark Wetzel

A half a megawatt.

Jordan Sadler – KeyBanc Capital Markets

Half a megawatt. And then you said they have to give you notice by September or by the end of 1Q?

Mark Wetzel

No. September's the first time, then it rolls from there.

Jordan Sadler – KeyBanc Capital Markets

Okay. That's the first notice period?

Mark Wetzel

And it actually is a 1.1 megawatt room.

Hossein Fateh

Jordan, it's a government contract, this Systems Integrator has a government contract. And we normally don't give that. But they kind of proved] to us that for them to do anything they need to match their term lease with the government contract. So they're confident that they'll continue expanding it like most government things.

Jordan Sadler – KeyBanc Capital Markets

Okay.

Mark Wetzel

And it's the one lease, Jordan on our lease expiration table in '11.

Jordan Sadler – KeyBanc Capital Markets

Okay.

Mark Wetzel

It's 1% of revenues.

Jordan Sadler – KeyBanc Capital Markets

Okay. Got it. Perfect. And then just to commentary – comment on the free rent. I – just following up on Michael Bilerman's comment there.

I think – I think it would just really be helpful if you could split that out. So I would also encourage any incremental disclosure on the straight-line rent between free rent and rent bumps or additional straight-line rent, as it just – it just helps us in really figuring out what your run rate NOI is and your – and your normalized sort of cash NOI as opposed to something that's distorted by a short-term period of free rent. So it obviously helps out in NAV calculations and things of that sort. So any help would be appreciated.

Hossein Fateh

Okay. We will –

Jordan Sadler – KeyBanc Capital Markets

Thank you.

Hossein Fateh

Take it under advisement.

Operator

And that –

Mark Wetzel

Thank you, everyone, for joining our call.

Operator

Ladies and gentlemen, that does conclude today's conference. We thank you for your participation.

Hossein Fateh

Thank you, everyone, for joining our call.

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