Gladstone Commercial Corp (GOOD) 2007 Q3 法說會逐字稿

Greetings, ladies and gentlemen, and welcome to the Gladstone Commercial third quarter 2007 financial results. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (OPERATOR INSTRUCTIONS). As a reminder this conference is being recorded.

It is now my pleasure to introduce your host, Mr. David Gladstone, Chairman, for the third quarter 2007 financial results. Thank you, Mr. Gladstone. You may now begin.

Thank you, Jackie, for that nice introduction and thanks all for you getting up this morning on Halloween to take this call. We enjoy the time we share shareholders and wish there were a lot more time to talk to shareholders. Please come visit us if you are ever in the D.C. area. We are located in McLean, VA, and you have an open invitation to stop by and say hello.

With this being Halloween, I suppose I'm supposed to say trick-or-treat but today all we have is a lot of treats for shareholders.

But before we get started, let's talk about the forward-looking statements. This report that I'm about to give may include statements that may constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Security and Exchange Act of 1934, including statements with regard to the future performance of the Company.

These forward-looking statements involve certain risks and uncertainties that are based on our current plan and we believe that plan to the reasonable. There may these factors which may cause our actual results to be materially different from any future results expressed or implied by these forward-looking statements including all those factors listed under the caption "Risk Factors" of our Company's 10-K and 10-Q filings that are filed with the Securities and Exchange Commission.

Those 10-Ks and 10-Qs can be found on our website at gladstonecommercial.com and on the SEC website as well. The Company undertakes no obligation to publicly update or revise any of these forward-looking statements whether as a result of new information or future events or otherwise.

In my talk today I plan to talk about the term called Funds From Operation or FFO. Since FFO is a non-GAAP accounting term I need to define FFO as net income excluding the gains or losses from the sale of real estate plus depreciation and amortization of the real estate assets. The National Association of Real Estate Investment Trust or NAREIT has endorsed FFO as one of those nonaccounting standards that we can use in discussion of REIT and I plan to use that term. Please see our 10-Q filed yesterday with the SEC and our financial statements for detailed descriptions of FFO.

Our September 2007 quarter inch results reflect another positive step forward. We invested at a good pace and the outlook is still optimistic for Gladstone Commercial. During September quarter we purchased four fully leased properties for approximately $32 million. Most of these closed at the end of the September quarter so they had little impact on the earnings of the September quarter. We currently have a strong pipeline and are anticipating good growth for the remainder of this year and as we realize the benefits of holding our 2007 acquisitions for the entire fourth quarter, I think the fourth quarter will be good.

We are building a portfolio by using our line of credit funded by a group of banks. Once we buy our property, we get a long-term fixed rate mortgage on the property as soon as we can get the mortgage in place and we pay off the line of credit. By doing this, we lock in the profits on the property and we expect the profits to continue for five to 10 years or longer.

The current credit market is in some difficulty and the traditional commercial mortgage lenders that we deal with have become a little more difficult to please and certainly charging higher rates. (inaudible) subsequent to the quarter end we completed a financing that was about 8.5% greater than the last financing we closed in June of 2007. The new rate was 6.63%, now which is a bit higher than we have been paid but nonetheless the good news is that there's liquidity.

We have another one of these in the works that I hope will close om the next few weeks and that will give us much more liquidity. As long as liquidity holds up and we have the spread that we need between the mortgage that we are borrowing that and the rental rate then this Company will continue to go along just fine.

I think with all the turmoil in the credit markets, 2008 will be a banner year for this Company. If we are one of the few that can close and finance commercial real estate property then it will be a grand opportunity.

At quarter end we had approximately $186 million in long-term mortgages and a weighted average interest rate of 5.8% that we borrowed against the properties that we own.

Let's talk about leverage now. In all total we have approximately $216 million in liabilities at quarter end so we are about 1.5 to 1 in debt to equity at the end of the quarter. We have still a very conservative position on our balance sheet. We have low leverage today and I think that we will be increasing the leverage over time. We are still looking to increase leverage at 2.5 times equity and I think that's a reasonable area to be in. And I'm hopeful that we can get there even in this more difficult mortgage market.

Assuming the leverage at 2.5 to 1 we should be able to invest another $146 million so the new property based on this method of operation. And let me explain what I mean by what we're doing here. Each time we close another investment we will borrow let's say at 6.6% and we purchase a building and now the yields have gone up. I hope to get about 8.9% then every $10 million of new properties we generate an estimated $230,000 to pay increased expenses and increase the dividend. Based on the financial assumptions by placing another $146 million in new properties on the books that would then yield about an additional $3.4 million in FFO on the books or about $0.40 on FFO per share based on the current share count.

This is the strategy that we are using to leverage up. That is our vision for the Company. I'm still optimistic that we can execute that strategy. As we buy real estate properties that have long-term leases and then place mortgages on the properties at lower rates than the rents that incremental difference is what we use to pay expenses and increase the distribution to shareholders.

As I talk about per share numbers today please know that I am talking about fully diluted weighted average common shares. That is the most conservative approach you can take on earnings per share. Net income available to common shareholders for the quarter ending September 30, 2007, was approximately $567,000 or about $0.07 a share. This results was impacted only by the event of the acquisition of four properties during the quarter for a total investment of about $32 million and most of those closed at the end of the quarter. So they didn't have any impact on the earnings for the quarter.

For the quarter, Funds From Operation -- this is FFO -- this is the FFO available to common shareholders was approximately $3.2 million or $0.38 a share. This is a 38% increase in FFO for the same period last year; and on a per-share basis that's a 31% increase. So really very strong numbers for that quarter.

And for the nine months ending September 30, 2007, our FFO was approximately $9.3 million or about $1.08 per share. This was a 30% increase in FFO for the same period last year and on a per-share basis was about a 20% increase from last year. Again, very strong results.

I'm very proud of the team that has increased our FFO and FFO per share. By these numbers I think they are working hard to do the same thing next year and I personally believe that 2008 is going to be a very strong year for this Company.

As discussed previously we borrowed $16 million pursuant to a long-term note payable collateralized by security interest in three of our properties and of a rate 6.63%. We will use these proceeds to pay down our outstanding balance on a line of credit.

Because the rate has increased, it will make us -- it will take as a few deals to yield income that we need to pay new higher rates on these mortgages. So what we have to do is find good properties with fair returns on our equity and that's a little bit harder to do in this marketplace. The good news is that there is liquidity out there and I know some of the people in this business have found that there is no liquidity for their properties. And I'm optimistic that we will see more liquidity as the year goes on.

Our backlog, we remained positive about closing on the properties that we have on our backlog. We see hundreds of properties for sale but often priced way too high or we discover a problem during the investigations of the property or the tenant that leads us to turn down the opportunity.

We are seeing much better opportunities now that the debt marketplace has changed. I believe that there is now as much as twice as many commercial and industrial properties on the market for sale as there was last year at this time. And I believe as the year goes on many will drop the price that they are asking, much like the home mortgage business and the home sales business, and we will see many more opportunities.

The real estate marketplace has changed and that is because the mortgage marketplace has changed. This will cause more sellers to be realistic and lower their sales price and if we have mortgages available to us at reasonable rates we can capture a lot of this marketplace.

As I have explained before the triple net real estate marketplace is divided into three parts -- the tenants that have AAA ratings or better or let's say BBB located in high-quality real estate area and they are sought after by many of the very large REITs. And these are typically very large transactions with cap rates that even though they are changing are still much too low for us and we don't play in that marketplace.

Some small real estate properties like fast food chains or pharmacy chains, those types of locations are being purchased by individual investors instead of buying bonds and they do this for income and they roll over some profits perhaps from another piece of real estate in what is known as a 1031 transaction. They are still paying top dollar for many of these properties although I think now that they are having trouble getting mortgages on these properties. The cap rates or the interest rate on the properties which used to be about 6.5% I think is going to move up into the 7, 7.5. I'm not sure we're going to enter this marketplace, but we are certainly keeping our eye on it.

As I mentioned before, our investment space is in this third area. It is a middle marketplace. We see non rated tenants and small- and medium-sized businesses or the people that are wanting to do these sell on leasebacks and our expertise here is in the ability to underwrite these businesses -- nonrated businesses -- and certainly underwrite the real estate. We are in a good position to see a lot of these kinds of transactions.

We are certainly doing our best to buy good properties and used long-term financing to match up these long-term leases and lock in all the financing in place and it should really be good for our future. Our leases have escalation clauses in them so every year there is a little bump up in the rents and of course if you have fixed rate mortgage that means that money comes into the Company to help us increase the dividend.

The industrial base that rents industrial and commercial properties remains pretty steady out there. We don't think it will grow much in 2000 -- the remainder of 2007 and perhaps not much in 2008 but we certainly don't think it is going to shrink at this point in time. I am optimistic about the future for this Company and believe it will perform well over the next six to 12 months and really no problems in the portfolio today. So we are in very good position to go forward.

The housing market certainly has corrected as we suggested it would in many other phone calls that we have had here they there are now more homes for sale than any period in the past and construction is an all-time lows. So that marketplace is in disarray and unfortunately because of the type of mortgages that they put out, a lot of people have pulled back from making any kind of mortgage. And I think that's hurtful to us and to others as well.

The big question of course is what final impact will all those home mortgage loan defaults have on the economy. There are a lot of defaults in the subprime and even the next level up called Alt A mortgages. Both of these loan types are seeing major difficulties and lots of lenders who hold those mortgages or parts of [pools] of those mortgages are having problems and this is -- has caused the banking world to be a bit unstable today. If this moves over to prime mortgages and certainly commercial mortgages it would be a significant signal that the economy is having some real difficulty.

We have also seen some pullback in the commercial mortgage area, but mostly it's been a change in the rate of interest being charged and a little bit lowering of the leverage. That is, we used to be able to get 80% loan to value and now it is more like 75. Many of the commercial mortgage lenders have shut down and because the buyers or the strips of the pools that they have they have shut down. That is when they pool these together they need to sell them to somebody and some of those people have gone away.

So it will be a slow period for mortgages for the next six months. Typical commercial mortgage lender is usually a bank-sponsored group that packages loans in pools and then sells them off. Most of them are in good shape; they just need to get past this period of time over the home mortgages that has caused so much damage to them and others in the business.

In October 2007 the Board set the monthly distribution at $0.12 a month or $1.44 per year. That's a very nice rate and of course most of you know that the distribution is about a 75% return of capital. That is because of the huge depreciation shield that we have.

Please know that this is just a guess and it may change by the time we issued the 1099s to shareholders. That's their form we send out to shareholders at the end of the year. This is because the depreciation of the real estate asset causes us not to have a lot of earnings after depreciation. And that is why we talk about FFO because that adds that the real estate depreciation.

Depreciation of a building is a bit of a fiction since at the end of 20 years the building is still standing. The great thing -- that is if you own the stock personally you don't pay a lot of taxes because a great deal of the distribution is shielded by this depreciation. And that's nice because it is considered a return of capital. That is a really nice tax break for people who own it personally.

With the stock price now at $18.47 as it closed yesterday the FFO yield on our stock -- it's about 7.8% in terms of the distribution. Many REITs are trading at 4 or 5% yields. We should trade at that, but quite frankly I guess we are just too small for the big institutions to get into our REIT. So as a result we are hampered by that small size.

We will declare the next monthly dividend in early January 2008 for the month of January, February and March. So stay tuned for that.

And now Operator if you will come back on and, Jackie, and we will have some questions from our loyal fans out there. Please come on board and lead us in that.

(OPERATOR INSTRUCTIONS) Tony Howard of JJB Hilliard W.L. Lyons Incorporated.

Good news is GDP was up this morning. It seems like every quarter is that there's some changes on you the way you do the income statement. This quarter I don't see where there's a line item for real estate taxes and our licenses. They used to be showing in the 10-Q. I wonder if you explain that and also there's I guess you were (inaudible) the new line item called property operating expenses?

Yes, the property operating expenses is a summation of some things that were in G&A and taxes and some insurance. These are things that we get reimbursements and so on. And we were trying to match that out with some of the stuff that comes in the front door with stuff that is going out the back door.

So in that area of property operating expenses, we've got some property management fees of about $12,000, some franchise tax and state taxes of $45,000. This is for the quarter. The operating expense which used to be in G&A are $41,000 and these are national operating expenses like general repairs and maintenance on buildings that we get reimbursed for.

Due diligence expenses, we had about $8500 related to a [dead] deal that we put into that and then property insurance of about $63,000. Some of these are reimbursed to us and reflected in the tenant recovery revenues. They don't match up exactly.

Then we have some rents on land leases. This is the [Hawk Wellman] deal that we did. That is about $11,000 a month or $33,600 for the quarter and that's reimbursed by the tenant. We pay it directly and then the tenant pays us. So we are trying to put these together. I think what this was a suggestion of Price Waterhouse wasn't it? To help us get this under control a little better. I don't know if that helps you or not, Tony.

Yes it does. I was wondering, though, is it possible to get past quarters' numbers because I saw where you restated last year's third quarter and you show them for the nine months.

Yes we can go back and put that -- we will put that under the Q&A section of our -- we should do that for you so you can go back and -- .

Because we will have to redo our earnings models.

Yes. I understand. We'll go back and redo some of those and certainly going forward of course we'll bhe reporting that way. Sorry to mess you up on your model.

No, it just seems like it happens every quarter now.

Second question is that the incentive fee, I guess in the second quarter 100% got waived but in the third quarter 78% is the way I calculate got waived?

That's correct.

Now do you expect to as (inaudible) improve the profitability to (inaudible)? Hopefully your goal is to reduce that in the waiving and the incentive fee?

Yes. The goal is, over time, to get past this period. As you know this is a transition period for us as we move from giving up all the stock options to go into an incentive fee. And at some point in time, we should be able to remove that altogether.

I think you mentioned before this is not a cumulative kind of expense.

I'm sorry?

This is not a cumulative kind of (multiple speakers)

No it's not. I'm sorry I -- yes. Yes, you're right. Whatever has been rebated for the quarter is done.

So it's not like where you expect to (inaudible) past quarters' amount?

No I mean we would be taking up all your income for a while if we did that. So we are not going to do that.

Go back to the property (inaudible) expenses. There some kind of a ratio as far as percent of revenues would you expect, David?

No, we don't have any goal per se. Maybe we should. I will take a look at that.

Final question regarding your acquisition. You seem more positive this time around than you did at the second quarter. Obviously it seems like you should be able to benefit with the current (inaudible) credit account.

We are seeing a lot of busted deals coming back around. For example the other day, one deal that we lost, I think it was in the summer, to a tenant in common as they call it tick player. They just couldn't get financing for it and couldn't sell that issue. So they reneged on their agreement to purchase the property. And the seller came back to us, even though we were substantially lower than the tenant in common buyer because they needed to sell the property.

So we are seeing a lot of changes going out there. But this is not going to be quick. What is happening is just like what happens in the home mor -- home business. That is you have got a house, it is for sale. You'd like to sell it for X but nobody else is buying at that rate and nobody is selling at those rates. So you got to, at some point in time, lower your price.

We are seeing right now a buildup of commercial and industrial properties for sale for sellers that were trying to sell it at a higher price. They should have sold it six months ago or a year ago. They waited too late and now they are caught in this downdraft.

The real question is, when will they give up and lower their price? We had several of those come through here and we told them if they ever got down to a certain price we were interested. We will just have to see if the marketplace turns around and gets hot again. And they can sell it at that price or if they get tired at some point in time and come back and offer to us at a reasonable price.

Everybody is going to have to adjust their prices if the mortgages have all gone up in price and I think most mortgages have gone up pretty substantially. We were lucky enough to still get a few mortgages at what I would call reasonable rates and many of these mortgages are tied to ten-year Ts and as you know Tony ten-year T-bills have been dropping. The rates on them have been dropping.

So that has helped remove some of the sting from the increase that the mortgage guys are -- mortgages are being quoted now at 180 -- I'm sorry -- one point -- 180 over the ten-year T. So if they are 180 over T's and T's have gone down by 50 you are only out 130 in difference. But that just means you have to find a property that is paying higher rents or your -- a lower price on the property so that it yields more in order to make the numbers work.

It is still a numbers game in the sense that you need to have a certain amount of spread to compensate you for the risks that you are taking on the property. Obviously with a great tenant you are willing to take a little less spread. On a more risky tenant you would want a lot of spread in order to make up for the risk that you are taking.

I think the marketplace is going to burst wide open. I think it will be a very cold winter and a lot of people will sit around hoping that somebody will show up to buy their property and then at some point in time they will relenit and start to sell their properties at prices that make sense for us.

Next question or, Tony, have you got another question?

Chris Lucas of Robert W. Baird and Co.

Just a follow-on to that general discussion. Are you -- can you give us a sense as to the opportunities you are seeing in the current environment in terms of either geographic location, size, volume, relative to where you were, say, six months ago in terms of what your acquisition pipeline looks like?

It's certainly more robust than it was six months ago and it is more robust with deals that we like in terms of the spreads that we are able to get and the tenants that are in the buildings. I think we have held our own with the terms of our real estate and our tenants and I don't think that's changed in the sense that we've lowered it in order to get more deals in. I just think the marketplace is in disarray right now with the mortgage marketplace and that stuff.

As you know, many of the conduit lenders have in essence just walked away and are no longer doing deals. So those lenders, those mortgage lenders known as conduit lenders are just not out there. And with the reduction of the number of lenders, in essence the competition for those who are left is less and they've raised their prices and God bless them as long as they are there to do deals and the spread is there, the opportunities have to match up or you don't do them.

So the opportunities right now are very robust. I think they are going to get even better in 2008 as people get tired of waiting and lower the price by 10, 15, 20% in order to move the property.

Thank you. Can you talk to us about your -- the sort of credit quality of the current portfolio and if there are any concerns or weaknesses from any of your tenants that you see that you are worrying about right now?

Well, I should have mentioned that right along. All the tenants are paying as agreed and we have a good tenant base. All the buildings are 100% occupied and everything is working just as you would want it to work in an ideal situation. So we are very lucky to have chosen some really good property and some really good tenants. I don't have anybody that we are foreclosing on today or trying to foreclose on and none of that is in our portfolio.

Don't know how long that will last. Someday we are going to have a problem, but right now it's in good shape.

And then, you talked before about the issue in the credit markets and your concerns about your ability to sort of finance the way you really want to which is at a 2.5 times the one kind of level. Any thoughts looking at some additional equity in the interim timeframe just to make sure you get through this process with the capital necessary to execute your strategy?

Yes. We've talked about it internally. Probably won't do anything this fiscal year, this calendar fiscal year, but I would say next year if the marketplace really does open up and we see incredible opportunity I think we would go back to the market even though the stock price is incredibly depressed at this price. Should be over 20 and it's so low. If we could just get some of these analysts to put a recommended buy on it it would be really great.

Ouch.

Sorry, I am just teasing.

I know. I guess just a couple detail questions. On the balance sheet there's a liability item for $788,000 that's labeled Due to Adviser. What is that related to?

It is just a management fee that we accrue and at the end of the quarter we haven't paid it. So it's sitting there as a line validated to to the adviser that hasn't been paid.

Then the other question I had has to do with the line of credit, the covenant that relates to the dividend distribution being no more than 95% of FFO. Are there more restrictions in future periods along those lines or is that sort of beginning, I guess, the fourth quarter of this year and go forward through the term of the line?

That's through the term of a line and we will make it this year and looks like based on projections we will make it next year as well.

Rich Shane of Jefferies & Co.

Obviously good to see some progress in terms of reducing the subsidy or whatever you want to describe it as on the incentive fee. I guess the question I would like to ask is from a long-term perspective and from a Board perspective, will you consider increasing the dividend and subsidizing the incentive fee? Or do we need to get through sort of the [subsidation] period before we should expect to see dividend growth accelerate?

I think you'll see an increase in the dividend at some point in time regardless of where we are in fulfilling all of the so-called subsidies as we call it to give back. We have been discussing how to do that at the Board for the last two Board meetings and have some creative ideas. Not quite ready to explain them to the world, but I think coming 2008 you'll see some of that.

Great. That's very helpful. Thank you.

Tony Howard.

I might have missed it but was there a temporary given for the acquisitions in the third quarter?

I'm sorry. I missed what you said.

Was there a cap rate given for the four acquisitions you had?

The four acquisitions, the cap rate. We didn't give it. Can we -- ? We put that as a question-and-answer on the Q&A on the website. That will be the second item that we put on the website.

I'm sorry. Well, we just started huddling here. We don't have that. We didn't disclose it but we can put it down for you.

I guess also do you plan to attend any of the REIT conference?

No, I'm not going out to Las Vegas. It's not my style to be in Vegas, but we do the REIT week in New York that the Association puts on, but don't go to Las Vegas and the big show.

[Ming Chao], Strategic Alternative Solutions.

I had a quick question with reference to how do you hold each real estate property that you purchased under the REIT. Do you hold that in separate entities to protect your liability?

First of all we have as you probably have read an up REIT so we have a partnership underneath us. And underneath the partnership is an LLC for each one of the properties. So that if something happened to that property, it certainly doesn't get all the way into the REIT. I should mention, also, that these mortgage borrowings that we do are not liabilities of the REIT itself. So if something happened to those properties, that mortgage would not be a liability of the parent company, the REIT itself.

So yes, from your perspective they are encapsulized both for liabilities from the outside world and the mortgage liabilities that are on the property.

Charlie Place of Ferris Baker Watts Inc.

Real quick -- quickly. The $33,000 of foreign currency net realized income, should we think that that is now completely behind us as far as pluses and minuses related to the Canadian properties?

Yes. That's the last little piece. We got paid back some money that was held in escrow so we had to make that little change. So it's all gone. We are out of Canada.

Kind of based on what you've been saying and how I've interpreted your expecting cap rates and certainly your third quarter acquisitions imply a little bit higher cap rate than were -- some of your earlier deals were, what is your view or thought on how that impacts the NAV of the portfolio as a whole? (multiple speakers)

Do you see that -- I mean, do you see that these higher cap rates have an implication to the value of your portfolio?

Absolutely. I think if we were selling that portfolio today and it didn't have the mortgage in place on it, it would be at a lower price as we paid lower cap rate when we bought them. So therefore it would be -- we would probably take a loss on those if we had to sell them today.

But the movement has not been that great yet. Now it might be over time and that's what happens. There are many people out there that were buying real estate at 6.5 cap rates that have very substantial depreciation or not depreciation, but very substantial reduced value of their real estate because cap rates have moved. That's like -- you can do stocks and same thing.

TE's change in industries and same thing here. So yes, I think there would be some depreciation in the portfolio. We never got down to those low rates. So I think the amount would be smaller for us than say some of the other firms that paid through the nose for quite a bit of their properties.

I know several of the private REITs have tried to make it to the public marketplace and have been unable to do so because cap rates have changed in the yield. And the return to shareholders has been changed dramatically. Because we locked ours in with long-term mortgages we have that spread that is there for in some cases 10, 15 years.

So as a result, we are protected from that today and if we were selling our properties with the mortgages in place I think we would do very, very well today. So again it depends on how you run your business and as you know we like to matchbook, on the one hand, fixed rents that are going up small amounts every year with a fixed-rate mortgage so that we can maintain that spread. We are in the spread business if you think about it.

Thank you, Mr. Gladstone. There are no further questions at this time.

Again, thanks to all of you and don't get too many candies on the trick-or-treat rounds tonight. That's bad for your health. We'll see you all next time.

Ladies and gentlemen, this does conclude today's teleconference. You may connect your lines at this time. Thank you for your participation.