FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

(Mark One)

 

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2015

OR

 

 ¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                     

 

Commission File Number 001-36109

 

 

QTS Realty Trust, Inc.

QualityTech, LP

(Exact name of registrant as specified in its charter)

 

 

 

   

Maryland (QTS Realty Trust, Inc.)

46-2809094

Delaware (QualityTech, LP)

(State or other jurisdiction of

incorporation or organization)

 

27-0707288

(I.R.S. Employer

Identification No.)

 

   
12851 Foster Street, Overland Park, Kansas 66213
(Address of principal executive offices) (Zip Code)

(Registrant’s telephone number, including area code) (913) 312-5503

  

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

 

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

QTS Realty Trust, Inc. Yes  ý     No  ¨                            QualityTech, LP Yes  ý     No  ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). 

 

QTS Realty Trust, Inc. Yes  ý     No  ¨                            QualityTech, LP Yes  ý     No  ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

QTS Realty Trust, Inc.

 

Large accelerated filer ¨ Accelerated filer ý
Non-accelerated filer ¨  (Do not check if a smaller reporting company) Smaller reporting company ¨

 

QualityTech, LP

Large accelerated filer ¨ Accelerated filer ¨
Non-accelerated filer ý  (Do not check if a smaller reporting company) Smaller reporting company ¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

QTS Realty Trust, Inc. Yes  ¨     No  ý                             QualityTech, LP Yes  ¨     No  ý

 

There were 41,019,436 shares of Class A common stock, $0.01 par value per share, and 133,000 shares of Class B common stock, $0.01 par value per share, of QTS Realty Trust, Inc. outstanding on November 3, 2015.

 

 

 

 

EXPLANATORY NOTE

 

This report combines the quarterly reports on Form 10-Q of QTS Realty Trust, Inc. (“QTS”) and QualityTech, LP, a Delaware limited partnership, which is our operating partnership (the “Operating Partnership”). 

 

Management operates QTS and the Operating Partnership as one business. The management of QTS consists of the same employees as the management of the Operating Partnership. QTS is the sole general partner of the Operating Partnership, and, as of September 30, 2015, its only material asset consisted of its ownership of approximately 85.7% of the Operating Partnership. QTS does not conduct business itself, other than acting as the sole general partner of the Operating Partnership and issuing public equity from time to time. QTS has not issued or guaranteed any indebtedness. Except for net proceeds from public equity issuances by QTS, which are contributed to the Operating Partnership in exchange for units of limited partnership interest of the Operating Partnership, the Operating Partnership generates all remaining capital required by our business through its operations, the direct or indirect incurrence of indebtedness, and the issuance of partnership units. Therefore, as general partner with control of the Operating Partnership, QTS consolidates the Operating Partnership for financial reporting purposes.

 

We believe, therefore, that a combined presentation with respect to QTS and the Operating Partnership, including providing one set of notes for the financial statements of QTS and the Operating Partnership, provides the following benefits:

 

·enhances investors’ understanding of QTS and the Operating Partnership by enabling investors to view the business as a whole in the same manner as management views and operates the business;

 

·eliminates duplicative disclosure and provides a more streamlined and readable presentation since a substantial portion of the disclosure in this report applies to both QTS and the Operating Partnership; and

 

·creates time and cost efficiencies through the preparation of one presentation instead of two separate presentations.

 

In addition, in light of these combined disclosures, we believe it is important for investors to understand the few differences between QTS and the Operating Partnership in the context of how QTS and the Operating Partnership operate as a consolidated company. The presentation of stockholders’ equity and partners’ capital are the main areas of difference between the consolidated balance sheets of QTS and those of the Operating Partnership. The Operating Partnership’s capital includes general and limited common units that are owned by QTS and the other partners. QTS' stockholders’ equity includes common stock, additional paid in capital, accumulated other comprehensive income (loss) and accumulated dividends in excess of earnings. The remaining equity is the portion of net assets that are retained by partners other than QTS, referred to as noncontrolling interests. The primary difference in QTS' Statements of Operations and Comprehensive Income (Loss) is that for net income (loss), QTS retains its proportionate share of the net income (loss) based on its ownership of the Operating Partnership, with the remaining balance being retained by the Operating Partnership.


In order to highlight the few differences between QTS and the Operating Partnership, there are sections and disclosure in this report that discuss QTS and the Operating Partnership separately, including separate financial statements, separate controls and procedures sections, separate Exhibit 31 and 32 certifications, and certain accompanying notes to the financial statements, including Note 8 – Partners’ Capital, Equity and Incentive Compensation Plans. In the sections that combine disclosure for QTS and the Operating Partnership, this report refers to actions or holdings as being actions or holdings of “we,” “our,” “us,” “our company” and “the Company.” Although the Operating Partnership is generally the entity that enters into contracts, holds assets and issues debt, we believe that these general references to “we,” “our,” “us,” “our company” and “the Company” in this context are appropriate because the business is one enterprise operated through the Operating Partnership.

 

2 

 

 

QTS Realty Trust, Inc.

QualityTech, LP

Form 10-Q

For the Quarterly Period Ended September 30, 2015

 

 

INDEX

    Page
PART I. FINANCIAL INFORMATION    
       
ITEM 1. Financial Statements of QTS Realty Trust, Inc.   4
       
  Financial Statements of QualityTech, LP   8
       
  Notes to QTS Realty Trust, Inc. and QualityTech, LP Financial Statements   12
       
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations   32
       
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk   57
       
ITEM 4. Controls and Procedures   58
       
PART II. OTHER INFORMATION    
       
ITEM 1. Legal Proceedings   59
       
ITEM 1A. Risk Factors   59
       
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds   60
     
ITEM 3. Defaults Upon Senior Securities   60
       
ITEM 4. Mine Safety Disclosures   60
       
ITEM 5. Other Information   60
       
ITEM 6. Exhibits   61
       
  Signatures   63

 

3 

 

 

PART I. FINANCIAL INFORMATION

ITEM 1. Financial Statements

QTS REALTY TRUST, INC.

INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

BALANCE SHEETS

(in thousands except share data)

 

   September 30, 2015   December 31, 2014 
   (unaudited)     
ASSETS          
Real Estate Assets          
Land  $52,430   $48,577 
Buildings and improvements   1,108,758    914,286 
Less: Accumulated depreciation   (222,373)   (180,167)
    938,815    782,696 
Construction in progress   353,782    214,719 
Real Estate Assets, net   1,292,597    997,415 
           
Cash and cash equivalents   10,730    10,788 
Rents and other receivables, net   31,024    15,579 
Acquired intangibles, net   119,402    18,000 
Deferred costs, net   38,522    37,058 
Prepaid expenses   9,074    3,079 
Goodwill   174,697    - 
Other assets, net   29,445    24,640 
TOTAL ASSETS  $1,705,491   $1,106,559 
           
LIABILITIES          
Mortgage notes payable  $70,000   $86,600 
Unsecured credit facility   400,000    239,838 
Senior notes, net of discount   297,914    297,729 
Capital lease and lease financing obligations   53,023    13,062 
Accounts payable and accrued liabilities   80,893    64,607 
Dividends and distributions payable   15,349    10,705 
Advance rents, security deposits and other liabilities   19,079    3,302 
Deferred income taxes   15,634    - 
Deferred income   25,046    10,531 
TOTAL LIABILITIES   976,938    726,374 
EQUITY          
Common stock, $0.01 par value, 450,133,000 shares authorized, 41,101,507 and 29,408,138 shares issued and outstanding as of September 30, 2015 and December 31, 2014, respectively   412    294 
Additional paid-in capital   668,246    324,917 
Accumulated dividends in excess of earnings   (44,142)   (22,503)
Total stockholders’ equity   624,516    302,708 
Noncontrolling interests   104,037    77,477 
TOTAL EQUITY   728,553    380,185 
TOTAL LIABILITIES AND EQUITY  $1,705,491   $1,106,559 


See accompanying notes to financial statements.

 

4 

 

 

QTS REALTY TRUST, INC.

INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (UNAUDITED)

(in thousands except share and per share data)

                 
   Three Months Ended September 30,   Nine Months Ended September 30, 
Revenues:  2015   2014   2015   2014 
     Rental  $62,744   $45,448   $164,270   $127,993 
     Recoveries from customers   6,158    6,131    17,404    13,674 
     Cloud and managed services   18,573    5,242    32,588    14,443 
     Other   1,415    1,124    4,131    2,116 
     Total revenues   88,890    57,945    218,393    158,226 
Operating Expenses:                    
     Property operating costs   30,925    20,369    72,292    53,121 
     Real estate taxes and insurance   1,462    1,377    4,421    3,713 
     Depreciation and amortization   24,486    15,210    58,791    42,274 
     General and administrative   19,440    11,045    47,893    33,296 
     Restructuring   -    226    -    1,272 
     Transaction and integration costs   1,482    (195)   6,256    958 
     Total operating expenses   77,795    48,032    189,653    134,634 
Operating income   11,095    9,913    28,740    23,592 
                     
Other income and expenses:                    
     Interest income   1    -    2    8 
     Interest expense   (5,418)   (5,410)   (15,559)   (9,683)
     Other (expense) income, net   -    (470)   (83)   (580)
Income before taxes   5,678    4,033    13,100    13,337 
     Tax benefit (expense) of taxable REIT subsidiaries   2,560    (27)   5,695    (82)
Net income   8,238    4,006    18,795    13,255 
Net income attributable to noncontrolling interests   (1,229)   (849)   (3,072)   (2,810)
Net income attributable to QTS Realty Trust, Inc.  $7,009   $3,157   $15,723   $10,445 
                     
Net income per share attributable to common shares:                    
     Basic  $0.17   $0.11   $0.43   $0.36 
     Diluted   0.17    0.11    0.43    0.36 
                     
Weighted average common shares outstanding:                    
     Basic   40,994,387    29,016,774    36,354,738    29,006,620 
     Diluted   48,733,417    37,251,769    44,181,583    37,039,603 

 

 See accompanying notes to financial statements.

 

5 

 

 

QTS REALTY TRUST, INC.

INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

CONSOLIDATED STATEMENT OF EQUITY

(unaudited and in thousands)

 

                      Accumulated                    
    Common stock     Additional     dividends in     Total            
    Shares     Amount     paid-in
capital
    excess of
earnings
    Stockholders’
equity
    Noncontrolling
interests
    Total  
Balance January 1, 2015     29,408     $ 294     $ 324,917     $ (22,503 )   $ 302,708     $ 77,477     $ 380,185  
Issuance of shares through equity award plan     263       3       (3 )     -       -       -       -  
Reclassification of noncontrolling interest upon conversion of partnership units to common stock     680       7       8,495       -       8,502       (8,502 )     -  
Equity-based compensation expense     -       -       4,355       -       4,355       851       5,206  
Net proceeds from equity offering     10,750       108       330,482       -       330,590       37,830       368,420  
Dividends to shareholders     -       -       -       (37,362 )     (37,362 )     -       (37,362 )
Distributions to noncontrolling interests     -       -       -       -       -       (6,691 )     (6,691 )
Net income     -       -       -       15,723       15,723       3,072       18,795  
Balance September 30, 2015     41,101     $ 412     $ 668,246     $ (44,142 )   $ 624,516     $ 104,037     $ 728,553  

 

 

See accompanying notes to financial statements.

 

6 

 

 

QTS REALTY TRUST, INC.

INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

STATEMENTS OF CASH FLOW

(unaudited and in thousands)

For the nine months ended September 30, 2015 and 2014

         
Cash flow from operating activities:  2015   2014 
Net income  $18,795   $13,255 
     Adjustments to reconcile net income to net cash provided by operating activities:          
     Depreciation and amortization   57,347    40,070 
     Amortization of deferred loan costs   2,372    1,894 
     Amortization of senior notes discount   184    38 
     Equity-based compensation expense   5,206    2,901 
     Bad debt expense   640    402 
     Write off of deferred loan costs   83    580 
     Deferred tax benefit   (5,695)   - 
     Changes in operating assets and liabilities          
          Rents and other receivables, net   (2,382)   104 
          Prepaid expenses   (4,713)   (2,245)
          Other assets   (352)   596 
          Accounts payable and accrued liabilities   (2,427)   (7,833)
          Advance rents, security deposits and other liabilities   (437)   (44)
          Deferred income   3,698    1,637 
Net cash provided by operating activities   72,319    51,355 
Cash flow from investing activities:          
Acquisitions, net of cash acquired   (288,865)   (91,064)
Additions to property and equipment   (252,156)   (156,008)
Cash used in investing activities   (541,021)   (247,072)
Cash flow from financing activities:          
Credit facility proceeds   420,162    230,500 
Senior Notes proceeds   -    297,633 
Debt repayment   (260,000)   (290,000)
Payment of deferred financing costs   (577)   (9,648)
Payment of cash dividends   (32,756)   (23,783)
Distribution to noncontrolling interests   (6,652)   (6,932)
Principal payments on capital lease obligations   (4,415)   (553)
Mortgage principal debt repayments   (16,600)   (1,665)
Equity proceeds, net of costs   369,482    - 
Net cash provided by financing activities   468,644    195,552 
           
Net decrease in cash and cash equivalents   (58)   (165)
Cash and cash equivalents, beginning of period   10,788    5,210 
Cash and cash equivalents, end of period  $10,730   $5,045 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION          
Cash paid for interest (excluding deferred financing costs and amounts capitalized)  $17,785   $4,599 
Noncash investing and financing activities:          
     Accrued capital additions  $48,540   $36,381 
     Capital lease and lease financing obligations assumed  $43,832   $- 

 

See accompanying notes to financial statements.

 

7 

 

 

QUALITYTECH, LP

INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

BALANCE SHEETS

(in thousands)

         
   September 30, 2015   December 31, 2014 
   (unaudited)     
ASSETS          
Real Estate Assets          
Land  $52,430   $48,577 
Buildings and improvements   1,108,758    914,286 
Less: Accumulated depreciation   (222,373)   (180,167)
    938,815    782,696 
Construction in progress   353,782    214,719 
Real Estate Assets, net   1,292,597    997,415 
           
Cash and cash equivalents   10,730    10,788 
Rents and other receivables, net   31,024    15,579 
Acquired intangibles, net   119,402    18,000 
Deferred costs, net   38,522    37,058 
Prepaid expenses   9,074    3,079 
Goodwill   174,697    - 
Other assets, net   29,445    24,640 
TOTAL ASSETS  $1,705,491   $1,106,559 
           
LIABILITIES          
Mortgage notes payable  $70,000   $86,600 
Unsecured credit facility   400,000    239,838 
Senior notes, net of discount   297,914    297,729 
Capital lease and lease financing obligations   53,023    13,062 
Accounts payable and accrued liabilities   80,893    64,607 
Dividends and distributions payable   15,349    10,705 
Advance rents, security deposits and other liabilities   19,079    3,302 
Deferred income taxes   15,634    - 
Deferred income   25,046    10,531 
TOTAL LIABILITIES   976,938    726,374 
PARTNERS' CAPITAL          
Partners' capital   728,553    380,185 
TOTAL LIABILITIES AND PARTNERS' CAPITAL  $1,705,491   $1,106,559 

 

See accompanying notes to financial statements.

 

8 

 

  

QUALITYTECH, LP

INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (UNAUDITED)

(in thousands)

 

   Three Months Ended September 30,   Nine Months Ended September 30, 
Revenues:  2015   2014   2015   2014 
     Rental  $62,744   $45,448   $164,270   $127,993 
     Recoveries from customers   6,158    6,131    17,404    13,674 
     Cloud and managed services   18,573    5,242    32,588    14,443 
     Other   1,415    1,124    4,131    2,116 
     Total revenues   88,890    57,945    218,393    158,226 
Operating Expenses:                    
     Property operating costs   30,925    20,369    72,292    53,121 
     Real estate taxes and insurance   1,462    1,377    4,421    3,713 
     Depreciation and amortization   24,486    15,210    58,791    42,274 
     General and administrative   19,440    11,045    47,893    33,296 
     Restructuring   -    226    -    1,272 
     Transaction and integration costs   1,482    (195)   6,256    958 
     Total operating expenses   77,795    48,032    189,653    134,634 
Operating income   11,095    9,913    28,740    23,592 
                     
Other income and expenses:                    
     Interest income   1    -    2    8 
     Interest expense   (5,418)   (5,410)   (15,559)   (9,683)
     Other (expense) income, net   -    (470)   (83)   (580)
Income before taxes   5,678    4,033    13,100    13,337 
     Tax benefit (expense) of taxable REIT subsidiaries   2,560    (27)   5,695    (82)
Net income  $8,238   $4,006   $18,795   $13,255 

 

See accompanying notes to financial statements.

 

9 

 

 

QUALITYTECH, LP

INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

CONSOLIDATED STATEMENT OF PARTNERS’ CAPITAL

(unaudited and in thousands)

 

   Limited Partners' Capital   General Partner's Capital     
   Units   Amount   Units   Amount   Total 
Balance January 1, 2015   36,935   $380,185    1   $-   $380,185 
Issuance of shares through equity award plan   263    -    -    -    - 
Equity-based compensation expense   -    5,206    -    -    5,206 
Net proceeds from QTS Realty Trust, Inc. equity offering   10,750    368,420    -    -    368,420 
Dividends to QTS Realty Trust, Inc.   -    (37,362)   -    -    (37,362)
Partnership distributions   -    (6,691)   -    -    (6,691)
Net income   -    18,795    -    -    18,795 
Balance September 30, 2015   47,948   $728,553    1   $-   $728,553 

 

See accompanying notes to financial statements.

 

10 

 

 

QUALITYTECH, LP

INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

STATEMENTS OF CASH FLOW

(unaudited and in thousands)

For the nine months ended September 30, 2015 and 2014

 

Cash flow from operating activities:  2015   2014 
Net income  $18,795   $13,255 
Adjustments to reconcile net income to net cash provided by
     operating activities:
          
     Depreciation and amortization   57,347    40,070 
     Amortization of deferred loan costs   2,372    1,894 
     Amortization of senior notes discount   184    38 
     Equity-based compensation expense   5,206    2,901 
     Bad debt expense   640    402 
     Write off of deferred loan costs   83    580 
     Deferred tax benefit   (5,695)   - 
     Changes in operating assets and liabilities          
          Rents and other receivables, net   (2,382)   104 
          Prepaid expenses   (4,713)   (2,245)
          Other assets   (352)   596 
          Accounts payable and accrued liabilities   (2,427)   (7,833)
          Advance rents, security deposits and other liabilities   (437)   (44)
          Deferred income   3,698    1,637 
Net cash provided by operating activities   72,319    51,355 
Cash flow from investing activities:          
Acquisitions, net of cash acquired   (288,865)   (91,064)
Additions to property and equipment   (252,156)   (156,008)
Cash used in investing activities   (541,021)   (247,072)
Cash flow from financing activities:          
Credit facility proceeds   420,162    230,500 
Senior Notes proceeds   -    297,633 
Debt repayment   (260,000)   (290,000)
Payment of deferred financing costs   (577)   (9,648)
Payment of cash dividends   (32,756)   (23,783)
Partnership distributions   (6,652)   (6,932)
Principal payments on capital lease obligations   (4,415)   (553)
Mortgage principal debt repayments   (16,600)   (1,665)
Equity proceeds, net of costs   369,482    - 
Net cash provided by financing activities   468,644    195,552 
           
Net decrease in cash and cash equivalents   (58)   (165)
Cash and cash equivalents, beginning of period   10,788    5,210 
Cash and cash equivalents, end of period  $10,730   $5,045 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION          
Cash paid for interest (excluding deferred financing costs and amounts capitalized)  $17,785   $4,599 
Noncash investing and financing activities:          
     Accrued capital additions  $48,540   $36,381 
     Capital lease and lease financing obligations assumed  $43,832   $- 

 

See accompanying notes to financial statements.

 

11 

 

 

QTS REALTY TRUST, INC.

QUALITYTECH, LP

NOTES TO UNAUDITED INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. Description of Business 

 

QTS Realty Trust, Inc. (“QTS”) through its controlling interest in QualityTech, LP (the “Operating Partnership” and collectively with QTS and their subsidiaries, the “Company”) and the subsidiaries of the Operating Partnership, is engaged in the business of owning, acquiring, redeveloping and managing multi-tenant data centers. The Company’s portfolio consists of 25 wholly-owned and leased properties with data centers located throughout the United States, Canada, Europe and the Asia-Pacific region.

 

QTS was formed as a Maryland corporation on May 17, 2013. On October 15, 2013, QTS completed its initial public offering of 14,087,500 shares of Class A common stock, $0.01 par value per share (the “IPO”), including shares issued pursuant to the underwriters’ option to purchase additional shares, which was exercised in full, and received net proceeds of approximately $279 million. QTS elected to be taxed as a real estate investment trust (“REIT”), for U.S. federal income tax purposes, commencing with its taxable year ended December 31, 2013. As a REIT, QTS generally is not required to pay federal corporate income taxes on its taxable income to the extent it is currently distributed to its stockholders.

 

Concurrently with the completion of the IPO, the Company consummated a series of transactions, including the merger of General Atlantic REIT, Inc. with the Company, pursuant to which the Company became the sole general partner and majority owner of QualityTech, LP, the Operating Partnership. QTS contributed the net proceeds received from the IPO to the Operating Partnership in exchange for partnership units therein. As of September 30, 2015, QTS owned approximately 85.7% of the interests in the Operating Partnership. Substantially all of QTS’ assets are held by, and QTS’ operations are conducted through, the Operating Partnership. QTS’ interest in the Operating Partnership entitles QTS to share in cash distributions from, and in the profits and losses of, the Operating Partnership in proportion to QTS’ percentage ownership. As the sole general partner of the Operating Partnership, QTS generally has the exclusive power under the partnership agreement to manage and conduct the Operating Partnership’s business and affairs, subject to certain limited approval and voting rights of the limited partners. QTS’ board of directors manages the Company’s business and affairs.

 

2. Summary of Significant Accounting Policies

 

Basis of Presentation – The accompanying financial statements have been prepared by management in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included.

The accompanying financial statements are presented for both QTS Realty Trust, Inc. and QualityTech, LP. References to “QTS” mean QTS Realty Trust, Inc. and its controlled subsidiaries; and references to the “Operating Partnership” mean QualityTech, LP and its controlled subsidiaries.

 

Management operates QTS and the Operating Partnership as one business. The management of QTS consists of the same employees as the management of the Operating Partnership. QTS is the sole general partner of the Operating Partnership, and its only material asset consists of its ownership interest in the Operating Partnership. QTS does not conduct business itself, other than acting as the sole general partner of the Operating Partnership and issuing public equity from time to time. QTS has not issued or guaranteed any indebtedness. Except for net proceeds from public equity issuances by QTS, which are contributed to the Operating Partnership in exchange for units of limited partnership interest of the Operating Partnership, the Operating Partnership generates all remaining capital required by the business through its operations, the direct or indirect incurrence of indebtedness, and the issuance of partnership units. As general partner with control of the Operating Partnership, QTS consolidates the Operating Partnership for financial reporting purposes.

 

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The Company believes, therefore, that providing one set of notes for the financial statements of QTS and the Operating Partnership provides the following benefits:

 

·enhances investors’ understanding of QTS and the Operating Partnership by enabling investors to view the business as a whole in the same manner as management views and operates the business;
·eliminates duplicative disclosure and provides a more streamlined and readable presentation since a substantial portion of the disclosure applies to both QTS and the Operating Partnership; and
·creates time and cost efficiencies through the preparation of one set of notes instead of two separate sets of notes.

 

In addition, in light of these combined notes, the Company believes it is important for investors to understand the few differences between QTS and the Operating Partnership in the context of how QTS and the Operating Partnership operate as a consolidated company. The presentation of stockholders’ equity and partners’ capital are the main areas of difference between the consolidated balance sheets of QTS and those of the Operating Partnership. The Operating Partnership’s capital includes general and limited common units that are owned by QTS and the other partners. QTS' stockholders’ equity includes common stock, additional paid in capital, accumulated other comprehensive income (loss) and accumulated dividends in excess of earnings. The remaining equity is the portion of net assets that are retained by partners other than QTS, referred to as noncontrolling interests. The primary difference in QTS' Statements of Operations and Comprehensive Income (Loss) is that for net income (loss), QTS retains its proportionate share of the net income (loss) based on its ownership of the Operating Partnership, with the remaining balance being retained by the Operating Partnership. These combined notes refer to actions or holdings as being actions or holdings of “the Company.” Although the Operating Partnership is generally the entity that enters into contracts, holds assets and issues debt, management believes that these general references to “the Company” in this context is appropriate because the business is one enterprise operated through the Operating Partnership.

 

As discussed above, QTS owns no operating assets and has no operations independent of the Operating Partnership and its subsidiaries. Also, the Operating Partnership owns no operating assets and has no operations independent of its subsidiaries. Obligations under the 5.875% Senior Notes due 2022 and the unsecured credit facility, both discussed in Note 5, are fully, unconditionally, and jointly and severally guaranteed by the Operating Partnership’s existing subsidiaries, other than QTS Finance Corporation, the co-issuer of the 5.875% Senior Notes due 2022. As such, condensed consolidating financial information for the guarantors is not being presented in the notes to the interim condensed consolidated financial statements. However, the indenture governing the 5.875% Senior Notes due 2022 restricts the ability of the Operating Partnership to make distributions to QTS, subject to certain exceptions, including distributions required in order for QTS to maintain its status as a real estate investment trust under the Internal Revenue Code of 1986, as amended.

 

The interim condensed consolidated financial statements of QTS Realty Trust, Inc. for the three and nine months ended September 30, 2015 and 2014, and as of September 30, 2015 and December 31, 2014 present the accounts of QTS Realty Trust, Inc. and its majority owned subsidiaries. This includes the operating results of the Operating Partnership for all periods presented.

 

Use of Estimates – The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant items subject to such estimates and assumptions include the useful lives of fixed assets, allowances for doubtful accounts and deferred tax assets and the valuation of derivatives, real estate assets, acquired intangible assets and certain accruals.

 

Principles of Consolidation – The consolidated financial statements of QTS Realty Trust, Inc. include the accounts of QTS Realty Trust, Inc. and its majority-owned subsidiaries. The consolidated financial statements of QualityTech, LP include the accounts of QualityTech, LP and its subsidiaries. All significant intercompany accounts and transactions have been eliminated in the financial statements.

 

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Real Estate Assets – Real estate assets are reported at cost. All capital improvements for the income-producing properties that extend their useful lives are capitalized to individual property improvements and depreciated over their estimated useful lives. Depreciation is generally provided on a straight-line basis over 40 years from the date the property was placed in service. Property improvements are depreciated on a straight-line basis over the life of the respective improvement ranging from 20 to 40 years from the date the components were placed in service. Leasehold improvements are depreciated over the lesser of 20 years or through the end of the respective life of the lease. Repairs and maintenance costs are expensed as incurred. For the three months ended September 30, 2015, depreciation expense related to real estate assets and non-real estate assets was $15.2 million and $2.7 million, respectively, for a total of $17.9 million. For the three months ended September 30, 2014, depreciation expense related to real estate assets and non-real estate assets was $10.3 million and $1.6 million, respectively, for a total of $11.9 million. For the nine months ended September 30, 2015, depreciation expense related to real estate assets and non-real estate assets was $38.5 million and $6.2 million, respectively, for a total of $44.7 million. For the nine months ended September 30, 2014, depreciation expense related to real estate assets and non-real estate assets was $28.2 million and $4.6 million, respectively, for a total of $32.8 million. The Company capitalizes certain development costs, including internal costs incurred in connection with development. The capitalization of costs during the construction period (including interest and related loan fees, property taxes and other direct and indirect costs) begins when development efforts commence and ends when the asset is ready for its intended use. Capitalization of such costs, excluding interest, aggregated to $2.7 million and $2.9 million for the three months ended September 30, 2015 and 2014, respectively, and $8.6 million and $7.5 million for the nine months ended September 30, 2015 and 2014, respectively. Interest is capitalized during the period of development by first applying the Company’s actual borrowing rate on the related asset and second, to the extent necessary, by applying the Company’s weighted average effective borrowing rate to the actual development and other costs expended during the construction period. Interest is capitalized until the property is ready for its intended use. Interest costs capitalized totaled $2.7 million and $1.3 million for the three months ended September 30, 2015 and 2014, respectively, and $7.1 million and $4.7 million for the nine months ended September 30, 2015 and 2014, respectively.

 

Acquisitions – Acquisitions of real estate and other entities are either accounted for as asset acquisitions or business combinations depending on facts and circumstances. Purchase accounting is applied to the assets and liabilities related to all real estate investments acquired in accordance with the accounting requirements of ASC 805, Business Combinations, which requires the recording of net assets of acquired businesses at fair value. The fair value of the consideration transferred is allocated to the acquired tangible assets, consisting primarily of land, building and improvements, and identified intangible assets and liabilities, consisting of the value of above-market and below-market leases, value of in-place leases, value of customer relationships, trade names, software intangibles and capital leases. The excess of the fair value of liabilities assumed, common stock issued and cash paid over the fair value of identifiable assets acquired is allocated to goodwill, which is not amortized by the Company.

 

In developing estimates of fair value of acquired assets and assumed liabilities, management analyzed a variety of factors including market data, estimated future cash flows of the acquired operations, industry growth rates, current replacement cost for fixed assets and market rate assumptions for contractual obligations. Such a valuation requires management to make significant estimates and assumptions, particularly with respect to the intangible assets.

 

Acquired in-place leases are amortized as amortization expense on a straight-line basis over the remaining life of the underlying leases. Amortization of acquired in place lease costs totaled $0.4 million and $0.5 million for the three months ended September 30, 2015 and 2014, respectively, and $1.3 million and $1.8 million for the nine months ended September 30, 2015 and 2014, respectively. This amortization expense is accounted for as real estate amortization expense.

 

Acquired customer relationships are amortized as amortization expense on a straight-line basis over the expected life of the customer relationship. Amortization of acquired customer relationships totaled $2.0 million and $0.3 million for the three months ended September 30, 2015 and 2014, respectively, and $3.0 million and $1.0 million for the nine months ended September 30, 2015 and 2014, respectively. This amortization expense is accounted for as real estate amortization expense.

 

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Other acquired intangible assets, which includes platform, above or below market leases, and trade name intangibles, are amortized on a straight-line basis over their respective expected lives. Platform and trade name intangibles are amortized as amortization expense. Platform amortization expense was $0.8 million and $0.9 million for the three and nine months ended September 30, 2015, respectively. Trade name amortization expense was $0.3 million for the three and nine months September 30, 2015. Above or below market leases are amortized as rent expense, which totaled $0.1 million for both the three and nine months ended September 30, 2015. There was no amortization expense or rent expense related to platform, trade name, and above or below market lease intangibles for the three and nine months ended September 30, 2014. The expense associated with above and below market leases and trade name intangibles is accounted for as real estate expense, whereas the expense associated with the amortization of platform intangibles is accounted for as non-real estate expense.

 

See Note 3 for discussion of the preliminary purchase price allocation for the acquisition of Carpathia Hosting, Inc. (“Carpathia”) on June 16, 2015.

 

Impairment of Long-Lived and Intangible Assets – The Company reviews its long-lived assets for impairment when events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Recoverability of assets to be held and used is generally measured by comparison of the carrying amount to the future net cash flows, undiscounted and without interest, expected to be generated by the asset group. If the net carrying value of the asset exceeds the value of the undiscounted cash flows, the fair value of the asset is assessed and may be considered impaired. An impairment loss is recognized based on the excess of the carrying amount of the impaired asset over its fair value. No impairment losses were recorded for the three and nine months ended September 30, 2015 and 2014, respectively.


As a result of the Carpathia acquisition, the Company recognized approximately $175 million in goodwill. The fair value of goodwill is the consideration transferred which is not allocable to identifiable intangible and tangible assets. The Company believes that it has one reporting unit for goodwill purposes, and will assess goodwill for impairment annually on October 1 on that basis.

 

Cash and Cash Equivalents – The Company considers all demand deposits and money market accounts purchased with a maturity date of three months or less at the date of purchase to be cash equivalents. The Company’s account balances at one or more institutions periodically exceed the Federal Deposit Insurance Corporation (“FDIC”) insurance coverage and, as a result, there is concentration of credit risk related to amounts on deposit in excess of FDIC coverage. The Company mitigates this risk by depositing a majority of its funds with several major financial institutions. The Company also has not experienced any losses and, therefore, does not believe that the risk is significant.

 

Deferred Costs – Deferred costs, net, on the Company’s balance sheets include both financing costs and leasing costs.

 

Deferred financing costs represent fees and other costs incurred in connection with obtaining debt and are amortized over the term of the loan and are included in interest expense. Amortization of the deferred financing costs was $0.8 million and $0.5 million for the three months ended September 30, 2015 and 2014, respectively, and $2.4 million and $1.7 million for the nine months ended September 30, 2015 and 2014, respectively. During the three months ended September 30, 2014, the Company wrote off unamortized financing costs of $0.5 million primarily in connection with paying down $75 million of its unsecured credit facility term loan. No unamortized financing costs were written off during the three months ended September 30, 2015. During the nine months ended September 30, 2015, the Company wrote off unamortized financing costs of $0.1 million in connection with the repayment of the Atlanta Metro equipment loan in June 2015, as discussed in Note 5. During the nine months ended September 30, 2014, in addition to the aforementioned $0.5 million write off, the Company wrote off unamortized financing costs of $0.1 million in connection with the modification of its credit facility that is secured by the Richmond data center. Deferred financing costs, net of accumulated amortization are as follows:

 

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   September 30,   December 31, 
(dollars in thousands)  2015   2014 
   (unaudited)     
         
Deferred financing costs  $18,646   $18,152 
Accumulated amortization   (4,090)   (1,683)
     Deferred financing costs, net  $14,556   $16,469 

 

Deferred leasing costs consist of external fees and internal costs incurred in the successful negotiations of leases and are deferred and amortized over the terms of the related leases on a straight-line basis. If an applicable lease terminates prior to the expiration of its initial term, the carrying amount of the costs are written off to amortization expense. Amortization of deferred leasing costs totaled $3.1 million and $2.5 million for the three months ended September 30, 2015 and 2014, respectively, and $8.6 million and $6.7 million for the nine months ended September 30, 2015 and 2014, respectively. Deferred leasing costs, net of accumulated amortization are as follows (excluding $2.9 million, net of amortization, related to a leasing arrangement at the Company’s Princeton facility in 2014):

 

   September 30,   December 31, 
(dollars in thousands)  2015   2014 
   (unaudited)     
         
Deferred leasing costs  $35,652   $26,799 
Accumulated amortization   (14,565)   (9,378)
     Deferred leasing costs, net  $21,087   $17,421 

 

Advance Rents and Security Deposits – Advance rents, typically prepayment of the following month’s rent, consist of payments received from customers prior to the time they are earned and are recognized as revenue in subsequent periods when earned. Security deposits are collected from customers at the lease origination and are generally refunded to customers upon lease expiration.

 

Deferred Income – Deferred income generally results from non-refundable charges paid by the customer at lease inception to prepare their space for occupancy. The Company records this initial payment, commonly referred to as set-up fees, as a deferred income liability which amortizes into rental revenue over the term of the related lease on a straight-line basis. Deferred income was $25.0 million and $10.5 million as of September 30, 2015 and December 31, 2014, respectively. Additionally, $1.5 million and $1.1 million of deferred income was amortized into revenue for the three months ended September 30, 2015 and 2014, respectively, and $4.1 million and $3.5 million for the nine months ended September 30, 2015 and 2014, respectively.

 

Interest Rate Derivative Instruments – The Company utilizes derivatives to manage its interest rate exposure. During February 2012, the Company entered into interest rate swaps with a notional amount of $150 million which were cash flow hedges and qualified for hedge accounting. For these hedges, the effective portion of the change in fair value was recognized through other comprehensive income or loss. Amounts were reclassified out of other comprehensive income (loss) as the hedged item was recognized in earnings, either for ineffectiveness or for amounts paid relating to the hedge. The Company reflected all changes in the fair value of the swaps in other comprehensive income (loss) during the three and nine months ended September 30, 2014, as there was no ineffectiveness recorded in that period. The Company had no interest rate swaps outstanding at September 30, 2015 and December 31, 2014.

 

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Equity-based Compensation – All equity-based compensation is measured at fair value on the grant date or date of modification, as applicable, and recognized in earnings over the requisite service period. Depending upon the settlement terms of the awards, all or a portion of the fair value of equity-based awards may be presented as a liability or as equity in the consolidated balance sheets. Equity-based compensation costs are measured based upon their estimated fair value on the date of grant or modification. Equity-based compensation expense net of forfeited and repurchased awards was $2.1 million and $0.9 million for the three months ended September 30, 2015 and 2014, respectively, and $5.2 million and $2.9 million for the nine months ended September 30, 2015 and 2014, respectively.

 

Rental Revenue – The Company, as a lessor, has retained substantially all of the risks and benefits of ownership and accounts for its leases as operating leases. For lease agreements that provide for scheduled rent increases, rental income is recognized on a straight-line basis over the non-cancellable term of the leases, which commences when control of the space has been provided to the customer. The amount of the straight-line rent receivable on the balance sheets included in rents and other receivables, net was $7.3 million and $4.0 million as of September 30, 2015 and December 31, 2014, respectively. Rental revenue also includes amortization of set-up fees which are amortized over the term of the respective lease as discussed above.

 

Cloud and Managed Services Revenue – The Company may provide both its cloud product and use of its managed services to its customers on an individual or combined basis. Service fee revenue is recognized as the revenue is earned, which generally coincides with the services being provided.

 

Allowance for Uncollectible Accounts Receivable – Rents receivable are recognized when due and are carried at cost, less an allowance for doubtful accounts. The Company records a provision for losses on rents receivable equal to the estimated uncollectible accounts, which is based on management’s historical experience and a review of the current status of the Company’s receivables. As necessary, the Company also establishes an appropriate allowance for doubtful accounts for receivables arising from the straight-lining of rents. The aggregate allowance for doubtful accounts was $5.3 million and $3.7 million as of September 30, 2015 and December 31, 2014, respectively.

 

Capital Leases and Lease Financing Obligations – The Company evaluates leased real estate to determine whether the lease should be classified as a capital or operating lease in accordance with U.S GAAP.

 

The Company periodically enters into capital leases for certain equipment. In addition, through its acquisition of Carpathia Hosting, Inc. on June 16, 2015, the Company is now party to capital leases for property and equipment, as well as financing obligations related to a sale-leaseback transaction. The outstanding liabilities for the capital leases were $29.6 million and $13.1 million as of September 30, 2015 and December 31, 2014, respectively. The outstanding liabilities for the lease financing obligations were $23.4 million as of September 30, 2015. The value of the assets associated with these leases approximates the outstanding obligations as of September 30, 2015 and December 31, 2014, respectively. Depreciation related to the associated assets is included in depreciation and amortization expense in the Statements of Operations and Comprehensive Income.

 

See Note 3 for further discussion of the acquisition of Carpathia and Note 5 for further discussion of capital leases and lease financing obligations.

 

Recoveries from Customers – Certain customer leases contain provisions under which the customers reimburse the Company for a portion of the property’s real estate taxes, insurance and other operating expenses, which include certain power and cooling-related charges. The reimbursements are included in revenue as recoveries from customers in the Statements of Operations and Comprehensive Income in the period the applicable expenditures are incurred. Certain customer leases are structured to provide a fixed monthly billing amount that includes an estimate of various operating expenses, with all revenue from such leases included in rental revenues.

 

Segment Information – The Company manages its business as one operating segment and thus one reportable segment consisting of a portfolio of investments in data centers located primarily in the United States with others in Canada, Europe and the Asia-Pacific region.

 

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Customer Concentrations – As of September 30, 2015, one of the Company’s customers represented 8.2% of its total monthly rental revenue. No other customers exceeded 5% of total monthly rental revenue.

 

As of September 30, 2015, three of the Company’s customers exceeded 5% of total accounts receivable. In aggregate, these three customers accounted for 40% of total accounts receivable. Two of these three customers individually exceeded 10% of total accounts receivable.

 

Income Taxes – The Company elected for three of its existing subsidiaries to be taxed as taxable REIT subsidiaries pursuant to the REIT rules of the U.S. Internal Revenue Code.

 

For the taxable REIT subsidiaries, income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized.

 

As of December 31, 2014, one of the taxable REIT subsidiaries’ deferred tax assets were primarily the result of U.S. net operating loss carryforwards. A valuation allowance was recorded against its gross deferred tax asset balance as of December 31, 2014. As a result of the acquisition of Carpathia, the Company has determined that it is more likely than not that pre-existing deferred tax assets will be realized by the combined entity, and the valuation allowance was eliminated. The change in the valuation allowance resulting from the change in circumstances is included in income, recognized in deferred income tax benefit in the three and nine months ended September 30, 2015.

 

In addition to the deferred income tax benefit recognized in connection with the elimination of the valuation allowance, a deferred tax benefit is being recognized in the third quarter and nine months ended September 30, 2015 in connection with recorded operating losses. The taxable REIT subsidiary consolidated group has a net deferred tax liability position primarily due to the customer-based intangibles acquired as part of the Carpathia acquisition.

 

The Company provides for income taxes during interim periods based on the estimated effective tax rate for the year. The effective tax rate is subject to change in the future due to various factors such as the operating performance of the taxable REIT subsidiary, tax law changes and future business acquisitions. The Company’s effective tax rates were 28.4% and 0% for the nine months ended September 30, 2015 and 2014, respectively. The increase in the effective tax rate is primarily due to the elimination of the valuation allowance as a result of the Carpathia acquisition, as well as recorded operating losses in the current year.

 

Fair Value Measurements – ASC Topic 820, Fair Value Measurements, emphasizes that fair-value is a market-based measurement, not an entity-specific measurement. Therefore, a fair-value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair-value measurements, a fair-value hierarchy is established that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).

 

Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates, and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair-value measurement is based on inputs from different levels of the fair-value hierarchy, the level in the fair-value hierarchy within which the entire fair-value measurement falls is based on the lowest level input that is significant to the fair-value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair-value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.

 

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As the Company’s previous interest rate swaps matured on September 28, 2014, there are no financial assets or liabilities measured at fair value on a recurring basis on the consolidated balance sheets as of September 30, 2015 and December 31, 2014. The Company’s purchase price allocation of Carpathia is a fair value estimate that utilized Level 3 inputs and is measured on a non-recurring basis. See Note 3 for further detail.

 

New Accounting Pronouncements

 

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers (Topic 606),” which supersedes the current revenue recognition requirements in ASC 606, Revenue Recognition. Under this new guidance, entities should recognize revenues to depict the transfer of promised goods or services to customers in an amount that reflects the consideration the entity expects to receive in exchange for those goods or services. This ASU also requires enhanced disclosures. In July 2015, the FASB finalized its decision to delay the effective date of the amendments in this ASU by one year, and as such, they are effective for annual and interim periods beginning after December 15, 2017. Early adoption is permitted; however, entities are not permitted to adopt the standard earlier than December 15, 2016, the original effective date. Retrospective and modified retrospective application is allowed. The Company is currently assessing the impact of this standard on its consolidated financial statements.

 

In April 2015, the FASB issued ASU 2015-03, “Interest - Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs”. The amendments in this ASU require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts, and not as a separate deferred charge. The recognition and measurement guidance for debt issuance costs are not affected by the amendments in this ASU. In June 2015, the Securities and Exchange Commission (“SEC”) stated that given the absence of authoritative guidance within this ASU for debt issuance costs related to revolving debt arrangements, the SEC staff would not object to an entity deferring and presenting such costs as an asset and subsequently amortizing them ratably over the term of the revolving debt arrangement. This announcement confirms that revolver arrangement costs are not within the scope of this ASU. The amendments in this ASU are effective for financial statements issued for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years. Early adoption is permitted. The amendments are required to be applied on a retrospective basis, and upon transition, an entity is required to comply with the applicable disclosures for a change in an accounting principle. Adoption of this standard will affect the Company’s Consolidated Balance Sheets.

 

In September 2015, the FASB issued ASU 2015-16, “Simplifying the Accounting for Measurement-Period Adjustments,” that eliminates the requirement to restate prior period financial statements for measurement period adjustments. The new guidance requires that the cumulative impact of a measurement period adjustment (including the impact on prior periods) be recognized in the reporting period in which the adjustment is identified. The amendments in this ASU are effective for fiscal years beginning after December 15, 2015, including interim periods within those fiscal years, and should be applied prospectively to adjustments to provisional amounts that occur after the effective date with earlier application permitted for financial statements that have not been issued. The Company is currently assessing the impact of this standard on its consolidated financial statements.


3. Acquisitions

 

Carpathia Acquisition

 

On June 16, 2015, the Company completed the acquisition of 100% of the outstanding stock of Carpathia Hosting, Inc. (“Carpathia”), a Virginia-based colocation, cloud and managed services provider for approximately $354.4 million (based on the preliminary assessment of the fair value of assets acquired and liabilities assumed). Upon completion of this acquisition, the Company assumed all of the assets and liabilities of Carpathia Acquisition, Inc. Carpathia Acquisition, Inc. and its subsidiaries, including Carpathia, became indirect, wholly-owned subsidiaries of the Company. Carpathia is a provider of colocation, hybrid cloud and Infrastructure-as-a-Service (IaaS) servicing enterprise customers and federal agencies, with a customer base of approximately 230 customers as of June 16, 2015. Carpathia utilizes eight domestic data centers located in Dulles, Virginia; Phoenix, Arizona; San Jose, California; Harrisonburg, Virginia and Ashburn, Virginia; and five international data centers located in Toronto; Amsterdam; London; Hong Kong and Sydney.

 

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The Company accounted for this acquisition in accordance with ASC 805, Business Combinations, as a business combination. The preliminary purchase price allocation was based on an assessment of the fair value of the assets acquired and liabilities assumed, and excludes acquisition-related costs which in accordance with ASC 805 were expensed as incurred. The Company is valuing the assets acquired and liabilities assumed using Level 3 inputs.

 

The following table summarizes the consideration for the Carpathia acquisition and the preliminary allocation of the fair value of assets acquired and liabilities assumed at the acquisition date (in thousands). This allocation is subject to change pending the final valuation of these assets and liabilities:

 

    June 16, 2015 
Land  $1,130 
Buildings and improvements   78,898 
Construction in process   12,127 
Acquired intangibles, net   90,947 
Net working capital   2,390 
Total identifiable assets acquired   185,492 
      
Capital lease and lease financing obligations   43,832 
Deferred income taxes   21,673 
Total liabilities assumed   65,505 
      
Net identifiable assets acquired   119,987 
Goodwill   174,697 
Net assets acquired  $294,684 
      

 

Goodwill recognized in the transaction relates primarily to anticipated operating synergies, Carpathia’s in-place workforce and access to Carpathia’s broader customer base. Based on the preliminary purchase price allocation, amortization expenses relative to the intangible assets acquired are expected to be approximately $5.9 million, $11.0 million, $11.0 million, $8.8 million and $6.7 million for the years ended December 31, 2015 through December 31, 2019, respectively.

The following table represents the pro forma condensed consolidated statements of operations of the combined entities for the three-month period ended September 30, 2014, and for the nine-month periods ended September 30, 2015 and 2014 (in thousands):

 

   (Unaudited) Pro Forma Condensed Consolidated Statements of Operations
   Three Months Ended September 30,  Nine Months Ended September 30,
   2014  2015  2014
Revenue  $78,951  $285,769  $218,918
Net income  $1,550  $10,901  $7,949

 

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These amounts have been calculated after applying the Company’s accounting policies, and give effect to the Carpathia acquisition. The purchase price allocation for this acquisition has been prepared on a preliminary basis. Accordingly, the purchase accounting adjustments made in connection with the development of the unaudited pro forma consolidated statements of operations are preliminary and subject to change.

 

The unaudited pro forma condensed consolidated financial information is for comparative purposes only and not necessarily indicative of what actual results of operations of the Company would have been had the transactions noted above been consummated on January 1, 2014, nor does it purport to represent the results of operations for future periods.

 

Revenue and net income generated by Carpathia entities subsequent to the Company’s acquisition from June 16, 2015 to September 30, 2015 were $25.9 million and $0.7 million, respectively.

 

4. Real Estate Assets and Construction in Progress

 

The following is a summary of properties owned or leased by the Company as of September 30, 2015 and December 31, 2014 (in thousands):

 

As of September 30, 2015 (unaudited):

 

Property Location  Land   Buildings and Improvements   Construction in Progress   Total Cost 
                 
Owned Properties                
     Suwanee, Georgia (Atlanta-Suwanee)  $3,521   $146,714   $16,558   $166,793 
     Atlanta, Georgia (Atlanta-Metro)   15,396    386,397    48,403    450,196 
     Santa Clara, California*   -    93,895    990    94,885 
     Richmond, Virginia   2,180    166,283    122,746    291,209 
     Sacramento, California   1,481    61,112    302    62,895 
     Princeton, New Jersey   20,700    32,583    314    53,597 
     Dallas-Fort Worth, Texas   5,808    70,710    113,115    189,633 
     Chicago, Illinois   -    -    43,098    43,098 
     Miami, Florida   1,777    30,038    306    32,121 
     Lenexa, Kansas   437    3,511    -    3,948 
     Wichita, Kansas   -    1,409    -    1,409 
    51,300    992,652    345,832    1,389,784 
                     
Leased Properties                    
     Carpathia properties ***   1,130    87,425    6,384    94,939 
     Jersey City, New Jersey   -    27,767    1,566    29,333 
     Overland Park, Kansas **   -    914    -    914 
    1,130    116,106    7,950    125,186 
   $52,430   $1,108,758   $353,782   $1,514,970 

 

 

* Owned facility subject to long-term ground sublease.
** This does not include the portion of the business that is used for QTS office space or other real estate not used by customers.
*** Includes 13 facilities. All facilities are leased, including those subject to capital leases.

 

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As of December 31, 2014:

 

Property Location  Land   Buildings and Improvements   Construction in Progress   Total Cost 
                     
Owned Properties                    
     Suwanee, Georgia (Atlanta-Suwanee)  $3,521   $138,991   $6,345   $148,857 
     Atlanta, Georgia (Atlanta-Metro)   15,397    356,122    22,693    394,212 
     Santa Clara, California*   -    90,332    650    90,982 
     Richmond, Virginia   2,180    127,080    71,794    201,054 
     Sacramento, California   1,481    60,094    278    61,853 
     Princeton, New Jersey   17,976    35,951    90    54,017 
     Dallas-Fort Worth, Texas   5,808    44,053    89,982    139,843 
     Chicago, Illinois   -    -    21,786    21,786 
     Miami, Florida   1,777    28,786    129    30,692 
     Lenexa, Kansas   437    3,298    25    3,760 
     Wichita, Kansas   -    1,409    -    1,409 
    48,577    886,116    213,772    1,148,465 
                     
Leased Properties                    
     Jersey City, New Jersey   -    27,318    920    28,238 
     Overland Park, Kansas **   -    852    27    879 
    -    28,170    947    29,117 
   $48,577   $914,286   $214,719   $1,177,582 

_____________________________

* Owned facility subject to long-term ground sublease.
** This does not include the portion of the business that is used for QTS office space or other real estate not used by customers.

 

5. Debt

Below is a listing of the Company’s outstanding debt, including capital leases and lease financing obligations, as of September 30, 2015 and December 31, 2014 (in thousands):

 

   September 30,   December 31, 
   2015   2014 
   (Unaudited)     
           
Unsecured Credit Facility  $400,000   $239,838 
Senior Notes, net of discount   297,914    297,729 
Richmond Credit Facility   70,000    70,000 
Atlanta-Metro Equipment Loan   -    16,600 
Capital Lease and Lease Financing Obligations   53,023    13,062 
Total  $820,937   $637,229 

 

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Credit Facilities, Senior Notes and Mortgage Notes Payable

 

(a) Unsecured Credit Facility – On May 1, 2013, the Company entered into a $575 million unsecured credit facility comprised of a five-year $225 million term loan and a four-year $350 million revolving credit facility with a one year extension, subject to satisfaction of certain conditions, and had the ability to expand the total credit facility by an additional $100 million subject to certain conditions set forth in the credit agreement. In July 2014, the Company’s term loan was reduced by $75 million to $150 million in connection with the issuance of the Senior Notes. On December 17, 2014, the Company amended and restated its unsecured credit facility to provide for a $650 million unsecured credit facility comprised of a five-year $100 million term loan scheduled to mature on December 17, 2019 and a four-year $550 million revolving credit facility scheduled to mature on December 17, 2018, with the option to extend one year until December 17, 2019, subject to the satisfaction of certain conditions. The lenders under the unsecured credit facility could issue up to $30 million in letters of credit subject to the satisfaction of certain conditions.  The total unsecured credit facility could be increased from the current capacity of $650 million to up to $850 million subject to certain conditions set forth in the credit agreement, including the consent of the administrative agent and obtaining necessary commitments. As of September 30, 2015, borrowings under the unsecured credit facility consisted of $300.0 million outstanding under the revolving credit facility and $100.0 million outstanding under the term loan.

 

In October 2015, the Company amended the unsecured credit facility, increasing the total capacity by $250 million and extending the term.  At the same time, the Company terminated its secured credit facility relating to the Richmond data center. The amended unsecured credit facility has a total capacity of $900 million and includes a $150 million term loan which matures on December 17, 2020, another $150 million term loan which matures on April 27, 2021, and a $600 million revolving credit facility which matures on December 17, 2019, with a one year extension option. Amounts outstanding under the amended unsecured credit facility bear interest at a variable rate equal to, at the Company’s election, LIBOR or a base rate, plus a spread that will vary depending upon the Company’s leverage ratio. For revolving credit loans, the spread ranges from 1.55% to 2.15% for LIBOR loans and 0.55% to 1.15% for base rate loans. For term loans, the spread ranges from 1.50% to 2.10% for LIBOR loans and 0.50% to 1.10% for base rate loans. The amended unsecured credit facility also includes a $200 million accordion feature.

 

The unsecured credit facility requires monthly interest payments and requires the Company to comply with various customary affirmative and negative covenants and quarterly financial covenant requirements relating to the debt service coverage ratio, fixed charge ratio, leverage ratio and tangible net worth and various other operational requirements. In connection with the unsecured credit facility, as of September 30, 2015, the Company had an additional $2.5 million letter of credit outstanding. The letter of credit was reduced to $2.0 million on October 1, 2015. As of September 30, 2015, the weighted average interest rate for amounts outstanding under the unsecured credit facility was 1.89%.

 

(b) Senior Notes – On July 23, 2014, the Operating Partnership and QTS Finance Corporation, a subsidiary of the Operating Partnership formed solely for the purpose of facilitating the offering of the notes described below (collectively, the “Issuers”), issued $300 million aggregate principal amount of 5.875% Senior Notes due 2022 (the “Senior Notes”). The Senior Notes have an interest rate of 5.875% per annum, were issued at a price equal to 99.211% of their face value and mature on August 1, 2022. The proceeds from the offering were used to repay amounts outstanding under the unsecured credit facility, including $75 million outstanding under the term loan. The Senior Notes are unconditionally guaranteed, jointly and severally, on a senior unsecured basis by all of the Operating Partnership’s existing subsidiaries (other than foreign subsidiaries and receivables entities) and future subsidiaries that guarantee any indebtedness of QTS Realty Trust, Inc., the Issuers or any other subsidiary guarantor. The Company will not initially guarantee the Senior Notes and will not be required to guarantee the Senior Notes except under certain circumstances. The offering was conducted pursuant to Rule 144A of the Securities Act of 1933, as amended, and the Senior Notes were issued pursuant to an indenture, dated as of July 23, 2014, among the Operating Partnership, QTS Finance Corporation, the Company, the guarantors named therein, and Deutsche Bank Trust Company Americas, as trustee (the “Indenture”).

 

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On March 23, 2015, the SEC declared effective the Operating Partnership and QTS Finance Corporation’s registration statement on Form S-4 pursuant to which the issuers exchanged the originally issued Senior Notes for $300 million of 5.875% Senior Notes due 2022 (the “Exchange Notes”) that are registered under the Securities Act of 1933, as amended. The exchange offer was completed on April 23, 2015, and all outstanding originally issued Senior Notes were tendered. The Exchange Notes did not provide the Company with any additional proceeds and satisfied its obligations under a registration rights agreement entered into in connection with the issuance of the Senior Notes.

 

(c) Richmond Credit Facility – In December 2012, the Company entered into a credit facility secured by the Company’s Richmond data center (the “Richmond Credit Facility”). As of September 30, 2015, the Richmond Credit Facility had capacity of $120 million and included an accordion feature that allowed the Company to increase the size of the credit facility up to $200 million. It also required the Company to comply with covenants similar to the unsecured credit facility. The Richmond Credit Facility was scheduled to mature June 30, 2019; however, as discussed above, the Company terminated the Richmond Credit Facility in conjunction with the October 2015 amendment of its unsecured credit facility.

 

As of September 30, 2015, amounts outstanding under the Richmond Credit Facility bore interest at a variable rate equal to, at the Company’s election, LIBOR or a base rate, plus a spread that ranged, depending upon the Company’s leverage ratio, from 2.10% to 2.85% for LIBOR loans or 1.10% to 1.85% for base rate loans. As of September 30, 2015, the interest rate for amounts outstanding under the Richmond Credit Facility was 2.29%.

 

(d) Atlanta-Metro Equipment Loan – On April 9, 2010, the Company entered into a $25 million loan to finance equipment related to an expansion project at the Company’s Atlanta-Metro data center (the “Atlanta-Metro Equipment Loan”). The loan originally required monthly interest-only payments and subsequently required monthly interest and principal payments. The loan bore interest at 6.85% and was scheduled to mature on June 1, 2020. This debt was repaid in June 2015 when its prepayment penalties expired.

 

The annual remaining principal payment requirements as of September 30, 2015 per the contractual maturities and excluding extension options, capital leases and lease financing obligations, are as follows (in thousands). The amounts shown do not include the effects of the October 2015 amendment to the unsecured credit facility discussed above:

 

2015  $- 
2016   - 
2017   - 
2018   300,000 
2019   170,000 
Thereafter   300,000 
     Total  $770,000 


As of September 30, 2015, the Company was in compliance with all of its covenants.

 

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Capital Leases

 

The Company has historically entered into capital leases for certain equipment. In addition, through its acquisition of Carpathia on June 16, 2015, the Company acquired capital leases of both equipment and certain properties. Total outstanding liabilities for capital leases were $29.6 million as of September 30, 2015, of which $18.0 million were assumed through the Carpathia acquisition, $17.9 million of which was related to the lease of real property. Carpathia had entered into capital lease arrangements for datacenter space under two lease agreements expiring in 2018 and 2019 at its Harrisonburg, Virginia and Ashburn, Virginia locations. Total recurring monthly payments range from approximately $0.2 million to $0.5 million during the terms of the leases, in addition to payments made for utilities. Depreciation related to the associated assets for the capital leases is included in depreciation and amortization expense in the Statements of Operations and Comprehensive Income.

 

Lease Financing Obligations

 

Through the acquisition of Carpathia, the Company acquired lease financing obligations totaling $23.4 million at September 30, 2015, of which $20.9 million related to a sale-leaseback transaction where Carpathia has continuing involvement. On December 23, 2011, Carpathia sold the shell of a building and the associated land to an unrelated third party. Carpathia leases the property back and is a party to an agreement with the same third party to construct a new building on the adjoining property for use as a data center. Carpathia is primarily responsible for financing the improvements and outfitting the building with the necessary equipment. The third party leases back the new building in stages to Carpathia as the various stages are completed. In accordance with ASC 840-40, Leases, Carpathia has continuing involvement with the related leased assets; therefore, the Company will continue to account for the existing building shell and the associated land as fixed assets and will capitalize the construction costs of the new building. The financing obligation related to the building and equipment was $19.2 million at September 30, 2015. In addition, due to Carpathia’s continuing involvement, it was required to defer a gain on the sale of the assets. The deferred gain was $1.7 million at September 30, 2015, and is also included in lease financing obligations.

 

The financing obligation is reduced as rental payments are made on the existing building, which payments started in January 2012. Rental payments, which include amounts attributable to both principal and interest, increased to approximately $0.2 million per month in March 2013, which is when the newly constructed building was inhabited by Carpathia. Depreciation expense on the related asset is included in depreciation and amortization expense in the Statements of Operations and Comprehensive Income.

 

The Company, through its acquisition of Carpathia, also has a lease financing agreement in connection with a $4.8 million tenant improvement allowance on one of its data center lease agreements. The financing requires monthly payments of principal and interest of less than $0.1 million through February 2019. The outstanding balance on the financing agreement was $2.5 million as of September 30, 2015. Depreciation expense on the related leasehold improvements is included in depreciation and amortization expense in the Statements of Operations and Comprehensive Income.

 

The following table summarizes the Company’s combined future payment obligations, excluding interest, as of September 30, 2015, on the capital leases and lease financing obligations above (in thousands):

 

     
2015  $3,262 
2016   12,558 
2017   12,388 
2018   8,804 
2019   2,461 
Thereafter   13,550 
     Total  $53,023 

 

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6. Interest Rate Derivative Instruments

 

The Company entered into interest rate swap agreements with a notional amount of $150 million on February 8, 2012, which were designated as cash flow hedges for hedge accounting, and matured on September 28, 2014. For derivative instruments that are accounted for as hedges, the change in fair value for the effective portions of qualifying hedges is recorded through other comprehensive income (loss). The total amount of unrealized gains recorded in other comprehensive income (loss) for the nine months ended September 30, 2014 was $0.2 million, with no unrealized gains or losses recorded for the nine months ended September 30, 2015. Interest expense related to payments on interest rate swaps for the three and nine months ended September 30, 2014 was $0.2 million and $0.5 million, respectively, with no interest expense recorded for the three and nine months ended September 30, 2015.


7. Commitments and Contingencies

 

The Company is subject to various routine legal proceedings and other matters in the ordinary course of business. The Company does not currently have any litigation that would have a material adverse impact on the Company’s financial statements.

8. Partners’ Capital, Equity and Incentive Compensation Plans

 

QualityTech, LP

 

QTS has the full power and authority to do all the things necessary to conduct the business of the Operating Partnership.

 

As of September 30, 2015, the Operating Partnership had three classes of limited partnership units outstanding: Class A units of limited partnership interest (“Class A units”), Class RS LTIP units of limited partnership interest (“Class RS units”) and Class O LTIP units of limited partnership units (“Class O units”). The Class A Units are redeemable at any time on or after one year following the later of November 1, 2013 (which is the beginning of the first full calendar month following the completion of the IPO) or the date of initial issuance. The Company may in its sole discretion elect to assume and satisfy the redemption amount with cash or its shares. Class RS units or Class O units were issued upon grants made under the QualityTech, LP 2010 Equity Incentive Plan (the “2010 Equity Incentive Plan”). Class RS units and Class O units may be subject to vesting and are pari passu with Class A units. Each Class RS unit and Class O unit is convertible into Class A units by the Operating Partnership at any time or by the holder at any time following full vesting (if such unit is subject to vesting) based on formulas contained in the partnership agreement. In addition, upon certain circumstances set forth in the partnership agreement, vested Class RS units automatically convert into Class A units of the Operating Partnership.

 

QTS Realty Trust, Inc.

 

In connection with its IPO, QTS issued Class A common stock and Class B common stock. Class B common stock entitles the holder to 50 votes per share and was issued to enable the Company’s Chief Executive Officer to exchange 2% of his Operating Partnership units so he may have a vote proportionate to his economic interest in the Company. Also in connection with its IPO, QTS adopted the QTS Realty Trust, Inc. 2013 Equity Incentive plan (the “2013 Equity Incentive Plan”), which authorized 1.75 million shares of Class A common stock to be issued under the plan, including options to purchase Class A common stock, restricted Class A common stock, Class O units, and Class RS units. In March 2015, the Board of Directors approved an amendment to the 2013 Equity Incentive Plan to, among other things, increase the number of shares available for issuance under the plan by 3,000,000, subject to stockholder approval. The stockholders approved the amendment at the annual meeting of stockholders held on May 4, 2015, increasing the total number of shares available for issuance under the 2013 Equity Incentive Plan to 4,750,000.

 

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The following is a summary of award activity under the 2010 Equity Incentive Plan and 2013 Equity Incentive Plan and related information for the nine months ended September 30, 2015:

                                         
   2010 Equity Incentive Plan   2013 Equity Incentive Plan 
   Number of Class O units   Weighted average exercise price   Weighted average fair value   Number of Class RS units   Weighted average grant date value   Options   Weighted average exercise price   Weighted average fair value   Restricted Stock   Weighted average grant date value 
Outstanding at December 31, 2014   1,518,717   $23.49   $3.75    74,625   $23.49    584,949   $22.87   $4.10    246,785   $29.13 
     Granted                       317,497    36.16    8.03    231,722    36.72 
     Exercised/Vested (2)   (55,066)   21.78    5.04            (12,780)   21.55    3.71    (27,341)   22.99 
     Released from restriction (1)               (26,062)   25.00                     
     Cancelled/Expired (3)                       (11,407)   21.00    3.52    (12,278)   23.64 
Outstanding at September 30, 2015   1,463,651   $23.56   $3.70    48,563   $22.68    878,259   $27.72   $5.53    438,888   $33.67 

 

 

 

(1)This represents Class RS units that upon vesting have converted to Operating Partnership units.
(2)This represents the Class A common stock that has been released from restriction and which was not surrendered by the holder to satisfy their statutory minimum federal and state tax obligations associated with the vesting of restricted common stock.
(3)Includes 12,278 restricted Class A common stock surrendered by certain employees to satisfy their statutory minimum federal and state tax obligations associated with the vesting of restricted common stock.

 

The assumptions and fair values for restricted stock and options to purchase shares of Class A common stock granted for the nine months ended September 30, 2015 are included in the following table on a per unit basis. Class O units and options to purchase shares of Class A common stock were valued using the Black-Scholes model.

 

               
              Three and Nine Months Ended September 30, 2015
Fair value of restricted stock granted       $35.81-$37.69
Fair value of options granted       $8.00-$8.77
Expected term (years)       5.5-6.1
Expected volatility       33%
Expected dividend yield       3.40-3.57%
Expected risk-free interest rates       1.67-1.94%

 

 The following table summarizes information about awards outstanding as of September 30, 2015.

 

   Operating Partnership Awards Outstanding 
   Exercise prices   Awards outstanding   Weighted average remaining vesting period (years) 
Class RS Units  $-    48,563    1 
Class O Units  $20-25    1,463,651    1 
Total Operating Partnership awards outstanding        1,512,214      

 

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   QTS Realty Trust, Inc. Awards Outstanding 
   Exercise prices   Awards outstanding   Weighted average remaining vesting period (years) 
Restricted stock  $-    438,888    3 
Options to purchase Class A common stock  $21-37.69    878,259    1 
Total QTS Realty Trust, Inc. awards outstanding        1,317,147      

 

All nonvested LTIP unit awards are valued as of the grant date and generally vest ratably over a defined service period. Certain nonvested LTIP unit awards vest on the earlier of achievement by the Company of various performance goals or specified dates in 2015 and 2016. As of September 30, 2015 there were 0.5 million, 0.4 million and 0.4 million nonvested Class O units, restricted Class A common stock and options to purchase Class A common stock outstanding, respectively. As of September 30, 2015, there were no Class RS units outstanding. As of September 30, 2015 the Company had $16.7 million of unrecognized equity-based compensation expense which will be recognized over the remaining vesting period of up to 4 years. The total intrinsic value of the awards outstanding at September 30, 2015 was $58.4 million.

 

On January 7, 2014, the Company paid its first and prorated dividend to common stockholders of $0.24 per common share and the Operating Partnership made a distribution to its partners of $0.24 per unit in an aggregate amount of $9.0 million. On April 8, 2014, the Company paid its regular quarterly cash dividend of $0.29 per common share and the Operating Partnership made a distribution to its partners of $0.29 per unit in an aggregate amount of $10.7 million. Additionally, a distribution of approximately $200,000 was made to Class O LTIP holders during the three months ended June 30, 2014 to cover federal, state and local taxes on the allocated taxable income of the O LTIPs. On July 8, 2014, the Company paid its regular quarterly cash dividend of $0.29 per common share and per unit in the Operating Partnership to stockholders and unit holders of record as of the close of business on June 20, 2014 in an aggregate amount of $10.7 million.

 

On January 7, 2015, the Company paid its regular quarterly cash dividend of $0.29 per common share and the Operating Partnership made a distribution to its partners of $0.29 per unit in an aggregate amount of $10.7 million. On April 7, 2015, the Company paid its regular quarterly cash dividend of $0.32 per common share and the Operating Partnership made a distribution to its partners of $0.32 per unit in an aggregate amount of $13.4 million. On July 8, 2015, the Company paid its regular quarterly cash dividend of $0.32 per common share and per unit in the Operating Partnership to stockholders and unit holders of record as of the close of business on June 19, 2015 in an aggregate amount of $15.3 million.

 

On March 2, 2015, the Company issued 5,000,000 shares of QTS’ Class A common stock and GA QTS Interholdco, LLC, a selling stockholder and an affiliate of General Atlantic LLC, sold 4,350,000 shares of QTS’ Class A common stock at a price of $34.75 per share in an underwritten public offering. The selling stockholder granted the underwriters a 30-day option to purchase an aggregate of up to an additional 1,402,500 shares of QTS’ Class A common stock at the public offering price, which the underwriters exercised. The Company used the net proceeds of approximately $166.0 million to repay amounts outstanding under its unsecured revolving credit facility. The Company did not receive any proceeds from the offering of shares by the selling stockholder.

 

On June 5, 2015, the Company issued 5,750,000 shares of QTS’ Class A common stock and GA QTS Interholdco, LLC, a selling stockholder, sold 1,250,000 shares of QTS’ Class A common stock at a price of $37.00 per share in an underwritten public offering. The selling stockholder granted the underwriters a 30-day option to purchase an aggregate of up to an additional 1,050,000 shares of QTS’ Class A common stock at the public offering price, which the underwriters exercised. The Company used the net proceeds of approximately $203.4 million to fund a portion of the cash consideration payable by the Company in the Carpathia acquisition, and prior to such use, it used a portion of the net proceeds to repay amounts outstanding under its unsecured revolving credit facility and to pay off its Atlanta-Metro Equipment Loan. The Company did not receive any proceeds from the offering of shares by the selling stockholder.

 

On August 14, 2015, GA QTS Interholdco, LLC, a selling stockholder, sold 2,400,000 shares of QTS’ Class A common stock at a price of $41.00 per share in an underwritten public offering. The selling stockholder granted the underwriter a 30-day option to purchase an aggregate of up to an additional 360,000 shares of QTS’ Class A common stock at a price of $41.00 per share, of which the underwriters partially exercised the option with respect to 261,000 shares. The Company did not receive any proceeds from the offering of shares by the selling stockholder.

 

QTS Realty Trust, Inc. Employee Stock Purchase Plan

 

In June 2015, the Company established the QTS Realty Trust, Inc. Employee Stock Purchase Plan (the “Plan”) to give eligible employees the opportunity to purchase, through payroll deductions, shares of the Company’s Class A common stock in the open market by an independent broker selected by the Company’s Board of Directors (the “Board”) or the plan’s administrator. Eligible employees include employees of the Company and its majority-owned subsidiaries (excluding executives) who have been employed for at least thirty days and who perform at least thirty hours of service per week for the Company. The Plan became effective July 1, 2015 and is administered by the Board or by a committee of one or more persons appointed by the Board. The Company has reserved 250,000 shares for purchase under the Plan and has also agreed to pay the brokerage commissions and fees associated with a Plan participant's purchase of shares. An eligible employee may deduct a minimum of $40 per month and a maximum of $2,000 per month towards the purchase of shares. On June 17, 2015, the Company filed a registration statement on Form S-8 to register the 250,000 shares of the Company’s Class A common stock related to the Plan.

 

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9. Related Party Transactions

 

The Company periodically executes transactions with entities affiliated with its Chairman and Chief Executive Officer. Such transactions include automobile, furniture and equipment purchases as well as building operating lease payments and receipts, and reimbursement for the use of a private aircraft service by the Company’s officers and directors.

 

The transactions which occurred during the three and nine months ended September 30, 2015 and 2014 are outlined below (in thousands):

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
(dollars in thousands)  2015   2014   2015   2014 
                 
Tax, utility, insurance and other reimbursement  $63   $296   $208   $464 
Rent expense   254    253    761    772 
Capital assets acquired   38    86    163    160 
Total  $355   $635   $1,132   $1,396 

 

10. Noncontrolling Interest

 

Concurrently with the completion of the IPO, QTS consummated a series of transactions pursuant to which QTS became the sole general partner and majority owner of QualityTech, LP, which then became its operating partnership. The previous owners of QualityTech, LP retained 21.2% ownership of the Operating Partnership.

 

Commencing at any time beginning November 1, 2014, at the election of the holders of the noncontrolling interest, the Class A units are redeemable for cash or, at the election of the Company, common stock of the Company on a one-for-one basis. During the first, second and third quarters of 2015, approximately 230,000, 300,000 and 150,000 Class A units, respectively, were redeemed for the Company’s Class A common stock. As a result, the noncontrolling ownership interest of QualityTech, LP, after taking into account the Class A units redeemed, the grant of equity awards and the issuance of 5,000,000 and 5,750,000 shares of common stock in March and June 2015, respectively, was 14.3% at September 30, 2015.

 

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11. Earnings per share of QTS Realty Trust, Inc.

Basic income (loss) per share is calculated by dividing the net income (loss) attributable to common shares by the weighted average number of common shares outstanding during the period. Diluted income (loss) per share adjusts basic income (loss) per share for the effects of potentially dilutive common shares.

 

The computation of basic and diluted net income per share is as follows (in thousands, except per share data):

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2015   2014   2015   2014 
Numerator:                    
     Net income available to common stockholders - basic  $7,009   $3,157   $15,723   $10,445 
     Effect of net income attributable to noncontrolling interests   1,229    849    3,072    2,810 
     Net income available to common stockholders - diluted  $8,238   $4,006   $18,795   $13,255 
Denominator:                    
     Weighted average shares outstanding - basic   40,994    29,017    36,355    29,007 
     Effect of Class A and Class RS partnership units *   6,932    7,797    7,103    7,797 
     Effect of Class O units and options to purchase Class A common stock on an "as if" converted basis *   807    438    724    236 
     Weighted average shares outstanding - diluted   48,733    37,252    44,182    37,040 
                     
     Net income per share attributable to common stockholders - basic  $0.17   $0.11   $0.43   $0.36 
     Net income per share attributable to common stockholders - diluted  $0.17   $0.11   $0.43   $0.36 

 

*The Class A units, Class RS units and Class O units represent limited partnership interests in the Operating Partnership, and are described in more detail in Note 8.

 

No securities were antidilutive for the three months ended September 30, 2015 and 2014, nor for the nine months ended September 30, 2015 and 2014, and as such, no securities were excluded from the computation of diluted net income per share for those periods.

 
12. Customer Leases, as Lessor

 

Future minimum lease payments to be received under non-cancelable operating customer leases (inclusive of payments for contracts which have not yet commenced, and exclusive of recoveries of operating costs from customers) are as follows for the years ending December 31 (in thousands):

 

Period Ending December 31,    
2015 (Oct - December)  $79,926 
2016   282,466 
2017   213,490 
2018   142,574 
2019   95,281 
Thereafter   280,587 
          Total  $1,094,324 

 

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13. Fair Value of Financial Instruments

 

ASC Topic 825 requires disclosure of fair value information about financial instruments, whether or not recognized in the consolidated balance sheets, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based upon the application of discount rates to estimated future cash flows based upon market yields or by using other valuation methodologies. Considerable judgment is necessary to interpret market data and develop estimated fair value. Accordingly, fair values are not necessarily indicative of the amounts the Company could realize on disposition of the financial instruments. The use of different market assumptions and/or estimation methodologies may have a material effect on estimated fair value amounts.

 

Short-term instruments: The carrying amounts of cash and cash equivalents and restricted cash approximate fair value.

 

Credit facilities, Senior Notes and mortgage notes payable: The fair value of the Company’s floating rate mortgage loans was estimated using Level 2 “significant other observable inputs” such as available market information based on borrowing rates that the Company believes it could obtain with similar terms and maturities. The Company’s unsecured credit facility and Richmond Credit Facility did not have interest rates which were materially different than current market conditions and therefore, the fair value of each of the credit facilities approximated the carrying value of each note. The fair value of the Company’s Senior Notes was estimated using Level 2 “significant other observable inputs,” primarily based on quoted market prices for the same or similar issuances. At September 30, 2015, the fair value of the Senior Notes was approximately $297.9 million.

 

Other debt instruments: The fair value of the Company’s other debt instruments (including capital leases and lease financing obligations) were estimated in the same manner as the credit facilities and mortgage notes payable above. Similarly, because each of these instruments did not have interest rates which were materially different than current market conditions and therefore, the fair value of each instrument approximated the respective carrying values.

 

14. Subsequent Events

 

On October 6, 2015, the Company paid its regular quarterly cash dividend of $0.32 per common share and per unit in the Operating Partnership to stockholders and unit holders of record as of the close of business on September 18, 2015.

 

As discussed in Note 5, in October 2015, the Company amended and restated its unsecured credit facility, and at the same time terminated its Richmond Credit Facility.

 

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ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis presents the financial condition and results of operations of QTS Realty Trust, Inc. (“QTS”), which includes the operations of QualityTech, LP (the “Operating Partnership”), for the three and nine months ended September 30, 2015 and 2014. You should read the following discussion and analysis in conjunction with QTS’ and the Operating Partnership’s accompanying consolidated financial statements and related notes contained elsewhere in this Form 10-Q. We believe it is important for investors to understand the few differences between the financial statements of QTS and the Operating Partnership. See “Explanatory Note” for an explanation of these few differences. Since the financial data presented in this Item 2 does not contain any differences between QTS and the Operating Partnership, all periods presented reflect the operating results of the Operating Partnership.

 

Forward-Looking Statements

 

Some of the statements contained in this Form 10-Q constitute forward-looking statements within the meaning of the federal securities laws. Forward-looking statements relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. In particular, statements pertaining to our capital resources, portfolio performance and results of operations contain forward-looking statements. Likewise, all of our statements regarding anticipated growth in our funds from operations and anticipated market conditions are forward-looking statements. In some cases, you can identify forward-looking statements by the use of forward-looking terminology such as “may,” “will,” “should,” “expects,” “intends,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” or “potential” or the negative of these words and phrases or similar words or phrases which are predictions of or indicate future events or trends and which do not relate solely to historical matters. You can also identify forward-looking statements by discussions of strategy, plans or intentions.

 

The forward-looking statements contained in this Form 10-Q reflect our current views about future eventsand are subject to numerous known and unknown risks, uncertainties, assumptions and changes in circumstances that may cause our actual results to differ significantly from those expressed in any forward-looking statement. We do not guarantee that the transactions and events described will happen as described (or that they will happen at all). The following factors, among others, could cause actual results and future events to differ materially from those set forth or contemplated in the forward-looking statements:

 

·adverse economic or real estate developments in our markets or the technology industry;

 

·global, national and local economic conditions;

 

·risks related to our international operations;

 

·difficulties in identifying properties to acquire and completing acquisitions;

 

·our failure to successfully develop, redevelop and operate acquired properties, including data centers acquired in our acquisition of Carpathia Hosting, Inc.;

 

·significant increases in construction and development costs;

 

·the increasingly competitive environment in which we operate;

 

·defaults on, or termination or non-renewal of, leases by customers;

 

·increased interest rates and operating costs, including increased energy costs;

 

·financing risks, including our failure to obtain necessary outside financing;

 

·decreased rental rates or increased vacancy rates;

 

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·dependence on third parties to provide Internet, telecommunications and network connectivity to our data centers;

 

·our failure to qualify and maintain QTS’ qualification as a real estate investment trust (“REIT”);

 

·environmental uncertainties and risks related to natural disasters;

 

·financial market fluctuations; and

 

·changes in real estate and zoning laws and increases in real property tax rates.

 

While forward-looking statements reflect our good faith beliefs, they are not guarantees of future performance. We disclaim any obligation to publicly update or revise any forward-looking statement to reflect changes in underlying assumptions or factors, of new information, data or methods, future events or other changes. For a further discussion of these and other factors that could cause our future results to differ materially from any forward-looking statements, see the section entitled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2014 and Item 1A. “Risk Factors” of this Form 10-Q.

 

Overview

 

We are a leading owner, developer and operator of state-of-the-art, carrier-neutral, multi-tenant data centers. Our data centers are facilities that house the network and computer equipment of multiple customers and provide access to a range of communications carriers. We have a fully integrated platform through which we own and operate our data centers and provide a broad range of IT infrastructure solutions. We refer to our spectrum of core data center products as our “3Cs,” which consists of Custom Data Center, Colocation and Cloud and Managed Services. We believe that we own and operate one of the largest portfolios of multi-tenant data centers in the United States, as measured by gross square footage, and have the capacity to more than double our leased raised floor without constructing or acquiring any new buildings.

 

Inclusive of the recent acquisition of Carpathia Hosting, Inc. discussed below, we operate a portfolio of 25 data centers located throughout the United States, Canada, Europe and the Asia-Pacific region. Within the U.S., we are located in some of the top U.S. data center markets plus other high-growth markets. Our data centers are highly specialized, full-service, mission-critical facilities used by our customers to house, power and cool the networking equipment and computer systems that support their most critical business processes. We believe that our data centers are best-in-class and engineered to adhere to the highest specifications commercially available to customers, providing fully redundant, high-density power and cooling sufficient to meet the needs of major national and international companies and organizations. This is in part reflected by our operating track record of “five-nines” (99.999%) reliability and by our diverse customer base of more than 1,000 customers, including financial institutions, healthcare companies, government agencies, communications service providers, software companies and global Internet companies.

 

On June 16, 2015, we completed the acquisition of 100% of the outstanding stock of Carpathia Hosting, Inc. (“Carpathia”), a Virginia-based colocation, cloud and managed services provider, for approximately $354.4 million (based on the preliminary assessment of the fair value of assets acquired and liabilities assumed). Upon completion of this acquisition, we assumed all of the assets and liabilities of Carpathia Acquisition, Inc. In addition, Carpathia Acquisition, Inc. and its subsidiaries, including Carpathia, became indirect, wholly-owned subsidiaries of us. Carpathia is a provider of colocation, hybrid cloud services and Infrastructure-as-a-Service (IaaS) servicing enterprise customers and federal agencies, with a customer base of approximately 230 customers as of June 16, 2015. Carpathia utilizes eight domestic data centers located in Dulles, VA, Phoenix, AZ, San Jose, CA, Harrisonburg, VA and Ashburn, VA, and five international data centers located in Toronto, Amsterdam, London, Hong Kong and Sydney.

 

As of September 30, 2015, QTS owned an approximate 85.7% ownership interest in the Operating Partnership. Substantially all of our assets are held by, and our operations are conducted through, the Operating Partnership.

 

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The Operating Partnership is a Delaware limited partnership formed on August 5, 2009 and was QTS’ historical predecessor prior to the initial public offering (“IPO”), having operated the Company’s business until the IPO.

 

We believe that QTS has operated and has been organized in conformity with the requirements for qualification and taxation as a REIT commencing with our taxable year ended December 31, 2013. Our qualification as a REIT, and maintenance of such qualification, depends upon our ability to meet, on a continuing basis, various complex requirements under the Internal Revenue Code of 1986, as amended (the “Code”) relating to, among other things, the sources of our gross income, the composition and values of our assets, our distributions to our stockholders and the concentration of ownership of our equity shares.

 

Our Customer Base

 

We provide data center solutions to a diverse set of customers. Our customer base is comprised of companies of all sizes representing an array of industries, each with unique and varied business models and needs. We serve Fortune 1000 companies as well as small and medium-sized businesses, or SMBs, including financial institutions, healthcare companies, government agencies, communications service providers, software companies and global Internet companies.

 

Our Custom Data Center, or C1, customers typically are large enterprises with significant IT expertise and specific IT requirements, including financial institutions, “Big Four” accounting firms and the world’s largest global Internet companies. Our Colocation, or C2, customers consist of a wide range of organizations, including major healthcare, telecommunications and software and web-based companies. Our C3 Cloud customers include both large organizations and SMBs seeking to reduce their capital expenditures and outsource their IT infrastructure on a flexible basis. Examples of current C3 Cloud customers include a global financial processing company and various U.S. government agencies.

 

As a result of our diverse customer base, customer concentration in our portfolio is limited. As of September 30, 2015, only five of our more than 1,000 customers individually accounted for more than 3% of our monthly recurring revenue (“MRR”) (as defined below), with the largest customer accounting for approximately 8% of our MRR. In addition, greater than 50% of our MRR was attributable to customers who use more than one of our 3C products.

 

Our Portfolio

 

Inclusive of the recent acquisition of Carpathia, we develop and operate 25 data centers located throughout the United States, Canada, Europe and the Asia-Pacific region, containing an aggregate of approximately 4.8 million gross square feet of space (approximately 91% of which is wholly owned by us), including approximately 2.2 million “basis-of-design” raised floor square feet, which represents the total data center raised floor potential of our existing data center facilities. This represents the maximum amount of space in our existing buildings that could be leased following full build-out, depending on the configuration that we deploy. We build out our data center facilities for both general use (colocation) and for executed leases that require significant amounts of space and power, depending on the needs of each facility at that time. As of September 30, 2015, this space included approximately 1,076,000 raised floor operating net rentable square feet, or NRSF, plus approximately 1.1 million square feet of additional raised floor in our development pipeline, of which approximately 45,000 NRSF is expected to become operational by December 31, 2015. Of the total 1.1 million NRSF in our development pipeline, approximately 90,000 square feet was related to customer leases which had been executed but not yet commenced. Our facilities collectively have access to over 500 megawatts (“MW”) of gross utility power with 439 MW of available utility power. We believe such access to power gives us a competitive advantage in redeveloping data center space, since access to power is usually the most limiting and expensive component in data center redevelopment.

 

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The following table presents an overview of the portfolio of operating properties that we own or lease, based on information as of September 30, 2015:

 

           Operating Net Rentable Square Feet (Operating NRSF) (3)                     
Property  Year Acquired (1)   Gross Square Feet (2)   Raised Floor (4)   Office & Other (5)   Supporting Infrastructure (6)   Total   % Occupied and Billing (7)   Annualized Rent (8)   Available Utility Power (MW) (9)   Basis of Design NRSF   % Raised Floor 
Richmond, VA  2010   1,318,353   121,623   51,093   131,324   304,040   86.2%  $ 26,249,863   110   556,623   21.9
                                                        
Atlanta, GA (Metro)   2006    968,695    417,986    36,953    315,676    770,615    93.1%  $79,308,328    72    527,186    79.3%
                                                        
Dallas-Fort Worth, TX   2013    698,000    54,014    2,321    35,825    92,160    90.2%  $8,441,882    140    292,000    18.5%
                                                        
Princeton, NJ   2014    553,930    58,157    2,229    111,405    171,791    100.0%  $9,665,340    22    158,157    36.8%
                                                        
Suwanee, GA   2005    369,822    185,422    8,697    108,266    302,385    81.8%  $52,778,916    36    208,008    89.1%
                                                        
Chicago, IL   2014    317,000    -    -    -    -    -%  $-    8    133,000    -%
                                                        
Santa Clara, CA**   2007    135,322    55,494    944    45,687    102,125    97.2%  $24,986,083    11    80,347    69.1%
                                                        
Jersey City, NJ*   2006    122,448    31,503    14,208    41,901    87,612    97.9%  $12,228,150    7    52,744    59.7%
                                                        
Sacramento, CA   2012    92,644    54,595    2,794    23,916    81,305    46.0%  $11,523,173    8    57,906    94.3%
                                                        
Miami, FL   2008    30,029    19,887    -    6,592    26,479    68.2%  $5,111,352    4    19,887    100.0%
                                                        
Carpathia facilities ***   2015    154,693    72,332    5,242    14,169    91,743    74.0%  $83,389,172    20    96,280    75.1%
                                                        
Other   Misc    81,921    5,129    37,854    38,723    81,706    20.4%  $891,338    1    5,129    100.0%
                                                        
Total        4,842,857    1,076,142    162,335    873,484    2,111,961    87.1%  $314,573,597    439    2,187,267    49.2%

 

(1)Represents the year a property was acquired or, in the case of a property under lease, the year our initial lease commenced for the property.
(2)With respect to our owned properties, gross square feet represents the entire building area. With respect to leased properties, gross square feet represents that portion of the gross square feet subject to our lease. This includes 218,926 square feet of our office and support space, which is not included in operating NRSF.
(3)Represents the total square feet of a building that is currently leased or available for lease plus developed supporting infrastructure, based on engineering drawings and estimates, but does not include space held for redevelopment or space used for our own office space.
(4)Represents management’s estimate of the portion of NRSF of the facility with available power and cooling capacity that is currently leased or readily available to be leased to customers as data center space based on engineering drawings.
(5)Represents the operating NRSF of the facility other than data center space (typically office and storage space) that is currently leased or available to be leased.
(6)Represents required data center support space, including mechanical, telecommunications and utility rooms, as well as building common areas.
(7)Calculated as data center raised floor that is subject to a signed lease for which billing has commenced (735,574 square feet as of September 30, 2015) divided by leasable raised floor based on the current configuration of the properties (844,410 square feet as of September 30, 2015), expressed as a percentage.
(8)We define annualized rent as MRR multiplied by 12. We calculate MRR as monthly contractual revenue under executed contracts as of a particular date, which includes revenue from our C1, C2 and C3 rental activities and cloud and managed services, but excludes customer recoveries, deferred set up fees and other one-time and variable revenues. MRR does not include the impact from booked-not-billed contracts as of a particular date, unless otherwise specifically noted.
(9)Represents installed utility power and transformation capacity that is available for use by the facility as of September 30, 2015.

 

*Represents facilities that we lease.
**Subject to long term ground lease
***Includes 13 facilities. All facilities are leased, including those subject to capital leases.

 

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Key Operating Metrics

 

The following sets forth definitions for our key operating metrics. These metrics may differ from similar definitions used by other companies.

 

Monthly Recurring Revenue (“MRR”). We calculate MRR as monthly contractual revenue under signed leases as of a particular date, which includes revenue from our C1, C2 and C3 rental and cloud and managed services activities, but excludes customer recoveries, deferred set-up fees, variable related revenues, non-cash revenues and other one-time revenues. MRR does not include the impact from booked-not-billed leases as of a particular date, unless otherwise specifically noted.

 

Annualized Rent. We define annualized rent as MRR multiplied by 12.

 

Rental Churn. We define rental churn as the MRR impact from a customer completely departing our platform in a given period compared to the total MRR at the beginning of the period.

 

Leasable Raised Floor. We define leasable raised floor as the amount of raised floor square footage that we have leased plus the available capacity of raised floor square footage that is in a leasable format as of a particular date and according to a particular product configuration. The amount of our leasable raised floor may change even without completion of new redevelopment projects due to changes in our configuration of C1, C2 and C3 product space.

 

Percentage (%) Occupied and Billing Raised Floor. We define percentage occupied and billing raised floor as the square footage that is subject to a signed lease for which billing has commenced as of a particular date compared to leasable raised floor as of that date, expressed as a percentage.

 

Booked-not-Billed. We define booked-not-billed as our customer leases that have been signed, but for which lease payments have not yet commenced.

 

Factors That May Influence Future Results of Operations and Cash Flows

 

Revenue. Our revenue growth will depend on our ability to maintain the historical occupancy rates of leasable raised floor, lease currently available space, lease new capacity that becomes available as a result of our development and redevelopment activities, attract new customers and continue to meet the ongoing technological requirements of our customers. As of September 30, 2015, we had in place customer leases generating revenue for approximately 87% of our leasable raised floor. Our ability to grow revenue also will be affected by our ability to maintain or increase rental, cloud and managed services rates at our properties. Future economic downturns, regional downturns or downturns in the technology industry could impair our ability to attract new customers or renew existing customers’ leases on favorable terms, or at all, and could adversely affect our customers’ ability to meet their obligations to us. Negative trends in one or more of these factors could adversely affect our revenue in future periods, which would impact our results of operations and cash flows. We also at times may elect to reclaim space from customers in a negotiated transaction where we believe that we can redevelop and/or re-lease that space at higher rates, which may cause a decrease in revenue until the space is re-leased.

 

Leasing Arrangements. As of September 30, 2015, 20% of our MRR came from customers which individually occupied greater than or equal to 6,600 square feet of space (or approximately 1 MW of power), and which had metered power. As of September 30, 2015, approximately 33% of our MRR came from C1 customers that are subject to the metered power model. Under the metered power model, the customer pays us a fixed monthly rent amount, plus reimbursement of certain other operating costs, including actual costs of sub-metered electricity used to power its data center equipment and an estimate of costs for electricity used to power supporting infrastructure for the data center, expressed as a factor of the customer’s actual electricity usage. Fluctuations in our customers’ utilization of power and the supplier pricing of power do not significantly impact our results of operations or cash flows under the metered power model. These leases generally have a minimum term of five years. As of September 30, 2015, 80% of our MRR was leased to customers which individually occupied less than 6,600 square feet of space, many of whom are billed on a gross lease basis. Our C2/C3 customers are billed under a gross lease model and as of September 30, 2015, represented 67% of our MRR. Under a gross lease, the customer pays us a fixed rent on a monthly basis, and does not separately reimburse us for operating costs, including utilities, maintenance, repair, property taxes and insurance, as reimbursement for these costs is factored into MRR. However, if customers access more utility costs than their leases permit, we are able to charge these customers for overages. For leases under the gross lease model, fluctuations in our customers’ utilization of power and the prices our utility providers charge us will impact our results of operations and cash flows. Our leases on a gross lease basis generally have a term of three years or less.

 

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Scheduled Lease Expirations. Our ability to minimize rental churn and customer downgrades at renewal and renew, lease and re-lease expiring space will impact our results of operations and cash flows. Leases representing approximately 3% and 12% of our total leased raised floor are scheduled to expire during the years ending December 31, 2015 (including all month-to-month leases) and 2016, respectively. These leases also represented approximately 9% and 27%, respectively, of our annualized rent as of September 30, 2015. At expiration, as a general matter, based on current market conditions, we expect that expiring rents will be at or below the then-current market rents.

 

Acquisitions, Redevelopment and Financing. Our revenue growth also will depend on our ability to acquire and redevelop and subsequently lease data center space at favorable rates. We generally fund the cost of data center acquisition and redevelopment from our net cash provided by operations, credit facilities, other unsecured and secured borrowings or the issuance of additional equity. We believe that we have sufficient access to capital from our current cash and cash equivalents, and borrowings under our credit facilities to fund our redevelopment projects.

 

Operating Expenses. Our operating expenses generally consist of direct personnel costs, utilities, property and ad valorem taxes, insurance and site maintenance costs and rental expenses on our ground and building leases. In particular, our buildings require significant power to support the data center operations conducted in them. Although substantially all of our long-term leases—leases with a term greater than three years—contain reimbursements for certain operating expenses, we will not in all instances be reimbursed for all of the property operating expenses we incur. We also incur general and administrative expenses, including expenses relating to senior management, our in-house sales and marketing organization, cloud and managed services support personnel and legal, human resources, accounting and other expenses related to professional services. We also incur additional expenses arising from being a publicly traded company, including employee equity-based compensation. Increases or decreases in our operating expenses will impact our results of operations and cash flows. We expect to incur additional operating expenses as we continue to expand.

 

General Leasing Activity

 

 During the three and nine months ended September 30, 2015, we entered into customer leases representing approximately $0.5 million and $2.5 million of incremental MRR, net of downgrades (and representing approximately $5.6 million and $29.8 million of incremental annualized rent) at $1,686 and $836 per square foot, respectively. In addition, $2.4 million and $9.8 million of leasing commissions was associated with new and renewal leasing activity for the three and nine months ended September 30, 2015, respectively.

 

During the three and nine months ended September 30, 2015, we renewed leases with a total annualized rent of $9.2 million and $22.1 million at an average rent per square foot of $742 and $784, respectively, which was 0.9% and 2.4% higher than the annualized rent prior to their respective renewals. Customers that renew with adjustments to square feet are reflected in the net leasing activity discussed above. The rental churn rate for the three and nine months ended September 30, 2015 was 0.8% and 2.0%, respectively.

 

During the three and nine months ended September 30, 2015, we commenced customer leases representing approximately $3.2 million and $6.9 million of incremental MRR (and representing approximately $37.9 million and $82.6 million of annualized rent) at $490 and $549 per square foot, respectively.

 

As of September 30, 2015, our booked-not-billed MRR balance (which represents customer leases that have been executed, but for which lease payments have not commenced as of September 30, 2015) was approximately $5.1 million, or $61.3 million of annualized rent. The booked-not-billed balance is expected to contribute an incremental $4.1 million to revenue in 2015 (representing $22.5 million in annualized revenues), an incremental $15.4 million in 2016 (representing $21.3 million in annualized revenues), and an incremental $17.5 million in annualized revenues thereafter. We estimate the remaining capital cost to provide the space, power, connectivity and other services to the customer contracts which had been booked but not billed as of September 30, 2015 to be approximately $40 million. This estimate generally includes C1 customers with newly contracted space of more than 3,300 square feet. The space, power, connectivity and other services provided to customers that contract for smaller amounts of space is generally provided by existing space which was previously developed.


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Results of Operations

 

Three Months Ended September 30, 2015 Compared to Three Months Ended September 30, 2014

Changes in revenues and expenses for the three months ended September 30, 2015 compared to the three months ended September 30, 2014 are summarized below (unaudited, in thousands):

 

   Three Months Ended September 30, 
   2015   2014   $ Change   % Change 
Revenues:                
     Rental  $62,744   $45,448   $17,296    38%
     Recoveries from customers   6,158    6,131    27    0%
     Cloud and managed services   18,573    5,242    13,331    254%
     Other   1,415    1,124    291    26%
     Total revenues   88,890    57,945    30,945    53%
                     
Operating expenses:                    
     Property operating costs   30,925    20,369    10,556    52%
     Real estate taxes and insurance   1,462    1,377    85    6%
     Depreciation and amortization   24,486    15,210    9,276    61%
     General and administrative   19,440    11,045    8,395    76%
     Restructuring   -    226    (226)   * 
     Transaction and integration costs   1,482    (195)   1,677    -860%
     Total operating expenses   77,795    48,032    29,763    62%
                     
Operating income   11,095    9,913    1,182    12%
                     
Other income and expense:                    
     Interest income   1    -    1    * 
     Interest expense   (5,418)   (5,410)   (8)   0%
     Other expense   -    (470)   470    *
Income before taxes   5,678    4,033    1,645    41%
     Tax benefit (expense) of taxable REIT subsidiaries   2,560    (27)   2,587    * 
Net income  $8,238   $4,006   $4,232    106%

 

*not applicable for comparison

 

Revenues. Total revenues for the three months ended September 30, 2015 were $88.9 million compared to $57.9 million for the three months ended September 30, 2014. The increase of $30.9 million, or 53%, was primarily due to the acquisition of Carpathia on June 16, 2015, which contributed $22.2 million in incremental revenue for the three months ended September 30, 2015, as well as organic growth in our customer base.

 

The increase of $30.6 million, or 60%, in combined rental and cloud and managed services revenue was primarily due to the acquisition of Carpathia which contributed $22.3 million to the increase, as well as newly leased space and increases in rents from previously leased space, net of downgrades at renewal and rental churn.

 

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As of September 30, 2015, our data centers were approximately 87% occupied and billing based on leasable raised floor of approximately 844,000 square feet, with approximately 736,000 square feet occupied and paying rent, with an average annualized rent of $427 per leased raised floor square foot including cloud and managed services revenue, or $328 per leased raised floor square foot excluding cloud and managed services revenue. As of September 30, 2015, the average annualized rent for our C1 product, including managed services for our C1 product, was $187 per leased raised floor square foot, and the average annualized rent for our C2 product, including Cloud and managed services combined was $1,167 per leased raised floor square foot. As of September 30, 2014, our data centers were 84% occupied and billing based on leasable raised floor of approximately 687,000 square feet, with approximately 576,000 square feet occupied and paying rent, with an average annualized rent of $344 per leased raised floor square foot including cloud and managed services revenue, or $308 per leased raised floor square foot excluding cloud and managed services revenue. The increase in leasable raised floor between 2014 and 2015 is primarily related to the addition of raised floor square footage from our redevelopment activities primarily in the Dallas-Fort Worth, Atlanta-Metro, and Richmond facilities, as well as the acquisition of Carpathia. The increase in average annualized rent per leased raised floor square foot, both including and excluding cloud and managed services revenue, is primarily due to the acquisition of Carpathia. The increase in average annualized rent per leased raised floor square foot including cloud and managed service revenue from $344 to $427 is primarily due to the increase in C3 product mix associated with the Carpathia acquisition. As of September 30, 2015, a larger portion of our product mix was attributable to C3 revenue (23% of MRR) compared to September 30, 2014 (9% of MRR). Due to the fact that C3 customers utilize less space than C1/C2 customers in proportion to MRR received, our weighted average rent per square feet price has increased.

 

Higher recoveries from customers for the three months ended September 30, 2015 compared to the three months ended September 30, 2014 were primarily due to increased utility costs generally related to an increase in usage from customers operating under our metered power model at our Atlanta-Metro and Richmond data centers contributing $0.4 million to the increase as well as the opening of our Dallas-Fort Worth data center contributing $0.2 million to the increase and an increase in metered billings to new and existing customers. These increases were offset by a utility credit remitted to customers of $0.2 million related to a retroactive adjustment in billing rates for the current year from Georgia Power, as well as $0.4 million of reduced reimbursements at our Princeton facility due to lower operating costs we incurred from the transition of using our in-house workforce as compared to contracted outside personnel that existed when we acquired the facility in the prior year, with a corresponding increase in cloud and managed services revenue within recurring revenue. The $0.3 million increase in other revenue for the three months ended September 30, 2015 compared to the three months ended September 30, 2014 was primarily due to higher straight line rent.

 

Property Operating Costs. Property operating costs for the three months ended September 30, 2015 were $30.9 million compared to property operating costs of $20.4 million for the three months ended September 30, 2014, an increase of $10.6 million, or 52%. The breakdown of our property operating costs is summarized in the table below (unaudited, in thousands):

 

   Three Months Ended September 30, 
   2015   2014   $ Change   % Change 
Property operating costs:                
     Direct payroll  $4,689   $2,826   $1,863    66%
     Rent   4,932    1,226    3,706    302%
     Repairs and maintenance   2,442    1,897    545    29%
     Utilities   9,630    8,834    796    9%
     Management fee allocation   4,866    2,279    2,587    114%
     Other   4,366    3,307    1,059    32%
     Total property operating costs  $30,925   $20,369   $10,556    52%

 

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The acquisition of Carpathia contributed $9.8 million to the total increase in property operating costs for the three months ended September 30, 2015, of which $0.8 million related to direct payroll, $3.7 million related to rent expense, $0.5 million related to repairs and maintenance, $0.7 million related to utilities, $2.3 million related to management fee allocation and $1.8 million related to other property operating costs. Management fee allocation for Carpathia facilities is based on 10% of cash rental revenues for each facility and reflects an allocation of internal charges to cover back-office and service-related costs associated with the day-to-day operations of our data center facilities, with a corresponding offset to general and administrative expenses. The remaining $0.8 million increase in total property operating costs was primarily attributable to increased direct payroll allocation of $1.0 million, increased software license costs of $0.2 million, increased utility costs of $0.1 million due primarily to increased usage in our Richmond data center, offset by a credit received from Georgia Power related to a retroactive adjustment in billing rates for the current year, increased repairs and maintenance expense of $0.1 million which tends to fluctuate from period to period and will increase with the expansion and lease-up of our facilities, and other costs of $0.2 million. In addition, management fee allocation increased $0.3 million (exclusive of the increase attributable to Carpathia as discussed above). Management fee allocation for QTS facilities is based on 4% of cash rental revenues for each facility. These increases were offset by a $0.7 million reduction in operating expenses primarily related to efficiencies gained at our Princeton facility, as well as a $0.5 million net utility credit received from Georgia Power for bill corrections dating back to 2013.

Real Estate Taxes and Insurance. Real estate taxes and insurance for the three months ended September 30, 2015 were $1.5 million compared to $1.4 million for the three months ended September 30, 2014. The increase of $0.1 million, or 6%, was primarily attributable to property taxes at our Dallas and Atlanta-Suwanee data centers.

 

Depreciation and Amortization. Depreciation and amortization for the three months ended September 30, 2015 was $24.5 million compared to $15.2 million for the three months ended September 30, 2014. The increase of $9.3 million, or 61%, was primarily due to depreciation expense of $3.8 million and amortization expense of $2.8 million associated with the Carpathia acquisition. The remaining increase of $2.7 million was due to additional depreciation of $2.2 million, primarily due to additional depreciation of the Dallas-Fort Worth data center, as well as expansion of the Richmond, Atlanta-Metro and Atlanta-Suwanee data centers, and higher amortization expense of $0.5 million primarily related to a higher level of leasing commissions.

 

General and Administrative Expenses. General and administrative expenses were $19.4 million for the three months ended September 30, 2015 compared to general and administrative expenses of $11.0 million for the three months ended September 30, 2014, an increase of $8.4 million, or 76%, of which the acquisition of Carpathia contributed $4.5 million. The remaining increase in general and administrative expenses was attributable to increased payroll expenses related to sales and marketing personnel of $0.2 million, higher equity based compensation expense of $1.1 million, higher net payroll costs of $1.9 million, and other costs of $0.7 million primarily related to outside services for temporary personnel and consulting fees.

 

Restructuring Costs. For the three months ended September 30, 2014, we incurred $0.2 million in restructuring costs related to severance for various remote employees. No such costs were incurred in the three months ended September 30, 2015.

 

Transaction and Integration Costs. For the three months ended September 30, 2015 we incurred $0.1 million in costs related to the examination of actual and potential acquisitions. We also recognized $1.4 million in integration costs for the three months ended September 30, 2015 related to the acquisition of Carpathia. For the three months ended September 30, 2014, we recovered $0.2 million due to a refund of previously expensed transaction costs.

Acquisition-related costs for acquisitions accounted for as a business combination in accordance with ASC 805, Business Combinations, are expensed in the periods in which the costs are incurred and the services are received.

 

Interest Expense. Interest expense was $5.4 million for the three months ended September 30, 2015 and 2014. The increase in the average debt balance of $222.6 million compared to the prior year, which was primarily a result of a higher revolving credit facility balance and the assumption of approximately $43.8 million in capital leases as a result of the Carpathia acquisition on June 16, 2015, was fully offset by a decrease in the weighted average interest rate on our borrowings and higher capitalized interest during the period due to the growth in construction projects. The average debt balance for the three months ended September 30, 2015 was $805.7 million, with a weighted average interest rate, including the effect of amortization of deferred financing costs, of 4.04%. This compared to an average debt balance of $583.1 million for the three months ended September 30, 2014, with a weighted average interest rate, including the effect of interest rate swaps and amortization of deferred financing costs, of 4.62%. Interest capitalized in connection with our redevelopment activities during the three months ended September 30, 2015 and September 30, 2014 was $2.7 million and $1.3 million, respectively.

 

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Tax (Expense) Benefit of Taxable REIT Subsidiaries. Tax benefit of taxable REIT subsidiaries for the three months ended September 30, 2015 primarily relates to recorded operating losses which includes certain transaction and integration costs.

 

Net Income. A summary of the components of the increase in net income of $4.2 million for the three months ended September 30, 2015 as compared to the three months ended September 30, 2014 is as follows (in millions):

     
   $ Change 
Increase in revenues, net of property operating costs, real estate taxes and insurance  $20.3 
Increase in general and administrative expense   (8.4)
Increase in depreciation and amortization   (9.3)
Decrease in restructuring charges   0.2 
Increase in transaction and integration costs   (1.7)
Increase in tax benefit   2.6 
Decrease in other expense   0.5 
Increase in net income  $4.2 

 

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Nine Months Ended September 30, 2015 Compared to Nine Months Ended September 30, 2014


Changes in revenues and expenses for the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014 are summarized below (unaudited, in thousands):

 

   Nine Months Ended September 30, 
   2015   2014   $ Change   % Change 
Revenues:                
     Rental  $164,270   $127,993   $36,277    28%
     Recoveries from customers   17,404    13,674    3,730    27%
     Cloud and managed services   32,588    14,443    18,145    126%
     Other   4,131    2,116    2,015    95%
     Total revenues   218,393    158,226    60,167    38%
                     
Operating expenses:                    
     Property operating costs   72,292    53,121    19,171    36%
     Real estate taxes and insurance   4,421    3,713    708    19%
     Depreciation and amortization   58,791    42,274    16,517    39%
     General and administrative   47,893    33,296    14,597    44%
     Restructuring   -    1,272    (1,272)   * 
     Transaction and integration costs   6,256    958    5,298    553%
     Total operating expenses   189,653    134,634    55,019    41%
                     
Operating income   28,740    23,592    5,148    22%
                     
Other income and expense:                    
     Interest income   2    8    (6)   -75%
     Interest expense   (15,559)   (9,683)   (5,876)   61%
     Other expense   (83)   (580)   497    -86%
Income (loss) before taxes   13,100    13,337    (237)   -2%
     Tax benefit (expense) of taxable REIT subsidiaries   5,695    (82)   5,777    * 
Net income (loss)  $18,795   $13,255   $5,540    42%

 

*not applicable for comparison

 

Revenues. Total revenues for the nine months ended September 30, 2015 were $218.4 million compared to $158.2 million for the nine months ended September 30, 2014. The increase of $60.2 million, or 38%, was primarily due to the acquisitions of Carpathia and the Princeton facility, which contributed $34.0 million in incremental revenue for the nine months ended September 30, 2015, as well as organic growth in our customer base and placing additional square footage into service in conjunction with the development and expansion of our Dallas-Fort Worth, Richmond, Atlanta-Suwanee and Atlanta-Metro data centers.

 

The increase of $54.4 million, or 38%, in combined rental and cloud and managed services revenue was primarily due to the acquisitions of Carpathia and the Princeton facility, which contributed $31.2 million in combined rental and cloud and managed services revenue for the nine months ended September 30, 2015, as well as newly leased space and increases in rents from previously leased space, net of downgrades at renewal and rental churn.

 

Higher recoveries from customers for the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014 were primarily due to reimbursements associated with the acquisition of the Princeton facility which contributed $2.6 million to the increase. The remaining increase of $1.1 million in recoveries revenue was primarily attributable to increased utility costs generally related to an increase in usage from customers operating under our metered power model at our Atlanta-Metro and Richmond data centers, which contributed $1.3 million and $0.6 million to the increase, respectively, as well as $0.3 million of increased recoveries related to the opening of our Dallas-Fort Worth data center. These increases were partially offset by a utility credit remitted to customers of $0.6 million related to a retroactive adjustment in billing rates for the current year from Georgia Power, as well as decreased utility costs generally related to a reduction in usage from customers operating under our metered power model at our Sacramento data center reducing the increase by $0.5 million. The $2.0 million increase in other revenue for the nine months ended September 30, 2015 compared to the nine months ended September 30, 2014 was primarily due to higher straight line rent.

 

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Property Operating Costs. Property operating costs for the nine months ended September 30, 2015 were $72.3 million compared to property operating costs of $53.1 million for the nine months ended September 30, 2014, an increase of $19.2 million, or 36%. The breakdown of our property operating costs is summarized in the table below (unaudited, in thousands):

 

   Nine Months Ended September 30, 
   2015   2014   $ Change   % Change 
Property operating costs:                
     Direct payroll  $12,212   $8,616   $3,596    42%
     Rent   7,983    3,670    4,313    118%
     Repairs and maintenance   6,578    4,228    2,350    56%
     Utilities   25,223    22,528    2,695    12%
     Management fee allocation   9,973    6,275    3,698    59%
     Other   10,323    7,804    2,519    32%
     Total property operating costs  $72,292   $53,121   $19,171    36%

 

The acquisitions of Carpathia and the Princeton facility contributed $13.9 million to the total increase in property operating costs for the nine months ended September 30, 2015, of which $2.3 million related to direct payroll, $4.3 million related to rent expense, $1.1 million related to repairs and maintenance, $1.7 million related to utilities, $2.7 million related to management fee allocation and $1.8 million related to other property operating costs. Management fee allocation for Carpathia facilities is based on 10% of cash rental revenues for each facility and reflects an allocation of internal charges to cover back-office and service-related costs associated with the day-to-day operations of our data center facilities, with a corresponding offset to general and administrative expenses. The remaining $5.3 million increase in total property operating costs was primarily attributable to the revenue growth and expansion of our existing facilities, which included increased direct payroll allocation of $1.3 million throughout our facilities, $1.2 million of increased repairs and maintenance expense which tends to fluctuate from period to period and will increase with the expansion and lease-up of our facilities, and a $0.9 million increase in utilities expense primarily related to increased utilities usage in our Atlanta-Metro and Richmond facilities as well as the opening of our Dallas-Fort Worth data center, offset by reduced utilities usage at our Sacramento data center and reduced utilities due to a credit received from Georgia Power related to a retroactive adjustment in billing rates for the current year. In addition, management fee allocation increased $1.0 million (exclusive of the increase attributable to Carpathia and Princeton as discussed above). Management fee allocation for QTS facilities is based on 4% of cash rental revenues for each facility. The remaining $0.9 million increase in other property operating costs was primarily due to higher software license costs, higher outside services expenses from consulting fees and outsourcing of our facility security personnel, which resulted in lower direct payroll costs, offset by an increase in other income related to credits received from Georgia Power for bill corrections related to prior years.

Real Estate Taxes and Insurance. Real estate taxes and insurance for the nine months ended September 30, 2015 were $4.4 million compared to $3.7 million for the nine months ended September 30, 2014. The increase of $0.7 million, or 19%, was primarily attributable to the acquisition of our Princeton data center, which contributed $0.5 million to the increase. The remaining $0.2 million is primarily attributable to a $0.3 million increase in property taxes at our Dallas data center, partially offset by a $0.1 million decrease in property taxes at our Santa Clara data center.

 

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Depreciation and Amortization. Depreciation and amortization for the nine months ended September 30, 2015 was $58.8 million compared to $42.3 million for the nine months ended September 30, 2014. The increase of $16.5 million, or 39%, was primarily due to depreciation expense of $4.5 million and amortization expense of $3.3 million associated with the Carpathia acquisition, and depreciation expense of $0.4 million and amortization expense of $1.1 million associated with the Princeton acquisition. The remaining increase of $7.2 million was due to additional depreciation of $7.0 million, primarily due to additional depreciation of the Dallas-Fort Worth data center, as well as expansion of the Richmond, Atlanta-Metro and Atlanta-Suwanee data centers, and higher amortization expense of $0.2 million primarily related to a higher level of leasing commissions.

 

General and Administrative Expenses. General and administrative expenses were $47.9 million for the nine months ended September 30, 2015 compared to general and administrative expenses of $33.3 million for the nine months ended September 30, 2014, an increase of $14.6 million, or 44%, of which the acquisition of Carpathia contributed $5.3 million. The remaining increase in general and administrative expenses was attributable to increased advertising expenses of $1.1 million, increased payroll expenses related to sales and marketing personnel of $0.9 million, higher equity based compensation expense of $2.3 million, higher net payroll costs of $2.6 million, and other costs of $2.4 million. Other costs were primarily related to increased outside services for temporary personnel and consulting fees, increased software license costs, and increased travel and entertainment expenses, offset by lower repairs and maintenance expense primarily related to computer and software.

 

Restructuring Costs. For the nine months ended September 30, 2014, we incurred $1.3 million in restructuring costs related to severance for various remote employees. No such costs were incurred in the nine months ended September 30, 2015.

 

Transaction and Integration Costs. For the nine months ended September 30, 2015 and 2014 we incurred $4.5 million and $1.0 million, respectively, in costs related to the examination of actual and potential acquisitions. We also recognized $1.8 million in integration costs for the nine months ended September 30, 2015 related to the acquisition of Carpathia. Acquisition-related costs for acquisitions accounted for as a business combination in accordance with ASC 805, Business Combinations, are expensed in the periods in which the costs are incurred and the services are received.

 

Interest Expense. Interest expense for the nine months ended September 30, 2015 was $15.6 million compared to $9.7 million for the nine months ended September 30, 2014. The increase of $5.9 million, or 61%, was due primarily to an increase in the weighted average interest rate on our borrowings and an increase in the average debt balance of $209.5 million, primarily as a result of our $300 million aggregate principal amount of 5.875% Senior Notes Due 2022 (the “Senior Notes”) issuance in July 2014, as well as the assumption of approximately $43.8 million in capital leases as a result of the Carpathia acquisition on June 16, 2015, partially offset by higher capitalized interest during the period due to the growth in construction projects. The average debt balance for the nine months ended September 30, 2015 was $688.5 million, with a weighted average interest rate, including the effect of amortization of deferred financing costs, of 4.39%. This compared to an average debt balance of $479.0 million for the nine months ended September 30, 2014, with a weighted average interest rate, including the effect of interest rate swaps and amortization of deferred financing costs, of 4.02%. Interest capitalized in connection with our redevelopment activities during the nine months ended September 30, 2015 and 2014 was $7.1 million and $4.7 million, respectively.

 

Tax (Expense) Benefit of Taxable REIT Subsidiaries. Tax benefit of taxable REIT subsidiaries for the nine months ended September 30, 2015 primarily relates to recorded operating losses, including transaction and integration costs, as well as the reversal of valuation allowances which were related to the deferred tax assets. These deferred tax assets were generally created by net operating losses of the taxable REIT subsidiary, and previously had valuation allowances applied to them in their entirety as there were continuing losses for that entity.  With the acquisition of Carpathia, deferred tax liabilities were created, which in turn caused the Company to release the previously recorded valuation allowances of approximately $3.4 million during the second quarter of 2015. To the extent that the Company’s taxable REIT subsidiaries continue to generate operating losses, a tax benefit will continue to be recognized due to the existing net deferred tax liability of $15.6 million at September 30, 2015.

 

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Net Income. A summary of the components of the increase in net income of $5.5 million for the nine months ended September 30, 2015 as compared to the nine months ended September 30, 2014 is as follows (in millions):

 

   $ Change 
Increase in revenues, net of property operating costs, real estate taxes and insurance  $40.3 
Increase in general and administrative expense   (14.6)
Increase in depreciation and amortization   (16.5)
Decrease in restructuring charges   1.3 
Increase in transaction and integration costs   (5.3)
Increase in interest expense net of interest income   (5.9)
Increase in tax benefit   5.8 
Decrease in other expense   0.4 
Increase in net income  $5.5 

 

Non-GAAP Financial Measures

 

We consider the following non-GAAP financial measures to be useful to investors as key supplemental measures of our performance: (1) FFO; (2) Operating FFO; (3) Adjusted Operating FFO; (4) MRR; (5) NOI; (6) EBITDA; and (7) Adjusted EBITDA. These non-GAAP financial measures should be considered along with, but not as alternatives to, net income or loss and cash flows from operating activities as a measure of our operating performance and liquidity. FFO, Operating FFO, Adjusted Operating FFO, MRR, NOI, EBITDA and Adjusted EBITDA, as calculated by us, may not be comparable to FFO, Operating FFO, Adjusted Operating FFO, MRR, NOI, EBITDA and Adjusted EBITDA as reported by other companies that do not use the same definition or implementation guidelines or interpret the standards differently from us.

 

FFO, Operating FFO and Adjusted Operating FFO

 

We consider funds from operations (“FFO”) to be a supplemental measure of our performance which should be considered along with, but not as an alternative to, net income (loss) and cash provided by operating activities as a measure of operating performance and liquidity. We calculate FFO in accordance with the standards established by the National Association of Real Estate Investment Trusts (“NAREIT”). FFO represents net income (loss) (computed in accordance with GAAP), adjusted to exclude gains (or losses) from sales of property, real estate related depreciation and amortization and similar adjustments for unconsolidated partnerships and joint ventures. Our management uses FFO as a supplemental performance measure because, in excluding real estate related depreciation and amortization and gains and losses from property dispositions, it provides a performance measure that, when compared year over year, captures trends in occupancy rates, rental rates and operating costs.

 

Due to the volatility and nature of certain significant charges and gains recorded in our operating results that management believes are not reflective of our core operating performance and liquidity, management computes an adjusted measure of FFO, which we refer to as Operating FFO. We generally calculate Operating FFO as FFO excluding certain non-routine and primarily non-cash charges and gains and losses that management believes are not indicative of the results of our operating real estate portfolio. We believe that Operating FFO provides investors with another financial measure that may facilitate comparisons of operating performance and liquidity between periods and, to the extent they calculate Operating FFO on a comparable basis, between REITs.

 

Adjusted Operating Funds From Operations (“Adjusted Operating FFO”) is a non-GAAP measure that is used as a supplemental operating measure for comparing year over year ability to fund dividend distributions from operating activities. We use Adjusted Operating FFO as a basis to address cash flow and our ability to fund dividend payments. We calculate Adjusted Operating FFO by adding or subtracting from Operating FFO items such as: maintenance capital investment, paid leasing commissions, amortization of deferred financing costs and bond discount, non-real estate depreciation, straight line rent adjustments, and non-cash compensation.

 

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We offer these measures because we recognize that FFO, Operating FFO and Adjusted Operating FFO will be used by investors as a basis to compare our operating performance and liquidity with that of other REITs. However, because FFO, Operating FFO and Adjusted Operating FFO exclude real estate depreciation and amortization and capture neither the changes in the value of our properties that result from use or market conditions, nor the level of capital expenditures and capitalized leasing commissions necessary to maintain the operating performance of our properties, all of which have real economic effect and could materially impact our financial condition, cash flows and results of operations, the utility of FFO, Operating FFO and Adjusted Operating FFO as measures of our operating performance and liquidity is limited. Our calculation of FFO may not be comparable to measures calculated by other companies who do not use the NAREIT definition of FFO or do not calculate FFO in accordance with NAREIT guidance. In addition, our calculations of FFO, Operating FFO and Adjusted Operating FFO are not necessarily comparable to FFO, Operating FFO and Adjusted Operating FFO as calculated by other REITs that do not use the same definition or implementation guidelines or interpret the standards differently from us. FFO, Operating FFO and Adjusted Operating FFO are non-GAAP measures and should not be considered a measure of our results of operations or liquidity or as a substitute for, or an alternative to, net income (loss), cash provided by operating activities or any other performance measure determined in accordance with GAAP, nor is it indicative of funds available to fund our cash needs, including our ability to make distributions to our stockholders.

 

A reconciliation of net income to FFO, Operating FFO and Adjusted Operating FFO is presented below:

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2015   2014   2015   2014 
FFO                
Net income  $8,238   $4,006   $18,795   $13,255 
Real estate depreciation and amortization   21,022    13,596    51,649    37,663 
                            FFO   29,260    17,602    70,444    50,918 
                     
Operating FFO                    
Write off of unamortized deferred finance costs   -    470    83    580 
Restructuring costs   -    226    -    1,272 
Integration costs   1,360    -    1,783    - 
Transaction costs   122    (195)   4,473    958 
Non-cash deferred tax benefit associated with transaction and integration costs   (1,206)   -    (1,206)   - 
Non-cash reversal of deferred tax asset valuation allowance   -    -    (3,175)   - 
                         Operating FFO   29,536    18,103    72,402    53,728 
                     
Maintenance Capex   (1,408)   (1,877)   (2,034)   (1,972)
Leasing commissions paid   (3,005)   (5,516)   (9,871)   (10,604)
Amortization of deferred financing costs and bond discount   849    522    2,552    1,725 
Non real estate depreciation and amortization   3,463    1,612    7,086    4,610 
Straight line rent revenue   (1,463)   (961)   (3,270)   (1,283)
Straight line rent expense   984    72    1,266    221 
Non-cash deferred tax benefit from operating results   (1,354)   -    (1,354)   - 
Equity-based compensation expense   2,068    925    5,206    2,901 
                         Adjusted Operating FFO  $29,670   $12,880   $71,983   $49,326 

 

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Monthly Recurring Revenue (MRR) and Recognized MRR

 

We calculate MRR as monthly contractual revenue under signed leases as of a particular date, which includes revenue from our C1, C2 and C3 rental and cloud and managed services activities, but excludes customer recoveries, deferred set-up fees, variable related revenues, non-cash revenues and other one-time revenues. MRR does not include the impact from booked-not-billed leases as of a particular date, unless otherwise specifically noted.

 

Separately, we calculate recognized MRR as the recurring revenue recognized during a given period, which includes revenue from our C1, C2 and C3 rental and cloud and managed services activities, but excludes customer recoveries, deferred set-up fees, variable related revenues, non-cash revenues and other one-time revenues.

 

Management uses MRR and recognized MRR as supplemental performance measures because they provide useful measures of increases in contractual revenue from our customer leases. MRR and recognized MRR should not be viewed by investors as alternatives to actual monthly revenue, as determined in accordance with GAAP. Other companies may not calculate MRR or recognized MRR in the same manner. Accordingly, our MRR and recognized MRR may not be comparable to other companies’ MRR and recognized MRR. MRR and recognized MRR should be considered only as supplements to total revenues as a measure of our performance. MRR and recognized MRR should not be used as measures of our results of operations or liquidity, nor is it indicative of funds available to meet our cash needs, including our ability to make distributions to our stockholders.


A reconciliation of total revenues to recognized MRR in the period and MRR at period end is presented below:

                 
   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2015   2014   2015   2014 
Recognized MRR                    
Total period revenues (GAAP basis)  $88,890   $57,945   $218,393   $158,226 
Less: Total period recoveries   (6,158)   (6,131)   (17,404)   (13,674)
          Total period deferred setup fees   (1,477)   (1,125)   (4,135)   (3,508)
          Total period straight line rent and other   (2,959)   (1,726)   (8,221)   (3,711)
Recognized MRR (in the period)   78,296    48,963    188,633    137,333 
                     
MRR                    
Total period revenues (GAAP basis)  $88,890   $57,945   $218,393   $158,226 
Less: Total revenues excluding last month   (59,455)   (38,439)   (188,958)   (138,720)
Total revenues for last month of period   29,435    19,506    29,435    19,506 
Less: Last month recoveries   (1,661)   (1,771)   (1,661)   (1,771)
          Last month deferred setup fees   (269)   (391)   (269)   (391)
          Last month straight line rent and other   (1,291)   (823)   (1,291)   (823)
MRR (at period end) *  $26,214   $16,521   $26,214   $16,521 
 
 

* Does not include our booked-not-billed MRR balance, which was $5.1 million and $5.2 million as of September 30, 2015 and 2014, respectively.

 

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Net Operating Income (NOI)

 

We calculate net operating income (“NOI”), as net income (loss), excluding interest expense, interest income, tax expense (benefit) of taxable REIT subsidiaries, depreciation and amortization, write off of unamortized deferred financing costs, gain on extinguishment of debt, transaction and integration costs, gain (loss) on legal settlement, gain (loss) on sale of real estate, restructuring charge and general and administrative expenses. We allocate a management fee charge of 4% of cash rental revenues for QTS facilities and 10% of cash rental revenues for Carpathia facilities as a property operating cost and a corresponding reduction to general and administrative expense to cover the day-to-day administrative costs to operate our data centers. The management fee charge is reflected as a reduction to net operating income.

 

Management uses NOI as a supplemental performance measure because it provides a useful measure of the operating results from our customer leases. In addition, we believe it is useful to investors in evaluating and comparing the operating performance of our properties and to compute the fair value of our properties. Our NOI may not be comparable to other REITs’ NOI as other REITs may not calculate NOI in the same manner. NOI should be considered only as a supplement to net income as a measure of our performance and should not be used as a measure of our results of operations or liquidity or as an indication of funds available to meet our cash needs, including our ability to make distributions to our stockholders. NOI is a measure of the operating performance of our properties and not of our performance as a whole. NOI is therefore not a substitute for net income as computed in accordance with GAAP.

 

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A reconciliation of net income to NOI is presented below:

 

   Three Months Ended   Nine Months Ended 
   September 30,   September 30, 
   2015   2014   2015   2014 
Net Operating Income (NOI)                
Net income  $8,238   $4,006   $18,795   $13,255 
Interest expense   5,418    5,410    15,559    9,683 
Interest income   (1)   -    (2)   (8)
Depreciation and amortization   24,486    15,210    58,791    42,274 
Write off of unamortized deferred finance costs   -    470    83    580 
Tax (benefit) expense of taxable REIT subsidiaries   (2,560)   27    (5,695)   82 
Restructuring costs   -    226    -    1,272 
Integration costs   1,360    -    1,783    - 
Transaction costs   122    (195)   4,473    958 
General and administrative expenses   19,440    11,045    47,893