ITEM 1. BUSINESS
The Company
DuPont Fabros Technology, Inc. (the “REIT” or “DFT”) was formed on March 2, 2007 under the laws of the State of Maryland and is headquartered in Washington, D.C. DFT is a fully integrated, self-administered and self-managed company that owns, acquires, develops and operates wholesale data centers. DFT is a real estate investment trust, or REIT, for federal income tax purposes and is the sole general partner of, and, as of December 31, 2011, owned 76.7% of the common economic interest in, DuPont Fabros Technology, L.P. (the “Operating Partnership” or “OP” and collectively with DFT and their operating subsidiaries, the “Company”). The remaining 23.3% common economic interest was owned by certain individuals and entities that hold redeemable noncontrolling interests-operating partnership. DFT’s common stock trades on the New York Stock Exchange, or NYSE, under the symbol “DFT”. DFT’s 7.875% Series A Cumulative Redeemable Perpetual Preferred Stock (the “Series A Preferred Stock”) and 7.625% Series B Cumulative Redeemable Perpetual Preferred Stock (the “Series B Preferred Stock”) also trade on the NYSE under the symbols “DFTPrA” and “DFTPrB”, respectively.
The Company is a leading owner, developer, operator and manager of large-scale data center facilities leased to tenants under long-term leases-commonly referred to as “wholesale data centers.” The Company’s data centers are highly specialized, secure facilities used by the Company’s tenants-primarily national and international technology companies, including Microsoft, Yahoo!, Facebook and Google-to house, power and cool the computer servers which support many of their most critical business processes. The Company leases the raised square feet and available power of each of the Company’s facilities to tenants under long-term triple-net leases, most of which contain annual rental increases. The Company’s data centers are strategically located in major population centers with significant electrical power availability and hubs of extensive fiber network connectivity. For the year ended December 31, 2011, the Company generated $287.4 million of total revenues, $79.5 million in net income and $44.1 million of net income attributable to common shares, and, as of December 31, 2011, the Company had total assets of $2.5 billion.
As of December 31, 2011, the Company held a fee simple interest in ten operating data centers-referred to as ACC2, ACC3, ACC4, ACC5, ACC6 Phase I, VA3, VA4, CH1 Phase I, NJ1 Phase I and SC1 Phase I; one data center property under development-referred to as CH1 Phase II; three data center properties held for future development-referred to as NJ1 Phase II, SC1 Phase II and ACC6 Phase II; and land to be used to develop three additional data centers-referred to as ACC7, ACC8 and SC2. With this portfolio of operating and development properties, the Company believes that it is well positioned as a fully integrated wholesale data center provider, capable of developing, leasing, operating and managing the Company’s growing portfolio.
The Company derives substantially all of its revenue from rents received from tenants under existing leases at each of the Company’s operating properties. The Company believes that its data centers are engineered to the highest specifications commercially available and provide sufficient power to meet the needs of the world’s largest technology companies. For example, the ACC5 data center is designed to provide tenants with a total of 36.4 megawatts, or MW, of power, which the Company refers to as critical load. Critical load is that portion of each facility’s total power capacity that is made available for the exclusive use by the Company’s tenants to operate their computer servers. Because the Company believes that critical load is the primary factor used by tenants in evaluating their data center requirements, the Company’s rents are based primarily on the amount of power made available to its tenants, rather than the amount of space that they occupy. Accordingly, throughout this Form 10-K, we discuss our operations in terms of critical load because it is one of the primary metrics that the Company uses to manage its business. Also provided is information relating to a facility’s total gross building area and its raised square feet, which is the net rentable square feet of each of the Company’s facilities.
Through the Company’s taxable REIT subsidiary, the Company also provides certain technical services to its tenants as a contractor on a purchase order basis, including layout design and installation of electrical power circuits, data cabling, server cabinets and racks, computer room airflow analyses and monitoring and other services requested by its tenants.
Market Opportunity
Data centers are buildings that house a large number of computer servers and include the key related infrastructure necessary for operation of the servers, including systems for power distribution, environmental control, fire suppression and security. Network access is typically provided into a data center using optical fiber. The data center market in North America is highly fragmented with more than 350 companies providing different forms of internet data center services, although not all data center providers are wholesale data center providers. Wholesale data center providers lease to a limited number of tenants relatively large amounts of data center space, which are referred to as cells or pods, that generally range in size from 2,500 to 50,000 square feet. In contrast, colocation providers operate on a retail model and rent space to many customers based on individual racks/cabinets or cages which generally range in size from 500 to 5,000 square feet in size. Wholesale providers generally offer greater power through a single data center facility than can a colocation provider; provide savings on the cost to operate the data center infrastructure through economies of scale; provide secure facilities with on-site security staffed 24 hours a day, seven days a week to support critical business processes; and allow technology companies to manage their own servers.
The top ten United States global wholesale data center markets are projected to have increased demand in 2012, according to Tier1Research’s December 2011 report “Multi-Tenant Datacenter Supply Top Markets-2011.” This report forecasts the following growth in demand for 2012 in each of the markets in which we own and operate data centers: Santa Clara-11%, New Jersey-14%, Northern Virginia-16% and Chicago-13%. The Company believes that the total data center market is increasing primarily as a result of the continued strong growth in Internet traffic.
Competitive Strengths
The Company believes that it distinguishes itself from other data center providers through the following competitive strengths:
Data centers strategically located with high power capacity. The Company’s operating and planned development properties are strategically located in the Northern Virginia; suburban Chicago, Illinois; Piscataway, New Jersey and Santa Clara, California markets, each of which is located near sources of abundant and relatively inexpensive power, major population centers and significant fiber optic networks. The Company believes these locations help attract and retain tenants because access to less expensive power yields significant cost savings for its tenants under the terms of its triple-net leases, and the proximity to large population centers enhances performance by reducing latency (the time it takes a packet of information to reach the end user). Additionally, the Company’s facilities are engineered to provide critical load sufficient to serve many of the world’s largest technology companies, which require more power than colocation facilities are designed to provide.
Long-term triple net leases to industry-leading tenants with strong credit. The Company’s tenant base includes leading national and international technology companies, such as Microsoft, Yahoo!, Facebook and Google. As of December 31, 2011, the Company’s three largest tenants, Microsoft, Yahoo! and Facebook, which are currently under long term leases with staggered lease expirations, collectively accounted for 55% of its annualized base rent. Under the terms of its triple net leases, the Company’s tenants occupy all or a percentage of each of its data centers and are obligated to reimburse it for property-level operating expenses. In addition, under the Company’s triple-net lease structure, its tenants pay for only the power they use to operate their computer servers and the power that is used to cool their space. The Company believes that this lease structure, together with the economies of scale resulting from the size of its data centers, results in its tenants paying less for power and operating expenses over time than they would in a comparable colocation setting, where power costs and
operating expenses are included in the license fee paid to the provider. The Company’s triple-net lease terms also enable customers to control costs during any ramp-up phase (the period before they are utilizing all of the power they have contracted for). Most of the Company’s leases provide for annual rent increases, and, as of December 31, 2011, the Company’s weighted average remaining lease term was approximately 6.6 years.
Strong development track record and pipeline. The Company currently owns and operates ten data centers, six of which are 100% leased and one of which is 98% leased as of February 7, 2012. The three non-stabilized properties were placed in service from November 2010 to October 2011 and are currently in lease-up. Phase II of CH1 was placed in service on February 1, 2012 and is 79% leased as of February 7, 2012. The Company believes that its in-house development expertise, together with its relationships with contractors who are experienced in the construction of data centers, gives it a significant advantage over those of the Company’s competitors who are required to rely exclusively on third parties to develop and maintain their properties. The Company also believes that its development properties and parcels of land suitable for data center development gives it an advantage over those of its competitors who may have to acquire suitable sites for future development.
Business Strategy
The Company’s primary business objective is to maximize cash flow through the prudent management of a balanced portfolio of operating and development properties. The Company’s business strategies to achieve these objectives are:
Maximize cash flow from existing properties. The Company derives substantially all of its revenue from rents received from tenants under existing leases at each of its operating properties. The Company strives to maximize its cash flows under these leases by including a monthly base rent obligation and property management fee to compensate it for the management of its properties, and a “triple net” structure, which obligates the Company’s tenants to reimburse it for the costs that it incurs to operate the data center, including the cost of electricity used by tenants to power their computer equipment and their pro rata share of most other operating expenses, such as real estate taxes and insurance. Most of the Company’s leases provide for annual increases of base rent-either a flat rate of about 3% or in some cases based on the consumer price index.
Lease available space at four properties recently placed into service. The Company’s primary focus for 2012 is to lease all available vacant space. Currently, the Company has five operating properties with vacant space available to be leased: NJ1 Phase I, placed into service in November 2010; ACC6 Phase I, place into service in September 2011; SC1 Phase I, placed into service in October 2011; CH1 Phase I, placed into service in August 2008; and CH1 Phase II, place into service in February 2012. The Company will continue to market its properties to technology companies, financial services companies, government agencies and enterprise companies.
Expand and diversify tenant base. The Company’s existing tenant base consists primarily of large technology companies, and three of its stabilized data center properties are leased by two of its largest tenants under long-term leases with staggered lease expirations in two of the facilities. In recent years, the Company has been expanding and diversifying its tenant base by marketing its remaining available space at its existing properties and new space at its development properties to other customers, including financial services companies, government agencies and enterprise companies, which demand data center space in smaller quantities-generally 10 MW or less-than large technology companies.
Prudently build-out the current development pipeline. The Company determines when to develop data center properties based on the amount of available space in its operating properties and demand for data center space in each applicable market. Although the Company currently does not have any data center sites under
development, the Company plans to develop the second phases of NJ1, ACC6 and SC1 in the future. The Company will develop the second phase of a data center only after substantially completing the lease-up of the first phase or if there is a significant pre-lease commitment in the second phase. Additionally, the Company will look to develop ACC7 and ACC8 located in Northern Virginia and SC2 located in Santa Clara, California in the future. The Company intends to finance future developments through a combination of equity and debt capital.
Properties
Operating Properties
For the year ended December 31, 2011, the Company executed 14 leases and pre-leases comprising a total of 24.92 MW of critical load and 133,716 raised square feet with an average lease term of 7.9 years. In addition, for the year ended December 31, 2011, the Company renewed one lease comprising a total of 9.6 MW of critical load and 90,000 raised square feet for an average of eight additional years which expires, on average, in 1.6 MW increments from 2020 to 2025. The average total revenue rate for the Company’s operating properties as of December 31, 2011 was $142 per kW per month. This amount includes base rent on a straight-lined basis plus recoveries of operating expenses and management fees from our tenants.
The following table presents a summary of the Company’s operating properties as of December 31, 2011:
Operating Properties
As of December 31, 2011
(1) Stabilized operating properties are either 85% or more leased or have been in service for 24 months or greater.
(2) Gross building area is the entire building area, including raised square footage (the portion of gross building area where the tenants’ computer servers are located), tenant common areas, areas controlled by the Company (such as the mechanical, telecommunications and utility rooms) and, in some facilities, individual office and storage space leased on an as available basis to the tenants.
(3) Raised square footage is that portion of gross building area where the tenants locate their computer servers. The Company considers raised square footage to be the net rentable square footage in each of its facilities.
(4) Critical load (also referred to as IT load or load used by tenants’ servers or related equipment) is the power available for exclusive use by tenants expressed in terms of megawatt, or MW, or kilowatt, or kW (1 MW is equal to 1,000 kW).
(5) Percentage leased is expressed as a percentage of critical load that is subject to an executed lease. Percentage commenced is expressed as a percentage of critical load where the lease has commenced under generally accepted accounting principles. Leases executed as of December 31, 2011 represent $192 million of base rent on a straight-line basis and $190 million on a cash basis over the next twelve months. This excludes contractual management fees and approximately $3 million net amortization increase in revenue of above and below market leases.
(6) As of February 7, 2012, SC1 Phase I is 25% leased and commenced.
Tenant Diversification
As of December 31, 2011, the Company’s portfolio was leased to 31 data center tenants with 67 different lease expiration dates. As of December 31, 2011, the Company’s three largest tenants, Yahoo!, Facebook and Microsoft, accounted for 55% of its annualized base rent. Revenues in 2011 from Yahoo!, Facebook and Microsoft were $61.7 million, $58.5 million and $49.8 million, respectively, each of which accounted for greater than 10% of the Company’s 2011 consolidated revenues. The Company has three leases with one of these tenants with expiration dates ranging from 2012 to 2019 and options by the tenant to renew these leases for five years. This tenant has determined not to renew one lease that will expire in April 2012, as disclosed in the Lease Expiration table below. The Company has two leases with another of these tenants with expiration dates ranging from 2018 to 2022. The Company has two leases with another of these tenants with expiration dates ranging from 2016 to 2025 and options by the tenant to renew these leases for eight years for one of these leases.
For revenue information for these three tenants for the last three years, see Note 5 to the Company’s consolidated financial statements included herein.
Lease Expirations
Lease Expirations
As of December 31, 2011
The following table sets forth a summary schedule of lease expirations of the operating properties for each of the ten calendar years beginning with 2012. The information set forth in the table below assumes that tenants exercise no renewal options and takes into account tenants’ early termination options.
(1) Represents 31 tenants with 67 lease expiration dates. Top three tenants represent 55% of annualized base rent as of December 31, 2011.
(2) Raised square footage is that portion of gross building area where the tenants locate their computer servers. The Company considers raised square footage to be the net rentable square footage in each of its facilities.
(3) One MW is equal to 1,000 kW.
(4) One lease will expire on April 30, 2012, representing 67,000 raised square feet, 7.6% of leased raised square feet and 5,740 kW of critical load as of December 31, 2011. The second lease has an option to terminate on six months notice.
Development Projects
The following table presents a summary of the Company’s development properties as of December 31, 2011:
Development Projects
As of December 31, 2011
($ in thousands)
(1) Gross building area is the entire building area, including raised square footage (the portion of gross building area where the tenants’ computer servers are located), tenant common areas, areas controlled by the Company (such as the mechanical, telecommunications and utility rooms) and, in some facilities, individual office and storage space leased on an as available basis to the tenants.
(2) Raised square footage is that portion of gross building area where the tenants locate their computer servers. The Company considers raised square footage to be the net rentable square footage in each of its facilities.
(3) Critical load (also referred to as IT load or load used by tenants’ servers or related equipment) is the power available for exclusive use by tenants expressed in terms of MW or kW (1 MW is equal to 1,000 kW).
(4) Current development projects include land, capitalization for construction and development, capitalized interest and capitalized operating carrying costs, as applicable, upon completion.
(5) Amount capitalized as of December 31, 2011. Future Phase II development projects include only land, shell, underground work and capitalized interest through Phase I opening.
(6) Placed in service on February 1, 2012 with 57% of leases commencing.
Competition
The Company believes it has two types of competitors:
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Companies who choose to build, own and operate their own datacenters rather than outsource, and
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Owners, operators and developers of both wholesale and colocation data centers.
The data center market in North America is highly fragmented with more than 350 companies providing different forms of internet data center services. In operating and managing its portfolio, the Company competes for tenants based on factors including location, available critical load, amount of raised square feet, flexibility, total cost for the tenant and expertise in the design and operation of data centers.
The Company also faces competition for the acquisition of land suitable for the development of wholesale data centers from real estate developers in its and in other industries. Such competition may have the effect of reducing the number of available properties for acquisition, increasing the price of any acquisition, and reducing the supply of wholesale data center space in the markets the Company seeks to serve.
Regulation
Environmental Matters
The Company is required to obtain a number of permits from various government agencies to construct a data center facility, including the customary zoning, land use and related permits, and permits from state and local environmental regulatory agencies related to the installation of the diesel engine generators that it uses for emergency back-up power at its facilities. In addition, various environmental agencies that regulate air quality require that the Company obtains permits for the operation of its diesel engine generators. These permits set forth specified levels of certain types of emissions permitted from these engines, such as nitrogen oxides. Changes to any applicable regulations, including changes to air quality standards or permitted emissions levels, that are applicable to the Company, or the inability of the Company to obtain the necessary permits to install or operating its diesel engines, could delay or preclude its ability to construct or operate its data center facilities.
Under various federal, state and local laws, regulations and ordinances relating to the protection of the environment, a current or former owner, operator or tenant of real property may be liable for the cost to remove or remediate contamination resulting from the presence or discharge of hazardous or toxic substances, wastes or petroleum products on, under, from or in such property. These costs could be substantial and liability under these laws may attach without regard to whether the owner or operator knew of, or was responsible for, the presence of the contaminants, and the liability may be joint and several. Previous owners used some of the Company’s properties for industrial and retail purposes (CH1, NJ1, SC1, SC2 and ACC8), so those properties may contain some level of environmental contamination. In addition, many of the Company’s properties presently contain large fuel storage tanks for emergency power, which is critical to the Company’s operations. If any of these tanks has a release of fuel to the environment, the Company would likely have to pay to clean up the contamination. The presence of contamination or the failure to remediate contamination at the Company’s properties may expose it to third-party liability or materially adversely affect its ability to sell, lease or develop the real estate or to borrow using the real estate as collateral.
Some of the Company’s properties may contain asbestos-containing building materials. Environmental laws require that owners or operators of buildings with asbestos-containing building materials properly manage and maintain these materials, adequately inform or train those who may come into contact with asbestos and undertake special precautions, including removal or other abatement, in the event that asbestos is disturbed during building renovation or demolition. These laws may impose fines and penalties on building owners or operators for failure to comply with these requirements. In addition, these laws may also allow third parties to seek recovery from owners or operators for personal injury associated with exposure to asbestos-containing building materials.
Environmental laws and regulations regarding the handling of regulated substances and wastes apply to the Company’s properties, in particular regulations regarding the storage of petroleum for emergency/auxiliary power. The properties in the Company’s portfolio are also subject to various federal, state and local health and safety requirements, such as state and local fire requirements. If the Company or its tenants fail to comply with these various requirements, the Company might incur governmental fines or private damage awards. Moreover, the Company does not know whether existing requirements will change or whether future requirements will require it to make significant unanticipated expenditures that will materially adversely impact its financial condition, results of operations, cash flow, cash available for distributions, the per share trading price of its common stock and its ability to satisfy its debt service obligations. The Company requires its tenants to comply with these environmental, health and safety laws and regulations and to indemnify it for any related liabilities. Environmental noncompliance liability could also affect a tenant’s ability to make rental payments to the Company.
Although each of the Company’s properties have been subjected to Phase I environmental site assessments, they are limited in scope, and may not identify all potential environmental liabilities or risks associated with these properties. Unless required by applicable laws or regulations, the Company may not further investigate, remedy or ameliorate any liabilities disclosed in the Phase I assessments.
The Company’s NJ1 property located in Piscataway, New Jersey, is subject to New Jersey’s Industrial Site Recovery Act, or ISRA. Under ISRA, the state’s Department of Environmental Protection, or NJDEP, can require a landowner to undertake efforts to remediate pollution caused by its activities on the site. In this case, the prior owner of the New Jersey site, GlaxoSmithKline (“the Seller”) ceased operation at the site in 2004 and has undertaken remediation efforts in accordance with ISRA, including removal of certain structures on the site and remediation of soil and groundwater. The Company was not involved in the activities that led to the pollution of this site and the Seller remains liable for the cleanup costs. In addition to its responsibilities under ISRA, the Seller is obligated under the surviving provisions of its purchase contract with the Company to diligently proceed with ISRA compliance, to take all reasonable action to complete the work set forth in the NJDEP-approved remedial actions work plan, and to obtain no further action letters with regard to soils and groundwater. The Seller has indemnified the Company with regard to any fines, charges or liability in connection with ISRA and compliance therewith. Moreover, the Company is named as an additional insured on a number of the Seller’s environmental, workers’ compensation, and professional liability insurance policies, and the Company carries insurance regarding some of the risks associated with the known contamination as well. Nonetheless, as the current landowner, under ISRA, the Company may be held liable for all or a portion of the cost to clean up the site to the extent that Seller is unable or is otherwise not required to pay for the cleanup. The Seller is legally obligated to continue to operate the existing groundwater remediation system for a number of years in accordance with the Remedial Action Work Plan approved by NJDEP in accordance with ISRA. If the Seller were to cease its monitoring activities, the Company could be required to continue them under applicable law. However, the Company does not anticipate that such costs would be material and it would seek to recover them from the Seller. The Company does not expect the groundwater remediation system to have a material impact on the development of the site as presently planned, although it could make it more difficult to sell the property in the future. As a result of the contamination, there are or will be restrictions on certain uses of the property, such as for residential use. However, the Company’s current use is not subject to such restrictions and, furthermore, has been confirmed as a permitted use under applicable zoning regulations and ordinances by the relevant zoning authority, so the Company does not expect such restrictions to have a material impact on its business. However, if the Company were to be held liable for any unanticipated costs associated with the environmental contamination or on-going cleanup of this site, such costs could be material and could have a material adverse impact on its financial condition and results of operations.
Americans With Disabilities Act
The Company’s properties must comply with Title III of the Americans with Disabilities Act, or ADA, to the extent that such properties are “public accommodations” as defined by the ADA. The ADA may require removal of structural barriers to access by persons with disabilities in certain public areas of the Company’s
properties where such removal is readily achievable. While it has not conducted a formal audit or investigation of its compliance with the ADA, the Company believes that its operating properties are in substantial compliance with the ADA and that it will not be required to make substantial capital expenditures to address the requirements of the ADA. However, noncompliance with the ADA could result in imposition of fines or an award of damages to private litigants. The obligation to make readily achievable accommodations is ongoing, and the Company will continue to assess its properties and make alterations as appropriate in this respect.
Insurance
The Company carries comprehensive liability, fire, extended coverage, business interruption and rental loss insurance covering all of the properties in its portfolio, which includes coverage for riots, terrorism, earthquakes, acts of God and floods. The Company has policy specifications and insured limits which it believes to be appropriate given the relative risk of loss, the cost of the coverage and industry practice and, in the opinion of the Company’s management, the properties in its portfolio are currently adequately insured. See “Item 1A.
ITEM 1A. RISK FACTORS
Set forth below are the risks that we believe are material to our stockholders. You should carefully consider the following risks in evaluating our Company, our properties and our business. The occurrence of any of the following risks could materially adversely impact our financial condition, results of operations, cash flow, the per share trading price of our common stock and our ability to, among other things, satisfy our debt service obligations and to make distributions to our stockholders, which in turn could cause our stockholders to lose all or a part of their investment. Some statements in this report including statements in the following risk factors constitute forward-looking statements. Please refer to the section entitled “Special Note Regarding Forward-Looking Statements” at the beginning of this annual report.
Risks Related to Our Business and Operations
We face significant competition and may be unable to lease available space at four data centers recently placed into service which could have a material adverse effect on us, including our business, results of operations and growth prospects.
We compete with numerous developers, owners and operators of technology-related real estate, many of which own properties similar to ours in the same submarkets in which our properties are located, or in markets where the cost to operate a data center is less than the cost to operate our data centers. Some of our competitors have significant advantages over us, including greater name recognition, longer operating histories, pre-existing relationships with current or potential tenants, significantly greater financial, marketing and other resources and more ready access to capital, all of which allows them to respond more quickly to new or changing opportunities, including Digital Realty Trust, Inc. and CoreSite Realty Corporation, as well as various privately held companies and local developers. If our competitors offer space that our tenants or potential tenants perceive to be superior to ours based on numerous factors, including available power, security considerations, location, or connectivity, or if they offer rental rates below current market rates, or below the rental rates we are offering, we may lose tenants or potential tenants or be required to incur costs to improve our properties or reduce our rental rates.
We recently placed into service four data centers-NJ1 Phase I, ACC6 Phase I, SC1 Phase I and CH1 Phase II-and we are focused in 2012 on leasing available space at these data centers. Our leasing efforts at NJ1 to date have been slower than anticipated. Our ability to lease available space at NJ1 and the other data centers recently placed into service depends on many factors. Our experience to date indicates that it is more difficult and may take more time to lease up a data center in a new market, such as NJ1, than a market in which we already have an established presence. We may be unable to lease available space at the four data centers recently placed into service at net effective rental rates equal to or above our current average net effective rental rates. If we are unable to lease available space at the four data centers we recently placed into service on a timely basis or at net effective rental rates that are favorable, it could have a material adverse effect on us, including our business, results of operations and growth prospects.
Any decrease in the demand for data centers, including resulting from a downturn in the technology industry, could materially adversely affect our business, results of operations and financial condition.
Our portfolio of properties consists entirely of wholesale data centers leased primarily by technology companies. A decline in the technology industry could lead to a decrease in the demand for space in our data centers, which would have a greater adverse effect on our business and financial condition than if we owned a more diversified real estate portfolio. We are also susceptible to adverse developments in the technology industry such as business layoffs or downsizing, industry slowdowns, relocations of businesses, costs of complying with government regulations or increased regulation and other factors. We also may be materially adversely affected by any downturns in the market for data centers due to, among other things, oversupply of or reduced demand for space or a slowdown in web-based commerce. Also, a lack of demand for data center space by enterprise customers could have a material adverse effect on our business, results of operations and financial condition.
Our tenants may choose to develop new data centers or expand their own existing data centers, which could result in the loss of one or more key tenants or reduce demand for our newly developed data centers, which could have a material adverse effect on our business, results of operations and financial condition.
Some of our tenants, including Yahoo!, Microsoft and Facebook, have developed or have announced plans to develop their own data center facilities. Other tenants with their own existing data centers may choose to expand their data centers in the future. In the event that any of our key tenants were to develop or expand their data centers, it could result in a loss of business to us or put pressure on our pricing. If we lose a tenant, there is no assurance that we would be able to replace that tenant at a competitive rate or at all, which could have a material adverse effect on our business, results of operations and financial condition.
As of December 31, 2011, our three largest tenants, Yahoo!, Microsoft and Facebook, collectively accounted for 55% of our annualized base rent, and the loss of any such tenant or any other significant tenant could have a materially adverse effect on us, including our business, results of operations and financial condition.
Any of our tenants could experience a downturn in their businesses, which in turn could result in their inability or failure to make timely rental payments under their leases with us. In the event of any tenant default, we may experience delays in enforcing our rights as landlord and may incur substantial costs in protecting our investment. These risks would be particularly significant if one of our three largest tenants were to default under their leases. Also, some of our largest tenants may compete with one another in various aspects of their businesses. The competitive pressures on our tenants may have a negative impact on our operations.
In addition, if one or more of our significant tenants fail to renew their leases with us and we could not find new tenants to utilize this space at the same rental rates, the expiration of these leases, as well as any future lease expirations, could have a material adverse effect on our business. For example, Yahoo! has decided not to renew one lease with us in our VA3 data center facility that expires on April 30, 2012. This space represents approximately 19% of the data center space that Yahoo! currently leases from us and approximately 3% of our annualized base rent. There is no assurance that we will be able to re-lease this space at a competitive rate or at all.
Any adverse developments in the economic or regulatory environment of our four markets-Northern Virginia, suburban Chicago, Illinois, Northern New Jersey and Santa Clara, California may materially adversely affect our business and operating results.
Our current portfolio of operating data center facilities is located in only four markets-Northern Virginia, Chicago, Northern New Jersey and Santa Clara, California. Consequently, we may be exposed to greater economic risks than if our portfolio was more geographically diverse. Also, we may be susceptible to adverse developments in the economic and regulatory environment in any of those markets, including, but not limited to, business layoffs or downsizing, industry slowdowns, relocations of businesses, increases in real estate and other taxes and costs of complying with governmental regulations or increased regulation. In addition, other markets in the United States could become more attractive for developers, operators and tenants of data center facilities based on favorable costs to construct or operate data center facilities in those markets. For example, some states have created tax incentives for developers and operators to locate data center facilities in their jurisdictions. Any adverse developments in the economy or real estate market in general, or any decrease in demand for data center space resulting from the Northern Virginia, Chicago, Northern New Jersey and Santa Clara, California regulatory or business environment, could materially adversely impact our business, results of operations and financial condition.
Our long-term growth depends upon the successful development of our data centers, and unexpected costs or changes in permitting or environmental regulations may delay or preclude the construction of our
data centers, thereby materially adversely affecting our business, results of operations and financial condition.
For any future data center developments, we will be subject to certain risks that could result in a delay in completion of a project, including, but not limited too, risks related to financing, zoning, environmental and other
regulatory approvals, and construction costs. Any delay or denial of an applicable entitlement or permit, including zoning, land use, environmental, emissions or other related permits would impact our plans for future development adversely. Changes to any applicable regulations, including changes to air quality standards or emissions limitations, that are applicable to us could delay or preclude our ability to construct or operate our data center facilities, which would have a material adverse effect on our growth and future results of operations and financial condition. In addition, we will be subject to risks and, potentially, unanticipated costs associated with obtaining access to a sufficient amount of power from local utilities, including the need, in some cases, to develop utility substations on our properties in order to accommodate our power needs, constraints on the amount of electricity that a particular locality’s power grid is capable of providing at any given time, and risks associated with the negotiation of long-term power contracts with utility providers. We may not be able to successfully negotiate such contracts on acceptable terms or at all. Any inability to negotiate utility contracts on a timely basis or on acceptable financial terms or in volumes sufficient to supply the critical load presently anticipated for each of our development properties would have a material adverse effect on our growth, future results of operations and financial condition.
We generally commence development of a data center facility prior to having received any commitments from tenants to lease any space in them and any extended vacancies could have a material adverse effect on us, including our business, results of operations and financial condition.
We generally commence development of a data center facility prior to having received any commitments from tenants to lease any space in them-known as developing “on speculation.” This type of development involves the risk that we will be unable to attract tenants to the properties that we are developing on a timely basis or at all. Once development of a data center facility is complete, we incur a certain amount of operating expenses even if there are no tenants occupying any space. In addition, each tenant reimburses us only for its pro rata share of a facility’s operating expenses under our triple net leasing structure. Consequently, if any of our properties have significant vacancies for an extended period of time, our business and financial condition could be materially adversely affected.
The loss of access to key third-party technical service providers and suppliers could materially adversely affect our current and any future development projects.
Our success depends, to a significant degree, on having timely access to certain key technical personnel who are in limited supply and great demand, such as engineering firms and construction contractors capable of developing our properties, and to key suppliers of electrical and mechanical equipment that complement the design of our data center facilities. For any future development projects, we will continue to rely on these personnel and suppliers to develop wholesale data centers. Competition for such technical expertise is intense, and there are a limited number of electrical and mechanical equipment suppliers that design and produce the equipment that we require. We may not always have or retain access to the key service providers and equipment suppliers on which we rely which could materially adversely affect our current and any future development projects.
We are dependent upon third-party suppliers for power and certain other services, and we are vulnerable to service failures of our third-party suppliers and to price increases by such suppliers.
We rely on third parties to provide power to our data centers, and we cannot ensure that these third parties will deliver such power in adequate quantities or on a consistent basis. If the amount of power available to us is inadequate to support our customer requirements, we may be unable to satisfy our obligations to our customers. In addition, our data centers are susceptible to power shortages and planned or unplanned power outages caused by these shortages. If the duration of an outage exceeds the time that the fuel stored on-site can power our backup engine generators, we would be dependent on the regular delivery of diesel fuel to our sites. If we are not able to operate any of our data centers during an outage with our backup engine generators, our customers, reputation and business would be harmed.
In addition, we may be subject to risks and unanticipated costs associated with obtaining power from various utility companies. Utilities that serve our data centers may be dependent on, and sensitive to price increases for, a particular type of fuel, such as coal, oil or natural gas. Increases in the cost of power at any of our data centers would put those locations at a competitive disadvantage relative to data centers served by utilities that can provide less expensive power.
We depend on third parties to provide Internet connectivity to the tenants in our data centers and any delays or disruptions in connectivity may materially adversely affect our business, results of operations and financial condition.
Our tenants require connectivity to the fiber networks of multiple third party telecommunications carriers, and we depend upon the presence of telecommunications carriers’ fiber networks serving the locations of our data centers in order to attract and retain tenants. Any carrier may elect not to offer its services within our data centers, and any carrier that has decided to provide Internet connectivity to our data centers may not continue to do so for any period of time. If carriers were to consolidate or otherwise downsize or terminate connectivity within our data centers, it could have an adverse effect on the businesses of our tenants and, in turn, our own operating results and cash flow.
Each new data center that we develop requires the construction and operation of a sophisticated redundant fiber network. The construction required to connect multiple carrier facilities to our data centers is complex and involves factors outside of our control, including regulatory requirements and the availability of construction resources. If the establishment of highly diverse Internet connectivity to our data centers does not occur, is materially delayed or is discontinued, or is subject to failure, our operating results and cash flow may be materially adversely affected. Any hardware or fiber failures on this network may result in significant loss of connectivity to our data centers, which could negatively affect our ability to attract new tenants or retain existing tenants.
Failure to abide by applicable service level commitments could subject us to material liability under the terms of our leases, which could materially adversely affect our business, results of operations and financial condition.
Our leases generally include terms requiring us to meet certain service level commitments primarily in terms of electrical output to, and maintenance of environmental conditions in, the computing rooms leased by tenants. Any failure to meet these commitments, including as a result of mechanical failure, power outage, human error on our part or for other reasons, could subject us to liability under our lease terms, including loss of management fee reimbursements or rent abatement, or, in certain cases of repeated failures, give the tenant a right to terminate the lease. Any such failures also could materially adversely affect our reputation and adversely impact our ability to lease our properties, which could have a material adverse effect on our business, financial condition and results of operations.
Certain of our leases include restrictions on the sale of our properties to third parties, which could have a material adverse effect on us, including our business, results of operations and financial condition.
Certain of our leases give the tenant a right of first refusal to purchase certain properties if we propose to sell those properties to a third party or prohibit us from selling certain properties to a third party that is a competitor of the tenant. The existence of such restrictions could hinder our ability to sell one or more of these properties, which could materially adversely affect our business, financial condition and results of operations.
The bankruptcy or insolvency of a major tenant would have a material adverse impact on us, including our business, results of operations and financial condition.
The bankruptcy or insolvency of a major tenant would materially adversely affect our business and the income produced by our properties. If any tenant becomes a debtor in a case under the U.S. Bankruptcy Code, we
cannot evict the tenant solely because of the bankruptcy. In addition, the bankruptcy court might authorize the tenant to reject and terminate its lease with us. Our claim against the tenant for unpaid future rent would be subject to a statutory cap that might be substantially less than the remaining rent owed under the lease. In either case, our claim for unpaid rent would likely not be paid in full. Our business, including our revenue and cash available for distribution to our stockholders, could be materially adversely affected if any of our significant tenants were to become bankrupt or insolvent, suffer a downturn in its business, or fail to renew its lease at all or renew on terms less favorable to us than its current terms.
Future consolidation in the technology industry could materially adversely affect our business, results of operations and financial condition by eliminating some of our potential tenants and could make us more dependent on a more limited number of tenants.
Mergers or consolidations of technology companies in the future could reduce the number of our tenants and potential tenants. If our tenants merge with or are acquired by other entities that are not our tenants, they may discontinue or reduce the use of our data centers in the future. Any of these developments could have a material adverse effect on our business, results of operations and financial condition.
Our data center infrastructure may become obsolete and we may not be able to upgrade our power and cooling systems cost-effectively or at all, which could have a material adverse effect on our business and results of operations.
The data center market is characterized by evolving industry standards and changing tenant demands. Our data center infrastructure may become obsolete due to the development of new systems to deliver power to or eliminate heat from the servers we house. Additionally, our data center infrastructure could become obsolete as a result of the development of new server technology that does not require the levels of critical load and heat removal that our facilities are designed to provide and could be run less expensively on a different platform. In addition, our power and cooling systems are difficult and expensive to upgrade. Accordingly, we may not be able to efficiently upgrade or change these systems to meet new demands or industry standards without incurring significant costs that we may not be able to pass on to our tenants. The obsolescence of our power and cooling systems could have a material adverse effect on our business, results of operations and financial condition.
Our properties are not suitable for use other than as data centers, which could make it difficult to reposition them if we are not able to lease available space and could materially adversely affect our business, results of operations and financial condition.
Our data centers are designed solely to house and run computer servers and related equipment and, therefore, contain extensive electrical and mechanical systems and infrastructure. As a result, they are not suited for use by tenants as anything other than as data centers and major renovations and expenditures would be required in order for us to re-lease vacant space for more traditional uses, or for us to sell a property to a buyer for use other than as a data center.
Declining real estate valuations could result in impairment charges, the determination of which involves a significant amount of judgment on our part. Any impairment charge would materially adversely affect our business, results of operations and financial condition.
We review our properties for impairment on a quarterly and annual basis and whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. Indicators of impairment include, but are not limited to, a sustained significant decrease in the market price of or the cash flows expected to be derived from a property. A significant amount of judgment is involved in determining the presence of an indicator of impairment. If the total of the expected undiscounted future cash flows is less than the carrying amount of a property, a loss is recognized for the difference between the fair value and carrying value of the property. The evaluation of anticipated cash flows requires a significant amount of judgment regarding assumptions that could
differ materially from actual results in future periods, including assumptions regarding future occupancy, rental rates and capital requirements. Any impairment charge would materially adversely affect our business, financial condition and results of operations.
Any losses to our properties that are not covered by insurance, or that exceed our policy coverage limits, would materially adversely affect our business, results of operations and financial condition.
We carry comprehensive liability, fire, earthquake, extended coverage, business interruption and rental loss insurance covering all of the properties in our portfolio, which includes coverage for riots, terrorism, acts of God and floods that are subject to policy specifications and insured limits. In addition, some of our policies, like those covering losses due to floods, are subject to limitations involving large deductibles or co-payments and policy limits that may not be sufficient to cover potential losses. If we experience a loss that is uninsured or exceeds policy limits, we could lose the capital invested in the damaged properties as well as the anticipated future cash flows from those properties. In addition, if the damaged properties are subject to recourse indebtedness, we would continue to be liable for the indebtedness, even if these properties were irreparably damaged. These events would materially adversely affect our business, financial condition and results of operations.
We could become subject to liability for failure to comply with environmental and other laws and regulations.
We are subject to environmental laws and regulations regarding the handling of regulated substances and wastes, including, in particular, regulations regarding the storage of petroleum for auxiliary or emergency power. The properties in our portfolio are also subject to various federal, state and local laws and regulations, including those related to: air quality and exhaust emissions; discharges of treated and storm water; and health, safety and fire (See “Business-Regulation-Environmental Matters”). If we or our tenants fail to comply with these various requirements, we might incur governmental fines or other sanctions or private damage awards. Moreover, existing requirements could change and future requirements could require us to make significant unanticipated expenditures that will materially adversely impact our business, results of operations and financial condition.
We may be adversely affected by regulations related to climate change.
If we, or other companies with which we do business, particularly utilities that provide our facilities with electricity, become subject to laws or regulations related to climate change, our business, results of operations and financial condition could be impacted adversely. The U.S. Environmental Protection Agency and some of the states and localities in which we operate have enacted certain climate change laws and regulations and/or have begun regulating carbon footprints and greenhouse gas emissions. Although these laws and regulations have not had any known adverse effects on our business to date, they could limit our ability to develop new facilities or result in substantial compliance costs, retrofit costs and construction costs, including capital expenditures for environmental control facilities and other new equipment. Our reputation could be negatively affected if we violate climate change laws or regulations.
Hedging transactions may limit our gains or result in material losses.
We use derivatives to hedge other liabilities of ours from time to time, although, as of December 31, 2011, we had no hedging transaction in place. Any hedging transactions into which we enter could expose us to certain risks, including:
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losses on a hedge position reducing the cash available for distribution to stockholders and such losses exceeding the amount invested in such instruments;
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counterparties to a hedging arrangement defaulting on their obligations;
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paying certain fees, such as transaction or brokerage fees; and.
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incurring costs if we elect to terminate a hedging agreement early.
Although the REIT rules impose certain restrictions on our ability to utilize hedges, swaps, and other types of derivatives to hedge our liabilities, we may use these hedging instruments in our risk management strategy to limit the effects of changes in interest rates on our operations. However, hedges may not be effective in eliminating all of the risks inherent in any particular position. Our profitability may be materially adversely affected during any period as a result of the use of such derivatives.
The departure of any key personnel, including Mr. Fateh, who has developed significant relationships with many of our tenants (including with leading technology companies), could have a material adverse impact on us, including our business, results of operations and financial condition.
We depend on the efforts of key personnel, particularly Mr. Fateh, our President and Chief Executive Officer and a member of our board. In particular, our reputation among and our relationships with our key tenants are the direct result of a significant investment of time and effort by Mr. Fateh to build our credibility in a highly specialized industry. If we lost his services, our business and investment opportunities and our relationships with existing and prospective tenants and industry personnel and our reputation among our key tenants could be diminished, which could materially adversely affect our results of operations. This risk may be even more pronounced given the terms of certain of our debt instruments. See “Risks Related to Our Debt Financing-We may be unable to satisfy our debt obligations upon a change of control of us.”
If we fail to establish and maintain an effective system of integrated internal controls, we may not be able to accurately and timely report our financial results.
If we fail to maintain proper overall business controls, our results of operations could be materially adversely affected or we could fail to meet our reporting obligations, including the accurate and timely reporting of our financial results. In addition, the existence of a material weakness could result in errors in our consolidated financial statements that could require a restatement of our consolidated financial statements, cause us to fail to meet our reporting obligations and cause investors to lose confidence in our reported financial information, leading to, among other things, a decline in the market value of our common stock.
Risks Related to the Real Estate Industry
Our performance and value are subject to risks associated with real estate assets and with the real estate industry.
Real estate investments are subject to various risks and fluctuations and cycles in value and demand, many of which are beyond our control. Certain events may decrease our cash available for distribution, as well as the value of our properties. These events include, but are not limited to:
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inability to collect rent from tenants;
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vacancies or our inability to rent space on favorable terms, including possible market pressures to offer tenants rent abatements, tenant improvements, early termination rights or below-market renewal options;
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adverse changes in financial conditions of buyers, sellers and tenants of properties, including data centers;
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reductions in the level of demand or increase in the supply for data center space;
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inability to finance development on favorable terms;
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fluctuations in interest rates, which could adversely affect our ability, or the ability of buyers and tenants of properties, including data centers, to obtain financing on favorable terms or at all;
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increases in expenses that are not paid for by or cannot be passed on to our tenants;
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changes in, and in enforcement of, laws, regulations and governmental policies, and the costs of compliance thereof; and
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the relative illiquidity of real estate investments, especially the specialized real estate properties that we hold and seek to acquire and develop.
Illiquidity of real estate investments and the terms of certain of our leases could significantly impede our ability to respond to adverse changes in the performance of our properties, which could materially adversely affect our business, results of operations and financial condition.
Because real estate investments are relatively illiquid, our ability to promptly sell one or more properties in our portfolio to raise cash in response to adverse changes in the performance of such properties may be limited and thus could materially adversely affect our financial condition.
In addition, data centers represent an illiquid part of the overall real estate market, due to the relatively small number of potential purchasers of such data centers-including other data center operators and large corporate users-and the relatively high cost per square foot to develop data centers, which limits a potential buyer’s ability to purchase a data center property with the intention of redeveloping it for an alternative use, such as an office building, or may substantially reduce the price buyers are willing to pay for the property.
As the present or former owner or operator of real property, we could become subject to liability for environmental contamination, regardless of whether we caused such contamination, which could have a materially adverse effect on our business, results of operations and financial condition.
Under various federal, state and local laws, regulations and ordinances that relate to the protection of the environment, a current or former owner, operator or tenant of real property may be liable for the cost to remove or remediate contamination resulting from the presence or discharge of hazardous or toxic substances, wastes or petroleum products on, under, from or in such property. These costs could be substantial and liability under these laws may attach without regard to whether the owner or operator knew of, or was responsible for, the presence of the contaminants, and the liability may be joint and several. Previous owners of some or our properties-including previous owners of sites where our CH1, NJ1, SC1 and SC2 facilities are located and the undeveloped land for our ACC8 and SC2 facilities-used these properties for industrial and retail purposes. As a result, these properties may (and in the case of the NJ1 property, did) contain some level of environmental contamination (See “Business-Regulation-Environmental Matters”). In addition, many of our properties presently contain large underground fuel storage tanks for emergency power, which is critical to our operations. We likely would be liable for contamination that results from a release of fuel from any of these storage tanks. Moreover, the presence of contamination or the failure to remediate contamination at our properties may expose us to third-party liability or materially adversely affect our ability to sell, lease or develop the real estate or to borrow using the real estate as collateral.
As the owner of real property, we could become subject to liability for asbestos-containing building materials in the buildings on our property, which could have a materially adverse effect on our business, results of operations and financial condition.
Some of our properties may contain asbestos-containing building materials. Environmental laws require that owners or operators of buildings with asbestos-containing building materials properly manage and maintain these materials, adequately inform or train those who may come into contact with asbestos and undertake special precautions, including removal or other abatement, in the event that asbestos is disturbed during building renovation or demolition. These laws may impose fines and penalties on building owners or operators for failure to comply with these requirements. In addition, these laws may also allow third parties to seek recovery from owners or operators for personal injury associated with exposure to asbestos-containing building materials.
Our properties may contain or develop harmful mold or suffer from other adverse conditions, which could lead to liability for adverse health effects and costs of remediation.
When excessive moisture accumulates in buildings or on building materials, mold growth may occur, particularly if the moisture problem remains undiscovered or is not addressed over a period of time. Some molds may produce airborne toxins or irritants. Indoor air quality issues can also stem from inadequate ventilation, chemical contamination from indoor or outdoor sources and other biological contaminants such as pollen, viruses and bacteria. Indoor exposure to airborne toxins or irritants above certain levels may cause a variety of adverse health effects and symptoms, including allergic or other reactions. As a result, the presence of significant mold or other airborne contaminants at any of our properties could require us to undertake a costly remediation program to contain or remove the mold or other airborne contaminants from the affected property or increase indoor ventilation. In addition, the presence of significant mold or other airborne contaminants could expose us to liability from our tenants, employees of our tenants and others if property damage or health concerns arise.
We may incur significant costs complying with the Americans with Disabilities Act, or ADA, and similar laws, which could materially adversely affect our business, results of operations and financial condition.
Under the ADA, all places of public accommodation must meet federal requirements related to access and use by disabled persons. A number of additional federal, state and local laws may also require modifications to our properties. We have not conducted an audit or investigation of all of our properties to determine our compliance with the ADA. If one of our properties is not in compliance with the ADA, we would be required to incur additional costs to bring the property into compliance. Additional federal, state and local laws may require modifications to our properties, or restrict our ability to renovate our properties. We cannot predict the ultimate amount of the cost of compliance with the ADA or other legislation. If we incur substantial costs to comply with the ADA and any other similar legislation, our business, financial condition and results of operations could be materially adversely affected.
We may incur significant costs complying with other regulations, which could materially adversely affect our business, results of operations and financial condition.
The properties in our portfolio are subject to various federal, state and local regulatory requirements. If we fail to comply with these various requirements, we might incur governmental fines or private damage awards. In addition, we do not know whether existing requirements will change or whether future requirements will require us to make significant unanticipated expenditures that could materially adversely affect our business, results of operations and financial condition.
Risks Related to Our Debt and Preferred Stock Financing
We depend on external sources of capital to fund our growth and refinance existing indebtedness, which capital may not be available to us at all or on terms favorable or acceptable to us.
The cash that we used for the development of data center facilities exceeded the cash provided by our operating activities in each of the last four years. Our operating activities are not expected to generate sufficient cash to provide the capital necessary to construct the second phases of our ACC6, NJ1 and SC1 data center facilities, to develop the land that we hold for future data center development or to refinance our existing indebtedness. In addition, as a REIT, DFT is required under the Internal Revenue Code of 1986, as amended (the “Code”) to distribute at least 90% of its “REIT taxable income,” excluding any net capital gain, to its stockholders annually. Consequently, we rely on third-party sources of capital to fund our development projects and refinance our existing indebtedness. Our access to capital depends, in part, on:
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general business conditions;
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financial market conditions;
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the market’s perception of our business prospects and growth potential;
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our current debt levels;
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our current and expected earnings and cash flow; and
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the market price of our common stock.
There is no assurance that we will be able to obtain equity or debt financing at all or on terms favorable or acceptable to us.
Future increases in interest rates and credit spreads would increase interest expense related to our floating rate indebtedness and affect our results of operations negatively, which could in turn reduce our access to the capital markets.
If we are unable to obtain capital from third parties, we may need to find alternative ways to increase our liquidity, which may include curtailing development activity or disposing of one or more of our properties possibly on disadvantageous terms.
We have significant outstanding indebtedness and preferred stock, which requires that we generate significant cash flow to satisfy the payment and other obligations under the terms of these securities, and exposes us to the risk of default under the terms of these securities.
As of December 31, 2011, our total consolidated indebtedness was $714.8 million, which exceeds the total of our cash on hand at December 31, 2011 and our annual cash flows from operating activities for 2011. As of December 31, 2011, we also had outstanding, in the aggregate, $286.3 million of Series A Preferred Stock and Series B Preferred Stock, and in January 2012, we issued an additional $65.0 million of Series B Preferred Stock. We may incur additional debt or issue additional preferred stock for various purposes, including, without limitation, to fund future acquisition and development activities and operational needs.
The terms of our outstanding indebtedness and preferred stock provide for significant principal, interest and dividend payments in 2012, including:
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$5.2 million of principal on the term loan secured by our ACC5 and ACC6 data center facilities;
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$52.1 million of interest on our outstanding indebtedness, based on current interest rates; and
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$27.0 million of preferred stock dividends.
Our ability to meet these and the ongoing payment obligations of these securities depends on our ability to generate significant cash flow in the future. Our ability to generate cash flow, to some extent, is subject to general economic, financial, competitive, legislative and regulatory factors, as well as other factors that are beyond our control. We cannot assure you that our business will generate cash flow from operations, or that capital will be available to us, in amounts sufficient to enable us to meet our payment obligations under our senior notes, our credit agreements and our outstanding preferred stock and to fund our other liquidity needs. If we are not able to generate sufficient cash flow to service these obligations, we may need to refinance or restructure our debt, sell assets (which we may be limited in doing in light of the relatively illiquid nature of our properties), reduce or delay capital investments, or seek to raise additional capital. If we are unable to implement one or more of these alternatives, we may not be able to meet these payment obligations, which could materially and adversely affect our liquidity.
Our outstanding indebtedness, and the limitations imposed on us by the agreements that govern our outstanding indebtedness, and the fixed charge obligations under our outstanding preferred stock, could have significant adverse consequences, including the following:
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make it more difficult for us to satisfy our obligations;
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limit our ability to obtain additional financing to fund future working capital, capital expenditures and other general corporate requirements, or to carry out other aspects of our business plan;
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limit our ability to refinance our indebtedness at maturity or impose refinancing terms that may be less favorable than the terms of the original indebtedness;
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require us to dedicate a substantial portion of our cash flow from operations to payments on obligations under our outstanding indebtedness and preferred stock, thereby reducing the availability of such cash flow to fund working capital, capital expenditures and other general corporate requirements, or adversely affect our ability to meet REIT distribution requirements imposed by the Code;
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cause us to violate restrictive covenants in the documents that govern our indebtedness, which would entitle our lenders to accelerate our debt obligations;
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cause us to default on our obligations, causing lenders or mortgagees to foreclose on properties that secure our loans and receive an assignment of our rents and leases;
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force us to dispose of one or more of its properties, possibly on unfavorable terms or in violation of certain covenants to which we may be subject; and
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limit our ability to make material acquisitions or take advantage of business opportunities that may arise and limit our flexibility in planning for, or reacting to, changes in its business and industry, thereby limiting our ability to compete effectively or operate successfully.
If any one of these events was to occur, our business, results of operations and financial condition would be materially adversely affected.
The documents that govern our outstanding indebtedness restrict our ability to engage in some business activities, which could materially adversely affect our business, results of operations and financial condition.
The documents that govern our outstanding indebtedness contain customary negative covenants and other financial and operating covenants that place restrictions on DFT, the Operating Partnership and their respective subsidiaries. These covenants restrict, among other things, the ability of DFT, the Operating Partnership and their respective subsidiaries to:
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incur debt and liens;
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enter into sale and leaseback transactions;
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make certain dividend payments, distributions and investments;
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enter into transactions with affiliates;
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enter into agreements limiting the Operating Partnership’s ability to make certain transfers and other payments from subsidiaries;
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sell assets; and
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merge or consolidate.
In addition, covenants contained in the documents that govern our outstanding indebtedness require the Operating Partnership and/or its subsidiaries to meet certain financial performance tests.
These restrictive operational and financial covenants will reduce our flexibility in conducting our operations, limit our flexibility in planning for, or reacting to, changes in our business and industry, and limit our ability to engage in activities that may be in our long-term best interest, including the ability to make acquisitions or take advantage of other business opportunities that may arise, any of which could materially adversely affect our growth prospects, future operating results and financial condition.
Our failure to comply with these restrictive covenants could result in an event of default that, if not cured or waived, could result in the acceleration of all or a substantial portion of our outstanding debt (which might also
cause cross-defaults with respect to our other debt obligations). For a detailed description of the covenants and restrictions imposed by the documents governing our indebtedness, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Outstanding Indebtedness.”
The documents that govern our outstanding indebtedness require that we maintain certain financial ratios and, if we fail to do so, we would be in default under the applicable debt instrument, which in turn could trigger defaults under our other debt instruments, which could result in the maturities of all of our debt obligations being accelerated and would have a material adverse effect on us, including our business, results of operations and financial condition.
Each of our debt instruments requires that we maintain certain financial ratios. The credit agreement that is secured by our ACC5 and ACC6 data center facilities provides that the total indebtedness of the Operating Partnership and its subsidiaries cannot exceed 65% of the value of the assets of the Operating Partnership and its subsidiaries, determined based on the appraised value of stabilized data center properties, the amount of unrestricted cash and the book value of development properties and undeveloped land. Under this credit agreement, the administrative agent periodically has the right to have each of our stabilized data center properties appraised. If the total indebtedness of the Operating Partnership exceeds 65% of the applicable asset value, the indebtedness in question would have to be reduced to a level that resulted in compliance with this ratio.
The credit agreement that governs our unsecured revolving credit facility also requires that we maintain financial ratios relating to the following matters: (i) unsecured debt not exceeding 60% of the value of unencumbered assets; (ii) net operating income generated from unencumbered properties divided by the amount of unsecured debt being not less than 12.5%; (iii) total indebtedness not exceeding 60% of gross asset value; (iv) fixed charge coverage ratio being not less than 1.70 to 1.00; and (v) tangible net worth being not less than $750 million plus 80% of the sum of (x) net equity offering proceeds and (y) the value of equity interests issued in connection with a contribution of assets to the Operating Partnership or its subsidiaries.
In addition, the indenture that governs our senior notes requires, among other things, that the Operating Partnership and our subsidiaries that guaranty the notes maintain total unencumbered assets of at least 150% of their unsecured debt on a consolidated basis.
If we do not continue to satisfy these covenant ratios, we will be in default under the applicable debt instrument, which in turn would trigger defaults under our other debt instruments, which could result in the maturities of all of our debt obligations being accelerated. These events would have a material adverse effect on our liquidity.
The terms of the agreements that govern our indebtedness limit our ability to sell the data center properties that have been pledged as collateral for our indebtedness, which could reduce our liquidity.
Two of our income producing data center properties-ACC5 and ACC6-serve as collateral under an existing credit agreement. This credit agreement limits our ability to sell these properties. The indenture that governs our senior notes and the credit agreement that governs our unsecured revolving credit facility limit our ability to sell or transfer assets and, under certain circumstances, the indenture requires that we use any net cash proceeds to reduce outstanding indebtedness. Consequently, our ability to raise capital through the disposition of assets is limited.
Indebtedness secured by our properties exposes us to the possibility of foreclosure, which could result in the loss of the property that secures the indebtedness and any rents to which we would be entitled from leases on that property.
The obligations under one of our credit agreements-with an outstanding principal balance at December 31, 2011 of $144.8 million-is secured by our ACC5 and ACC6 data center facilities. A default of any of the
obligations under this credit agreement could result in foreclosure actions by our lenders and the loss of the property securing the indebtedness and an assignment to the lenders of our rents and leases related to any such property.
For tax purposes, a foreclosure of any such property would be treated as a sale of the property for a purchase price equal to the outstanding balance of the underlying indebtedness. If the outstanding balance of this debt exceeds our tax basis in the property, we would recognize taxable income on foreclosure, but would not receive any cash proceeds from the disposition of the properties.
In the future, we may assume or incur additional indebtedness secured by one or more properties that we own or in connection with property acquisitions.
Disruptions in the financial markets may materially and adversely affect our ability to secure additional financing.
The credit markets continue to experience significant price volatility, dislocations and liquidity disruptions, the concern of which has led many lenders and institutional investors to reduce, and in some cases cease, to provide credit to businesses and has caused spreads on prospective debt financings to widen considerably. Continued uncertainty in these markets may affect our ability to obtain debt financing at all or on terms favorable or acceptable to us. These events also may make it more difficult or costly for us to raise capital through the issuance of our common stock or preferred stock. Our inability to secure additional financing may impede our ability to initiate new development projects. Disruptions in the financial markets could have a material adverse effect on us, including our business, results of operations and our financial condition.
We may be unable to satisfy our debt obligations upon a change of control of us.
Under the documents that govern our indebtedness, if we experience a change of control, we could be required to repay the entire principal balance of our outstanding indebtedness. Under the credit agreement secured by our ACC5 and ACC6 data center facilities, if we experience a change of control, as defined in the credit agreement, the lenders have the right to accelerate the maturity of the loan. Under our senior notes indenture, if we experience a change of control, as defined in the indenture, we must offer to purchase the notes at 101% of their principal amount, plus accrued interest. Under the credit agreement that governs our unsecured revolving credit facility, if we experience a change of control, as defined in the credit agreement, we must repay the principal amount of any outstanding loans, plus accrued interest, and the obligation of the lenders to fund any additional loans would terminate. We might not have sufficient funds to repay the amounts due under the term loans or the unsecured revolving credit facility or pay the required price for the notes following a change of control. Under the credit agreement secured by our ACC5 and ACC6 data center facilities, we are deemed to have experienced a change of control if Mr. Fateh ceases to be one of our senior management executives and a comparable, competent and experienced successor senior management executive has not been approved by the lenders within 150 days of such event. Any of these events could have a material adverse impact on our liquidity, business, results of operations and financial condition.
Risks Related to Our Organizational Structure
Conflicts of interest exist or could arise in the future with holders of units of partnership interest in the Operating Partnership, or OP units, which may impede business decisions that could benefit DFT’s stockholders.
Conflicts of interest exist or could arise in the future as a result of the relationships between DFT and its affiliates, on the one hand, and the Operating Partnership or any of its partners, on the other. DFT’s directors and officers have duties to DFT and its stockholders under applicable Maryland law. At the same time, DFT, as general partner, has fiduciary duties to the Operating Partnership and to its limited partners under Maryland law. DFT’s duties as general partner to the Operating Partnership and its partners may come into conflict with the
duties of DFT’s directors and officers to DFT and its stockholders. The partnership agreement of the Operating Partnership provides that for so long as DFT is the general partner of the Operating Partnership, any conflict that cannot be resolved in a manner not adverse to either DFT’s stockholders or the limited partners will be resolved in favor of DFT’s stockholders.
Additionally, the partnership agreement expressly limits DFT’s liability by providing that DFT and its officers, directors, agents and employees, will not be liable or accountable to the Operating Partnership for losses sustained, liabilities incurred or benefits not derived if DFT, or such officer, director, agent or employee acted in good faith. In addition, the Operating Partnership is required to indemnify DFT, and its officers, directors, employees, agents and designees to the extent permitted by applicable law from and against any and all claims arising from operations of the Operating Partnership, unless it is established that (1) the act or omission was committed in bad faith, was fraudulent or was the result of active and deliberate dishonesty, (2) the indemnified party received an improper personal benefit in money, property or services or (3) in the case of a criminal proceeding, the indemnified person had reasonable cause to believe that the act or omission was unlawful. The provisions of Maryland law that allow the fiduciary duties of a general partner to be modified by a partnership agreement have not been resolved in a court of law, and we have not obtained an opinion of counsel covering the provisions set forth in the partnership agreement that purport to waive or restrict DFT’s fiduciary duties that would be in effect were it not for the partnership agreement.
DFT is also subject to the following additional conflicts of interest with holders of OP units:
DFT may pursue less vigorous enforcement of terms of the employment agreements with Messrs. du Pont and Fateh and their affiliates because of DFT’s dependence on them and conflicts of interest. Messrs. du Pont and Fateh entered into employment agreements with DFT, including clauses prohibiting them from competing with DFT, subject to certain exceptions, in the data center market. Neither of these agreements was negotiated on an arm’s-length basis. DFT may choose not to enforce, or to enforce less vigorously, its rights under these employment agreements because of its desire to maintain its ongoing relationship with Messrs. du Pont and Fateh and their affiliates and because of conflicts of interest with them, including allowing them to devote significant time to non-data center projects outside of the Company, to engage in activities that may compete with DFT, or to engage in transactions with DFT without receiving the appropriate board approval.
Tax consequences upon sale or refinancing. Sales of properties and repayment of related indebtedness will have different effects on holders of OP units than on DFT’s stockholders. The parties that contributed properties to the Operating Partnership may incur tax consequences upon the sale of these properties and on the repayment of related debt which differ from the tax consequences to DFT and its stockholders. Consequently, these holders of OP units may have different objectives regarding the appropriate pricing and timing of any such sale or repayment of debt. Although DFT has exclusive authority as general partner under the partnership agreement of the Operating Partnership to determine when to refinance or repay debt or whether, when, and on what terms to sell a property, any such decision would require the approval of DFT’s board of directors, and DFT’s ability to take such actions, to the extent that they may reduce the liabilities of the Operating Partnership, may be limited pursuant to the tax protection agreements that DFT entered into upon completion of its initial public offering. Certain of DFT’s directors and executive officers could exercise their influence in a manner inconsistent with the interests of some, or a majority, of its stockholders, including in a manner which could delay or prevent completion of a sale of a property or the repayment of indebtedness.
Messrs. du Pont and Fateh have the right to hold a significant percentage of DFT’s stock. DFT’s charter generally authorizes its directors to take such actions as are necessary and desirable to preserve DFT’s qualification as a REIT and to limit any person (other than a qualified institutional investor) to actual or constructive ownership of no more than 3.3% of the outstanding shares of its common stock by value or by number of shares, whichever is more restrictive and 3.3% of its outstanding capital stock by value. DFT’s board of directors, however, has granted, and in the future may grant, exemptions from the ownership limits described above if such exemptions do not jeopardize its status as a REIT. In addition, DFT’s charter provides that Mr. du Pont, certain of his affiliates, family members and trusts formed for the benefit of the foregoing, may own
up to 20.0% of the outstanding shares of DFT’s common stock by value or by number of shares, whichever is more restrictive, and 20.0% of DFT’s outstanding capital stock by value, and that Mr. Fateh, certain of his affiliates, family members and trusts formed for the benefit of the foregoing, may own up to 20.0% of the outstanding shares of DFT’s common stock by value or by number of shares, whichever is more restrictive, and 20.0% of DFT’s outstanding capital stock by value. These exemptions from the general ownership limits give Messrs. du Pont and Fateh the ability to own a combined interest in DFT’s stock equal to 40.0% of DFT’s shares outstanding. In addition, pursuant to their employment agreements, each of Messrs. du Pont and Fateh, if he holds at least 9.8% of our outstanding shares on a fully diluted basis, will have a contractual right to be nominated to the board of directors. These exemptions and contractual rights could allow Messrs. du Pont and Fateh to exercise, individually or in concert, a substantial degree of control over DFT’s affairs even if they are no longer executive officers.
Messrs. Du Pont and Fateh have significant influence over our affairs. As of December 31, 2011, Messrs. du Pont and Fateh, owned an aggregate of approximately 0.3% of DFT’s common stock (including shares of unvested restricted common stock) and approximately 35.6% of the OP units (not including those units held by DFT), equal to approximately 8.5% of DFT’s common stock, on a fully diluted basis. As a result, our senior management team, to the extent they vote their shares in a similar manner, can have influence over our affairs and could exercise such influence in a manner that is not in the best interests of DFT’s other stockholders, including by attempting to delay, defer or prevent a change in control transaction that might otherwise be in the best interests of DFT’s stockholders. If our senior management team exercises their redemption rights with respect to their OP units and DFT issues common stock in exchange thereof, our senior management team’s influence over our affairs would increase substantially.
Mr. Fateh has outside business interests that could require time and attention and may interfere with his ability to devote time to our business and affairs. Under the terms of our employment agreement with Mr. Fateh, he has agreed to devote substantially all of his business attention and time to our affairs. However, he owns interests in non-data center real estate assets, including, among other investments, the office building where our corporate headquarters is located, and undeveloped land located in Northern Virginia. Mr. Fateh has agreed, for the terms of his employment with us, not to sell any of this land to a competitor of our Company, as determined by at least 75% of our independent directors. Any purchase by us of the undeveloped land held by Mr. Fateh would require the approval of at least 75% of our independent directors.
DFT’s charter and Maryland law contain provisions that may delay, defer or prevent a change in control transaction, even if such a change in control may be in DFT’s stockholders’ interest, and as a result may depress our stock price.
DFT’s charter contains a 3.3% ownership limit. DFT’s charter, subject to certain exceptions, authorizes its directors to take such actions as are necessary and desirable to ensure DFT’s qualification as a REIT and to limit any person (other than a qualified institutional investor or an excepted holder) to actual or constructive ownership of no more than 3.3% of the outstanding shares of its common stock by value or by number of shares, whichever is more restrictive, and 3.3% of its outstanding capital stock by value. This ownership limit may delay, defer or prevent a transaction or a change in control that might involve a premium price for DFT’s common stock or otherwise be in the best interest of its stockholders.
DFT could increase the number of authorized shares of stock and issue stock without stockholder approval. DFT’s charter authorizes its board of directors, without stockholder approval, to increase the aggregate number of authorized shares of stock or the number of authorized shares of stock of any class or series, to issue authorized but unissued shares of DFT’s common stock or preferred stock and to classify or reclassify any unissued shares of its common stock or preferred stock and to set the preferences, rights and other terms of such classified or unclassified shares. DFT’s board of directors could establish a series of preferred stock that could, depending on the terms of such series, delay, defer or prevent a transaction or a change in control that might involve a premium price for its common stock or otherwise be in the best interest of its stockholders. For
instance, under the terms of our Series A Preferred Stock, if, following a change of control of DFT, the Series A Preferred Stock is not listed on the NYSE or quoted on NASDAQ, holders would be entitled to receive dividends at an increased rate of 11.875%.
Certain provisions of Maryland law could inhibit changes in control. Certain provisions of the Maryland General Corporation Law, or MGCL, may have the effect of inhibiting a third party from making a proposal to acquire us or of impeding a change in control under circumstances that otherwise could provide the holders of shares of our common stock with the opportunity to realize a premium over the then-prevailing market price of such shares, including:
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“business combination” provisions that, subject to limitations, prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our shares or an affiliate or associate of ours who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10% or more of our then outstanding voting shares) or an affiliate thereof for five years after the most recent date on which the stockholder becomes an interested stockholder, and thereafter imposes special appraisal rights and special stockholder voting requirements on these combinations; and
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“control share” provisions that provide that “control shares” of our Company (defined as shares which, when aggregated with other shares controlled by the stockholder, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights except to the extent approved by our stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares.
DFT has opted out of these provisions of the MGCL, in the case of the business combination provisions of the MGCL by resolution of its board of directors, and in the case of the control share provisions of the MGCL by a provision in its bylaws. However, DFT’s board of directors may by resolution elect to opt in to the business combination provisions of the MGCL and it may, by amendment to its bylaws (which such amendment could be adopted by its board of directors in its sole discretion), opt in to the control share provisions of the MGCL in the future.
The provisions of DFT’s charter on removal of directors and the advance notice provisions of its bylaws could delay, defer or prevent a transaction or a change in control of our Company that might involve a premium price for holders of DFT’s common stock or otherwise be in their best interest. Likewise, if DFT’s board of directors were to opt in to the business combination provisions of the MGCL or adopt a classified board of directors pursuant to Title 3, Subtitle 8 of the MGCL, or if the provision in DFT’s bylaws opting out of the control share acquisition provisions of the MGCL were rescinded, these provisions could have similar anti-takeover effects. Further, the partnership agreement provides that DFT may not engage in any merger, consolidation or other combination with or into another person, sale of all or substantially all of our assets or any reclassification or any recapitalization or change in outstanding shares of our common stock, unless in connection with such transaction DFT obtains the consent of holders of at least 50% of the OP units of the Operating Partnership (not including OP units held by DFT) and/or certain other conditions are met.
Certain provisions in the partnership agreement for the Operating Partnership may delay or prevent unsolicited acquisitions of us. Provisions in the partnership agreement for the Operating Partnership may delay or make more difficult unsolicited acquisitions of us or changes in our control. These provisions could discourage third parties from making proposals involving an unsolicited acquisition of us or change of our control, although some stockholders might consider such proposals, if made, desirable. These provisions include, among others:
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redemption rights of qualifying parties;
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transfer restrictions on the OP units;
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DFT’s ability, as general partner, in some cases, to amend the partnership agreement without the consent of the limited partners; and
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the right of the limited partners to consent to transfers of the general partnership interest and mergers under specified circumstances.
DFT’s rights and the rights of its stockholders to take action against its directors and officers are limited.
Maryland law provides that a director or officer has no liability in that capacity if he or she performs his or her duties in good faith, in a manner he or she reasonably believes to be in our best interests and with the care that an ordinarily prudent person in a like position would use under similar circumstances. As permitted by the MGCL, DFT’s charter limits the liability of its directors and officers to DFT and its stockholders for money damages, except for liability resulting from:
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actual receipt of an improper benefit or profit in money, property or services; or
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a final judgment based upon a finding of active and deliberate dishonesty by the director or officer that was material to the cause of action adjudicated.
In addition, DFT’s charter authorizes DFT to obligate our Company, and DFT’s bylaws require DFT, to indemnify its directors and officers for actions taken by them in those capacities to the maximum extent permitted by Maryland law. As a result, DFT and its stockholders have more limited rights against its directors and officers than might otherwise exist under common law. Accordingly, in the event that actions taken in good faith by any of our directors or officers impede the performance of our Company, stockholders’ ability to recover damages from such director or officer will be limited.
Future offerings of debt or equity securities or preferred stock, which would be senior to our common stock upon liquidation and for the purpose of distributions, may cause the market price of our common stock to decline.
In the future, we may attempt to increase our capital resources by making additional offerings of debt or equity securities, including commercial paper, medium-term notes, senior or subordinated notes and classes of preferred stock or common stock. For example, in March 2011, we sold 4.1 million shares of Series B Preferred Stock and in January 2012, we sold an additional 2.6 million shares of Series B Preferred Stock, each in underwritten public offerings. We will be able to issue additional shares of common stock or preferred stock without stockholder approval, unless stockholder approval is required by applicable law or the rules of any stock exchange or automated quotation system on which our securities may be listed or traded. Upon liquidation, holders of our debt securities and shares of preferred stock and lenders with respect to other borrowings will receive a distribution of our available assets prior to the holders of our common stock. Additional equity offerings may dilute the holdings of our existing stockholders or reduce the market price of our common stock, or both. Holders of our common stock are not entitled to preemptive rights or other protections against dilution. As data center acquisition or development opportunities arise from time to time, we may issue additional shares of common stock or preferred stock to raise the capital necessary to finance these acquisitions or developments or may issue common stock or preferred stock or OP units, which are redeemable for, at our option, cash or our common stock on a one-to-one basis, to acquire such properties. Such issuances could result in dilution of stockholders’ equity. Preferred stock and debt, if issued, could have a preference on liquidating distributions or a preference on dividend or interest payments that could limit our ability to make a distribution to the holders of our common stock. Because our decision to issue securities in any future offering or acquisition will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Thus, our stockholders bear the risk of our future offerings reducing the market price of our common stock and diluting their interest.
Risks Related to Our Status as a REIT
Failure to qualify as a REIT would have significant adverse consequences to us and the value of our stock.
DFT is a real estate investment trust, or REIT, for federal income tax purposes. Requirements under the Code for qualification and taxation as a REIT are extremely complex and interpretations of the federal income tax laws governing qualification and taxation as a REIT are limited. In addition, any new laws, Treasury regulations, interpretations, or court decisions could change the federal income tax laws or the federal income tax consequences of DFT’s qualification and taxation as a REIT. As a result, no assurance can be provided that DFT will continue to qualify as a REIT or that new legislation, Treasury regulations, administrative interpretations or court decisions will not significantly change the federal income tax laws with respect to, or the federal income tax consequences of, DFT’s qualification and taxation as a REIT. If DFT were to lose its REIT status, the tax consequences could reduce its cash available for distribution to its stockholders substantially for each of the years involved because:
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DFT would not be allowed a deduction for dividends paid to stockholders in computing its taxable income and would be subject to federal income tax at regular corporate rates;
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DFT could be subject to the federal alternative minimum tax and increased state and local taxes; and
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unless DFT is entitled to relief under applicable statutory provisions, DFT could not elect to be taxed as a REIT for four taxable years following the year during which it was disqualified.
The additional tax liability to us for the year or years in which DFT does not qualify as a REIT would reduce our net earnings available for investment, debt service or distribution to DFT’s stockholders. Furthermore, if DFT were to fail to qualify as a REIT, non-U.S. stockholders that own 5% or more of any class of DFT’s shares, who otherwise might not be subject to federal income tax on the sale of DFT’s shares, could be subject to federal income tax with respect to any gain on a net basis similar to the taxation of a U.S. stockholder. In addition, if DFT were to fail to qualify as a REIT, DFT would not be required to make distributions to stockholders, and all distributions to stockholders would be subject to tax as ordinary dividend income to the extent of its current and accumulated earnings and profits. As a result of all these factors, DFT’s failure to qualify as a REIT also could impair our ability to expand our business and raise capital, and would materially adversely affect the value of DFT’s common stock.
Qualification as a REIT involves the application of highly technical and complex Code provisions for which there are only limited judicial and administrative interpretations. The complexity of these provisions and of the applicable Treasury regulations that have been promulgated under the Code is greater in the case of a REIT that, like DFT, holds its assets through a partnership. The determination of various factual matters and circumstances not entirely within our control may affect DFT’s ability to qualify as a REIT. In order to continue to qualify as a REIT, DFT must satisfy a number of requirements, including requirements regarding the composition of its assets, the sources of its income and the diversity of its stock ownership. Also, DFT must make distributions to stockholders aggregating annually at least 90% of its “REIT taxable income,” excluding net capital gains. In addition, legislation, new Treasury regulations, administrative interpretations or court decisions may materially adversely affect our investors, DFT’s ability to qualify as a REIT for federal income tax purposes or the desirability of an investment in a REIT relative to other investments.
Failure to qualify as a domestically-controlled REIT could subject DFT’s non-U.S. stockholders to adverse federal income tax consequences.
DFT will be a domestically-controlled REIT if, at all times during a specified testing period, less than 50% in value of its shares of common stock is held directly or indirectly by non-U.S. stockholders. Because its shares of common stock are publicly traded, DFT cannot guarantee that it will, in fact, be a domestically-controlled REIT. If DFT fails to qualify as a domestically-controlled REIT, its non-U.S. stockholders that otherwise would not be subject to federal income tax on the gain attributable to a sale of DFT’s shares of common stock would be
subject to taxation upon such a sale if either (a) the shares of common stock were not considered to be “regularly traded” under applicable Treasury regulations on an established securities market, such as the NYSE, or (b) the shares of common stock were considered to be “regularly traded” on an established securities market and the selling non-U.S. stockholder owned, actually or constructively, more than 5% in value of the outstanding shares of common stock at any time during specified testing periods. If gain on the sale or exchange of DFT’s shares of common stock was subject to taxation for these reasons, the non-U.S. stockholder would be subject to federal income tax with respect to any gain on a net basis in a manner similar to the taxation of a taxable U.S. stockholder, subject to any applicable alternative minimum tax and special alternative minimum tax in the case of nonresident alien individuals, and corporate non-U.S. stockholders may be subject to an additional branch profits tax.
If the structural components of our properties were not treated as real property for purposes of the REIT qualification requirements, DFT would fail to qualify as a REIT.
A significant portion of the value of our properties is attributable to structural components related to the provision of electricity, heating ventilation and air conditioning, humidification regulation, security and fire protection, and telecommunication services. We have received a private letter ruling from the Internal Revenue Service (the “IRS”) holding, among other things, that our buildings, including the structural components, constitute real property for purposes of the REIT qualification requirements. We are entitled to rely upon that private letter ruling only to the extent that we did not misstate or omit a material fact in the ruling request we submitted to the IRS and that we operate in the future in accordance with the material facts described in that request. Moreover, the IRS, in its sole discretion, may revoke the private letter ruling. If our structural components are determined not to constitute real property for purposes of the REIT qualification requirements, including as a result of our being unable to rely upon the private letter ruling or the IRS revoking that ruling, DFT would fail to qualify as a REIT, which could have a material adverse impact on the value of DFT’s common stock.
If the Operating Partnership failed to qualify as a partnership for federal income tax purposes, DFT would fail to qualify as a REIT and suffer other adverse consequences.
We believe that the Operating Partnership is organized and operated in a manner so as to be treated as a partnership, and not an association or publicly traded partnership taxable as a corporation, for federal income tax purposes. As a partnership, it is not subject to federal income tax on its income. Instead, each of its partners, including DFT, is allocated that partner’s share of the Operating Partnership’s income. No assurance can be provided, however, that the IRS will not challenge the Operating Partnership’s status as a partnership for federal income tax purposes, or that a court would not sustain such a challenge. If the IRS were successful in treating the Operating Partnership as an association or publicly traded partnership taxable as a corporation for federal income tax purposes, DFT would fail to meet the gross income tests and certain of the asset tests applicable to REITs and, accordingly, would cease to qualify as a REIT. Also, the failure of the Operating Partnership to qualify as a partnership would cause it to become subject to federal corporate income tax, which would reduce significantly the amount of its cash available for debt service and for distribution to its partners, including DFT.
DFT will be subject to some taxes even though it qualifies as a REIT.
Even though DFT qualifies as a REIT for federal income tax purposes, it is subject to some federal, state and local taxes on its income and property. For example, DFT pays tax on certain types of income that it does not distribute. In addition, if assessed, DFT would incur a 100% excise tax on transactions with its taxable REIT subsidiary, or TRS, that are not conducted on an arm’s-length basis. A TRS is a corporation which is owned, directly or indirectly, by DFT and which, together with DFT, makes an election to be treated as our TRS. In addition, our TRS is subject to federal income tax as a corporation on its taxable income, if any, which consists of the revenues mainly derived from providing technical services, on a contract basis, to our tenants. The after-tax net income of our TRS is available for distribution to us but is not required to be distributed.
Moreover, if DFT has net income from “prohibited transactions,” that income will be subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of property held primarily for sale to customers in the ordinary course of business. The determination as to whether a particular sale is a prohibited transaction depends on the facts and circumstances related to that sale.
We will have a reduced carryover tax basis on certain of our assets as a result of the formation transactions, which could reduce our depreciation deductions.
All of our operating properties have a carryover tax basis that is lower than the fair market value of the property. This position could give rise to lower depreciation deductions on these assets that would have the effect of (1) increasing the distribution requirement imposed on us, which could materially adversely affect our ability to satisfy the REIT distribution requirement, and (2) decreasing the extent to which our distributions are treated as tax-free “return of capital” distributions.
Our tax protection agreements could limit our ability to sell or otherwise dispose of certain properties.
In connection with our formation transactions and October 2007 initial public offering, we entered into tax protection agreements with a number of limited partners of the Operating Partnership, including Messrs. du Pont and Fateh and certain of our directors. The agreements provide that, if we dispose of any interest in ACC2, ACC3, VA3, VA4 or CH1 in a taxable transaction through the year 2017, we will indemnify these partners for their tax liabilities (in varying amounts, depending on the year in which the disposition occurs) attributable to the built-in gain that exists with respect to such property interest as of the time of our October 2007 initial public offering (and tax liabilities incurred as a result of the reimbursement payment) if those tax liabilities exceed a certain amount. Consequently, although it otherwise may be in our best interest to sell one of these properties, these obligations may make it prohibitive for us to do so. In addition, any such sale must be approved by at least 75% of our disinterested directors. Additionally, the agreement contains various provisions to achieve minimum liability allocations to certain limited partners and indemnifies them for their tax liabilities resulting from any gain or income recognized due to breach of those provisions by the Operating Partnership.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
The information set forth under the captions “Properties” and “Offices” in Item 1 of this Annual Report on Form 10-K is incorporated by reference herein.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is involved from time to time in various legal proceedings, lawsuits, examinations by various tax authorities, and claims that have arisen in the ordinary course of business. Management believes that the resolution of such matters will not have a material adverse effect on the financial condition or results of operations.
ITEM 4.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Price of and Dividends on the Registrant’s Common Equity
Shares of the Company’s common stock, par value $.001 per share (“common stock”) trade on the New York Stock Exchange (“NYSE”) under the symbol “DFT.” As of February 23, 2012, the Company had less than 100 holders of record of its common stock. This figure does not reflect the beneficial ownership of shares held in nominee name. The following table sets forth, for the indicated periods, the high and low closing sale prices for the Company’s common stock on the NYSE and the cash distributions declared per share:
To qualify and maintain its qualification as a REIT, the Company intends to make annual distributions to its stockholders of at least 90% of its taxable income (which does not necessarily equal net income as calculated in accordance with generally accepted accounting principles). Dividends are declared by the board of directors. The Company’s ability to pay dividends to its stockholders is dependent on its receipt of distributions from its Operating Partnership, which in turn is dependent on its data center properties generating operating income. The indenture that governs the Company’s 8.5% senior unsecured notes due 2017 limits the Company’s ability to pay dividends, but allows it to pay the minimum necessary to meet its REIT income distribution requirements.
Issuer Purchases of Equity Securities
The Company did not purchase any of its registered equity securities during the quarter ended December 31, 2011.
Unregistered Sales of Equity Securities
During 2011, the Company issued 4.1 million shares of Series B Preferred Stock in an underwritten equity offering, which preferred shares are registered under the Securities Act of 1933, as amended (the “Act”). Pursuant to the Partnership Agreement of the Operating Partnership (the “Partnership Agreement”), the Operating Partnership issued to the Company an equal number of preferred units for the same price at which the shares of Series B Preferred Stock were sold, in a transaction that was not registered under the Act in reliance on Section 4(2) of the Act due to the fact that the preferred units were issued only to the Company and therefore, did not involve a public offering. Accordingly, during 2011, the Operating Partnership issued an aggregate of 4.1 million preferred units to the Company for the shares of Series B Preferred Stock issued in the equity offering of which 3.6 million shares were issued on March 8, 2011 and 450,000 shares were issued on March 14, 2011, for approximately $97 million.
The Company from time to time issues common shares pursuant to its equity compensation plans and pursuant to redemptions by the limited partners of the Operating Partnership of common units of limited partnership interest. Pursuant to the Partnership Agreement, each time the Company issues common shares as described above, the Operating Partnership issues to the Company, its general partner, an equal number of units for the same price at which the common shares were sold, in transactions that are not registered under the Act in reliance on Section 4(2) of the Act due to the fact that common units were issued only to the Company and therefore, did not involve a public offering. During 2011, the Operating Partnership issued 3,187,039 common units to the Company in connection with such redemptions and the issuances pursuant to the Company’s equity compensation plans, for approximately $67 million.
The following table sets forth, for the year ended December 31, 2011, the securities authorized for issuance under DFT’s equity compensation plans.
Performance Graph
The following line graph sets forth, for the period from October 18, 2007 (the date of the Company’s initial public offering) through December 31, 2011, a comparison of the percentage change in the cumulative total stockholder return on the Company’s common stock compared to the cumulative total return of the S&P 500 Index, the Russell 2000 Index and the FTSE National Association of Real Estate Investment Trusts Equity REIT Index. The graph assumes that $100 was invested on October 18, 2007 in shares of the Company’s common stock and each of the aforementioned indices and that all dividends were reinvested without the payment of any commissions. There can be no assurance that the performance of the Company’s common stock will continue in line with the same or similar trends depicted in the graph below.
The foregoing graph and chart shall not be deemed incorporated by reference by any general statement incorporating by reference this Annual Report on Form 10-K into any filing under the Securities Act of 1933, as amended, or under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), except to the extent the Company specifically incorporates this information by reference, and shall not otherwise be deemed filed under those acts.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
DuPont Fabros Technology, Inc. (the “REIT” or “DFT”) was formed on March 2, 2007, is a real estate investment trust, or REIT, and is headquartered in Washington, D.C. DFT is a fully integrated, self-administered and self-managed company that owns, acquires, develops and operates wholesale data centers. DFT is the sole general partner of, and, as of December 31, 2011, owned 76.7% of the common economic interest in DuPont Fabros Technology, L.P. (the “Operating Partnership” or “OP” and collectively with DFT and their operating subsidiaries, the “Company”). DFT’s common stock trades on the New York Stock Exchange, or NYSE, under the symbol “DFT”.
The Company is a leading owner, developer, operator and manager of wholesale data centers. The Company’s data centers are highly specialized, secure facilities used by its tenants-primarily national and international technology companies, including Microsoft, Yahoo!, Facebook and Google-to house, power and cool the computer servers that support many of their most critical business processes. The Company leases the raised square feet and available power of each of its facilities to its tenants under long-term triple-net leases, which generally contain annual rental increases. The phrase “wholesale data center,” or “wholesale infrastructure,” refers to specialized real estate assets consisting of large-scale data center facilities provided to tenants under long-term leases.
The Company completed its initial public offering, or IPO, on October 24, 2007. The IPO resulted in the sale of 35,075,000 common shares, generating net proceeds of $676.9 million.
Prior to August 7, 2007, each of the Company’s initial properties, or data centers, was directly owned by a single-property entity. To facilitate the closing of a credit facility on August 7, 2007 and in contemplation of the IPO, the Company combined the membership interests in the entities that hold interests in VA3, VA4, ACC2, ACC3 and CH1 into one holding company, Safari Ventures LLC (“Safari”), in order for those membership interests and certain of those properties to serve as collateral for the credit facility. Following the closing of the credit facility, each of the former members of the property-holding entities held a direct or indirect equity interest in Safari. Safari made borrowings under the Credit Facility to purchase land in Ashburn, Virginia that is being used for the development of ACC5 and ACC6. For accounting purposes, Quill Ventures LLC, the entity that owns ACC3, was determined to be the accounting acquirer (the “Predecessor”) in accordance with the authoritative guidance issued by the Financial Accounting Standards Board (“FASB”), in the Safari transaction, and ACC2, VA3, VA4 and CH1 were determined to be the “Acquired Properties”. The financial position and results of operations of the Predecessor are presented on a historical cost basis and the contribution of the interests of ACC2, VA3, VA4 and CH1 has been recorded at their estimated fair value. Subsequent to August 6, 2007, Safari is the accounting predecessor of the Company, resulting in the recording of the financial position and results of operations of Safari at historical cost basis at the IPO. Safari was merged into the Operating Partnership on December 30, 2009, with the Operating Partnership being the surviving entity. The merger resulted in the termination of Safari.
The Company also acquired as part of the IPO formation transactions on October 24, 2007, a data center known as ACC4, land held for the development of a data center in Ashburn, Virginia (ACC7), land held for development of a data center in Piscataway, New Jersey (NJ1), a contract to acquire land in Santa Clara, California and property management, development, leasing, asset management and technical services agreements and arrangements for all of the Company’s properties from entities affiliated with Lammot J. du Pont, the Chairman of the Company’s board of directors, and Hossein Fateh, the Company’s President and Chief Executive Officer. The contribution of the interests of ACC4 and the two undeveloped parcels of land were recorded at their estimated fair value.
Prior to August 7, 2007, operating results are presented for the Predecessor. Operating results for the Acquired Properties are only reflected for the period subsequent to August 7, 2007. Subsequent to October 24, 2007, operating results are presented for the Company, which includes the Predecessor, the Acquired Properties, ACC4, NJ1 and ACC7 and the other formation transactions.
The following tables set forth selected financial data for DFT and the Operating Partnership and should be read in conjunction with the financial statements and notes thereto included in “Item 8” of this report and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in “Item 7” of this report.
DuPont Fabros Technology, Inc. (“DFT”)
(1) Funds from operations, or FFO, is used by industry analysts and investors as a supplemental operating performance measure for REITs. The Company calculates FFO in accordance with the definition that was adopted by the Board of Governors of the National Association of Real Estate Investment Trusts, or NAREIT. FFO, as defined by NAREIT, represents net income determined in accordance with GAAP, excluding extraordinary items as defined under GAAP, impairment charges on depreciable real estate assets and gains or losses from sales of previously depreciated operating real estate assets, plus specified non-cash items, such as real estate asset depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. The Company also presents FFO attributable to common shares and OP units, which is FFO excluding preferred stock dividends. FFO attributable to common shares and OP units per share is calculated on a basis consistent with net income attributable to common shares and OP units and reflects adjustments to net income for preferred stock dividends.
The Company 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 period over period, captures trends in occupancy rates, rental rates and operating expenses. The Company also believes that, as a widely recognized measure of the performance of equity REITs, FFO may be used by investors as a basis to compare the Company’s operating performance with that of other REITs. However, because FFO excludes real estate related depreciation and amortization and captures neither the changes in the value of the Company’s properties that result from use or market conditions nor the level of capital expenditures and leasing commissions necessary to maintain the operating performance of the Company’s properties, all of which have real economic effects and could materially impact the Company’s results from operations, the utility of FFO as a measure of the Company’s performance is limited.
While FFO is a relevant and widely used measure of operating performance of equity REITs, other equity REITs may use different methodologies for calculating FFO and, accordingly, FFO as disclosed by such other REITs may not be comparable to the Company’s FFO. Therefore, the Company believes that in order to facilitate a clear understanding of its historical operating results, FFO should be examined in conjunction with net income as presented in the consolidated statements of operations. FFO should not be considered as an alternative to net income or to cash flow from operating activities (each as computed in accordance with GAAP) or as an indicator of the Company’s liquidity, nor is it indicative of funds available to meet the Company’s cash needs, including its ability to pay dividends or make distributions.
DuPont Fabros Technology, L.P. (The “Operating Partnership”)
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
DuPont Fabros Technology, Inc. (the “REIT” or “DFT”) was formed on March 2, 2007, is a real estate investment trust, or REIT, and is headquartered in Washington, D.C. DFT is a fully integrated, self-administered and self-managed company that owns, acquires, develops and operates wholesale data centers. DFT is the sole general partner of, and, as of December 31, 2011, owned 76.7% of the common economic interest in, DuPont Fabros Technology, L.P. (the “Operating Partnership” or “OP” and collectively with DFT and their operating subsidiaries, the “Company”). DFT’s common stock trades on the New York Stock Exchange, or NYSE, under the symbol “DFT”. DFT’s Series A and Series B preferred stock also trade on the NYSE under the symbols “DFTPrA” and “DFTPrB”, respectively.
As of December 31, 2011, the Company owns and operates ten data centers, seven of which are located in Northern Virginia, one of which is located in suburban Chicago, Illinois, one of which is located in Piscataway, New Jersey and one of which is located in Santa Clara, California. The Company’s ACC6 data center in Northern Virginia was placed in service on September 1, 2011, and on October 1, 2011, the Company placed its SC1 data center into service in Santa Clara, California. The Company placed CH1 Phase II into service on February 1, 2012. As discussed below, the Company also owns certain properties for future development and parcels of land that it intends to develop in the future, into wholesale data centers. With this portfolio of properties, the Company believes that it is well positioned as a fully integrated wholesale data center provider, capable of developing, leasing, operating and managing the its growing portfolio.
The following tables present the Company’s operating properties and development projects as of December 31, 2011:
Operating Properties
As of December 31, 2011
(1) Stabilized operating properties are either 85% or more leased or have been in service for 24 months or greater.
(2) Gross building area is the entire building area, including raised square footage (the portion of gross building area where the tenants’ computer servers are located), tenant common areas, areas controlled by the Company (such as the mechanical, telecommunications and utility rooms) and, in some facilities, individual office and storage space leased on an as available basis to the tenants.
(3) Raised square footage is that portion of gross building area where the tenants locate their computer servers. The Company considers raised square footage to be the net rentable square footage in each of its facilities.
(4) Critical load (also referred to as IT load or load used by tenants’ servers or related equipment) is the power available for exclusive use by tenants expressed in terms of megawatt, or MW, or kilowatt, or kW (1 MW is equal to 1,000 kW).
(5) Percentage leased is expressed as a percentage of critical load that is subject to an executed lease. Percentage commenced is expressed as a percentage of critical load where the lease has commenced under generally accepted accounting principles. Leases executed as of December 31, 2011 represent $192 million of base rent on a straight-line basis and $190 million on a cash basis over the next twelve months. This excludes contractual management fees and approximately $3 million net amortization increase in revenue of above and below market leases.
(6) As of February 7, 2012, SC1 Phase I is 25% leased and commenced.
Development Projects
As of December 31, 2011
($ in thousands)
(1) Gross building area is the entire building area, including raised square footage (the portion of gross building area where the tenants’ computer servers are located), tenant common areas, areas controlled by the Company (such as the mechanical, telecommunications and utility rooms) and, in some facilities, individual office and storage space leased on an as available basis to the tenants.
(2) Raised square footage is that portion of gross building area where the tenants locate their computer servers. The Company considers raised square footage to be the net rentable square footage in each of its facilities.
(3) Critical load (also referred to as IT load or load used by tenants’ servers or related equipment) is the power available for exclusive use by tenants expressed in terms of MW or kW (1 MW is equal to 1,000 kW).
(4) Current development projects include land, capitalization for construction and development, capitalized interest and capitalized operating carrying costs, as applicable, upon completion.
(5) Amount capitalized as of December 31, 2011. Future Phase II development projects include only land, shell, underground work and capitalized interest through Phase I opening.
(6) Placed in service on February 1, 2012 with 57% of leases commencing.
The Company derives substantially all of its revenue from rents received from tenants under existing leases at each of the operating properties. Because the Company believes that critical load is the primary factor used by tenants in evaluating data center requirements, rents are based primarily on the amount of power that is made available to tenants, rather than the amount of space that they occupy. In 2011, the Company executed 14 leases and pre-leases representing 24.92 MW of critical load and 133,716 raised square feet of space with an average lease term of 7.9 years. In the third quarter of 2011, the Company also renewed for an additional eight years a lease for 9.6 MW of critical load and 90,000 raised square feet which now expires in 1.6 MW increments in 2020 through 2025.
Each of the Company’s leases includes pass-through provisions under which tenants are required to pay for their pro rata share of most of the property-level operating expenses, such as real estate taxes and insurance-commonly referred to as a triple net lease. In addition, under the Company’s triple-net lease structure, tenants pay for only the power they use and power that is used to cool their space. The Company intends to continue to structure future leases as triple net leases. The Company’s leases also provide it with a property management fee based on a percentage of base rent collected and property-level operating expenses, other than charges for power used by tenants to run their servers and cool their space. Also, most of the Company’s leases provide for annual rent increases, generally at a rate of 3% or a function of the consumer price index.
The Company leases space on a long-term basis, and the Company’s weighted average remaining lease term was approximately 6.6 years as of December 31, 2011. Although less than 10% of the Company’s leases-in terms of annualized base rent - are scheduled to expire through 2014, the Company’s ability to generate rental income over time will depend on its ability to retain tenants when their leases expire and re-lease space available from leases that expire or are terminated at attractive rates. Changes in the conditions of any of the markets in which the Company’s operating properties are located will impact the overall performance of the Company’s current and future operating properties and the Company’s ability to fully lease its properties. The ability of the Company’s tenants to fulfill their lease commitments could be impacted by future economic or regional downturns in the markets in which the Company operates or downturns in the technology industry.
The opportunity for revenue growth in the near term primarily depends on the Company’s ability to lease vacant space in four of its operating properties that were recently placed into service-ACC6 Phase I, NJ1 Phase I, SC1 Phase I and CH1 Phase II. In each of its stabilized properties, the Company has been able to lease vacant space at rates that provide a favorable return on its investment in these facilities. Recently, there appears to be increased pricing pressure in some of the markets in which we compete, including lower rates and concessions. It is unclear to what extent this will adversely impact the rental rates that the Company can obtain as it pursues leasing available space at the four properties we recently placed into service. The returns on the Company’s investments it has achieved to date would be impacted negatively if it is unable to lease vacant space at net effective rental rates equal to or above its current average net effective rental rates.
The Company receives expense reimbursement from tenants only on space that is leased. Vacant space results in portions of the Company’s operating expenses being unreimbursed, which in turn negatively impacts revenues and net income. It is difficult for the Company to predict the timing for signing and commencing leases for available space. This uncertainty is particularly true with respect to the leasing of vacant space in data center facilities that are located in new markets for the Company-NJ1 Phase I in Piscataway, New Jersey and SC1 Phase I in Santa Clara, California.
Our three largest tenants comprised 55% of our annualized base rent as of December 31, 2011, and none of our three largest tenants’ leases have early termination rights. The Company expects these tenants to evaluate their lease expirations in the year before expiration is scheduled to occur, taking into account, among other factors, their anticipated need for server capacity and economic factors. If the Company cannot renew these leases at similar rates or attract replacement tenants on similar terms in a timely manner, the Company’s rental income could be materially adversely impacted in future periods.
The Company’s second largest tenant, Yahoo!, comprising 18.3% of the Company’s annualized base rent as of December 31, 2011, with lease expirations ranging from 2012 to 2019, informed the Company in June 2011 that it will not renew one of its leases comprising 3.2% of the Company’s consolidated annualized base rent as of December 31, 2011. This lease will expire on April 30, 2012 and the Company is actively marketing this space. This tenant’s next lease is scheduled to expire in the third quarter of 2015 and a third lease is scheduled to expire ratably in equal amounts in 2017, 2018 and 2019.
The Company’s taxable REIT subsidiary (“TRS”), DF Technical Services, LLC, generates revenue by providing certain technical services to the Company’s tenants on a non-recurring contract or purchase-order basis, which the Company refers to as “a la carte” services. Such services include the installation of circuits, racks, breakers and other tenant requested items. The TRS will generally charge tenants for these services on a cost-plus basis. Because the degree of utilization of the TRS for these services varies from period to period depending on the needs of the tenants for technical services, the Company has limited ability to forecast future revenue from this source. Moreover, as a taxable corporation, the TRS is subject to federal, state and local corporate taxes and is not required to distribute its income, if any, to the Company for purposes of making additional distributions to DFT’s stockholders. Because demand for its services is unpredictable, the Company anticipates that the TRS may retain a significant amount of its cash to fund future operations, and therefore the Company does not expect to receive distributions from the TRS on a regular basis.
In the current economic environment, certain types of real estate have experienced declines in value. If this trend were to be experienced by any of the Company’s data centers, the Company may have to write down the value of that data center, which would result in the Company recording a charge against earnings.
Results of Operations
This Annual Report on Form 10-K contains stand-alone audited and unaudited financial statements and other financial data for each of DFT and the Operating Partnership. DFT is the sole general partner of the Operating Partnership and, as of December 31, 2011, owned 76.7% of the common economic interests in the Operating Partnership, of which approximately 1% is held as general partnership units. All of the Company’s operations are conducted by the Operating Partnership which is consolidated by DFT, and therefore the following information is the same for DFT and the Operating Partnership, except for net income attributable to common shares is not a line item in the Operating Partnership’s consolidated statement of operations.
Year Ended December 31, 2011 Compared to Year Ended December 31, 2010
Operating Revenue. Operating revenue for the year ended December 31, 2011 was $287.4 million. This includes base rent of $193.9 million, tenant recoveries of $91.2 million, which includes our property management fee, and other revenue of $2.3 million. This compares to revenue of $242.5 million for the year ended December 31, 2010. The increase of $44.9 million, or 18.5%, was due to additional rent from the commencement of leases at ACC5 Phase II, CH1 Phase I and NJ1 Phase I, and the opening of ACC6 Phase I in September 2011 and SC1 Phase I in October 2011, partially offset by a decrease in other revenue from a la carte services provided to the tenants on a non-recurring basis due to a lower volume of a la carte projects.
Operating Expenses. Operating expenses for the year ended December 31, 2011 were $178.9 million, compared to $156.7 million for the year ended December 31, 2010. The increase of $22.2 million, or 14.2%, was due to the following: $14.4 million of increased operating costs, real estate taxes and insurance due to the opening of ACC5 Phase II and NJ1 Phase I in November 2010, the opening of ACC6 Phase I in September 2011 and SC1 Phase I in October 2011; $12.6 million increase from depreciation and amortization from ACC5 Phase II, NJ1 Phase I, ACC6 Phase I and SC1 Phase I; a $1.2 million increase in general and administrative expense primarily for compensation partially offset by a reduction of other expense of $6.0 million due to a lower volume of a la carte projects.
Interest Expense. Interest expense, including amortization of deferred financing costs, for the year ended December 31, 2011 was $29.5 million compared to interest expense of $43.2 million for the year ended December 31, 2010. Included in interest in 2010 is $2.5 million for the write-off of deferred financing costs for debt retired in 2010. Total interest incurred for the year ended December 31, 2011 was $57.9 million, of which $28.4 million was capitalized, compared to total interest incurred of $69.6 million in 2010, of which $26.4 million was capitalized. The decrease in total interest incurred period over period was primarily due to lower overall debt balances following the Company’s Series A preferred stock offering in October 2010, the proceeds from which were used to pay off in full a $196.5 million term loan and lower interest rates on the ACC5 Term Loan. On July 29, 2011, the Company executed an amendment to the ACC5 Term Loan that, among other things, removed the 1.5% LIBOR floor and reduced the applicable margin to 3.00%.
Net Income Attributable to Redeemable Noncontrolling Interests-Operating Partnership (DFT only). Net income attributable to redeemable noncontrolling interests-operating partnership for the year ended December 31, 2011 was $14.5 million compared to $13.3 million for the year ended December 31, 2010. The increase of $1.2 million was due to higher net income partially offset by a lower allocation of net income to redeemable noncontrolling interests due to the redemption of 2.9 million OP units in 2011.
Net Income Attributable to Common Shares. Net income attributable to common shares for the year ended December 31, 2011 was $44.1 million as compared to $27.3 million for the year ended December 31, 2010. The increase of $16.8 million was primarily due to higher operating income from new leases commencing and lower interest expense, described above, partially offset by an increase of $17.7 million of the preferred stock dividends due to issuance of $185.0 million of 7.875% Series A Preferred Stock in October 2010 and $ 101.3 million of the 7.625% Series B Preferred Stock in March 2011.
Year Ended December 31, 2010 Compared to Year Ended December 31, 2009
Operating Revenue. Operating revenue for the year ended December 31, 2010 was $242.5 million. This includes base rent of $154.9 million, tenant recoveries of $78.4 million, which includes our property management fee, and other revenue of $9.2 million, primarily from a la carte projects for our tenants performed by our TRS. This compares to revenue of $200.3 million for the year ended December 31, 2009. The increase of $42.2 million, or 21%, was due to the lease-up of CH1 Phase I and ACC5 Phase I, and the opening of ACC5 Phase II and NJ1 Phase I in November 2010, partially offset by a decrease in revenue from a la carte services provided to the tenants on a non-recurring basis due to a lower volume of a la carte projects. Also offsetting the increase in revenue is a $5.1 million reduction in 2010 due to energy costs savings from the Company’s participation in load management and rate setting programs. These energy savings, while a reduction of revenue to the Company, represent a direct reduction of property operating costs as well, due to the triple net lease structure in place with tenants.
Operating Expenses. Operating expenses for the year ended December 31, 2010 were $156.7 million compared to $149.7 million for the year ended December 31, 2009. The increase of $7.0 million, or 5%, was primarily due to the following: $4.1 million of increased operating costs as ACC4, CH1 Phase I and ACC5 Phase I matured in their operations and ACC5 Phase II and NJ1 Phase I were opened in November 2010, which was partially offset by the decrease in energy costs discussed above, $5.8 million increase of depreciation and amortization resulting from a full year of depreciation and amortization of ACC5 Phase I and two months of depreciation and amortization in 2010 from ACC5 Phase II and NJ1 Phase I, $1.4 million of increased general and administrative expenses primarily for compensation partially offset by a decrease of $4.4 million of other expenses for non-recurring tenant projects.
Interest Expense. Interest expense, including amortization of deferred financing costs, for the year ended December 31, 2010 was $43.2 million compared to interest expense of $34.3 million for the year ended December 31, 2009. Included in interest in 2010 is $2.5 million for the write-off of deferred financing costs for debt retired in 2010 as compared to $3.9 million in 2009. Total interest incurred for the year ended December 31,
2010 was $69.6 million, of which $26.4 million was capitalized, as compared total interest incurred of $41.3 million for the year ending December 31, 2009, of which $7.0 million was capitalized. The increase in total interest incurred period over period was primarily due to higher overall debt balances following the unsecured senior notes offering in 2009. Interest capitalized increased period over period as the Company had four projects under development in 2010 as compared to one project under development in 2009.
Loss on discontinuance of cash flow hedge. On December 16, 2009, we completed a $550 million debt offering and repaid and terminated a credit facility, as discussed further below. In addition, the Company paid $13.7 million to terminate the related interest rate swap agreement. In connection with the termination of the credit facility and swap agreement, the Company determined that the forecasted transaction under this swap agreement was no longer probable as originally forecasted and therefore all amounts previously recorded in accumulated other comprehensive loss were recognized in the statement of operations, resulting in $13.7 million being recorded as loss on the discontinuance of cash flow hedge. We did not incur any such loss in 2010.
Net Income Attributable to Redeemable Noncontrolling Interests-Operating Partnership (DFT only). Net income attributable to redeemable noncontrolling interests-operating partnership for the year ended December 31, 2010 was $13.3 million compared to $1.1 million for the year ended December 31, 2009. The decrease of $12.2 million was due to lower net income and a lower allocation of net income to redeemable noncontrolling interests due to the redemption of 3.3 million OP units in 2010.
Net Income Attributable to Common Shares. Net income attributable to common shares for the year ended December 31, 2010 was $27.3 million as compared to $1.8 million for the year ended December 31, 2009. The increase of $25.5 million was primarily due to the discontinuance of cash flow hedge in 2009, higher operating income primarily due to the lease up of ACC5 Phase I and CH1 Phase I, partially offset by higher interest expense and $3.2 million of preferred stock dividends related to the $185 million of preferred stock issued in October 2010.
Liquidity and Capital Resources
Discussion of Cash Flows
Year Ended December 31, 2011 Compared to Year Ended December 31, 2010
The discussion of cash flows below is for both DFT and the Operating Partnership. The only difference between the cash flows of DFT and the Operating Partnership for the year ended December 31, 2011 was a $4.3 million bank account at DFT that is not part of the Operating Partnership and a $0.2 million payment of offering expenses by DFT that is not reflected as a use of cash on the Operating Partnership’s cash flow statement.
Net cash provided by operating activities increased by $48.4 million, or 63.1%, to $125.1 million for the year ended December 31, 2011, as compared to $76.7 million for 2010. The increase is primarily due to new leases commencing at CH1 Phase I and ACC5 since the first quarter of 2010 and lower interest expense.
Net cash used in investing activities increased by $236.7 million, or 152.7%, to $391.7 million for the year ended December 31, 2011 compared to $155.0 million for 2010. This increase primarily consisted of expenditures for projects under development. Development-related expenditures were $351.1 million for the year ended December 31, 2011 which is an increase by $85.9 million year over year. Also, interest capitalized for real estate under development increased by $1.8 million year over year to $27.0 million for the year ended December 31, 2011. The Company expects development-related expenditures and capitalized interest to decrease significantly in 2012 as the Company does not currently have any developments in process since CH1 Phase II was placed in service on February 1, 2012. The Company also acquired 23 acres of land held for future development at a cost of $9.5 million during 2011. Expenditures for improvements to real estate were $3.8 million in the year ended December 31, 2011 which compared to $3.0 million in 2010. In addition during the year ended December 31, 2010, the Company redeemed $199.0 million in marketable securities held to maturity and purchased $60.0 million of these securities. The Company had no redemptions or purchases of marketable securities during the year ended December 31, 2011.
Net cash provided by financing activities decreased by $212.9 million to $54.1 million for the year ended December 31, 2011 compared to $267.0 million for 2010. Cash provided by financing activities for 2011 primarily consisted of $97.5 million of net proceeds from the issuance of 4.1 million shares of Series B Preferred Stock and $20.0 million of borrowings under the revolving credit facility partially offset by $58.6 million paid for dividends and distributions. Cash provided by financing activities for 2010 primarily consisted of $305.2 million of net proceeds from the issuance of 13.8 million shares of common stock, $178.6 million of net proceeds from the issuance of 7.4 million shares of Series A Preferred Stock and $8.9 million return of proceeds escrowed for the ACC5 Term Loan, as defined below, partially offset by $198.5 million of principal payments on the ACC4 Term Loan, as defined below, which was paid off in its entirety in October 2010 and $25.0 million paid for dividends and distributions.
Year Ended December 31, 2010 Compared to Year Ended December 31, 2009
The discussion of cash flows below is for both DFT and the Operating Partnership. The only difference between the cash flows of DFT and the Operating Partnership for the year ended December 31, 2010 was a $4.5 million bank account at DFT that is not part of the Operating Partnership and a $0.2 million payment of taxes by DFT that is not reflected as a use of cash on the Operating Partnership’s cash flow statement.
Net cash provided by operating activities increased by $10.8 million, or 16.4%, to $76.7 million for the year ended December 31, 2010, as compared to $65.9 million for the year ended December 31, 2009. The increase is primarily due to increased cash rents collected.
Net cash used in investing activities decreased by $107.4 million, or 40.9%, to $155.0 million for the year ended December 31, 2010 compared to $262.4 million for the year ended December 31, 2009. Cash used in investing activities for 2010 and 2009 primarily consisted of expenditures for projects under development. In addition, in 2010 and 2009, we invested $60.0 million and $139.0 million, respectively, in marketable securities held to maturity with funds from proceeds from our common stock and debt issuances, which were redeemed as of December 31, 2010. Our development expenditures increased by $151.3 million in 2010 as compared to 2009. In 2010, we had four projects under development, while there was only one project under development for most of 2009.
Net cash provided by financing activities increased by $85.8 million, or 47.4%, to $267.0 million for the year ended December 31, 2010 compared to $181.2 million for the year ended December 31, 2009. Cash provided by financing activities for 2010 primarily consisted of $305.2 million of net proceeds from the issuance of 13.8 million shares of common stock, $178.6 million of net proceeds from the issuance of 7.4 million shares of Series A Preferred Stock and $8.9 million return of proceeds escrowed for the ACC5 Term Loan, as defined below, partially offset by $198.5 million of principal payments on the ACC4 Term Loan, as defined below, which was paid off in its entirety in October 2010 and $25.0 million paid for dividends and distributions. Cash provided by financing activities for 2009 primarily consisted of $881.7 million of proceeds from the issuance of debt, partially offset by the repayment of $650.0 million of debt. Additionally, cash was used to fund an interest reserve of $10.0 million related to the ACC5 Term Loan and pay $21.3 million of financing costs, $13.7 million to terminate an interest rate swap and $5.4 million of dividends and distributions.
Market Capitalization
The following table sets forth the Company’s total market capitalization as of December 31, 2011 (in thousands except per share data):
Capital Structure as of December 31, 2011
(in thousands except per share data)
Capital Resources
The development and construction of wholesale data centers is very capital intensive. This development not only requires the Company to make substantial capital investments, but also increases its operating expenses, which impacts its cash flows from operations negatively until leases are executed and the Company begins to collect cash rents from these leases. In addition, because DFT has elected to be taxed as a REIT for federal income tax purposes, DFT is required to distribute at least 90% of “REIT taxable income,” excluding any net capital gain, to its stockholders annually.
The Company generally funds the cost of data center development from additional capital, which, for future developments, the Company would expect to obtain through unsecured and secured borrowings, construction financings and the issuance of additional preferred and/or common equity, when market conditions permit. In determining the source of capital to meet the Company’s long-term liquidity needs, the Company will evaluate its level of indebtedness and covenants, in particular with respect to the covenants under the Company’s unsecured notes and unsecured line of credit, its expected cash flow from operations, the state of the capital markets, interest rates and other terms for borrowing, and the relative timing considerations and costs of borrowing or issuing equity securities.
In March 2011, the Company sold 4.1 million shares of Series B Preferred Stock, raising net proceeds of approximately $97.5 million. The Company used the net proceeds from this offering, together with borrowings under its revolving credit facility, to complete the development of CH1 Phase II, which was placed in service on February 1, 2012.
The ability to pay dividends to stockholders is dependent on the receipt of distributions from the Operating Partnership, which in turn is dependent on the data center properties generating operating income. The indenture that governs the Company’s unsecured notes limits DFT’s ability to pay dividends, but allows DFT to pay the minimum necessary to meet its REIT income distribution requirements.
Outstanding Indebtedness
A summary of the Company’s total debt as of December 31, 2011 and 2010 is as follows:
Debt Summary as of December 31, 2011 and December 31, 2010
($ in thousands)
Note: The Company capitalized interest and deferred financing cost amortization of $3.3 million and $28.4 million during the three and twelve months ended December 31, 2011, respectively.
(1) Rates as of December 31, 2011.
(2) Repaid in full on January 19, 2012.
ACC5 Term Loan
On December 2, 2009, the Company entered into a $150 million term loan facility (the “ACC5 Term Loan”). An interest reserve in the amount of $10.0 million was withheld from the loan proceeds and the remaining interest reserve was classified as restricted cash on the Company’s consolidated balance sheets. As of December 31, 2011, this interest reserve was zero as the reserve was fully utilized for interest payments. Prior to July 1, 2011, borrowings under this loan bore interest at LIBOR plus 4.25% with a LIBOR floor of 1.5%. As of July 1, 2011, the interest rate decreased to LIBOR plus 4.00%. On July 29, 2011, the Company amended the ACC5 Term Loan to, among other things, remove the 1.5% LIBOR floor and reduce the applicable margin to 3.00%. As of December 31, 2011, the interest rate for this loan was 3.3%.
The ACC5 Term Loan matures on December 2, 2014. The Company is prohibited from prepaying the ACC5 Term Loan prior to July 31, 2012 and, from July 31, 2012 through November 30, 2012, the Company may prepay the loan, in whole or in part, if it pays exit fees ranging from 0.75% to 1.00% of the then-outstanding principal balance. After November 30, 2012, the Company may prepay the ACC5 Term Loan at any time, in whole or in part, without penalty or premium. The Company may increase the total loan on or before June 30, 2012 to not more than $250 million, subject to lender commitments, receipt of new appraisals of the ACC5 and ACC6 property, a minimum debt service coverage ratio of no less than 1.65 to 1, and a maximum loan-to-value of 50%.
The loan is secured by the ACC5 and ACC6 data centers and an assignment of the lease agreements between the Company and the tenants of ACC5 and ACC6. The Operating Partnership has guaranteed the outstanding principal amount of the ACC5 Term Loan, plus interest and certain costs under the loan.
The ACC5 Term Loan requires ongoing compliance with various covenants, including with respect to restrictions on liens, incurring indebtedness, making investments, effecting mergers and/or assets sales and maintenance of certain leases. In addition, the ACC5 Term Loan requires ongoing compliance with certain financial covenants, including, without limitation, the following:
•
The principal amount of the loan may not exceed 60% of the appraised value of ACC5 and ACC6;
•
The Company must maintain a minimum debt service coverage ratio of 1.50 to 1; provided, however, that if the Company exercises its right to increase the total amount of the loan above $150 million, 1.65 to 1;
•
Consolidated total indebtedness of the Operating Partnership and its subsidiaries to gross asset value of the Operating Partnership and its subsidiaries must not exceed 65% during the term of the loan;
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Ratio of adjusted consolidated Earnings Before Interest Taxes Depreciation and Amortization to consolidated fixed charges must not be less than 1.45 to 1 during the term of the loan; and
•
Minimum consolidated tangible net worth of the Operating Partnership and its subsidiaries must not be less than approximately $575 million (plus 75% of the sum of (i) the net proceeds from any offerings after December 2, 2009 and (ii) the value of any interests in the Operating Partnership or DFT issued upon the contribution of assets to DFT, the Operating Partnership or its subsidiaries after December 2, 2009) during the term of the loan.
The terms of the ACC5 Term Loan limit the Company’s investment in development properties to $1 billion and the Company is not permitted to have more than five properties in development at any time. If a development property is being developed in multiple phases, only the phase actually being constructed shall be considered a development property for this test. Once construction of a phase is substantially complete and the phase is 80% leased, it is no longer deemed a development property for purposes of this covenant.
The credit agreement that governs the ACC5 Term Loan also has customary events of default, including, but not limited to, nonpayment, breach of covenants, and payment or acceleration defaults in certain other of the Company’s indebtedness. Upon an event of default, the lenders may declare the loan due and immediately payable. Also, upon a change in control, lenders that hold two-thirds of the outstanding principal amount of the loan may declare it due and payable.
The credit agreement that governs the ACC5 Term Loan contains definitions of many of the terms used in this summary of covenants. The Company was in compliance with all of the covenants under the loan as of December 31, 2011.
Unsecured Notes
On December 16, 2009, the Operating Partnership completed the sale of $550 million of 8.5% senior notes due 2017 (the “Unsecured Notes”). The Unsecured Notes were issued at face value. The Company pays interest on the Unsecured Notes semi-annually, in arrears, on December 15 and June 15 of each year. On each of December 15, 2015 and December 15, 2016, $125 million in principal amount of the Unsecured Notes will become due and payable, with the remaining $300 million due on December 15, 2017.
The Unsecured Notes are unconditionally guaranteed, jointly and severally on a senior unsecured basis by DFT and certain of the Operating Partnership’s subsidiaries, including the subsidiaries that own the ACC2, ACC3, ACC4, ACC5, ACC6, VA3, VA4, CH1 and NJ1 data centers (collectively, the “Subsidiary Guarantors”), but excluding the subsidiaries that own the SC1 data center, the ACC7, ACC8 and SC2 parcels of land, and the Company’s taxable REIT subsidiary (“TRS”), DF Technical Services, LLC.
The Unsecured Notes rank (i) equally in right of payment with all of the Operating Partnership’s existing and future senior unsecured indebtedness, (ii) senior in right of payment with all of its existing and future
subordinated indebtedness, (iii) effectively subordinate to any of the Operating Partnership’s existing and future secured indebtedness and (iv) effectively junior to any liabilities of any subsidiaries of the Operating Partnership that do not guarantee the Unsecured Notes. The guarantees of the Unsecured Notes by DFT and the Subsidiary Guarantors rank (i) equally in right of payment with such guarantor’s existing and future senior unsecured indebtedness, (ii) senior in right of payment with all of such guarantor’s existing and future subordinated indebtedness and (iii) effectively subordinate to any of such guarantor’s existing and future secured indebtedness.
At any time prior to December 15, 2013, the Operating Partnership may redeem the Unsecured Notes, in whole or in part, at a price equal to the sum of (i) 100% of the principal amount of the Unsecured Notes to be redeemed, plus (ii) a make-whole premium and accrued and unpaid interest. On or after December 15, 2013, the Operating Partnership may redeem the Unsecured Notes, in whole or in part, at (i) 104.250% from December 15, 2013 to December 14, 2014, (ii) 102.125% from December 15, 2014 to December 14, 2015 and (iii) 100% of the principal amount of the Unsecured Notes from December 15, 2015 and thereafter, in each case plus accrued and unpaid interest. In addition, on or prior to December 15, 2012, the Operating Partnership may redeem up to 35% of the Unsecured Notes at 108.500% of the principal amount thereof, plus accrued and unpaid interest, with the net cash proceeds of certain equity offerings consummated by DFT or the Operating Partnership.
If there is a change of control (as defined in the Indenture) of the Operating Partnership or DFT, Unsecured Note holders can require the Operating Partnership to purchase their Unsecured Notes at a price equal to 101% of the principal amount thereof, plus accrued and unpaid interest. In addition, in certain circumstances the Operating Partnership may be required to use the net proceeds of asset sales to purchase a portion of the Unsecured Notes at 100% of the principal amount thereof, plus accrued and unpaid interest.
The Unsecured Notes have certain covenants limiting or prohibiting the ability of the Operating Partnership and certain of its subsidiaries from, among other things, (i) incurring secured or unsecured indebtedness, (ii) entering into sale and leaseback transactions, (iii) making certain dividend payments, distributions and investments, (iv) entering into transactions with affiliates, (v) entering into agreements limiting the ability to make certain transfers and other payments from subsidiaries or (vi) engaging in certain mergers, consolidations or transfers/sales of assets. The Unsecured Notes also require the Operating Partnership and the Subsidiary Guarantors to maintain total unencumbered assets of at least 150% of their unsecured debt on a consolidated basis. All of the covenants are subject to a number of important qualifications and exceptions.
The Unsecured Notes also have customary events of default, including, but not limited to, nonpayment, breach of covenants, and payment or acceleration defaults in certain other indebtedness of the Company or certain of its subsidiaries. Upon an event of default, the holders of the Unsecured Notes or the trustee may declare the Unsecured Notes due and immediately payable. The Company was in compliance with all covenants under the Unsecured Notes as of December 31, 2011.
Unsecured Credit Facility
The Operating Partnership currently has a $100 million unsecured revolving credit facility. The facility has an initial maturity date of May 6, 2013, with a one-year extension option, subject to the payment of an extension fee equal to 50 basis points on the amount of the facility at initial maturity and certain other customary conditions. As of December 31, 2011, the balance of this facility was $20.0 million, which was repaid in full on January 19, 2011.
The facility is unconditionally guaranteed, jointly and severally, on a senior unsecured basis by the Company and all of the Operating Partnership’s subsidiaries that currently guaranty the obligations under the Company’s Indenture governing the terms of the Unsecured Notes, including the subsidiaries that own the ACC2, ACC3, ACC4, ACC5, ACC6, VA3, VA4, CH1 and NJ1 data centers, but excluding the subsidiaries that own the SC1 data center, the ACC7, ACC8 and SC2 parcels of land, and the TRS.
The Company may elect to have borrowings under the facility bear interest at either LIBOR or a base rate, in each case plus an applicable margin. The applicable margin added to LIBOR and the base rate is based on the table below.
As of December 31, 2011, the applicable margin was set at pricing level 1. The terms of the facility provide for the adjustment of the applicable margin from time to time according to the ratio of the Operating Partnership’s total indebtedness to gross asset value in effect from time to time.
The amount available for borrowings under the facility is determined according to a calculation comparing the value of certain unencumbered properties designated by the Operating Partnership at such time relative to the amount of the Operating Partnership’s unsecured debt. As of December 31, 2011, $80.0 million of the facility was available for borrowing. Up to $25 million of borrowings under the facility may be used for letters of credit. No letters of credit were outstanding at December 31, 2011.
The facility requires that the Company, the Operating Partnership and their subsidiaries comply with various covenants, including with respect to restrictions on liens, incurring indebtedness, making investments, effecting mergers and/or asset sales, and certain restrictions on dividend payments. In addition, the facility imposes financial maintenance covenants relating to, among other things, the following matters:
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unsecured debt not exceeding 60% of the value of unencumbered assets;
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net operating income generated from unencumbered properties divided by the amount of unsecured debt being not less than 12.5%;
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total indebtedness not exceeding 60% of gross asset value;
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fixed charge coverage ratio being not less than 1.70 to 1.00; and
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tangible net worth being not less than $750 million plus 80% of the sum of (i) net equity offering proceeds and (ii) the value of equity interests issued in connection with a contribution of assets to the Operating Partnership or its subsidiaries.
The facility includes customary events of default, the occurrence of which, following any applicable cure period, would permit the lenders to, among other things, declare the principal, accrued interest and other obligations of the Operating Partnership under the facility to be immediately due and payable. The Company was in compliance with all covenants under the facility as of December 31, 2011.
A summary of the Company’s debt maturity schedule as of December 31, 2011 is as follows:
Debt Maturity as of December 31, 2011
($ in thousands)
(1) The Unsecured Notes have mandatory amortizations of $125.0 million due in 2015, $125.0 million due in 2016 and $300.0 million due in 2017.
(2) The ACC5 Term Loan matures on December 2, 2014 with no extension option and requires quarterly principal payments of $1.3 million through maturity.
(3) The Unsecured Credit Facility matures on May 6, 2013 with a one-year extension option. The $20 million outstanding as of December 31, 2011 was repaid in full on January 19, 2012.
(4) Rates as of December 31, 2011.
Indebtedness Retired During 2010
ACC4 Term Loan
On October 24, 2008, the Company entered into a credit agreement relating to a $100.0 million term loan with a syndicate of lenders (the “ACC4 Term Loan”). The Company increased this loan to $250.0 million in February 2009 through the exercise of the loan’s “accordion” feature. In December 2009, the Company repaid $50.0 million of the outstanding principal amount. In October 2010, the Company paid off the $196.5 million remaining balance of the ACC4 Term Loan which resulted in a write-off of unamortized deferred financing costs of $2.5 million in the fourth quarter of 2010. The ACC4 Term Loan bore interest at LIBOR plus 3.50%.
Contractual Obligations
The following table summarizes the Company’s contractual obligations as of December 31, 2011, including the maturities assuming extension options are not exercised and scheduled principal repayments of the ACC5 Term Loan and the Unsecured Notes (in thousands):
(1) Included in the 2013-2014 long-term debt obligations is $20.0 million due under the Company’s Unsecured Credit Facility which was repaid on January 19, 2012.
Off-Balance Sheet Arrangements
As December 31, 2011, the Company did not have any off-balance sheet arrangements.
Critical Accounting Policies
The Company has provided a summary of its significant accounting policies in Note 2 to its financial statements included elsewhere in this Form 10-K. The preparation of these financial statements in conformity with GAAP requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. The Company’s actual results may differ from these estimates. The Company describes below those accounting policies that it deems critical and requires material subjective or complex judgments and that have the most significant impact on its financial condition and results of operations. The Company’s management evaluates these estimates on an ongoing basis, based upon information currently available and on various assumptions management believes are reasonable as of the date hereof.
Revenue Recognition. Rental income is recognized using the straight-line method over the terms of the tenant leases, which commences when control of the space and the critical power have been provided to the tenant. Deferred rent included in the Company’s consolidated balance sheets represents the aggregate excess of rental revenue recognized on a straight-line basis over the contractual rental payments that will be recognized under the remaining terms of the leases. The Company’s leases contain provisions under which the tenants reimburse it for a portion of property operating expenses it incurs. Such reimbursements are recognized in the period that the expenses are incurred. The Company recognizes amortization of the value of acquired above market tenant leases as a reduction of rental revenue and of below market leases as an increase to rental revenue.
The Company must make subjective estimates as to when its revenue is earned, including a determination of the lease commencement date for accounting purposes, the existence of lease inducements and early termination clauses with penalty payments and the collectability of its accounts receivable related to rent, deferred rent, expense reimbursements and other income. The Company analyzes individual accounts receivable and historical bad debts, tenant concentrations, tenant creditworthiness and current economic trends when evaluating the adequacy of the allowance for bad debts. These estimates have a direct impact on net income because a higher bad debt allowance would result in lower net income, and recognizing rental revenue as earned in one period versus another would result in higher or lower net income for a particular period.
Capitalization of costs. The Company capitalizes direct and indirect costs related to construction and development, including property taxes, insurance and financing costs relating to properties under development. In addition, the Company ceases cost capitalization after a development is placed in service and a certificate of occupancy is obtained, or if a project is temporarily suspended. The Company capitalizes pre-acquisition costs related to probable property acquisitions. The selection of costs to capitalize and the determination of whether a proposed acquisition is probable are subjective and depends on many assumptions including the timing of potential acquisitions and the probability that future acquisitions occur. Variations in these assumptions would yield different amounts of capitalized costs in the periods presented. All capital improvements for the income producing properties that extend the property’s useful life are capitalized. For the year ended December 31, 2011, the Company capitalized $3.6 million of internal development and leasing costs on all of its data centers.
Useful lives of assets. The Company is required to make subjective assessments as to the useful lives of the major components of its properties for purposes of determining the amount of depreciation to record on an annual basis with respect to its investments in real estate. These assessments have a direct impact on the Company’s net income. The following presents the major components of the Company’s properties and the useful lives over which they are depreciated.
The Company regularly performs preventive maintenance on its data center components to ensure continual operation and avoid downtime at its data centers. These maintenance costs are expensed as incurred and included as property operating costs in the Company’s consolidated statement of operations. The Company’s triple-net leases provide for the reimbursement of the tenant’s share of these costs and the reimbursements are included as recoveries from tenants on the Company’s consolidated statement of operations.
Asset impairment evaluation. The Company reviews the carrying value of its net real estate on a quarterly and annual basis. The Company bases its review on an estimate of the undiscounted future cash flows (excluding interest charges) expected to result from the real estate investment’s use and eventual disposition. The Company considers factors such as future operating income, trends and prospects, as well as the effects of leasing demand, competition and other factors. If the Company’s evaluation indicates that it may be unable to recover the carrying value of a real estate investment, an impairment loss would be recorded to the extent that the carrying value exceeds the estimated fair value of the property, which would result in an immediate negative adjustment to net income. The evaluation of anticipated cash flows is highly subjective and is based in part on assumptions regarding future occupancy, rental rates and capital requirements that could differ materially from actual results in future periods.
Since cash flows from properties considered to be long-lived assets to be held and used are considered on an undiscounted basis to determine whether an asset has been impaired, the Company’s strategy of holding properties over the long-term directly decreases the likelihood of recording an impairment loss. If this strategy changes or market conditions dictate an earlier sale date or if the Company determines that development of a project is no longer viable, an impairment loss may be recognized and such loss could be material. If the Company determines that impairment has occurred, the affected assets must be reduced to their fair value. No such impairment losses have been recognized to date. The Company estimates the fair value of rental properties utilizing a discounted cash flow analysis that includes projections of future revenues, expenses and capital improvement costs, similar to the income approach that is commonly utilized by appraisers.
Funds From Operations
(1) Funds from operations, or FFO, is used by industry analysts and investors as a supplemental operating performance measure for REITs. The Company calculates FFO in accordance with the definition that was adopted by the Board of Governors of the National Association of Real Estate Investment Trusts, or NAREIT. FFO, as defined by NAREIT, represents net income determined in accordance with GAAP, excluding extraordinary items as defined under GAAP, impairment charges on depreciable real estate assets and gains or losses from sales of previously depreciated operating real estate assets, plus specified non-cash items, such as real estate asset depreciation and amortization, and after adjustments for unconsolidated partnerships and joint ventures. The Company also presents FFO attributable to common shares and OP units, which is FFO excluding preferred stock dividends. FFO attributable to common shares and OP units per share is calculated on a basis consistent with net income attributable to common shares and OP units and reflects adjustments to net income for preferred stock dividends.
The Company 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 period over period, captures trends in occupancy rates, rental rates and operating expenses. The Company also believes that, as a widely recognized measure of the performance of equity REITs, FFO may be used by investors as a basis to compare the Company’s operating performance with that of other REITs. However, because FFO excludes real estate related depreciation and amortization and captures neither the changes in the value of the Company’s properties that result from use or market conditions nor the level of capital expenditures and leasing commissions necessary to maintain the operating performance of the Company’s properties, all of which have real economic effects and could materially impact the Company’s results from operations, the utility of FFO as a measure of the Company’s performance is limited.
While FFO is a relevant and widely used measure of operating performance of equity REITs, other equity REITs may use different methodologies for calculating FFO and, accordingly, FFO as disclosed by such other REITs may not be comparable to the Company’s FFO. Therefore, the Company believes that in order to facilitate a clear understanding of its historical operating results, FFO should be examined in conjunction with net income as presented in the consolidated statements of operations. FFO should not be considered as an alternative to net income or to cash flow from operating activities (each as computed in accordance with GAAP) or as an indicator of the Company’s liquidity, nor is it indicative of funds available to meet the Company’s cash needs, including its ability to pay dividends or make distributions.
Related Party Transactions
Land Purchase
In June 2011, the Company purchased an undeveloped parcel of land from an entity controlled by its Chairman of the Board and President and CEO for $9.6 million. The Chairman and the President and CEO owned a 24% and 18% interest in this entity, respectively. One of DFT’s independent directors is a non-managing member of the entity and has a 4% interest in this entity. The location of the parcel, which consists of approximately 23 acres, is adjacent to the Company’s ACC data center campus in Ashburn, Virginia and is being held for development of a 36.4 megawatt data center known as ACC7. The purchase process was managed by the Company’s audit committee, excluding the interested director, and the purchase price was based on appraisals prepared by independent appraisal firms and unanimously approved by the disinterested members of the Audit Committee.
Leasing Arrangements
As of December 31, 2011, the Company leased approximately 9,337 square feet of office space in Washington, D.C., an office building owned by entities affiliated with DFT’s Chairman of the Board and President and Chief Executive Officer. This lease expires in September 2016. The Company believes that the terms of this lease are fair and reasonable and reflect the terms it could expect to obtain in an arm’s length transaction for comparable space elsewhere in Washington, D.C. Rent expense under this lease was $0.4 million for the year ended December 31, 2011.
Aircraft Charter
From time to time during 2011, the Company chartered an aircraft owned by its President and CEO, at rates that the Company believes are fair and reasonable and reflect the terms that it would expect to obtain in an arm’s length transaction for use of a comparable aircraft. For the year ended December 31, 2011, the Company incurred a total of $0.4 million of expense under charters of this aircraft for business-related travel of the Company. For the year ended December 31, 2011, the Company incurred a total of $0.5 million of expenses for personal travel by the President and CEO paid for by the Company in lieu of the CEO’s annual salary under the terms of his employment agreement.
Subsequent Events
In January 2012, DFT issued an additional 2.6 million shares, or $65.0 million, of its Series B Preferred Stock in an underwritten public offering that resulted in proceeds to the Company, net of underwriting discounts, commissions, advisory fees and other offering costs, of $62.6 million. The Company used a portion of the proceeds from this offering to pay off the outstanding balance of its Unsecured Credit Facility and plans to use the remainder for general corporate purposes. For each share of Series B Preferred Stock issued by DFT, the Operating Partnership issued a preferred unit equivalent to DFT with the same terms.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company’s future income, cash flows and fair values relevant to financial instruments are dependent upon prevalent market interest rates. Market risk refers to the risk of loss from adverse changes in market prices and interest rates.
The Company’s variable rate debt consists of the ACC5 Term Loan and the Unsecured Credit Facility. The ACC5 Term Loan bears interest at a rate equal to LIBOR plus an applicable margin and the Unsecured Credit Facility bears interest at a rate equal to LIBOR or a base rate (which is either a prime rate or a federal funds rate) plus an applicable margin. If interest rates were to increase by 1%, the increase in interest expense on the Company’s variable rate debt outstanding as of December 31, 2011 would decrease future net income and cash flows by $1.6 million annually less the impact of capitalization of interest incurred on the Company’s net income. Because one month LIBOR was approximately 0.3% at December 31, 2011, a decrease of 0.3% would increase future net income and cash flows by $0.5 million annually less the impact of capitalization of interest incurred on the Company’s net income. Interest risk amounts were determined by considering the impact of hypothetical interest rates on the Company’s financial instruments. These analyses do not consider the effect of any change in overall economic activity that could occur in that environment. Further, in the event of a change of that magnitude, the Company may take specific actions to further mitigate its exposure to the change. However, due to the uncertainty of the specific actions that would be taken and their possible effects, these analyses assume no changes in the Company’s financial structure. The Company believes that it has effectively managed interest rate exposure because the majority of its indebtedness bears a fixed rate of interest. At December 31, 2011, 77% of the Company’s indebtedness was fixed rate debt. The Company also utilizes preferred stock to raise capital, the dividends required under the terms of which have a coupon rate that is fixed.
Pursuant to the ACC5 Term Loan agreement, the Operating Partnership is required to enter into an interest rate protection agreement upon the earlier to occur of (i) 30 days following the date on which U.S. dollar one month LIBOR equals or exceeds 3.75% or (ii) the occurrence of a default under the ACC5 Term Loan.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of DuPont Fabros Technology, Inc.
We have audited the accompanying consolidated balance sheets of DuPont Fabros Technology, Inc. (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of DuPont Fabros Technology, Inc. at December 31, 2011 and 2010, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2011 in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects, the information set forth herein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), DuPont Fabros Technology, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 23, 2012 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia
February 23, 2012
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of DuPont Fabros Technology, Inc.
We have audited DuPont Fabros Technology, Inc.’s (the “Company”) internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). DuPont Fabros Technology Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting in Item 9A. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, DuPont Fabros Technology, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of DuPont Fabros Technology, Inc. as of December 31, 2011 and 2010, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2011, and our report dated February 23, 2012 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia
February 23, 2012
Report of Independent Registered Public Accounting Firm
The Partners of DuPont Fabros Technology, L.P.
We have audited the accompanying consolidated balance sheets of DuPont Fabros Technology, L.P. (the “Company”) as of December 31, 2011 and 2010, and the related consolidated statements of operations, partners’ capital, and cash flows for each of the three years in the period ended December 31, 2011. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of DuPont Fabros Technology, L.P. at December 31, 2011 and 2010, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2011, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects, the information set forth herein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), DuPont Fabros Technology, L.P’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 23, 2012 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia
February 23, 2012
Report of Independent Registered Public Accounting Firm
The Partners of DuPont Fabros Technology, L.P.
We have audited DuPont Fabros Technology, L.P.’s (the “Company”) internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). DuPont Fabros Technology L.P.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting in Item 9A. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, DuPont Fabros Technology, L.P. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of DuPont Fabros Technology, L.P. as of December 31, 2011 and 2010, and the related consolidated statements of operations, partners’ capital, and cash flows for each of the three years in the period ended December 31, 2011, and our report dated February 23, 2012 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
McLean, Virginia
February 23, 2012
DUPONT FABROS TECHNOLOGY, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
See accompanying notes
DUPONT FABROS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except share and per share data)
See accompanying notes
DUPONT FABROS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except share data)
See accompanying notes
DUPONT FABROS TECHNOLOGY, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
See accompanying notes
DUPONT FABROS TECHNOLOGY, L.P.
CONSOLIDATED BALANCE SHEETS
(in thousands)
See accompanying notes
DUPONT FABROS TECHNOLOGY, L.P.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except unit and per unit data)
See accompanying notes
DUPONT FABROS TECHNOLOGY, L.P.
CONSOLIDATED STATEMENTS OF PARTNERS’ CAPITAL
(in thousands, except unit data)
See accompanying notes
DUPONT FABROS TECHNOLOGY, L.P.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
See accompanying notes
DUPONT FABROS TECHNOLOGY, INC.
DUPONT FABROS TECHNOLOGY, L.P.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2011
1. Description of Business
DuPont Fabros Technology, Inc. (the “REIT” or “DFT”), through its controlling interest in DuPont Fabros Technology, L.P. (the “Operating Partnership” or “OP” and collectively with DFT and their operating subsidiaries, the “Company”), is a fully integrated, self-administered and self-managed company that owns, acquires, develops and operates wholesale data centers. DFT is a real estate investment trust, or REIT, for federal income tax purposes and is the sole general partner of the Operating Partnership and, as of December 31, 2011, owned 76.7% of the common economic interests in the Operating Partnership, of which 1.1% is held as general partnership units. As of December 31, 2011, the Company holds a fee simple interest in the following properties:
•
ten operating data centers-referred to as ACC2, ACC3, ACC4, ACC5, ACC6 Phase I, VA3, VA4, CH1 Phase I, NJ1 Phase I and SC1 Phase I;
•
a data center project under development-referred to as CH1 Phase II;
•
data center projects available for future development-the second phases of ACC6, NJ1 and SC1; and
•
land that may be used to develop additional data centers-referred to as ACC7, ACC8 and SC2.
In the second quarter of 2011, the Company acquired land for development of a 36.4 megawatt data center that will be known as ACC7. The land held to develop a 10.4 megawatt data center formerly known as ACC7 was renamed ACC8.
ACC6 Phase I and SC1 Phase I were placed in service on September 1, 2011 and October 1, 2011, respectively. CH1 Phase II was placed in service on February 1, 2012.
2. Significant Accounting Policies
Basis of Presentation
This report combines the annual reports on Form 10-K for the year ended December 31, 2011 of DuPont Fabros Technology, Inc. and DuPont Fabros Technology, L.P. References to the “REIT” or “DFT” mean DuPont Fabros Technology, Inc. and its controlled subsidiaries; and references to the “Operating Partnership” or “OP” mean DuPont Fabros Technology, L.P. and its controlled subsidiaries. The term “the Company” refers to DFT and the Operating Partnership, collectively.
DFT is a real estate investment trust and the general partner of the Operating Partnership. The Operating Partnership’s capital includes general and limited common operating partnership units, or “OP units”. As of December 31, 2011, DFT owned 76.7% of the common economic interest in the Operating Partnership, with the remaining interest being owned by investors. As the sole general partner of the Operating Partnership, DFT has exclusive control of the Operating Partnership’s day-to-day management.
The Company believes combining the annual reports on Form 10-K of DFT and the Operating Partnership into this single report provides the following benefits:
•
enhances investors’ understanding of DFT 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 DFT and the Operating Partnership; and
•
creates time and cost efficiencies through the preparation of one combined report instead of two separate reports.
Management operates DFT and the Operating Partnership as one business. The management of DFT consists of the same members as the management of the Operating Partnership.
The Company believes it is important for investors to understand the few differences between DFT and the Operating Partnership in the context of how DFT and the Operating Partnership operate as a consolidated company. DFT is a REIT, whose only material asset is its ownership of OP units of the Operating Partnership. As a result, DFT does not conduct business itself, other than acting as the sole general partner of the Operating Partnership, issuing public equity from time to time and guaranteeing unsecured debt of the Operating Partnership. DFT has not issued any indebtedness, but has guaranteed all of the unsecured debt of the Operating Partnership. The Operating Partnership holds all the real estate assets of the Company. Except for net proceeds from public equity issuances by DFT, which are contributed to the Operating Partnership in exchange for OP units or preferred units, the Operating Partnership generates all remaining capital required by the Company’s business. These sources include the Operating Partnership’s operations, its direct or indirect incurrence of indebtedness, and the issuance of partnership units.
As general partner with control of the Operating Partnership, DFT consolidates the Operating Partnership for financial reporting purposes. The presentation of stockholders’ equity and partners’ capital are the main areas of difference between the consolidated financial statements of DFT and those of the Operating Partnership. The Operating Partnership’s capital includes preferred units and general and limited common units that are owned by DFT and the other partners. DFT’s stockholders’ equity includes preferred stock, common stock, additional paid in capital and accumulated deficit. The common limited partnership interests held by the limited partners (other than DFT) in the Operating Partnership are presented as “redeemable partnership units” in the Operating Partnership’s consolidated financial statements and as “redeemable noncontrolling interests-operating partnership” in DFT’s consolidated financial statements. The only difference between the total assets and cash flows of DFT and the Operating Partnership as of and for the year ended December 31, 2011 is a $4.3 million bank account held by DFT that is not part of the Operating Partnership and a $0.2 million payment of offering expenses paid by DFT that is not reflected as a use of cash on the Operating Partnership’s statement of cash flow. Net income is the same for DFT and the Operating Partnership.
In order to highlight the few differences between DFT and the Operating Partnership, there are sections in this report that discuss DFT and the Operating Partnership separately, including separate financial statements, controls and procedures sections, and separate Exhibit 31 and 32 certifications. In the sections that combine disclosure for DFT and the Operating Partnership, this report refers 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, we believe that reference to the Company in this context is appropriate because the business is one enterprise and the Company operates the business through the Operating Partnership.
The accompanying consolidated financial statements have been prepared by management in accordance with U.S. generally accepted accounting principles, or GAAP. All significant intercompany accounts and transactions have been eliminated in the consolidated financial statements.
The Company has one reportable segment consisting of investments in data centers located in the United States. All of our properties generate similar types of revenues and expenses related to tenant rent and reimbursements and operating expenses. The delivery of our products is consistent across all properties and although services are provided to a range of customers, the types of services provided to them are limited to a few core principles. As such, the properties in our portfolio have similar economic characteristics and the nature of the products and services provided to our customers and the method to distribute such services are consistent throughout the portfolio.
Use of Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
Property
All capital improvements for the income-producing properties that extend their useful life are capitalized to individual building components, including interest and real estate taxes incurred during the period of development, and depreciated over their estimated useful lives. Interest is capitalized during the period of development based upon applying the property’s specific borrowing rate to the actual development costs expended up to specific borrowings and then applying the weighted-average borrowing rate of the Company to the residual actual development costs expended during the construction period. Interest is capitalized until the property has reached substantial completion and is ready for its intended use. Interest costs capitalized totaled $28.4 million, $26.4 million and $7.0 million for the years ended December 31, 2011, 2010 and 2009, respectively. The Company ceases interest capitalization when a development is temporarily suspended or placed in service.
The Company capitalizes pre-development costs, including internal costs, incurred in pursuit of new development opportunities for which the Company currently believes future development is probable. Future development is dependent upon various factors, including zoning and regulatory approval, rental market conditions, construction costs and availability of capital. Pre-development costs incurred for which future development is not yet considered probable are expensed as incurred. In addition, if the status of such a pre-development opportunity changes, making future development by the Company no longer probable, any capitalized pre-development costs are written-off with a charge to expense. Furthermore, the revenue from incidental operations received from the current improvements in excess of any incremental costs are being recorded as a reduction of total capitalized costs of the development project and not as a part of net income. The capitalization of costs during the development of assets (including interest and related loan fees, property taxes and other direct and indirect costs) begins when development efforts commence and ends when the asset, or a portion of the asset, is substantially complete and ready for its intended use.
The fair value of in-place leases consists of the following components as applicable-(1) the estimated cost to replace the leases, including foregone rents during the period of finding a new tenant, foregone recovery of tenant pass-through, tenant improvements, and other direct costs associated with obtaining a new tenant (referred to as Tenant Origination Costs); (2) the estimated leasing commissions associated with obtaining a new tenant (referred to as Leasing Commissions); and (3) the above/below market cash flow of the leases, determined by comparing the projected cash flows of the leases in place to projected cash flows of comparable market-rate leases (referred to as Lease Intangibles). Tenant Origination Costs are included in buildings and improvements on the Company’s consolidated balance sheet and are amortized as depreciation expense on a straight-line basis over the average remaining life of the underlying leases. Leasing Commissions are classified as deferred costs and are amortized as amortization expense on a straight-line basis over the remaining life of the underlying leases. Lease Intangible assets and liabilities are classified as lease contracts above and below market value, respectively, and amortized on a straight-line basis as decreases and increases, respectively, to rental revenue over the remaining life of the underlying leases. Should a tenant terminate its lease, the unamortized portions of Leasing Commissions, and Lease Intangibles associated with that lease are written off to amortization expense, or rental revenue, respectively.
Depreciation on buildings is generally provided on a straight-line basis over 40 years from the date the buildings were placed in service. Building components are depreciated over the life of the respective improvement ranging from 20 to 40 years from the date the components were placed in service. Personal
property is depreciated over three to seven years. Depreciation expense was $70.6 million, $58.0 million and $52.0 million for the years ended December 31, 2011, 2010 and 2009, respectively. Included in these amounts is depreciation expense related to tenant origination costs, which was $4.3 million for the year ended December 31, 2011 and $4.8 million for each of the years ended December 31, 2010 and 2009. Repairs and maintenance costs are expensed as incurred.
The Company records impairment losses on long-lived assets used in operations or in development when events or changes in circumstances indicate that the assets might be impaired, and the estimated undiscounted cash flows to be generated by those assets are less than the carrying amounts. If circumstances indicating impairment of a property are present, the Company would determine the fair value of that property, and an impairment loss would be recognized in an amount equal to the excess of the carrying amount of the impaired asset over its fair value. Management assesses the recoverability of the carrying value of its assets on a property-by-property basis. No impairment losses were recorded during the three years ended December 31, 2011.
The Company classifies a data center property as held-for-sale when it meets the necessary criteria, which include when the Company commits to and actively embarks on a plan to sell the asset, the sale is expected to be completed within one year under terms usual and customary for such sales, and actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn. Data center properties held-for-sale are carried at the lower of cost or fair value less costs to sell. As of December 31, 2011, there were no data center properties classified as held-for-sale and discontinued operations.
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 a concentration of credit risk related to amounts on deposit in excess of FDIC insurance coverage. The Company has not experienced any losses and believes that the risk is not significant.
Deferred Costs
Deferred costs, net on the Company’s consolidated balance sheets include both financing costs and leasing costs.
Financing costs, which represent fees and other costs incurred in obtaining debt, are amortized using the effective-interest rate method or a method that approximates the effective-interest method, over the term of the loan and are included in amortization of deferred financing costs. In 2010, the Company paid off the $196.5 million balance of the ACC4 Term Loan which resulted in a write-off of $2.5 million of unamortized deferred financing costs. In 2009, the Company paid off the CH1 construction loan, a credit facility, the ACC5 construction loan and the SC1 term loan resulting in the write-off of $3.9 million in of unamortized deferred financing costs. Balances, net of accumulated amortization, at December 31, 2011 and 2010 are as follows (in thousands):
Leasing costs, which are either external fees and costs incurred in the successful negotiations of leases, internal costs expended in the successful negotiations of leases or the estimated leasing commissions resulting from the allocation of the purchase price of ACC2, VA3, VA4 and ACC4, 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. The Company incurred leasing costs of $1.8 million, $2.6 million and $2.9 million for the years ended December 31, 2011, 2010 and 2009, respectively. Amortization of deferred leasing costs totaled $4.5 million for each of the years ended December 31, 2011 and 2010, respectively, and $4.7 million for the year ended December 31, 2009. Balances, net of accumulated amortization, at December 31, 2011 and 2010 are as follows (in thousands):
Inventory
The Company maintains fuel inventory for its generators, which is recorded at the lower of cost (on a first-in, first-out basis) or market. At December 31, 2011 and 2010, the fuel inventory was $2.2 million and $2.0 million, respectively, and is included in prepaid expenses and other assets in the accompanying consolidated balance sheets.
Prepaid Rents
Prepaid rents, typically prepayment of the following month’s rent, consist of payments received from tenants prior to the time the payments are earned and are recognized as revenue in subsequent periods when earned.
Rental Income
The Company, as a lessor, has retained substantially all the risks and benefits of ownership and accounts for its leases as operating leases. For lease agreements that provide for scheduled fixed and determinable 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 and critical power have been provided to the tenant. If the lease contains an early termination clause with a penalty payment, the Company determines the lease termination date by evaluating whether the penalty reasonably assures that the lease will not be terminated early. Lease inducements, which include free rent or cash payments to tenants, are amortized as a reduction of rental income over the non-cancellable lease term. Straight-line rents receivable are included in deferred rent on the consolidated balance sheets. Lease intangible assets and liabilities that have resulted from above-market and below-market leases that were acquired are amortized on a straight-line basis as decreases and increases, respectively, to rental revenue over the remaining non-cancellable term of the underlying leases. If a lease terminates prior to the expiration of its initial term, the unamortized portion of lease intangibles associated with that lease will be written off to rental revenue. Balances, net of accumulated amortization, at December 31, 2011 and 2010 are as follows (in thousands):
The Company’s policy is to record a provision for losses on accounts receivable equal to the estimated uncollectible accounts. The estimate is based on management’s historical experience and a review of the current status of the Company’s receivables. The Company will also establish, as necessary, an appropriate allowance for doubtful accounts for receivables arising from the straight-lining of rents. This receivable arises from revenue recognized in excess of amounts currently due under the lease.
Tenant leases generally contain provisions under which the tenants reimburse the Company for a portion of operating expenses and real estate taxes incurred by the property. Recoveries from tenants are included in revenue in the consolidated statements of operations in the period the applicable expenditures are incurred. Recoveries from tenants also include the property management fees that the Company earns from its tenants.
Other Revenue
Other revenue primarily consists of services provided to tenants on a non-recurring basis. This includes projects such as the purchase and installation of circuits, racks, breakers and other tenant requested items. Revenue is recognized on a completed contract basis. Costs of providing these services are included in other expenses in the accompanying consolidated statements of operations.
Income Taxes
DFT elected to be taxed as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”), commencing with the taxable year ended December 31, 2007. In general, a REIT that meets certain organizational and operational requirements and distributes at least 90 percent of its REIT taxable income to its shareholders in a year will not be subject to income tax to the extent of the income it distributes. The Company currently qualifies and intends to continue to qualify as a REIT under the Code. As a result, no provision for federal income taxes on income from continuing operations is required, except for taxes on certain property sales and on income, if any, of the Company’s taxable REIT subsidiary (“TRS”). If DFT fails to qualify as a REIT in any taxable year, it will be subject to federal income tax (including any applicable alternative minimum tax) on its income at regular corporate tax rates for the year in which it does not qualify and the succeeding four years. Although DFT expects to qualify for taxation as a REIT, the Company may be subject to state and local income and franchise taxes and to federal income and excise taxes on any undistributed income.
The Company has elected to treat DF Technical Services LLC, a 100% owned subsidiary of the Operating Partnership, as a TRS. In general, a TRS may perform non-customary services for tenants, hold assets that the Company cannot hold directly and generally may engage in any real estate or non-real estate related business. A TRS is subject to corporate federal and state income taxes on its taxable income at regular statutory tax rates. For the year ended December 31, 2011, the Company recognized an income tax benefit of $0.6 million and recorded this benefit as a reduction of general and administrative expenses in the consolidated statements of operations. For the years ended December 31, 2010 and 2009, the Company incurred income taxes of $0.3 million and $0.4 million, respectively, and recorded these taxes as general and administrative expenses in the consolidated statements of operations.
Redeemable Noncontrolling Interests-Operating Partnership / Redeemable Partnership Units
Redeemable noncontrolling interests-operating partnership, as presented on DFT’s consolidated balance sheets, represent the limited partnership interests in the Operating Partnership (“OP units”) held by individuals and entities other than DFT. These interests are also presented on the Operating Partnership’s consolidated
balance sheets, referred to as “redeemable partnership units.” Accordingly, the following discussion related to redeemable noncontrolling interests-operating partnership of the REIT refers equally to redeemable partnership units of the Operating Partnership.
Redeemable noncontrolling interests-operating partnership, which require cash payment, or allow settlement in shares, but with the ability to deliver the shares outside of the control of DFT, are reported outside of the permanent equity section of the consolidated balance sheets of DFT and Operating Partnership. Redeemable noncontrolling interests-operating partnership are adjusted for income, losses and distributions allocated to OP units not held by DFT (normal noncontrolling interest accounting amount). Adjustments to redeemable noncontrolling interests-operating partnership are recorded to reflect increases or decreases in the ownership of the Operating Partnership by holders of OP units, including in the case of redemptions of OP units for cash or in exchange for shares of DFT’s common stock. If such adjustments result in redeemable noncontrolling interests-operating partnership being recorded at less than the redemption value of the OP units, redeemable noncontrolling interests-operating partnership are further adjusted to their redemption value (see Note 10). Redeemable noncontrolling interests-operating partnership are recorded at the greater of the normal noncontrolling interest accounting amount or redemption value. The following is a summary of activity for redeemable noncontrolling interests-operating partnership for the years ended December 31, 2011, 2010 and 2009 (dollars in thousands):
Net income is allocated to controlling interests and redeemable noncontrolling interests-operating partnership in accordance with the limited partnership agreement of the Operating Partnership. The following is a summary of net income attributable to controlling interests and transfers from redeemable noncontrolling interests-operating partnership for the years ended December 31, 2011, 2010 and 2009 (dollars in thousands):
Comprehensive Income
DFT reports comprehensive income on its consolidated statement of stockholders’ equity and within redeemable noncontrolling interests-operating partnership. The Operating Partnership reports comprehensive income on its consolidated statement of partners’ capital. Comprehensive income is defined as all changes in equity during each period except those resulting from investments by or distributions to shareholders of the REIT or partners of the Operating Partnership. For the years ended December 31, 2011 and 2010, comprehensive income attributable to controlling interests and noncontrolling interests was comprised exclusively of net income attributable to controlling interests and noncontrolling interests.
Earnings Per Share of the REIT
Basic earnings per share is calculated by dividing the net income attributable to common shares for the period by the weighted average number of common shares outstanding during the period using the two class method. Diluted earnings per share is calculated by dividing the net income attributable to common shares for the period by the weighted average number of common and dilutive securities outstanding during the period.
Earnings Per Unit of the Operating Partnership
Basic earnings per unit is calculated by dividing the net income attributable to common units for the period by the weighted average number of common units outstanding during the period using the two class method. Diluted earnings per unit is calculated by dividing the net income attributable to common units for the period by the weighted average number of common and dilutive securities outstanding during the period.
Stock-based Compensation
DFT awards stock-based compensation to employees and members of its Board of Directors in the form of common stock. For each stock award granted by DFT, the OP issues an equivalent common unit, which may be referred to herein as a common share, common stock, or common unit. The Company estimates the fair value of the awards and recognizes this value over the requisite vesting period. The fair value of restricted stock-based compensation is based on the market value of DFT’s common stock on the date of the grant. The fair value of options to purchase common stock is based on the Black-Scholes model.
Compensation paid with Company common shares, which is included in general and administrative expense on the consolidated statements of operations, totaled $6.0 million, $3.8 million and $1.9 million for the years ended December 31, 2011, 2010 and 2009, respectively.
Reclassifications
Certain amounts from the prior year have been reclassified for consistency with the current year presentation.
3. Real Estate Assets
The following is a summary of properties owned by the Company at December 31, 2011 (dollars in thousands):
(1) Properties located in Ashburn, VA (ACC6 Phase II, ACC7 and ACC8); Elk Grove Village, IL (CH1 Phase II); Piscataway, NJ (NJ1 Phase II) and Santa Clara, CA (SC1 Phase II and SC2).
The following presents the major components of the Company’s properties and the useful lives over which they are depreciated.
Component
Component
Life (years)
Land
N/A
Building improvements
Electrical structure-power distribution units
Electrical structure-uninterrupted power supply
Electrical structure-switchgear/transformers
Fire protection
Security systems
Mechanical structure-heating, ventilating and air conditioning
Mechanical structure-chiller pumps/building automation
Mechanical structure-chilled water storage and pipes
4. Intangible Assets and Liabilities
Leasing Costs are classified as deferred costs and are amortized as amortization expense on a straight-line basis over the remaining life of the underlying leases. As of December 31, 2011, these assets have a weighted average remaining life of 7.2 years with estimated future amortization as follows (in thousands):
Lease Intangible assets and liabilities are classified as lease contracts above and below market value, respectively, and amortized on a straight-line basis as decreases and increases, respectively, to rental revenue over the remaining term of the underlying leases. As of December 31, 2011, these net Lease Intangible liabilities have a weighted average remaining life of 10.9 years for above market leases and 5.1 years for below market leases with estimated net future amortization (as an increase (decrease) to rental income) as follows (in thousands):
Tenant Origination Costs are included in buildings and improvements on the Company’s consolidated balance sheet and are amortized as depreciation expense on a straight-line basis over the average remaining life of the underlying leases. As of December 31, 2011, these assets have a weighted average remaining life of 5.2 years with estimated future amortization as follows (in thousands):
5. Leases
For the years ended December 31, 2011, 2010 and 2009, the following tenants comprised more than 10% of the Company’s consolidated revenues:
As of December 31, 2011, these three tenants accounted for $15.3 million, $41.3 million and $11.7 million of deferred rent and $5.0 million, $0 and $4.7 million of prepaid rents, respectively. As of December 31, 2010, these three tenants accounted for $16.1 million, $23.8 million and $13.6 million of deferred rent and $5.1 million, $0 and $4.7 million of prepaid rents, respectively. The Company does not hold security deposits from these tenants. The majority of the Company’s tenants operate within the technology industry and, as such, their viability is subject to market fluctuations in that industry.
As of December 31, 2011, future minimum lease payments to be received under noncancelable operating leases are as follows for the years ending December 31, excluding properties under development (in thousands):
6. Debt
Debt Summary as of December 31, 2011 and December 31, 2010
($ in thousands)
Note: The Company capitalized interest and deferred financing cost amortization of $3.3 million and $28.4 million during the three and twelve months ended December 31, 2011, respectively.
(1) Rates as of December 31, 2011.
(2) Repaid in full on January 19, 2012.
Outstanding Indebtedness
ACC5 Term Loan
On December 2, 2009, the Company entered into a $150 million term loan facility (the “ACC5 Term Loan”). An interest reserve in the amount of $10.0 million was withheld from the loan proceeds and the remaining interest reserve was classified as restricted cash on the Company’s consolidated balance sheets. As of December 31, 2011, this interest reserve was zero as the reserve was fully utilized for interest payments. Prior to July 1, 2011, borrowings under this loan bore interest at LIBOR plus 4.25% with a LIBOR floor of 1.5%. As of July 1, 2011, the interest rate decreased to LIBOR plus 4.00%. On July 29, 2011, the Company amended the ACC5 Term Loan to, among other things, removed the 1.5% LIBOR floor and reduced the applicable margin to 3.00%. As of December 31, 2011, the interest rate for this loan was 3.3%.
The ACC5 Term Loan matures on December 2, 2014. The Company is prohibited from prepaying the ACC5 Term Loan prior to July 31, 2012 and, from July 31, 2012 through November 30, 2012, the Company may prepay the loan, in whole or in part, if it pays exit fees ranging from 0.75% to 1.00% of the then-outstanding principal balance. After November 30, 2012, the Company may prepay the ACC5 Term Loan at any time, in whole or in part, without penalty or premium. The Company may increase the total loan on or before June 30, 2012 to not more than $250 million, subject to lender commitments, receipt of new appraisals of the ACC5 and ACC6 property, a minimum debt service coverage ratio of no less than 1.65 to 1, and a maximum loan-to-value of 50%.
The loan is secured by the ACC5 and ACC6 data centers and an assignment of the lease agreements between the Company and the tenants of ACC5 and ACC6. The Operating Partnership has guaranteed the outstanding principal amount of the ACC5 Term Loan, plus interest and certain costs under the loan.
The ACC5 Term Loan requires ongoing compliance with various covenants, including with respect to restrictions on liens, incurring indebtedness, making investments, effecting mergers and/or assets sales and maintenance of certain leases. In addition, the ACC5 Term Loan requires ongoing compliance with certain financial covenants, including, without limitation, the following:
•
The principal amount of the loan may not exceed 60% of the appraised value of ACC5 and ACC6;
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The Company must maintain a minimum debt service coverage ratio of 1.50 to 1; provided, however, that if the Company exercises its right to increase the total amount of the loan above $150 million, 1.65 to 1;
•
Consolidated total indebtedness of the Operating Partnership and its subsidiaries to gross asset value of the Operating Partnership and its subsidiaries must not exceed 65% during the term of the loan;
•
Ratio of adjusted consolidated Earnings Before Interest Taxes Depreciation and Amortization to consolidated fixed charges must not be less than 1.45 to 1 during the term of the loan; and
•
Minimum consolidated tangible net worth of the Operating Partnership and its subsidiaries must not be less than approximately $575 million (plus 75% of the sum of (i) the net proceeds from any offerings after December 2, 2009 and (ii) the value of any interests in the Operating Partnership or DFT issued upon the contribution of assets to DFT, the Operating Partnership or its subsidiaries after December 2, 2009) during the term of the loan.
The terms of the ACC5 Term Loan limit the Company’s investment in development properties to $1 billion and the Company is not permitted to have more than five properties in development at any time. If a development
property is being developed in multiple phases, only the phase actually being constructed shall be considered a development property for this test. Once construction of a phase is substantially complete and the phase is 80% leased, it is no longer deemed a development property for purposes of this covenant.
The credit agreement that governs the ACC5 Term Loan also has customary events of default, including, but not limited to, nonpayment, breach of covenants, and payment or acceleration defaults in certain other of the Company’s indebtedness. Upon an event of default, the lenders may declare the loan due and immediately payable. Also, upon a change in control, lenders that hold two-thirds of the outstanding principal amount of the loan may declare it due and payable.
The credit agreement that governs the ACC5 Term Loan contains definitions of many of the terms used in this summary of covenants. The Company was in compliance with all of the covenants under the loan as of December 31, 2011.
Unsecured Notes
On December 16, 2009, the Operating Partnership completed the sale of $550 million of 8.5% senior notes due 2017 (the “Unsecured Notes”). The Unsecured Notes were issued at face value. The Company pays interest on the Unsecured Notes semi-annually, in arrears, on December 15 and June 15 of each year. On each of December 15, 2015 and December 15, 2016, $125 million in principal amount of the Unsecured Notes will become due and payable, with the remaining $300 million due on December 15, 2017.
The Unsecured Notes are unconditionally guaranteed, jointly and severally on a senior unsecured basis by DFT and certain of the Operating Partnership’s subsidiaries, including the subsidiaries that own the ACC2, ACC3, ACC4, ACC5, ACC6, VA3, VA4, CH1 and NJ1 data centers (collectively, the “Subsidiary Guarantors”), but excluding the subsidiaries that own the SC1 data center, the ACC7, ACC8 and SC2 parcels of land, and the Company’s taxable REIT subsidiary (“TRS”), DF Technical Services, LLC.
The Unsecured Notes rank (i) equally in right of payment with all of the Operating Partnership’s existing and future senior unsecured indebtedness, (ii) senior in right of payment with all of its existing and future subordinated indebtedness, (iii) effectively subordinate to any of the Operating Partnership’s existing and future secured indebtedness and (iv) effectively junior to any liabilities of any subsidiaries of the Operating Partnership that do not guarantee the Unsecured Notes. The guarantees of the Unsecured Notes by DFT and the Subsidiary Guarantors rank (i) equally in right of payment with such guarantor’s existing and future senior unsecured indebtedness, (ii) senior in right of payment with all of such guarantor’s existing and future subordinated indebtedness and (iii) effectively subordinate to any of such guarantor’s existing and future secured indebtedness.
At any time prior to December 15, 2013, the Operating Partnership may redeem the Unsecured Notes, in whole or in part, at a price equal to the sum of (i) 100% of the principal amount of the Unsecured Notes to be redeemed, plus (ii) a make-whole premium and accrued and unpaid interest. On or after December 15, 2013, the Operating Partnership may redeem the Unsecured Notes, in whole or in part, at (i) 104.250% from December 15, 2013 to December 14, 2014, (ii) 102.125% from December 15, 2014 to December 14, 2015 and (iii) 100% of the principal amount of the Unsecured Notes from December 15, 2015 and thereafter, in each case plus accrued and unpaid interest. In addition, on or prior to December 15, 2012, the Operating Partnership may redeem up to 35% of the Unsecured Notes at 108.500% of the principal amount thereof, plus accrued and unpaid interest, with the net cash proceeds of certain equity offerings consummated by DFT or the Operating Partnership.
If there is a change of control (as defined in the Indenture) of the Operating Partnership or DFT, Unsecured Note holders can require the Operating Partnership to purchase their Unsecured Notes at a price equal to 101% of the principal amount thereof, plus accrued and unpaid interest. In addition, in certain circumstances the Operating Partnership may be required to use the net proceeds of asset sales to purchase a portion of the Unsecured Notes at 100% of the principal amount thereof, plus accrued and unpaid interest.
The Unsecured Notes have certain covenants limiting or prohibiting the ability of the Operating Partnership and certain of its subsidiaries from, among other things, (i) incurring secured or unsecured indebtedness, (ii) entering into sale and leaseback transactions, (iii) making certain dividend payments, distributions and investments, (iv) entering into transactions with affiliates, (v) entering into agreements limiting the ability to make certain transfers and other payments from subsidiaries or (vi) engaging in certain mergers, consolidations or transfers/sales of assets. The Unsecured Notes also require the Operating Partnership and the Subsidiary Guarantors to maintain total unencumbered assets of at least 150% of their unsecured debt on a consolidated basis. All of the covenants are subject to a number of important qualifications and exceptions.
The Unsecured Notes also have customary events of default, including, but not limited to, nonpayment, breach of covenants, and payment or acceleration defaults in certain other indebtedness of the Company or certain of its subsidiaries. Upon an event of default, the holders of the Unsecured Notes or the trustee may declare the Unsecured Notes due and immediately payable. The Company was in compliance with all covenants under the Unsecured Notes as of December 31, 2011.
Unsecured Credit Facility
The Operating Partnership currently has a $100 million unsecured revolving credit facility. The facility has an initial maturity date of May 6, 2013, with a one-year extension option, subject to the payment of an extension fee equal to 50 basis points on the amount of the facility at initial maturity and certain other customary conditions. As of December 31, 2011, the balance of this facility was $20.0 million, which was repaid in full on January 19, 2012.
The facility is unconditionally guaranteed, jointly and severally, on a senior unsecured basis by the Company and all of the Operating Partnership’s subsidiaries that currently guaranty the obligations under the Company’s Indenture governing the terms of the Unsecured Notes, including the subsidiaries that own the ACC2, ACC3, ACC4, ACC5, ACC6, VA3, VA4, CH1 and NJ1 data centers, but excluding the subsidiaries that own the SC1 data center, the ACC7, ACC8 and SC2 parcels of land, and the TRS.
The Company may elect to have borrowings under the facility bear interest at either LIBOR or a base rate, in each case plus an applicable margin. The applicable margin added to LIBOR and the base rate is based on the table below.
As of December 31, 2011, the applicable margin was set at pricing level 1. The terms of the facility provide for the adjustment of the applicable margin from time to time according to the ratio of the Operating Partnership’s total indebtedness to gross asset value in effect from time to time.
The amount available for borrowings under the facility is determined according to a calculation comparing the value of certain unencumbered properties designated by the Operating Partnership at such time relative to the amount of the Operating Partnership’s unsecured debt. As of December 31, 2011, $80.0 million of the facility was available for borrowing. Up to $25 million of borrowings under the facility may be used for letters of credit. No letters of credit were outstanding at December 31, 2011.
The facility requires that the Company, the Operating Partnership and their subsidiaries comply with various covenants, including with respect to restrictions on liens, incurring indebtedness, making investments, effecting mergers and/or asset sales, and certain restrictions on dividend payments. In addition, the facility imposes financial maintenance covenants relating to, among other things, the following matters:
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unsecured debt not exceeding 60% of the value of unencumbered assets;
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net operating income generated from unencumbered properties divided by the amount of unsecured debt being not less than 12.5%;
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total indebtedness not exceeding 60% of gross asset value;
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fixed charge coverage ratio being not less than 1.70 to 1.00; and
•
tangible net worth being not less than $750 million plus 80% of the sum of (i) net equity offering proceeds and (ii) the value of equity interests issued in connection with a contribution of assets to the Operating Partnership or its subsidiaries.
The facility includes customary events of default, the occurrence of which, following any applicable cure period, would permit the lenders to, among other things, declare the principal, accrued interest and other obligations of the Operating Partnership under the facility to be immediately due and payable. The Company was in compliance with all covenants under the facility as of December 31, 2011.
A summary of the Company’s debt maturity schedule as of December 31, 2011 is as follows:
Debt Maturity as of December 31, 2011
($ in thousands)
(1) The Unsecured Notes have mandatory amortizations of $125.0 million due in 2015, $125.0 million due in 2016 and $300.0 million due in 2017.
(2) The ACC5 Term Loan matures on December 2, 2014 with no extension option and requires quarterly principal payments of $1.3 million through maturity.
(3) The Unsecured Credit Facility matures on May 6, 2013 with a one-year extension option. The $20 million outstanding as of December 31, 2011 was repaid in full on January 19, 2012.
(4) Rates as of December 31, 2011.
Indebtedness Retired During 2010
ACC4 Term Loan
On October 24, 2008, the Company entered into a credit agreement relating to a $100.0 million term loan with a syndicate of lenders (the “ACC4 Term Loan”). The Company increased this loan to $250.0 million in February 2009 through the exercise of the loan’s “accordion” feature. In December 2009, the Company repaid $50.0 million of the outstanding principal amount. In October 2010, the Company paid off the $196.5 million remaining balance of the ACC4 Term Loan which resulted in a write-off of unamortized deferred financing costs of $2.5 million in the fourth quarter of 2010. The ACC4 Term Loan bore interest at LIBOR plus 3.50%.
7. Derivative Instruments
On August 15, 2007, the Company entered into a $200.0 million interest rate swap agreement to manage the interest rate risk associated with a portion of a credit facility. The interest rate swap agreement was effective August 17, 2007 with a maturity date of August 7, 2011 and effectively fixed the interest rate on $200.0 million of this credit facility at 4.997% plus the credit spread of 1.5%. The Company had designated this agreement as a hedge for accounting purposes. Therefore, the effective portion of the changes in the fair value of the interest rate swap had been recorded in other comprehensive income (loss) and reclassified into interest expense as the hedged forecasted interest payments were recognized.
On December 16, 2009, in connection with the Company’s completion of a $550 million debt offering and repayment and termination of this credit facility, the Company paid $13.7 million to terminate the swap agreement, which was recorded as a loss on discontinuance of cash flow hedge on the consolidated statement of operations for the year ended December 31, 2009.
The Company has no outstanding derivative instruments as of December 31, 2011 and 2010.
8. Related Party Transactions
In June 2011, the Company purchased an undeveloped parcel of land from an entity controlled by its Chairman of the Board and President and CEO for $9.6 million. The Chairman and the President and CEO owned a 24% and 18% interest in this entity, respectively. One of DFT’s independent directors is a non-managing member of the entity and has a 4% interest in this entity. The location of the parcel, which consists of approximately 23 acres, is adjacent to the Company’s ACC data center campus in Ashburn, Virginia and is being held for development of a 36.4 megawatt data center known as ACC7. The process was managed by the Company’s audit committee, and the purchase price was based on appraisals prepared by independent appraisal firms.
For the years ended December 31, 2011, 2010 and 2009, the Company incurred $0.4 million, $0.3 million and $0.2 million of expense, respectively, to charter an aircraft that was jointly owned by the Chairman of the Board and the President and CEO in 2009 and was owned by the President and CEO in 2010 and 2011.
The Company leases space for its headquarters building from an affiliate of the Chairman of the Board and the President and CEO. Rent expense was $0.4 million for each of the years ended December 31, 2011, 2010 and 2009.
9. Commitments and Contingencies
The Company is involved from time to time in various legal proceedings, lawsuits, examinations by various tax authorities and claims that have arisen in the ordinary course of business. Management currently believes that the resolution of such matters will not have a material adverse effect on the Company’s financial condition or results of operations.
A contract related to the development of CH1 Phase II data center was in place as of December 31, 2011. This contract is cost-plus in nature whereby the contract sum is the aggregate of the cost of the actual work performed and equipment purchased plus a contractor fee. Control estimates, which are adjusted from time to time to reflect any contract changes, are estimates of the total contract cost at completion. As of December 31, 2011, the CH1 Phase II control estimate was $159.5 million of which $150.1 million has been incurred. Additionally, the Company has entered into contracts for various projects at its NJ1 property totaling $18.2 million of which $15.1 million was incurred as of December 31, 2011.
Concurrent with DFT’s October 2007 initial public offering, the Company entered into tax protection agreements with some of the contributors of the initial properties including DFT’s Chairman of the Board and President and CEO. Pursuant to the terms of these agreements, if the Company disposes of any interest in the initial contributed properties that generates more than a certain allowable amount of built-in gain for the
contributors, as a group, in any single year through 2017, the Company will indemnify the contributors for a portion of the tax liabilities incurred with respect to the amount of built-in gain and tax liabilities incurred as a result of the reimbursement payment. The amount of initial built-in gain that can be recognized as of December 31, 2011 without triggering the tax protection provisions is approximately 44% of the initial built in gain of $667 million (unaudited). This percentage grows each year by 10%, accumulating to 100% in 2017. The Company’s estimated aggregate built-in gain attributed to the initial contributors as of December 31, 2011 was approximately $440 million (unaudited). Additionally, the Company must provide an opportunity for certain of the contributors of the initial properties to guarantee a secured loan. Any sale by the Company that requires payments to any of DFT’s executive officers or directors pursuant to these agreements requires the approval of at least 75% of the disinterested members of DFT’s Board of Directors.
10. Redeemable noncontrolling interests-operating partnership / Redeemable partnership units
Redeemable noncontrolling interests-operating partnership, as presented on DFT’s consolidated balance sheets, represent the OP units held by individuals and entities other than DFT. These interests are also presented on the Operating Partnership’s consolidated balance sheets, referred to as “redeemable partnership units.” Accordingly, the following discussion related to redeemable noncontrolling interests-operating partnership of the REIT refers equally to redeemable partnership units of the Operating Partnership.
The redemption value of redeemable noncontrolling interests-operating partnership at December 31, 2011 and 2010 was $461.7 million and $466.8 million based on the closing share price of DFT’s common stock of $24.22 and $21.27, respectively, on those dates.
Holders of OP units are entitled to receive distributions in a per unit amount equal to the per share dividends made with respect to each share of DFT’s common stock, if and when DFT’s Board of Directors declares such a dividend. Holders of OP units have the right to tender their units for redemption, in an amount equal to the fair market value of DFT’s common stock. DFT may elect to redeem tendered OP units for cash or for shares of DFT’s common stock. During the years ended December 31, 2011, 2010 and 2009, OP unitholders redeemed 2,883,118, 3,341,474 and 6,214,441 OP units, respectively, in exchange for an equal number of shares of common stock. See Note 2.
11. Preferred Stock
Series A Preferred Stock
On October 13 and 21, 2010, DFT issued an aggregate of 7,400,000 shares of 7.875% Series A Cumulative Redeemable Perpetual Preferred Stock (“Series A Preferred Stock”) for $185.0 million in an underwritten public offering that resulted in proceeds to the Company, net of underwriting discounts, commissions, advisory fees and other offering costs, of $178.6 million. The liquidation preference on the Series A Preferred Stock is $25 per share and dividends are scheduled quarterly. For each share of Series A Preferred Stock issued by DFT, the Operating Partnership issued a preferred unit equivalent to DFT with the same terms.
For the year ended December 31, 2011, DFT declared and paid the following cash dividends on its Series A Preferred Stock, of which the OP paid equivalent distributions on preferred units:
For the year ended December 31, 2010, DFT declared and paid the following cash dividend on its Series A Preferred Stock, of which the OP paid equivalent distributions on its preferred partnership units:
Except in instances relating to preservation of the Company’s qualification as a REIT or pursuant to the special optional redemption right discussed below, the Series A Preferred Stock is not redeemable prior to October 15, 2015. On and after October 15, 2015, DFT may, at its option, redeem the Series A Preferred Stock, in whole, at any time, or in part, from time to time, for cash at a redemption price of $25 per share, plus any accrued and unpaid dividends to, but not including, the date of redemption.
If, at any time following a change of control, the Series A Preferred Stock is not listed on the NYSE or quoted on NASDAQ (or listed or quoted on a successor exchange or quotation system), holders will be entitled to receive dividends at an increased rate of 11.875%, and the Company will have the option to redeem the Series A Preferred Stock, in whole but not in part, within 90 days after the first date on which both the change of control has occurred and the Series A Preferred Stock is not so listed or quoted, for cash at $25 per share, plus accrued and unpaid dividends (whether or not declared) to, but not including, the redemption date.
Series B Preferred Stock
On March 8 and 14, 2011, DFT issued an aggregate of 4,050,000 shares of 7.625% Series B Cumulative Redeemable Perpetual Preferred Stock (“Series B Preferred Stock”) for $101.3 million in an underwritten public offering that resulted in proceeds to the Company, net of underwriting discounts, commissions, advisory fees and other offering costs, of $97.5 million. The liquidation preference on the Series B Preferred Stock is $25 per share and dividends are scheduled quarterly. For each share of Series B Preferred Stock issued by DFT, the Operating Partnership issued a preferred unit equivalent to DFT with the same terms.
For the year ended December 31, 2011, DFT declared and paid the following cash dividends on its Series B Preferred Stock, of which the OP paid equivalent distributions on preferred units:
Except in instances relating to preservation of the Company’s qualification as a REIT or pursuant to the special optional redemption right and conversion right discussed below, the Series B Preferred Stock is not redeemable prior to March 15, 2016 or convertible at any time. On and after March 15, 2016, the Company may, at its option, redeem the Series B Preferred Stock, in whole, at any time, or in part, from time to time, for cash at a redemption price of $25 per share, plus any accrued and unpaid dividends to, but not including, the date of redemption.
Upon the occurrence of a change of control, DFT has a special optional redemption right that enables it to redeem the Series B Preferred Stock within 120 days after the first date on which a change of control has occurred resulting in neither DFT nor the surviving entity having a class of common shares listed on the NYSE, NYSE Amex or NASDAQ. For this special redemption right, the redemption price is $25 per share in cash, plus accrued and unpaid dividends (whether or not declared) to, but not including, the redemption date.
Upon the occurrence of a change of control that results in neither DFT nor the surviving entity having a class of common shares listed on the NYSE, NYSE Amex or NASDAQ, the holder will have the right (subject to DFT’s special optional redemption right to redeem the Series B Preferred Stock) to convert some or all of the Series B Preferred Stock into a number of shares of DFT’s common stock equal to the lesser of (A) the quotient obtained by dividing (i) the sum of (x) $25.00, plus (y) an amount equal to any accrued and unpaid dividends, whether or not declared, to but not including, the date of conversion (unless the date of conversion is after a record date for a Series B Preferred Stock dividend payment and prior to the corresponding Series B Preferred Stock dividend payment date, in which case no additional amount for such accrued and unpaid dividend will be included in this quotient), by (ii) the price of our common stock, and (B) 2.105 (the Share Cap), subject to certain adjustments and provisions for the receipt of alternative consideration of equivalent value.
12. Stockholders’ Equity of the REIT and Partners’ Capital of the OP
During the years ended December 31, 2011, 2010, and 2009, DFT issued 165,608, 247,668 and 666,218 shares of common stock, respectively, in connection with the hiring of new employees, annual grants and retainers for its Board of Directors and the Company’s annual grant of restricted stock to employees. The OP issued an equivalent number of units to DFT.
DFT also issued 13,800,000 shares in an underwritten public offering on May 18, 2010 that resulted in proceeds to the Company, net of underwriting discounts, commissions, advisory fees and other offering costs of $305.2 million. The OP issued an equivalent number of units to DFT.
During the years ended December 31, 2011, 2010 and 2009, OP unitholders redeemed 2,883,118, 3,341,474 and 6,214,441 OP units, respectively, in exchange for an equal number of shares of common stock.
For the year ended December 31, 2011, the Company declared and paid the following cash dividends, of which the OP paid equivalent distributions on OP units:
Of the $0.12 dividend paid in January 2012, $0.01 (unaudited) will be included in 2012 taxable common dividends.
For the year ended December 31, 2010, the Company declared and paid the following cash dividends, of which the OP paid equivalent distributions on OP units:
Of the $0.12 dividend paid in January 2011, $0.10 (unaudited) was included in 2011 taxable common dividends.
For the year ended December 31, 2009, the Company declared and paid the following cash dividend, of which the OP paid equivalent distributions on OP units:
13. Equity Compensation Plan
In May 2011, DFT’s Board of Directors adopted the 2011 Equity Incentive Plan (the “2011 Plan”) following approval from its stockholders. The 2011 Plan is administered by the Compensation Committee of the Company’s Board of Directors. The 2011 Plan allows the Company to provide equity-based compensation to its personnel in the form of stock options, stock appreciation rights, dividend equivalent rights, restricted stock, restricted stock units, performance-based awards, unrestricted stock, long term incentives units (“LTIP units”) and other awards.
The 2011 Plan authorizes a maximum aggregate of 6,300,000 share equivalents be reserved for future issuances. In addition, shares that were awarded under the Company’s 2007 Equity Compensation Plan (the “2007 Plan”) that subsequently become available due to forfeitures of such awards will be available for issuance under the 2011 Plan.
The 2011 Plan provides that, as of its May 2011 effective date, awards can no longer be made under the 2007 Plan. Furthermore, under the 2011 Plan, shares of common stock that are subject to awards of options or stock appreciation rights will be counted against the 2011 Plan share limit as one share for every one share subject to the award. Any shares of stock that are subject to awards other than options or stock appreciation rights shall be counted against the 2011 Plan share limit as 2.36 shares for every one share subject to the award.
As of December 31, 2011, the maximum aggregate amount of share equivalents that may be issued under the 2011 Plan, including forfeitures under the 2007 Plan, is equal to 6,300,000 shares, of which 18,278 have been issued, leaving 6,281,722 share equivalents available for future issuance.
Restricted Stock
Restricted stock awards vest over specified periods of time as long as the employee remains employed with the Company, and are not subject to any performance criteria. A summary of the Company’s restricted stock activity for the years ended December 31, 2011, 2010 and 2009 is presented in the table below.
During the years ended December 31, 2011, 2010 and 2009, the Company issued 153,992, 236,184 and 607,632 shares of restricted stock, respectively, which had values of $3.6 million, $4.7 million and $3.1 million, respectively, on the grant dates. These amounts are amortized to expense over a three year vesting period. Also during the years ended December 31, 2011, 2010 and 2009, 288,582, 219,157 and 19,160 shares of restricted stock, respectively, vested at values of $7.0 million, $4.4 million and $0.1 million, respectively, on the vesting dates.
As of December 31, 2011, total unearned compensation on restricted stock was $4.5 million and the weighted average vesting period was 0.6 years.
Stock Options
Stock option awards are granted with an exercise price equal to the closing market price of DFT’s common stock at the date of grant and vest over specified periods of time as long as the employee remains employed with the Company. All shares to be issued upon option exercises will be newly issued shares and the options have 10-year contractual terms.
A summary of the Company’s stock option activity for the years ended December 31, 2011, 2010 and 2009 is presented in the tables below.
The following table sets forth the number of unvested options as of December 31, 2011, 2010 and 2009 and the weighted average fair value of these options at the grant date.
The following table sets forth the number of exercisable options as of December 31, 2011, 2010 and 2009 and the weighted average fair value and exercise price of these options at the grant date.
The intrinsic value of stock options exercised during the years ended December 31, 2011 and 2010 was $2.7 million and $3.2 million, respectively. No stock options were exercised during the year ended December 31, 2009.
The fair value of each option award is estimated on the date of grant using a Black-Scholes option valuation model. As DFT has been a publicly traded company only since October 24, 2007, expected volatilities used in the Black-Scholes model are based on the historical volatility of a group of comparable REITs. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. The following table summarizes the assumptions used to value the stock options granted and the fair value of these options granted during the years ended December 31, 2011, 2010 and 2009.
14. Earnings Per Share of the REIT
The following table sets forth the reconciliation of basic and diluted average shares outstanding used in the computation of earnings per share of common stock (in thousands except for share and per share amounts):
For the years ended December 31, 2011 and 2010, approximately 0.9 million and 0.3 million stock options, respectively, have been excluded from the calculation of diluted earnings per share as their effect would have been antidilutive. For the year ended December 31, 2009, 0.3 million LTIP units have been excluded from the calculation of diluted earnings per share as their effect would have been antidilutive.
15. Earnings Per Unit of the Operating Partnership
The following table sets forth the reconciliation of basic and diluted average units outstanding used in the computation of earnings per unit:
For the years ended December 31, 2011 and 2010, approximately 0.9 million and 0.3 million stock options, respectively, have been excluded from the calculation of diluted earnings per unit as their effect would have been antidilutive. For the year ended December 31, 2009, 0.3 million LTIP units have been excluded from the calculation of diluted earnings per unit as their effect would have been antidilutive.
16. Employee Benefit Plan
The Company has a tax qualified retirement plan (“401(k) Plan”) that provides employees with an opportunity to save for retirement on a tax advantaged basis. Employees participate in the 401(k) Plan on their first day of employment and are able to defer compensation up to the limits established by the Internal Revenue Service. The Company matches 50% of the employees’ contributions up to a maximum match contribution of 4% of the employee’s salary. The Company’s contributions vest immediately. During the years ended December 31, 2011, 2010 and 2009, the Company contributed $0.4 million, $0.3 million and $0.3 million, respectively, to the 401(k) Plan.
17. Fair Value of Financial Instruments
Assets and Liabilities Measured at Fair Value
The Company follows the authoritative guidance issued by the FASB relating to fair value measurements that defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. The guidance applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements; accordingly, the guidance does not require any new fair value measurements of reported balances. The guidance excludes the accounting for leases, as well as other authoritative guidance that address fair value measurements on lease classification and measurement. The authoritative guidance issued by the FASB 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.
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.
The authoritative guidance issued by the FASB requires disclosure of the fair value of financial instruments. Fair value estimates are subjective in nature and are dependent on a number of important assumptions, including estimates of future cash flows, risks, discount rates, and relevant comparable market information associated with each financial instrument. The use of different market assumptions and estimation methodologies may have a material effect on the reported estimated fair value amounts. Accordingly, the amounts are not necessarily indicative of the amounts the Company would realize in a current market exchange.
The following methods and assumptions were used in estimating the fair value amounts and disclosures for financial instruments as of December 31, 2011:
•
Cash and cash equivalents: The carrying amount of cash and cash equivalents reported in the consolidated balance sheet approximates fair value because of the short maturity of these instruments (i.e., less than 90 days).
•
Restricted cash: The carrying amount of restricted cash reported in the consolidated balance sheets approximates fair value because of the short maturities of these instruments.
•
Rents and other receivables, accounts payable and accrued liabilities, and prepaid rents: The carrying amount of these assets and liabilities reported in the balance sheet approximates fair value because of the short-term nature of these amounts.
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Debt: As of December 31, 2011, the combined balance of the Company’s Unsecured Notes and mortgage notes payable was $714.8 million with a fair value of $752.8 million based on Level 1 and Level 3 data. The Level 1 data is for the Unsecured Notes and consisted of a quote from the market maker in the Unsecured Notes. The Level 3 data is for the ACC5 Term Loan and the Line of Credit and is based on discounted cash flows using the one-month LIBOR swap rate as of December 31, 2011 plus a spread consistent with current market conditions.
18. Quarterly Financial Information (unaudited)
The table below reflects the selected quarterly information for the years ended December 31, 2011 and 2010 (in thousands except share data):
(1) Amounts may not equal full year results due to rounding.
19. Supplemental Consolidating Financial Data for Subsidiary Guarantors of 8.5% Senior Unsecured Notes
On December 16, 2009, the Operating Partnership issued the Unsecured Notes (See Note 6). The Unsecured Notes are unconditionally guaranteed, jointly and severally on a senior unsecured basis by DFT and certain of the Company’s subsidiaries, including the subsidiaries that own the ACC2, ACC3, ACC4, ACC5, ACC6, VA3, VA4, CH1 and NJ1 data centers, but excluding the subsidiaries that own the SC1 data center and the SC2 parcel of land, the ACC7 and ACC8 parcels of land, and the TRS. The following consolidating financial information sets forth the financial position as of December 31, 2011 and 2010, and the results of operations and cash flows for the years ended December 31, 2011, 2010 and 2009 of the Operating Partnership, Subsidiary Guarantors and the Subsidiary Non-Guarantors.
DUPONT FABROS TECHNOLOGY, L.P.
SUPPLEMENTAL CONSOLIDATING BALANCE SHEETS
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SUPPLEMENTAL CONSOLIDATING STATEMENTS OF CASH FLOWS
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SUPPLEMENTAL CONSOLIDATING STATEMENTS OF CASH FLOWS
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(in thousands)
20. Subsequent Events
In January 2012, DFT issued an additional 2.6 million shares, or $65.0 million, of its Series B Preferred Stock in an underwritten public offering that resulted in proceeds to the Company, net of underwriting discounts, commissions, advisory fees and other offering costs, of $62.6 million. The Company used a portion of the proceeds from this offering to pay off in full the outstanding balance of its Unsecured Credit Facility and plans to use the remainder for general corporate purposes. For each share of Series B Preferred Stock issued by DFT, the Operating Partnership issued a preferred unit equivalent to DFT with the same terms.
DUPONT FABROS TECHNOLOGY, INC.
DUPONT FABROS TECHNOLOGY, L.P.
SCHEDULE III
CONSOLIDATED REAL ESTATE AND ACCUMULATED DEPRECIATION
DECEMBER 31, 2011
(in thousands)
(1) The subsidiaries that own these data centers are guarantors of the Company’s $550.0 million 8.5% Unsecured Notes.
(2) The subsidiary that owns this data center is encumbered by the Company’s ACC5 Term Loan.
DUPONT FABROS TECHNOLOGY, INC.
DUPONT FABROS TECHNOLOGY, L.P.
SCHEDULE III
CONSOLIDATED REAL ESTATE AND ACCUMULATED DEPRECIATION
DECEMBER 31, 2011
The following is a reconciliation of real estate assets and accumulated depreciation for the years ended December 31, 2011, 2010 and 2009:
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Controls and Procedures with respect to DFT
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of DFT’s management, including DFT’s principal executive officer and principal financial officer, DFT conducted an evaluation of the effectiveness of the design and operation of DFT’s disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of the end of the period covered by this report (the “Evaluation Date”). Based on this evaluation, DFT’s principal executive officer and principal financial officer concluded as of the Evaluation Date that DFT’s disclosure controls and procedures were effective such that the information relating to DFT, including DFT’s consolidated subsidiaries, required to be disclosed in DFT’s Securities and Exchange Commission (“SEC”) reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to DFT’s management, including DFT’s principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control over Financial Reporting
Under the supervision and with the participation of DFT’s management, including DFT’s principal executive officer and principal financial officer, DFT conducted an evaluation of any changes in DFT’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during DFT’s most recently completed fiscal quarter. Based on that evaluation, DFT’s principal executive officer and principal financial officer concluded that there has not been any change in DFT’s internal control over financial reporting during that quarter that has materially affected, or is reasonably likely to materially affect, DFT’s internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
DFT’s management is responsible for establishing and maintaining adequate internal control over financial reporting. DFT’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. DFT’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of its assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of its management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of its assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
DFT’s management assessed the effectiveness of its internal control over financial reporting as of December 31, 2011, utilizing the criteria set forth by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on the assessment by its management, DFT determined that its internal control over financial reporting was effective as of December 31, 2011. The effectiveness of DFT’s internal control over financial reporting as of December 31, 2011 has been audited by Ernst & Young LLP, DFT’s independent registered public accounting firm, as stated in their report which appears on page 44 of this Annual Report on Form 10-K.
Controls and Procedures with respect to the Operating Partnership
Evaluation of Disclosure Controls and Procedures
Under the supervision and with the participation of DFT’s management, including DFT’s principal executive officer and principal financial officer, DFT conducted an evaluation of the effectiveness of the design and operation of the Operating Partnership’s disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of the end of the period covered by this report (the “Evaluation Date”). Based on this evaluation, DFT’s principal executive officer and principal financial officer concluded as of the Evaluation Date that the Operating Partnership’s disclosure controls and procedures were effective such that the information relating to the Operating Partnership, including the Operating Partnership’s consolidated subsidiaries, required to be disclosed in the Operating Partnership’s SEC reports (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to DFT’s management, including DFT’s principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.
Changes in Internal Control over Financial Reporting
Under the supervision and with the participation of DFT’s management, including DFT’s principal executive officer and principal financial officer, DFT conducted an evaluation of any changes in the Operating Partnership’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the Operating Partnership’s most recently completed fiscal quarter. Based on that evaluation, DFT’s principal executive officer and principal financial officer concluded that there has not been any change in the Operating Partnership’s internal control over financial reporting during that quarter that has materially affected, or is reasonably likely to materially affect, the Operating Partnership’s internal control over financial reporting.
Management’s Report on Internal Control over Financial Reporting
DTF’s management is responsible for establishing and maintaining adequate internal control over financial reporting. The Operating Partnership’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. The Operating Partnership’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of its assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of its management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of its assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
DFT’s management assessed the effectiveness of the Operating Partnership’s internal control over financial reporting as of December 31, 2011, utilizing the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on the assessment by DFT’s management, the Operating Partnership determined that its internal control over financial reporting was effective as of December 31, 2011. The effectiveness of the Operating Partnership’s internal control over financial reporting as of December 31, 2011 has been audited by Ernst & Young LLP, the Operating Partnership’s independent registered public accounting firm, as stated in their report which appears on page 46 of this Annual Report on Form 10-K.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Information on our directors and executive officers and the Audit Committee of our Board of Directors is incorporated by reference from the Company’s Proxy Statement (under the headings “Proposal 1: Election of Directors,” “Committees and Meetings of our Board of Directors and its Committees,” “Executive Officers” and “Section 16(a) Beneficial Ownership Reporting Compliance”) with respect to the 2012 Annual Meeting of Stockholders to be filed with the SEC no later than April 30, 2012.
Because our common stock is listed on the New York Stock Exchange (“NYSE”), our President and Chief Executive Officer is required to make, and will make, an annual certification to the NYSE stating that he was not aware of any violation by us of the corporate governance listing standards of the NYSE. Our President and Chief Executive Officer will make his annual certification to that effect to the NYSE within the 30-day period following the 2012 Annual Meeting of Stockholders. In addition, we have filed, as exhibits to this Annual Report on Form 10-K for the year ended December 31, 2011, the certifications of our principal executive officer and principal financial officer required under Section 302 of the Sarbanes Oxley Act of 2002.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
This information is incorporated by reference from the Company’s Proxy Statement (under the headings “Executive Compensation,” “Compensation of Directors,” “Compensation Committee Interlocks and Insider Participation” and “Compensation Committee Report”) with respect to the 2012 Annual Meeting of Stockholders to be filed with the SEC no later than April 30, 2012.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
This information is incorporated by reference to the Company’s Proxy Statement (under the headings “Security Ownership of Directors and Executive Officers”, “Security Ownership of Certain Beneficial Owners” and “Executive Compensation-Equity Compensation Plan Information”) with respect to the 2012 Annual Meeting of Stockholders to be filed with the SEC no later than April 30, 2012.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
This information is incorporated by reference from the Company’s Proxy Statement (under the headings “Certain Relationships and Related Transactions” and “Information About Our Board of Directors and its Committees”) with respect to the 2012 Annual Meeting of Stockholders to be filed with the SEC no later than April 30, 2012.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
This information is incorporated by reference from the Company’s Proxy Statement (under the heading “Relationship with Independent Registered Public Accounting Firm-Principal Accountant Fees and Services”) with respect to the 2012 Annual Meeting of Stockholders to be filed with the SEC no later than April 30, 2012.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) Financial Statements and Schedules. The following financial statements and schedules are included in this report:
(1) FINANCIAL STATEMENTS
The response to this portion of Item 15 is submitted under Item 8 of this Report on Form 10-K.
(2) FINANCIAL STATEMENT SCHEDULES
Schedule III-Consolidated Real Estate and Accumulated Depreciation. The response to this portion of Item 15 is submitted under Item 8 of this Report on Form 10-K.
All other schedules for which provision is made in the applicable accounting regulation of the SEC are not required under the related instructions or are inapplicable and therefore have been omitted.
(3) EXHIBITS
Any shareholder who wants a copy of the following Exhibits may obtain one from us upon request at a charge that reflects the reproduction cost of such Exhibits. Requests should be made to DuPont Fabros Technology, Inc., 1212 New York Avenue, NW, Suite 900, Washington, DC 20005.
(b) Exhibits. The exhibits required by Item 601 of Regulation S-K are listed below. Management contracts or compensatory plans are filed as Exhibits 10.5.1 through 10.9.2 and 10.12.1 through 10.19.
* Filed herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
EXHIBIT INDEX
* Filed herewith.