Earnings Call Transcript - DLR Q3 2022

Operator, Operator

Good afternoon, and welcome to the Digital Realty Third Quarter 2022 Earnings Call. Please note, this event is being recorded. I would now like to turn the call over to Jordan Sadler, Digital Realty's Senior Vice President of Public and Private Investor Relations. Jordan, please go ahead.

Jordan Sadler, Senior Vice President of Public and Private Investor Relations

Thank you, operator, and welcome, everyone, to Digital Realty's Third Quarter 2022 Earnings Conference Call. Joining me today on the call are CEO, Bill Stein; and President and CFO, Andy Power; Chief Investment Officer, Greg Wright; Chief Technology Officer, Chris Sharp; and Chief Revenue Officer, Corey Dyer, who is also on the call and will be available for Q&A. Management may make forward-looking statements, including guidance and underlying assumptions on today's call. Forward-looking statements are based on expectations that involve risks and uncertainties that could cause actual results to differ materially. For a further discussion of risks related to our business, see our 10-K and subsequent filings with the SEC. This call will contain non-GAAP financial information. Reconciliations to GAAP net income are included in the supplemental package furnished to the SEC and available on our website. One important item to note this quarter: while Teraco's results are consolidated into our financial statements since closing on August 1, we have excluded the platform's contribution from leasing backlog and other portfolio statistics that will be cited on this call and within our third quarter earnings materials. Before I turn the call over to Bill, let me offer a few key takeaways from our third quarter. First, we achieved another quarter of record bookings, led by robust demand within the greater than a megawatt segment. Second, the signs of improvement in our core portfolio continued to emerge in the quarter with a 120 basis point sequential improvement in base data center revenues on a constant currency basis. Third, with the closing on our investment in Teraco, we cemented our position as a leading provider of colocation and connectivity in South Africa. And lastly, our management team, guided by decades of experience, remains focused on navigating the current environment and maximizing the opportunity that lies before us. With that, I'd like to turn the call over to our CEO, Bill Stein.

Bill Stein, CEO

Thank you, Jordan, and thank you, everyone, for joining our call. The world has experienced significant change so far in 2022, and Digital Realty is adapting to that change. Our business continues to be leveraged to powerful long-term secular demand trends, broadly driven by ongoing digital transformation and the growth in IT and data, as our record leasing results underscore. We also have an unmatched global operating footprint that is supported by a strong development pipeline that allows us to capture opportunities wherever they may emerge. As you all understand, global capital markets have become extraordinarily volatile, and interest rates have risen sharply from historic lows to levels that we have not seen since 2008. At the same time, the U.S. dollar has strengthened against the euro to levels not seen in nearly 20 years, while you would have to look back over 30 years to find the last time the dollar was this elevated against the pound or the yen. This volatility is being driven by a number of factors, including a global economy emerging from the pandemic, the war in Ukraine, and of course, the heightened resolve of central bankers to curb elevated global inflation. And while the underlying fundamentals of our business remain strong, experience has taught us that a proactive approach is wise. And we feel that it is most prudent today to adapt to the current environment by: one, prioritizing and sharpening the lens through which we view new investments to ensure that we are focused on the most strategic transactions that offer the highest potential risk-adjusted returns; two, pressing our newly gained advantage on pricing and improving our internal growth profile and the longer-term durability of our cash flows; and three, enhancing liquidity to ensure we have the capital to meet the commitments we have made to our customers while maintaining a comfortable cushion. With over 300 data centers around the world and a revenue base of over $4.5 billion, Digital Realty remains focused on how to best position ourselves for the long run. Our third quarter results were strong, with a record $176 million of new bookings, making the third time in the past four quarters that our bookings have exceeded $150 million. Core FFO per share was $1.67 despite stiff FX and interest rate headwinds. On a constant currency basis, we see evidence of the turn that is starting to take shape in our core portfolio. Digital Realty's global platform enables us to capture demand wherever it emerges. North America was the standout this quarter, with our largest deals landing in the region. Multinational companies are using our platform to enable digital transformation across multiple regions and metros globally. A good example of this is a large multisite enterprise build-to-suit transaction signed with a top five financial services company that was inked in the quarter. Looking ahead, sales activity remains healthy as the secular trends driving data center demand remain in place. Enterprises continue their digital transformation with a growing preference for hybrid cloud architecture, while cloud and connectivity providers continue to expand their infrastructure to better serve their customers around the world. However, the world is changing. We are seeing sales cycles lengthen, and global uncertainty extends decision times. Importantly, we are pushing prices higher to reflect tightening supply and rising costs. Admittedly, some of the deals this quarter have been in process for many months and do not fully reflect today's environment. Today, new leases are being priced to reflect current market conditions, and while this will likely be an iterative process, we expect the strong secular trends driving demand toward third-party data centers to continue for years to come. Andy will provide further color on our results and our outlook shortly. During the third quarter, we successfully completed the acquisition of a majority interest in Teraco, a leading carrier and cloud-neutral data center and interconnection services provider in South Africa. Teraco is a gem, with seven data centers across three metros and robust interconnectivity, including more than 22,000 cross-connects, seven cloud on-ramps, and direct access to seven subsea cables, with more on the way. Teraco has plenty of room to expand and is expected to generate some of the best growth within our portfolio. Teraco uniquely enhances our position in EMEA, complementing our existing operations in Eastern Africa through iColo, Western Africa through Medallion, and in Europe and the Mediterranean with Interxion, Altus IT, Lamda Helix, and our newest JV with Mine in Israel. These are all highly connected assets that leverage subsea cable landing and link Europe, Asia, the Middle East, and Africa. Consistent with that strategy, we recently acquired land on the Greek island of Crete to create an interconnection hub in the Eastern Mediterranean to complement our existing hub in Marseille, along with developing hubs in Barcelona and Israel, which will feed additional traffic into Greece, the Balkans, Turkey, and Northern Africa. We expect that this highly differentiated project will generate strong double-digit returns while enhancing the value of our existing facilities in the region. Moving to our dispositions in the quarter. We sold a non-core mixed-use data center property in Dallas for $206 million and reached an agreement with a digital core REIT to sell a 25% interest in our Frankfurt data center campus for $140 million, with an option to acquire up to 90% of the same campus plus a 90% share of one of our Dallas data centers in a larger transaction valued at approximately $750 million. Both transactions are subject to unitholder approval, with a vote expected for November. Funding organic new market entry through the disposition of stabilized facilities is our preferred source of capital. It enables us to leverage our platform to capitalize on value creation opportunities and harvest capital once those facilities have stabilized. We also favor joint ventures like the one in Israel, where we leverage the local knowledge and expertise of our partner and pair that with our platform to expand our global footprint and better serve our customers. Before turning it over to Andy, I'd like to update you on our ESG success shown on Page 3 of our earnings presentation. We were honored to be recognized by GRESB as the sector leader for the technology and science category in the Americas for the second consecutive year, maintaining our five-star rating from this leading investor-driven ESG benchmarking organization. We are proud of our ESG-related efforts, and while the awards and recognition are nice, we are focused on ESG because our customers demand it, and simply put, it is the right thing to do. We are committed to minimizing our impact on the environment while delivering sustainable growth for all of our stakeholders. With that, I'd like to turn the call over to Andy to take you through our financial results.

Andrew Power, CFO

Thank you, Bill. Turning to Page 5. As Bill noted, we signed record bookings of $176 million, with a $13 million contribution from interconnection during the third quarter, excluding the results from Teraco. The greater than a megawatt business in the Americas was the big driver of this quarter's record leasing at nearly $100 million signed. Sub-1 megawatt plus interconnection accounted for 24% of the record quarterly bookings, while the shell portion of a large multisite enterprise build-to-suit deal fell into our other category. Importantly, as we've discussed, we have meaningfully shifted our cadence toward further insulating our portfolio from the effects of inflation through the addition of CPI-based escalators into our new leases. While more than 95% of our portfolio includes rent escalation clauses, less than 20% are specifically tied to CPI, while the balance are fixed. In our highest leasing volume quarter ever, we were able to achieve CPI-based escalators on 40% of the leases signed in the quarter, which demonstrates our resolve and our customers' acknowledgment of this important factor. The balance of our leases signed in Q3 includes fixed rent escalators. Moving on to markets. In North America, Portland and Dallas were particularly strong, with large deals landing in each of those metros, while demand in Northern Virginia also remained high. In EMEA, totals were consistent with expectations, with particular strength in Paris, while Sao Paulo led in LatAm, and Osaka led the APAC region. These deals drove additional starts within our development pipeline, which grew to over 400 megawatts, but is also now more than 60% pre-leased, mitigating much of the risk related to this capital spend and providing significant visibility into future revenue. As Bill touched on in his remarks, we signed four leases in the quarter with a large multinational financial services customer that has fully embarked upon its digital transformation journey. This large multi-site, multi-market build-to-suit transaction drove the upside in our greater than 1 megawatt North America leasing and also served to increase our development pipeline sequentially while reducing our anticipated yields. Importantly, this deal is structured as a yield-on-cost development supported by a long-term triple net lease to a strong investment-grade credit with fixed escalators, which serves to insulate Digital Realty from construction costs and operating expense volatility. Excluding this transaction, our development life cycle average yield will be closer to the yield we presented last quarter. During the third quarter, we added another 103 new customers, continuing the trend of 100-plus new logos added each quarter since the closing of the Interxion transaction 2.5 years ago. Key customer wins in the quarter include a Global 2000 luxury goods maker expanding its capabilities on our platform to add data exchange with its strategic cloud providers to its existing capabilities. A Global 2000 multinational technology manufacturer is expanding its hybrid IT capability in multiple metros across two global regions with our platform. A Global 2000 retailer is rationalizing its data centers and joining our platform as part of its hybrid IT architecture to have greater proximity to a key cloud service provider while enhancing both performance and ecosystem benefits. A Global 100 top insurance company is rationalizing its data centers and moving to our platform to gain strong access to two leading cloud service providers. Landing with us as a new logo in Q4 '21, a Global 2000 U.S. energy provider expanded into two more metros with Digital Realty as it continues to re-architect its network as part of a long-term hybrid IT transformation. And a Global 2000 aerospace and defense contractor is rationalizing its data center portfolio while supporting the re-architecture of its network and interconnecting with cloud providers on our platform. Turning to our backlog on Page 7. The current backlog of signed but not yet commenced leases grew to $466 million by quarter-end, as our record signings were partially offset by $90 million of commencements. The lag between signings and commencements moved up to 17 months for the leases signed in the third quarter due to the large multisite enterprise build-to-suit deal discussed by Bill a moment ago. Excluding this deal, our sign-to-commence average was under eight months, consistent with our historical average. Approximately 25% of our record backlog is slated to commence in the fourth quarter, while another 45% will commence in 2023, split fairly evenly throughout the first and second halves of next year. Moving on to Page 8. We signed $154 million of renewal leases during the third quarter, which rolled down 0.5% on a cash basis. Renewal rates for 0-1 megawatt renewals were positive across each region and up 3.1% overall, demonstrating the criticality of these deployments and the differentiation of our facilities. This product segment has historically experienced steadily positive renewal rates, and cash renewal rates have steadily increased throughout this year. After two consecutive 3-plus percent bumps in Q1 and Q2, the cash mark-to-market was weighed down by the greater than 1 megawatt segment in the third quarter. Despite this result, we are confident in a slightly positive cash releasing spread for the full year 2022. Importantly, we are encouraged by the general trajectory of market rents across our product line. We expect that the dislocation and volatility of capital markets coupled with rising costs and the reduced availability of power in several markets, including the world's largest market, Loudon County, Virginia, is constraining the ability to bring on new data center capacity despite the secular demand for data center infrastructure. With regard to power delivery in Northern Virginia, we are continuing to work with the primary power provider to ensure appropriate allocations with an acute focus on capacity needed to support our customers in this market. We have an incredibly unique footprint in Loudon and a set of capabilities that we are working to tap into in order to take advantage of this backdrop of continuing tightening market fundamentals. In terms of operating performance, total portfolio occupancy rebounded by 80 basis points sequentially, driven by the strong commencements. These improvements in our occupancy come despite our active intention to grow our global colocation inventory in order to meet the growing demand of our expanding customer base. Same capital cash NOI growth fell 7.3% in the third quarter, negatively impacted by another 480 basis point FX headwind. This is disappointing on the surface, but once the noise is removed, the improving operating picture that we have been painting starts to emerge. On a constant currency basis, data center operating revenue, rental revenue interconnection was actually up 10 basis points year-over-year and improved by 120 basis points sequentially, demonstrating the turn that has started to take hold in our core operations. The sequential step-up was supported by a 50 basis point occupancy improvement over the second quarter, along with the benefits of the positive renewing spreads we've seen year-to-date. Turning to our risk mitigation strategies on Page 9. 56% of our third quarter operating revenue was denominated in U.S. dollars, with 21% in euros, 6% in Singapore dollars, 5% in British pounds, and 2% in Japanese yen. The U.S. dollar continued to strengthen over the last few months, negatively impacting same capital revenue growth by 530 basis points and NOI growth by 480 basis points year-over-year, as shown in our constant currency analysis on Page 10. This strong headwind contrasts with typical FX impacts of 50 to 100 basis points in either direction during periods with more normal FX volatility. While the outsized depreciation of the euro this year has been a major driver of the headwinds for our P&L, it also represents the lion's share of our development pipeline. To be clear, we are operating and investing locally rather than repatriating proceeds into U.S. dollars. Our operations, investment pipeline, and funding in locally-denominated debt serve as a natural hedge. As we discussed on our call last quarter, given the growth of our global portfolio along with heightened FX volatility, we took a closer look at our hedging strategy during the third quarter and executed additional swaps to mitigate our remaining FX exposure. In August, we executed a U.S. dollar to euro currency swap against an existing $1 billion tranche of 2027 notes outstanding. And in late September, alongside our USD 550 million bond, we swapped those borrowings into euro and Japanese yen, which also reduced the effective interest rate on those five-year notes to just 3% versus the 5.55% coupon achieved via the offering. In terms of earnings growth, we reported third quarter core FFO per share of $1.67, which is 1% higher on a year-over-year basis and 3% lower sequentially due to the negative impact of FX, higher interest and operating expenses, and the initial dilution we incurred from the closure of Teraco, which is consistent with the forecast we provided last quarter. On a constant currency basis, core FFO was 6% higher year-over-year but down $0.01 sequentially. The reported core FFO underperformance versus our prior expectation for the quarter was purely a function of greater-than-expected FX headwinds. Looking forward, we expect core FFO per share will remain under pressure from stiff FX headwinds given the appreciation of the U.S. dollar, though this should be offset by core growth. As you can see from the bridge on Page 11, we expect FFO will remain flat sequentially in the fourth quarter as FX and interest expense headwinds are partly balanced by NOI growth. Accordingly, we've adjusted our underlying guidance assumptions to reflect the continued pressures of FX and interest rates. We are also updating our core FFO per share guidance range for the full year 2022 to $6.70 to $6.75, reflecting a $0.075 per share adjustment at the midpoint of the range. Importantly, due to the sharper-than-expected move in interest rates since our last call, we are reducing our constant currency core FFO per share range by $0.025 at the midpoint to a new range of $6.95 to $7 for 2022, which represents approximately 7% growth over 2021. We expect currency headwinds could represent a 400 to 500 basis point drag on full year 2022 revenue and core FFO per share growth. A review of our leverage is on Page 12. Our reported leverage ratio at quarter-end was 6.7x, while fixed charge coverage is at 5.5x. We drew $400 million down from last September's forward equity offering as part of our funding for Teraco. So pro forma for the remaining forward equity and adjusting for our full quarter's contribution from Teraco, our leverage ratio drops to 6.4x while pro forma fixed charge coverage is 5.7x. While leverage is above our historical average, we have bolstered our liquidity to ensure that we have the capital in hand to fund our committed development spend throughout the end of next year and maintain a comfortable cushion. Since our last earnings call, we have raised or received commitments for approximately $2 billion of debt capital at an effective blended average of just over 3%. These include more than $650 million of term loan commitments received subsequent to quarter-end. With cash and forward equity outstanding totaling more than $700 million, we have increased our current available liquidity to approximately $3 billion. We expect to see leverage moderate back towards our longer-term target over time through a combination of noncore dispositions, joint ventures of core holdings, lease-up of available capacity, and the retention of free cash flow. As Bill discussed, the current capital markets environment and increased cost of capital have led us to sharpen our lens and prioritize new investments to those that are of the highest strategic merit and offer the best potential risk-adjusted returns. Our financial strategy includes a diverse menu of available capital options while minimizing the related cost of our liabilities. The execution against this financing strategy reflects the strength of our global platform, which provides access to the full menu of public as well as private capital and enables us to fund our strategic objectives. As you can see from the chart on Page 13, our weighted average debt maturity is about 5.5 years, and our weighted average coupon is 2.4%. Approximately three-quarters of our debt is non-U.S. dollar denominated, reflecting the growth of our global platform. More than 80% of our net debt is fixed rate and 97% of our debt is unsecured, providing the greatest flexibility for capital recycling. Finally, we have no meaningful near-term debt maturities and a well-laddered debt maturity schedule. We repaid the remainder of our 2022 debt earlier this month and have only a small Swiss bond maturing in 2023. This concludes our prepared remarks, and now we'll be pleased to take your questions.

Operator, Operator

Our first question will come from Jon Atkin of RBC.

Jonathan Atkin, Analyst

I wondered if it's possible to kind of frame the magnitude and the timing of the CapEx associated with all the leasing that you did during the quarter. And then maybe to kind of bring it home to the $3 billion in liquidity that you talked about sources of funding that incremental CapEx.

Andrew Power, CFO

Thanks, Jon. So if you look at our development life cycle, it kind of lays it out region by region, and it has called, let's say, starts with a, call it, just $3.8 billion of, call it, approved projects. And that includes all the leases signed during the last quarter as well as some projects that are not leased because it's only 60% pre-leased, roughly. If you kind of break that down over the next, call it, five quarters, you're spending about $2.7 billion of that. Again, that is not all contractual spend. Only a portion of that is tied to customer contracts. So if you exclude the, call it, assumptive or speculative spend, you call it closer to $2 billion. The $3 billion of liquidity I mentioned includes, call it, really two parts: $1.7 billion of cash and revolver capacity and then $1.2 billion of the undrawn equity forward and new U.S. dollar term loan commitments in hand. So that total is just about $3 billion of contractual committed liquidity right now. That is everything we have at this minute. We're also continuing with our normal game plan of non-core dispositions, call it $1.5 billion over several quarters, as well as joint ventures on core holdings. So we feel pretty good about being able to fund this attractive growth for our customers.

Jonathan Atkin, Analyst

And then secondly, on the 17 month metric that you mentioned in the earnings release and in the script about kind of essentially book-to-bill. And then putting that in the context of what Bill said about elongated sales cycles, how much of that is due to perhaps the lack of server availability on part of the customers or from your standpoint, delays in power procurement or ability to construct just given supply chain which is facing data center infrastructure?

Andrew Power, CFO

I would break that down into two topics that seem interconnected. The extended book-to-bill was primarily driven by our largest deal with a major multinational financial services client. This transaction has been in development since the start of the year and involves four different locations. It's truly impressive and an honor to be involved in their digital transformation, which is moving towards a hybrid IT model. Since these projects are currently in the planning stage, we are tailoring our designs to their specifications. This is what is extending the timeline. If we exclude these four transactions with that client, the book-to-bill cycle appears to be normal. I'll let Bill elaborate on the elongated sales cycles he mentioned.

Bill Stein, CEO

It's a little bit elongated, Jon. But as Andy said, if you were to strip out the four build-to-suits that are in this quarter, the effect on the book-to-bill this quarter would be minimal.

Operator, Operator

The next question comes from Frank Louthan of Raymond James.

Frank Louthan, Analyst

Great. Have you increased pricing on cross-connects as well? If so, how much have you raised that and what percentage is under the new pricing? Also, you're quite innovative in bringing your effective financing rate down close to 3%. What expectations do you have for future financing, and do you think you'll be able to maintain that rate?

Andrew Power, CFO

Thanks, Frank. Maybe Chris can add on cross-connect pricing and pricing dynamics overall. I would remind you, we are essentially putting together some critical puzzle pieces through our M&A and aligning our cross-connect pricing across various regions, including the latest and greatest addition to our platform with Teraco, the leading platform across South Africa. So it's not necessarily a uniform step shift, but we have been investing in that platform, bringing more value to our customers and driving commensurate increases in prices. But Chris, anything you want to add on cross-connect prices or data points there?

Chris Sharp, Chief Technology Officer

Yes, absolutely. Thanks for the question, Frank. A couple of points, right? We definitely take a customer-led approach on aligning value to the overall reach and offering we're able to provide. I would echo Andy's sentiment that, like in the Westin Building, I think we've talked about it a couple of quarters ago, where we're driving consistency in our interconnection products and capabilities in that market to really just deliver more value, and you're going to start to see more revenue pick up in the next year on uniformly bringing that into our overall platform. I'd say the next piece is more probably pointing to your question in EMEA, right, where we've been talking for some time now about increasing those prices, and that's been performing great. I think that's something that you'll continue to see growing, which is represented in the interconnection numbers that we put up this last quarter. So you'll see that performing, I think, much better over the course of the next year here.

Andrew Power, CFO

And just not to leave you without any numbers in terms of rate or growth increases. I mean the ranges are pretty wide, but it's anywhere from the low mid-single digits to some definitely outliers that are in the teens at the very least. I think the overall pricing environment is probably even more relevant to the heart of your question, though. We are continuing to see improving pricing power across our platform, whether it's in our, let's call it, less than megawatt enterprise colocation footprint. We're seeing 10% to 15% sequential pricing changes in many markets and also seeing similar type of increases in the larger plus than a megawatt as well. In relation to your second question, I mean, big kudos to the Digital Realty Finance Capital Markets team for really staying nimble and acting fast in a volatile environment and really bringing together, call it, what is the $2 billion of capital in, call it, 60 days. We've also been tapping into incremental FX hedging, given the more volatile FX world and a more global business. We've been able to get our cost of capital to around 3%. I'm not sure that's a permanent number we go from here. We've had the most rapid increase in the U.S. Treasury in 40 years or Fed funds rates in 40 years. But we're definitely using all the tools in our toolkit to maximize those options and drive down the cost of our capital.

Operator, Operator

The next question comes from Dave Barden of Bank of America.

David Barden, Analyst

I guess first question would be, Andy, can you walk us through how this bubble of lease renewals in 2023 is going to work out? I guess, on supplement Page 23, 15% of annualized rent is coming due next year. You've had some success with positive lease renewing spreads year-to-date and it would be helpful to get some comfort level there. And then I guess the follow-up would be, I think we were hoping to get some comfort on what your understanding with Dominion and Northern Virginia energy availability would be in the development pipeline on a go-forward basis? And if you could share what your latest thinking is there.

Andrew Power, CFO

Thanks, Dave. I'll address the questions in reverse order, as the second one relates closely to the first. Just as a reminder, it was about 90 days ago that we received the recent news from Dominion regarding the constraints in Eastern Loudon County affecting power deliveries. We are maintaining regular communication with the power company to find a way forward. However, the initial message remains the same: significantly less power will be available for ongoing development in this region until 2026. Feedback indicates that by 2026, we should return to more standard practices. This situation is not permanent and stems from transmission issues rather than generation capabilities. We have been informed of this. In the meantime, we anticipate lower supply in a high-demand market. Consequently, we are observing a shift in pricing power back to us. As the largest incumbent with 500 megawatts of available capacity and just under 200 megawatts coming due contractually in the next three years, we are performing well in this market. In hindsight, we might wish we hadn't sold so much, but this situation was unexpected by market participants. We are not entirely exposed, as we still have a 200-megawatt parcel in Manassas that remains unaffected, which is advantageous at this time. While I can't guarantee anything right now, we are hopeful that the responsible parties in Loudon will collaborate with us to fulfill the contracts signed by customers who are in our backlog. Regarding the second question, the pricing power pendulum continues to shift in favor of providers due to sustained robust demand, a strong outlook, and the fact that supply has been absorbed. You noted the 15%, which is a small portion of our exploration schedule. In shifting price conditions, having more opportunities to create value for our contracts is beneficial. This segment typically features our most stable and committed clients at the front of our exploration schedules. I'm confident about retention and pricing action. Additionally, my commentary on Northern Virginia and other tightening markets suggests this trend of favorable cash spreads will continue, which were positive in the first two quarters of this year and are expected to remain positive for the year 2022.

Operator, Operator

The next question comes from Michael Rollins of Citi.

Michael Rollins, Analyst

So with some of the comments on demand but also a lengthening of the sales cycle, should investors look at Slide 5 a little differently in terms of the range of sales outcomes that you achieved over the last six to eight quarters relative to what the next six quarters or four quarters might look like? And then secondly, just given some of the comments that you provided on currency and on interest rates. If everything stays where it currently is, can you share a sense of what the potential headwinds could be on 2023 financial performance, thinking of revenue and core FFO per share?

Andrew Power, CFO

Let’s discuss the currency and interest rates first, and then we can explore expectations for signings in the coming quarters. Regarding currencies, particularly influenced by recent movements in the British pound, I believe they will continue to be a challenge in 2023 compared to 2022. This is not a permanent situation, but due to the ongoing increases in governmental base rates and currency fluctuations, we haven't fully assessed the impact of these factors, including interest rates. I anticipate that interest rates will have a lesser negative impact in 2023 compared to the previous year. Currently, we are managing 400 basis points. While I don’t have the precise figure, I don’t expect it to be anywhere near that level over the next year unless significantly impacted by a drastic drop in the euro and pound. Over 80% of our debt is fixed-rate, and we are exploring various capital markets to align our assets and revenue, mitigating some of the interest rate trends. A good estimate for potential headwinds on a year-over-year basis would be to look at our floating rate debt in light of anticipated software increases over the next year. Now, regarding our outlook for new signings, I'll leave that to Corey.

Corey Dyer, Chief Revenue Officer

Yes. So thanks, Mike, for the question, and Andy for going first. First off, I want to tell you that we don't forecast. I'm not going to try to play a game on what it's going to look like. What I will tell you from a demand and pipeline perspective is that our multi-quarter pipeline is resilient and very healthy, coming off of our quarter that was our top quarter ever. The demand is healthy across all regions. The one softness area would probably be in the small enterprises where they're more susceptible to the macro issues, like the war in Europe. We've seen those cycles lengthening, and it moderated some of our results in the sub-megawatt space. But broadly across the globe, we've got really strong hyperscale demand. We've got robust demand and increasing demand from our large $1 billion-plus multinationals. Our channel business is going well, and we're seeing new logos uptick from that cohort, as well as potential demands from new signings in that area. The overall outlook is positive, resilient, and really healthy after our best quarter ever.

Operator, Operator

The next question comes from Eric Luebchow of Wells Fargo.

Eric Luebchow, Analyst

Great. As we think about your impact on inflation on your development costs next year and beyond, just I believe you have some VMI contracts renewing in early 2023 for your equipment spend. Maybe you could talk about what your expectations are there in terms of cost inflation on development as we enter the new year? And then second, as we think about the better pricing power and perhaps some constraints on new development in markets like Ashburn, are you in a position to perhaps have declining capital intensity in the next few years, which would help reduce your needs for capital? Or how should we think about that dynamic as well?

Andrew Power, CFO

Sure. Thanks, Eric. So we have numerous risk mitigations when it comes to our development and construction, including our vendor management inventory program and other supplier contracts. At a more local level, we bundle our projects with GCs and subcontractors. When you put that all together in the current environment, we look at the next batch of projects, which will be probably more heavily into the back half of '23 and into '24. On a full-baked basis of the entire project, we're still estimating that our costs are in the mid- to high single-digit-type potential increase. Based on the current outlook, and you touched on the supply/demand dynamic, we believe that the rate of growth will outpace that or at least hold firm that our yields will hang in there and not degrade due to that inflationary impact. That's something we're working day in and day out to keep focused on and working with our great vendors worldwide. When it comes to pricing power and capital intensity, I would echo what Bill said at the outset of this call that in the last several months, the world has become more volatile. The capital markets have become more challenged. The talk of a looming recession and the war in Eastern Europe continues, and we are raising the bar at Digital Realty when it comes to focus on our strategic priorities. We obviously have an incredible pipeline of projects and one of the most distinguished land banks to support our customers. However, I think it is very likely we could spend a little less on speculative development as we're focused on projects that deliver the highest risk-adjusted returns.

Operator, Operator

The next question comes from Simon Flannery of Morgan Stanley.

Simon Flannery, Analyst

Great. Andy, I wonder if you could talk about the M&A market a little bit, both in terms of your ability to sell your assets, given the sort of derating of the public company multiples. Have you seen any change in the market on the private side, and how will that affect your fundraising? And you've obviously bought Teraco; how are you thinking about acquisitions in terms of market expansions or expanding in existing markets over the next year or two?

Andrew Power, CFO

We didn't share much on Teraco, and I'll start with that, then hand it to Greg to talk about both of your questions. Having spent some time down in the region with the Teraco team, I think we're even more pleased with the incredible addition to our global platform, not only in terms of the most highly connected destinations across South Africa but we're a really fantastic team delivering on behalf of their customers, our customers, and really growing that platform. I apologize, we did consolidate Teraco into our financials, but we did not roll them out into all the stats given we just closed in the middle of August. That's coming in a quarter's time, so please be patient with us on that. I'll give it to Greg to maybe speak to both your questions.

Gregory Wright, Chief Investment Officer

Yes. Thanks for the question, Simon. Look, I would say pricing on recent transactions in the private market has remained firm. We're fortunate to be in a sector that continues to experience growth and secular demand that is not common for other sectors. We have a product that's scarce in the market with growing demand. When you try to pin some numbers down, if you just look at the last two quarters, it's about $1.7 billion in transactions, and pricing has been very firm in terms of cap rate and per KW basis. So to date, the private capital is looking to increase its exposure to the space where there's a limited amount of supply. Thus, it's remained firm.

Operator, Operator

The next question comes from Matt Niknam of Deutsche Bank.

Matthew Niknam, Analyst

Just first on macro, and I think there may have been a question alluding to this before, but I just want to get a better sense of whether you're seeing tightening financial conditions maybe starting to have an impact on your customers' propensity or willingness to invest further in Digital's transformation as they think about 2023, and whether it varies across hyperscale enterprise or by geography? And then I have one housekeeping follow-up on Teraco; maybe, Andy, if you can talk about any incremental color you can give on expected contributions from Teraco, perhaps in fourth quarter or maybe on a more annualized basis heading into next year?

Andrew Power, CFO

So I'll handle the mundane question on Teraco, and then I'll pass it to Corey a little bit on buyer behavior in the current environment. So Teraco did about $28 million of revenue and $16 million of EBITDA over two months, just to clarify. Its signings are non-existent, and we kind of expect, based on what we're seeing, they have a substantial backlog. I think, from a construction perspective, they added almost $0.5 billion of construction in progress. We feel very good about that growth for the platform. Corey, do you want to handle the buyer behavior?

Corey Dyer, Chief Revenue Officer

Matt, thank you very much for the question. I would tell you that the financial situation changes and pricing rates have all affected small enterprises the most. We haven't seen an effect on our larger enterprises or the $1 billion-plus companies or in the multinational space that we've been targeting more broadly. In small enterprises, there's been a little bit more susceptibility to the macro issues. However, we are continuing to see strong demand in the hyperscale across all regions. We mentioned Portland was our largest this past quarter, and Paris had significant activity in EMEA. Osaka was significant in AP. So we are seeing it across the board with large scale deals, as mentioned earlier, with an enterprise customer in Texas and Virginia. So we're seeing large scale deals continue, but just a bit of moderation in the small enterprises. Overall, our pipeline is strong, resilient, and really healthy after our best quarter ever.

Operator, Operator

The next question comes from Aryeh Klein of BMO Capital Markets.

Aryeh Klein, Analyst

Bill, you mentioned sharpening the lens for new investments. Can you talk about what changes there? And then, Andy, just on the minus 8.8% renewal spreads for larger deals. You mentioned that negotiations began months ago. What would those rates look like if they were done today?

Bill Stein, CEO

So sharpening the lens, I think practically, what you'll see is over time higher returns from the deals that we do and lower-returning assets or investments dropping out of the mix. That's the practical implication. So obviously, it's more complicated. We look at risk-adjusted returns, what's the appropriate return in each market, whether it's a build-to-suit or speculative development, pre-leasing, and whether there are any magnetic attributes to the customer. But in general, I think you'll see higher yields over time.

Andrew Power, CFO

And then, Aryeh, before I get to your question, I want to apologize; I misspoke in answering Matt's question about Teraco. We had two months, not 1.5 months. Those numbers I quoted are in our financials. So as I mentioned before, the cash mark-to-markets have been moving in our favor since the beginning of 2022, and I would say it's been strengthening over the way you saw in our numbers and in our guidance. That being said, we won't be universally at this minute without any negative marking across markets in any given quarter. I think the driver of the negative 8.8 million was a data center, a one-off we acquired a couple of years back in Chicago. That customer's contract was in place; it was above market at the time. The market hasn't caught up to it when it rolled. The more strategic story about that asset is that we literally just greenlit conversion into growing our colo footprint in the suburbs of Chicago, which has been a great success. To go on to your question, regarding the larger deals' price action just in the past year, not our biggest deal, which was the build-to-suit, but our second biggest deal was a sizable plus megawatt deal. That transaction in North America was signed at almost 18% net effective rates higher than a similar transaction a year ago. The remaining space in that facility is probably being marketed up another 10% to 15%. You're seeing a quick reversal in some of these markets where demand is robust and diverse while supply is dwindling.

Operator, Operator

The next question comes from David Guarino of Green Street.

David Guarino, Analyst

On the inclusion of CPI linked to rent escalators, is that a trend you’re seeing from hyperscale tenants? Or is that more heavily skewed towards the 0 to 1 megawatt bucket? And then the second question is, switching gears, just with the supply and power restrictions in a few of the top markets like Northern Virginia, do you think that’s why you saw such strong demand in Dallas and Hillsboro this quarter? And are there any other spillover markets that you’re seeing early signs of demand picking up that maybe they could have gone to NOVA if there was capacity there?

Andrew Power, CFO

Thanks, David. So first off, CPI was a predominant term. I would say it's mostly in our European footprint, even before inflation was a buzzword. Hence, that's the majority of, call it, just under 20% of our in-place contracts that have CPI escalations. We've been discussing this in our customer conversations and it's not just on larger contracts but across sizes. For smaller contracts that likely had a shorter duration, such as two to three years, it's a little less priority because you get another chance to adjust as market rates change. But in our record quarter, we saw CPI escalation on 40% of our greater than 1 megawatt signings, showing our push and our customers’ acknowledgment of this factor. Looking at our activity: the majority in Dallas was due to this build-to-suit customer demand. They needed multiple cities, not just NOVA. The Portland demand was very locationally sensitive. I would say that we’re still seeing spillover effects as we speak. Early interests point to Atlanta, Northern New Jersey, potentially Chicago, and also a nearby spillover in Manassas, where we have a 200-megawatt facility.

Operator, Operator

The next question comes from Michael Elias of Cowen and Company.

Michael Elias, Analyst

Congrats on the leasing. Just two questions for me. First is, as you think of Northern Virginia and the power delays, you mentioned how the conversations are evolving with Dominion. But how are the conversations going with the customers themselves who pre-leased capacity? Is there any risk to those leases being canceled or anything like that? And then second, your leverage is now running around 6.7x or 6.4x if we adjust for forward. Based on the conversations you've had with the rating agencies, what's the highest level of leverage that you can hold before you run the risk of being downgraded or losing that investment-grade status?

Andrew Power, CFO

Thanks, Michael. I think we saved the best for last. Happy to walk you through both. So the customers are obviously concerned, right? Most of these customers probably never experienced anything like this. Yet, they're incredibly grateful that they're in our hands and not some upstart competitor. I'm biased in saying that, but I really believe it. We're the largest in the market with diverse campuses and an experienced team guiding them through these issues. I reiterate, while I cannot guarantee it now, we're optimistic that the responsible parties in Loudon will work with us to deliver for all these customers. Regarding your second question, leverage has ticked up a little. This isn't our desired position. We've had many moving parts in our capital stack with asset sales, joint ventures, and acquisition closings. We still have a half-billion of equity forward, not yet drawn, and we see a return to target leverage through leasing up our vacant capacities. You saw occupancy rise substantially, moving the needle on a sequential basis. We are also seeing a friendlier mark-to-market in our cash flows, and we plan to continue our capital recycling strategy with great partners willing to invest in Digital Realty. That will help bring leverage back down toward target levels.

Operator, Operator

That ends our question-and-answer portion of today's call. I'd now like to turn the call back over to CEO, Bill Stein, for his closing remarks. Bill, please go ahead.

Bill Stein, CEO

Thank you, Andrew. I'd like to wrap up our call today by recapping our highlights for the third quarter, as outlined on the last page of our presentation. First, digital transformation remains an important secular driver of our business and drove record quarterly bookings. These additional commitments are reflected in our growing development pipeline and the high level of preleasing. Second, we continue to enhance our global platform with the closing of Teraco, giving Digital Realty the leading position in South Africa and a critical complement to our existing capabilities elsewhere in EMEA. Third, we continue to execute with improving results in our core data center business, though these improvements are masked by foreign exchange headwinds. Finally, the capital markets were very volatile in the third quarter, and we've taken action by adding significant liquidity to our balance sheet and prioritizing our new investments. Before signing off, I'd like to thank our dedicated and exceptional team here at Digital Realty, who keep the digital world turning. I hope all of you will remain safe and healthy, and we look forward to seeing many of you at Nareit next month in San Francisco. Thank you.

Operator, Operator

That does conclude the conference for today. Thank you for participating, and you may now disconnect.