Gladstone Commercial Corp (GOOD) 2008 Q2 法說會逐字稿

Greetings, ladies and gentlemen and welcome to the Gladstone Commercial second-quarter 2008 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 Gladstone Commercial. Thank you, Mr. Gladstone, you may now begin.

Thank you, Doug, for that nice introduction and thanks to all of you for calling in. We always enjoy this time we share with shareholders and wish there were more times to talk to you, but this is the one time each quarter that we do have time to speak with each of you.

Now please come and visit us if you are ever in the DC area. We are located in McLean, Virginia and you have an open invitation to come by and say hello. You will see a great team at work.

Now let me read the forward-looking statement. This report that I am about to give may include statements that may constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Securities 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 be reasonable.

There are many factors that may cause our actual results to be materially different from any future results expressed or implied by the forward-looking statements, including those factors listed under the caption Risk Factors in the Company's 10-K and 10-Q filings that are filed with the Securities and Exchange Commission. Those 10-Ks and Qs can be found on our website at gladstonecommercial.com, as well as on the SEC website. The Company undertakes no obligation to publicly update or revise any of the forward-looking statements whether as a result of new information, future events or otherwise.

In my talk today, I plan to talk about the term called funds from operations or FFO and since FFO is a non-GAAP accounting term, I need to define FFO and it is defined as net income excluding capital gains or capital losses from the sale of real estate plus any depreciation, amortization of real estate assets.

The National Association of Real Estate Investment Trusts or NAREIT has endorsed FFO as one of the non-accounting standards that we can use in discussing REITs and I plan to use that term. Please see our 10-K and 10-Q filed yesterday with the SEC and our financial statements for a detailed description of FFO.

Well, our June 2008 end results reflect another positive step. We invested at a little bit slower pace, but a good pace. All of our tenants are paying as agreed, so the outlook is still very optimistic for Gladstone Commercial.

During the quarter we just ended, we completed one acquisition of a fully leased property, approximately $3.9 million by using funds that we borrowed under our line of credit. After the quarter-end, we have not made any new investments, but we have quite a few that are in closing or have purchase agreements that have been signed and we are working on the due diligence. We currently have a lot of properties that are in our pipeline and I still anticipate that we will have good growth for the rest of 2008 and I think it will be into 2009 as well.

We are building our portfolio by using our line of credit, which is funded by a group of banks that we borrow from the line to buy the property and then we obtain long-term fixed-rate mortgages on the property as soon as we can in order to get that mortgage in place and by doing this, we lock in the profit on the property and we expect the profit to continue for up to 10 years and some of them even longer.

We then use the proceeds from the mortgage to pay down the line of credit, so we can use that line of credit to buy the next property. The current credit marketplace is having a great deal of difficulty in long-term mortgages -- the long-term mortgage market, called the CMBS marketplace or conduit market, and we have dealt with them for most of the time this company has been in business.

That CMBS or conduit marketplace has gone away. It is literally closed and probably will not open for a while. CMBS is a method whereby the banks or other financial institutions will make or buy real estate mortgage loans and then place them in a single entity or pool and sell investors a participation in the pool. But the pool investors have gone away and so there is no new pools forming and no new mortgages getting done in these pools and this is one of the fallouts from the subprime home mortgage mess. Home mortgages were put in those pools and when those started showing a lot of profits, the same thing happened to the commercial and industrial mortgage marketplace.

We do have other mortgage lenders that we are working with and I hope to close on some of those soon as there are some lenders making mortgage loans on commercial and industrial properties and as long as we can have a decent spread between the rent coming in on the one hand and the mortgage payments going out on the other then our REIT will continue to go along just fine.

I think even with the turmoil in the credit markets, 2008 will still be a great year for our REIT. We have one of the few that can close and finance a commercial real estate property and as long as we can do that, we will have a great opportunity.

At the June quarter-end, we had approximately $201 million in long-term mortgages at a weighted average interest rate of 5.8% and we borrowed against our properties to get those mortgages. The rates on long-term mortgages will be higher in 2008. We are already seeing that and certainly with the collapse of the CMBS market, we are having to negotiate shorter-term mortgage loans with banks, some of them three to five years. Right now, we are working on a batch with five years in its term. And until the CMBS marketplace comes back or stabilizes, I think that 10-year mortgages are not going to be around for a while.

Rates on these shorter-term mortgages are approximately 6.5% today, but rates are very volatile. One day, they are up and then the next day, they are down and it is really hard to estimate where we may end up as rates continue to bounce around. We will see what the mortgage lenders do with the ones that we are working on and certainly report them to you at our next meeting.

At quarter-end, we had approximately $266 million in mortgages and short-term borrowings on our line of credit, meaning that we had about $1.90 in debt for every $1.00 in equity. As you know, if you round that off to 2 to 1, that is still a very conservative position to have on our balance sheet. We have relatively low leverage today. We are going to seek to increase it over time. For now, we are looking to increase the buy say to $2.50 of debt for every $1.00 of equity. We think that is as much debt as we would want to put on this Company at that time and assuming we can leverage at $2.50 to $1.00, we should be able to invest another $75 million in new properties.

Let me explain how you have the ability to do this that each time we close an investment, we borrow say at 6.5% and then purchase a building yielding in round numbers 9% today. Although we have some that are much higher than that that we are buying. So every $10 million of new properties would generate an estimated $250,000 to pay increased expenses and interest and dividends. We could assume a higher cap rate of 9.5%. We certainly are in that range today, but let's use 9%. And what that would do is by placing another $75 million of new properties on the books, it would then yield us $1.875 million of new FFO on the books or about $0.22 a share.

And that is the strategy of investment with leverage and that is our vision for the Company, but it only works if we can borrow at reasonable rates and right now, we still think we can do that. The strategy is to buy real estate properties that have long-term leases, then place the mortgage on the property and pay the difference between the interest on the loans and the rents we receive through our shareholders as monthly distributions and hopefully we can continue to increase the dividend as we do that.

The quality of our assets is extremely good today. All our properties are leased, all our tenants seem to be in good shape. They are all paying rent as agreed. I really couldn't ask for a better portfolio today.

And now to the quarterly results, as I talk about the per-share numbers as we go through these numbers, please know that I am talking about fully diluted weighted average common shares. Net income available to common shareholders for the quarter ending June 30, 2008 was approximately $196,000 or about $0.02 a share. The only impact on this was the one acquisition that we had during the quarter of $3.9 million.

And for this quarter, funds from operations to common shareholders -- this is the FFO number -- was approximately $3.4 million, or $0.39 a share. This is a 6.7% increase in FFO from the same period last year. For the six months June 30, 2008, net income available to common shareholders was $589,000 or about $0.07 a share. For the six months, FFO or funds from operations was approximately $6.8 million or $0.79 a share. And this is a 12.4% increase in FFO for the same period as last year.

And to all the shareholders out there, I just want to say how proud I am of the team that has increased the FFO and the FFO per share from these numbers. I think they are working hard to do the same going forward and I think the remainder of 2008 is going to be a really good year for us.

The real estate marketplace has changed dramatically in the last year because the mortgage market has changed so much. This will cause many more sellers to be realistic in their sale price and if we can have mortgages available to us then we can capture a lot of the market at a very good income rate. And there is still -- the marketplace is divided into three parts -- the tenants that have AAA or BBB ratings. These are the rated tenants and those tenants that are located in high-quality real estate areas are still being sought out by the very large real estate investment trust, as well as big insurance companies and some of the pension funds. Cap rates in this area have changed, but not a lot. They have gone up, but they still have not settled out at some number that I could give you. They are in flux today.

The second area is the small real estate properties like fast food locations or pharmacy chain locations. Those are being purchased by individual investors and some of those are what we call [1031] buyers, meaning that they are swapping their proceeds from one property into another at a tax-free kind of transaction. Cap rates there have changed also. They are somewhere between 6.75 and 7.5 today and that 7.5 is more and more becoming the real number that you can look to.

Many of these buyers do it as a way to produce income to live off of. They roll over the profits from one piece of real estate into another. This whole area too is in flux and I think we will see that marketplace come our way during this year.

Our investment space is in between those two and we seek the non-rated tenants. These are small and medium-size businesses like the kinds that we lend to with our other funds. So we have a great deal of expertise in being able to underwrite small business tenants and we have a team of real estate experts that are exceedingly good at underwriting the real estate that we are looking at. So we are in a good position to see a lot of business here. This dual underwriting standard is the hallmark of our Company and I think it is why we are doing so good.

We will do our best in the coming months and years to load up on good properties and long-term financing that match our long-term leases. Locking in all this financing in place should be good for us in the future. Our leases have escalation clauses in them so that every year or two they go up and that, of course, since you have a fixed rate loan in place, that is money that just comes directly into the Company and can be used for paying dividends.

I would like to also mention that the industrial base that we find ourselves buying property in, the rents in the industrial and commercial properties remain pretty steady. We don't think it will grow much in 2008, but it will grow and not shrink as we have seen so many other areas that are shrinking. And we now believe that the downturn has reached the bottom and we will begin to climb back out of this recession over the next two to three years.

At this point, I am really optimistic about the future of this Company and believe it will perform very, very well over the next 6 to 12 months. I do worry that this election tells us another story. Our country continues to lurch further toward socialism rather than capitalism and I always wonder what that will do and my guess is that this election will move us close to socialism. We are about 44% of all dollars spent today are spent by governments -- either federal, state or local -- and only 6% away now from being officially classified as a socialist country.

I know they keep talking about people making over $108,000 are going to be taxed more. They are already paying 71% of all the taxes that are paid. The burden on the middle class in my estimation is excessive and I think we are just near a tipping point and it is a very worrisome time. That is one of the reasons that I like the REIT so much. It has business tenants with good outlooks and I think this one will be a winner.

In July of 2008, the Board declared the monthly distributions of $0.125 per month per share and that was for July, August and September. That is at a run rate of $1.50 per year. This is a wonderful nice rate on such a good REIT and of course, most of you know that distributions last year were about 74% return on capital and I think it should be similar this year. This stock is a good one to hold in your regular account because it is so tax-friendly. The 74%, that is what I am estimating it's going to be this year, is a return of capital because of the depreciation on the real estate assets and the other items that we have on the balance sheet.

This causes us not to have a lot of earnings after depreciation and that is why we talk about FFO because it adds back the real estate depreciation. The depreciation of a building is a bit of a fiction since at the end of the depreciation period and in our case, it is 39 years, the building is then depreciated down to zero, but it is still standing. It is a great thing if you own the stock personally because you don't pay any taxes on that part of the dividend that is sheltered by depreciation, the 74%, because that is the return of capital.

However, the return on capital does reduce the cost basis on the stock, which may result in larger capital gains when the stock is sold. With a stock price averaging about $14.40 at yesterday's close, the FFO yield on the stock or the dividend now is around 10.4% and it is just exceedingly high. Many REITs are trading at 4% or 5% yields and we certainly should be trading at that rate too. But as a small REIT, we are overlooked by a lot of the institutions and the buyers, individual buyers. We will declare the next monthly distribution in early October and that will be for October, November and December.

And now I am going to stop, Doug, and if you'll come back on and we will get some questions from our loyal shareholders that are on the call.

(OPERATOR INSTRUCTIONS). Rich Shane, Jefferies & Co.

Good morning, David. Thanks for taking my question. How are you?

I am fine. How are you, Rick?

I am doing very well, thank you. Given your generally pretty cautious commentary, it is interesting to me that you are basically saying that you think we are approaching a bottom. I would love to hear conceptually what you are seeing within the portfolio that gives you that indication. Obviously, again, you think it is a pretty long recovery process, talking about two to three years, but, again, you have some pretty good insight given what you are looking at within the portfolio. What gives you that confidence?

Well, we have about 150 different transactions in our portfolio across the three funds and they are all performing reasonably well and in fact, the ones that aren't performing well are due more to management problems than economic problems.

And the other thing that tells me we are going in the right direction now is that most of the businesses that show up on our door are relatively healthy businesses and as a result, if you are not seeing the guy who needs to meet payroll on Friday or the person who has got a defaulted loan and is in foreclosure, it tells me that at least the small businesses and the midsize businesses that we are seeing are relatively strong and I have been preaching this for a long time.

The difficulty in the marketplace today is not from the operating side of the businesses; it is from the financial institutions that are trying to digest these changes in accounting and depreciation in their portfolio, as well as some of the faults in their home mortgages. And all of that has caused the banks to pull back. We are estimating that it is going to be a very large amount of bank loans that are not going to get done in 2008. I don't know what that number is going to be, but it won't be -- I don't think it will be as large as it was in 2001 when you had about $1 trillion come out. And as you know, Rick, the banks provide about $3 trillion worth of loans every year and cutting it by one-third is a huge amount. That would throw the recession into a longer-term basis.

Also, I think the oil bubble has burst. All of this speculation that was going on in the oil patch has come to an end and I think you will see that oil patch continue to have problems in terms of pricing and prices will continue to decline and given that impact on the economy, it will be a very positive stimulus.

With all the financial institutions finally getting to the bottom of the barrel in terms of all the problems that they have got, oil prices coming down, our portfolio is doing well, the companies that we are seeing out there coming to us for loans and doing well. The only thing that is holding this economy back right now is really the banks and the other financial institutions tuning up and lending again. I just think we are listening to the newspapers and the reporters too much and not looking at the statistics.

Got it. Okay, David, thank you very much.

Next question.

Chris Lucas, Robert W. Baird.

Good morning, David.

Good morning, Chris.

Just a couple of quick questions for you. On the advisory agreement, I guess in the Q, there was some notice that it was extended. I was just curious about the timing and what the length of term is and if this is something we should expect every second quarter going forward?

Yes, we go through that every year about the time we do it for all three companies and we take the results of the Company's performance over the past year. We compare it to others in the marketplace and they approved this time all three of the agreements. We have three agreements with them. We have the administrative agreement, the advisory agreement and then we have the tiny little amount of money -- I think it is $10 a quarter -- for the use of the name. Those were all approved by the Board and we do that every year as a matter of fact. I don't know that we have to do it in the REIT, but we have to do it in the other companies and so we just tag the REIT along with it.

And I am assuming no changes to the agreement from the prior one then?

No changes. Identical. They like what they see.

And then just in terms of the acquisition market, it was a slow quarter, great yield on the deal. What are you seeing in terms of just velocity of transaction flow? Is it getting better or worse than the last couple of quarters?

I think it is getting better in the sense that there are more properties for sale at reasonable prices. The difficulty is finding good mortgage money right now. As you know, CMBS is dead and having to find a bank in the area that will lend on it or deal with one of the larger finance companies makes it much longer to get a transaction together. I am hopeful that three or four of the banks that we are dealing with will come forward and close on the ones that we have got lined up.

We have a number of deals lined up that are subject to the mortgage and so as the mortgage finally gets in place, they can close and that is what slowed everything down in the second quarter. Hopefully, all of those will come to fruition in the third quarter. And you never want to get too far out in your line of credit buying properties without having a mortgage that you can put in place.

We are averaging wonderful cap rates right now. If you looked at the last four -- 10.0, 8.9, 11.2, 10.9 -- all of those are very nice cap rates that we can live with for a long time, but you have got to match it up with a good mortgage and finding the mortgage money is a lot more difficult today.

And then just on that balance sheet question and your line, you have a term loan that I guess has its first -- I guess the first maturity date is later this year. What is your thoughts about how you would look to refinance that out?

Yes, we are dealing with all of the banks that are out there and we have gotten a lot of interest in increasing the line of credit. So I think it will be increased. The $20 million unsecured line that we have, we have not asked them, but we will be asking them to roll it over. I feel highly confident that we will. We can always extend it for six months. We have it right in the agreement, so that would take it to June of '09 and my guess is that, at the end of the day, we have been exceedingly blessed with good banks that want to continue to honor their relationship with us and I think we will continue in that regard.

Even though KeyBanc, who is the main bank on that, was beat up pretty badly in the downturn, they raised money and seem to be back in business lending money and we also have several other banks that are very interested in coming into the credit. So I just don't think that's going to be our problem. Our problem is really the longer-term mortgages on the properties in order to pay off the line of credit. That is really where the rub is right now.

I guess just following up on that comment, when do you see the liquidity in the mortgage market getting better? Is that a six-month issue or an 18 or 24-month issue for you?

I think it is 18 -- I think it is a good year and a half. I think they will start to tune up again in '09. Right now, the buyers of CMBS pool participations are out buying up a lot of the old pools that are out there at rather attractive rates and I don't think a new pool could get done today beyond the AAA piece, which would probably be only about $0.50 on the dollar. Without being able to sell off 70% or 85% of the pool, I am not sure it makes sense for a lot of people to get it done.

And given the fact that Moody's and S&P and Fitch are all trying to make up for lost ground it seems to me in terms of being very conservative in their valuations now, I just don't know where the valuations of the strips would come out today from those three organizations given that they have hunkered down so far.

So you're going to have to have a lot of pieces come together and as you know, it takes a long time for people to get back into that mode. That is why I am forecasting -- like almost all the other recessions, it is going to take us two to three years to work our way back out of where we are. But it will happen. And if this is the bottom, we've sort of got a head fake May -- April and May looked like they were going to be strong months and we were out of the woods and of course, June and July were disasters in terms of the downturn. We are back on an upswing it seems to me right now, but who knows. Maybe that is another fake and we will go back down again in September or October. Right now, it does not look like that.

And then my last question is on the tenant credit quality, are you seeing -- with bad debt reserve changes or slower pay or anything in your portfolio that leads you to be a little more cautious about your underwriting going forward?

Chris, we are truly blessed. We haven't had a person miss a single payment by even more than one or two days and that is usually some foul-up in their administrative part of the business. So at this point in time, I would say we have zero problems. We do know one of our tenants wants to move out at the end of their lease. That is five years from now. We are already working on them getting another tenant that would take the whole building. I really don't see any problems in the portfolio.

And then I guess just a follow-up on that, you did have a couple of lease extensions. I was curious as to whether or not there were any one-time fee payments associated with that and sort of what you can comment about how the rents compared to the prior rents.

Oh, no. The rents were all equal to or better than or within slight -- I think we gave a slight discount on one of the extensions. If you can get somebody that's a good tenant to sign another 10 years and give them a little discount now, that is always a pleasure to do because the 2% to 3% bump every year picks that back up in probably a year or two. But all of those extensions have been at market and market has generally been in excess of where we are.

And the extensions were for leases that were maturing in the near future as opposed to --?

Actually, not in the near future. I think one of them were three or five years out and we did it just because we wanted to get it matched up with the longer-term debt that we already had on the property and they wanted to make sure they weren't going to be thrown out of the building or held hostage at some point, so they have been negotiating. One of them was in negotiations for at least 18 months as we sort of went back and forth saying we want this and they want that and finally came to some agreement of extending the least. It is always better for us to lock in a long-term lease with a 3% bump every year than it is to run up close to the one or two-year timeframe.

Thanks a lot, David. I appreciate your comments.

Sure. Next question.

Jim Altschul, Aviation Advisory Service.

Good morning. I have got a question about the waiver of the fees to the management company. I gather this quarter you partially waived the fee. In the previous few quarters, you waved it entirely. What is your decision-making process or thought process regarding to what extent you are going to be waiving these fees going forward?

Yes, the waiver of the fee has been based on the dividend yield and we have in the past made sure that the dividend was covered. In fact, we have been working at 95% payout because that is what our loan calls for. So the math is we figure out what it takes at 95% payout and then if the earnings aren't there, then we add back our incentive fee. We have been hoping over the year to work out of that situation completely. It arose because we had stock options in the Company and those stock options were surrendered in consideration for getting an incentive fee. But at the time that they were surrendered, the incentive fee would have caused us to have to lower the dividend and we didn't want to do that.

I think by the end of the year, if I am right, looking at our projections, we think that we will no longer be waiving any of the incentive fees, that is the earnings will have increased substantially enough to let us avoid doing that altogether. The hope is to do that because the incentive fee is what we use to pay our top producers and we want to keep them happy so they continue to produce great deals for the Company.

Terrific. Thank you.

Okay. Do we have another question?

(OPERATOR INSTRUCTIONS). There are no further questions in the queue, Mr. Gladstone.

All right. Well, this was very nice and we thank you all for attending and we will adjourn the meeting.

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