Gladstone Commercial Corp (GOOD) 2010 Q3 法說會逐字稿

Good morning and welcome to the Gladstone Commercial Corporation third quarter ending September 30, 2010 shareholders conference call. All participants will be in a listen-only mode. (Operator Instructions). After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded.

I would now like to turn the conference over to David Gladstone. Please go ahead, sir.

Thank you, Linnea, thank you for that nice introduction. And thank you all for calling in. We always enjoy these times that we talk with you, and wish we had more time to talk, but it only occurs once a quarter.

So if you are ever in the area, in the Washington, DC area, we are in a suburb of Washington called McLean, Virginia, and if you have a chance to come by and say hello, we would love to say hello and see you. You will see a great team working here.

And now let me read the forward-looking statement. This report that we are about to give may include statements that may constitute forward-looking statements within the meaning of the Securities Act of 1933 and Securities Exchange Act of 1934, including statements with regard to 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 may cause our actual results to be materially different from any future results expressed or implied in these forward-looking statements, including those factors listed under the caption "risk factors" in our Company's 10-K and 10-Q filings, and are filed with the Securities and Exchange Commission. Those 10-Ks and 10-Qs can be found on our website at www.GladstoneCommercial.com and also on the SEC's 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 our talk today, we plan to talk about funds from operation, or as we call it, FFO. And since FFO is a non-GAAP accounting term, I need to define FFO as net income, excluding gains or losses from the sale of real estate, plus -- and so that is we add back the 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 non-accounting standards that we can use in discussing our REIT, and all REITs do that. Please see our 10-Q filed yesterday with the SEC and our financial statements for the detailed description of FFO.

Well, we begin the day with hearing from our President, Chip Stelljes. Chip is also the Chief Investment Officer of all the Gladstone companies. Chip, take it away.

Thank you, David, and good morning. Our September 2010 quarter-end results were positive, as we collected the $3.3 million in additional income from the early repayment of our mortgage loan, which we reported on last quarter. However, we also wrote off $1.6 million in connection with the termination of our private offering of unregistered senior common stock. As of September 30, all but two of the buildings are occupied, and all occupied buildings are paying as agreed. The two empty buildings constituted about 2.6% of our revenue.

At the end of the quarter, one of our tenants, Workflow Management, declared bankruptcy. While we received the October rent, we don't expect them to confirm that lease, so we will begin marketing that building for lease or sale earlier than had been forecasted. This tenant represented $290,000 of rent annually, or less than 1% of our total annualized rental income. We are hopeful that the rest of the portfolio will continue to perform well into the future.

Equity and debt markets continued to improve. However, it is still somewhat difficult to obtain substantial new debt or equity capital in terms that we believe are attractive. However, our common stock price continued to rise during the quarter, and as a result, we were able to issue and sell $1 million of common stock during the quarter at an average price per share above $17.

We did make the decision during the quarter to terminate our private offering of unregistered senior common stock. Market conditions in the Regulation D marketplace just changed dramatically after we launched the offering. We do continue to look for options to raise additional equity and to grow the business.

On the debt side, the current credit market is still difficult. Long-term mortgage markets, including the CMBS market, where we traditionally sourced our long-term mortgage financing, are largely unavailable. We are seeing some banks willing to issue medium-term mortgages, up to say five years and maybe up to 10, albeit on less favorable terms than we could get in the past. But it is improving. So we are focusing on these medium-term mortgages until the market for long-term mortgages returns.

We have executed a commitment with a large national bank to replace our existing credit facility with KeyBanc, which expires this December. We are expecting to close the new facility during this fourth quarter. We don't plan to use the line of credit on new investments until we close on the new facility. However, even once we have closed on the new line of credit, we only plan to use the line to make acquisitions that we believe can be refinanced with longer-term mortgage debt.

As you'll recall, our original business model called for us to initially borrow from the line to buy properties. We then obtained longer-term, fixed-rate mortgages as soon as we could. We were able to secure a spread between the rent coming in and the mortgage payments going out. And by doing this, we were able to lock in the profit for five to 10 years, or in some cases longer. And the proceeds from the mortgages would then pay down our line of credit, thus making the line available for the purchase of our next property.

With the turmoil in the credit and equity markets, our model has adjusted to medium-term mortgages, so that we are matching as closely as possible long-term leases with longer-term credit. If we are not able to source attractive debt, we only plan to buy properties that already have long-term, assumable mortgages on them.

In addition to making acquisitions selectively, we will continue to improve the value of our existing portfolio of properties by reviewing and renegotiating existing leases, performing improvements at our properties and selling certain assets.

To this end, we extended the lease on our property located in Toledo, Ohio for 10 years, and the tenant has two options to extend the lease for additional periods of 10 years each. This lease was originally set to expire this December and will now expire December 2020.

We have one mortgage loan for $48 million which matured in October of this year. However, the mortgage has three annual extension options, and we exercised one of those options during the quarter to extend the term to October 2011, and we expect to exercise the other extension options as we need them.

Along with the extension, the interest rate reset, which will reduce the cost of that facility by about $1 million over the next year. We have no other mortgages that mature until 2013; thus, we are not under the near-term refinancing pressure.

The quality of assets remains very good. As I stated above, all but two of our properties are leased and all of our existing tenants are current in their rent payments as of September 30, 2010. And, as I mentioned earlier, we are working to locate new tenants for the two vacant properties and the one bankrupt tenant property we expect to vacate.

For one of the two properties, we are considering a plan to reposition that property to a much higher-value operation, and these transitions will require some level of capital outlay. With that, turn it back over to David.

All right. Thank you very much, Chip. That was a good presentation. Now let's turn to our Chief Financial Officer, Danielle Jones, for a report on the financial results. Danielle?

Thanks, David. As Chip stated, our quarterly results are positive and our portfolio continues to perform well. At the end of the quarter, we had $398 million in total assets, $376 million of which is our net investment in real estate. We had $112 million in both common and preferred equity and approximately $251 million in long-term mortgages borrowed against the properties we own.

With the extension of our $48 million mortgage loan and the resulting reduction of the interest rate to 4.58% from 6.85%, the weighted average fixed interest rate on our mortgage loans dropped to 5.6% from 6% last quarter. As Chip stated, this interest rate reduction will result in approximately $1.1 million in reduced interest expense over the next 12 months.

We had about $23 million outstanding under our line of credit at the end of the quarter, down from $36 million at June 30, at a weighted average interest rate of 2.5%, for a total of $274 million in mortgages and short-term borrowings.

With the reduction in our line of credit balance, coupled with the increase in our equity balance and common stock sales during the quarter, our debt-to-equity ratio decreased to 2.4-to-1. This is more in line with our target range.

At the end of the quarter, we had approximately $11.4 million of remaining borrowing capacity under our existing line of credit. The borrowing capacity in the line of credit is limited to a percentage of the value of properties pledged as collateral to the line, plus both the amount outstanding under the line and our outstanding letters of credit.

Our borrowing capacity increased significantly this quarter because we used the proceeds from the repayment of the mortgage loan to pay down the line. With the remaining capacity under our current line of credit and our current cash flows from operations, we remain confident we have ample liquidity to fund operations, service our debt, perform necessary capital improvements to our properties and maintain our distribution to shareholders.

And now, I will discuss the operating results. As I talk about per-share numbers, please know that I am talking about fully-diluted weighted average common shares. Funds from operations available to common stockholders, or FFO, for the quarter were approximately $4.3 million, or $0.50 per share, a 27% increase over the prior year's quarter. And FFO for the nine months was $11 million, or $1.29 per share, a 9% increase over the nine months in 2009.

Increase in FFO was a direct result of the $3.3 million of additional income we received in connection with the early repayment of our mortgage loan, coupled with reduced interest expense, partially offset by a decrease in our rental interest income and an increase in our professional fees.

Interest expense decreased because of the decrease in LIBOR from 2009, which reduced our interest expense under our line of credit, coupled with reduced interest expense on our long-term financings from amortizing principal payments made during 2009 and 2010.

Rental income decreased because of the two tenants who vacated their respective properties during the quarter, and interest income decreased due to the repayment of our mortgage loan receivable. Professional fees increased because of the write-off of the $1.6 million of fees associated with the termination of our private offering of unregistered senior common stock.

An increase in FFO also resulted in increasing the incentive fee that was paid during both the three and nine months ended September 30. We paid out the full incentive fee for the quarter and 98% of the incentive fee for the nine months of 2010.

We remain hopeful that we will be able to consistently pay out 100% of the incentive fee earned in the coming quarters, so that we will be able to continue to grow our FFO. However, we expect our FFO to drop next quarter without the one-time additional income from the mortgage loan payoff and the lost rental income from our two vacant buildings. So there can be no assurance that we will achieve this goal next quarter.

And now, I'll turn the program back over to David.

Okay, thank you, Danielle. That was a good report. The good news for this quarter is obviously that the team has maintained our FFO and allowed us to sustain the distributions to shareholders. That is the number one thing that we worry about, is making sure that distributions go out to shareholders.

Please know that the team here is working hard to achieve similar results, and just want you to know I'm very optimistic about the future for this Company.

We encourage all the listeners to read the press release and the quarterly report that we filed yesterday with the SEC. There is an awful lot of good information in that report that we file with the SEC. You can find all of these on our website at www.GladstoneCommercial.com and on our SEC website.

The price for commercial real estate in the marketplace in general has changed largely because the mortgage marketplace has continued to change. There is very limited amount of low-cost mortgage lenders out there, and especially those that will finance commercial real estate. Since buyers can't find the low-cost mortgages, they can't pay much for the real estate, and this has caused most of the sellers to become much more realistic in the sale price of their property or it just won't sell. You've seen this, obviously, in the housing business, and the same thing is going on in the commercial real estate business.

If we have mortgages or equity financing available to us, we can make a good number of acquisitions, and we are currently getting some term sheets from lenders to lend on our properties that we own that don't have mortgages on them, but the terms have not been acceptable to us. We had one term sheet; it was a very nice term sheet, but somewhere along the way they changed their mind and changed their term sheet.

We do have a couple of those that are working now, and I am hopeful that those won't fall away, that we'll actually mortgage some of our current buildings. We are also looking at ways to buy more buildings where the buildings already have mortgages on them. We would assume the mortgage, and we think we've found a number of these types. I think one will close -- one of those will close, hopefully, next month or maybe in December. And so we are working on these properties, where we are purchasing with the mortgage already in place.

I mention this each time and I want to mention it again, that the marketplace that we look at has three different sections, and we only participate in one of the sections. The first section is where the tenants are rated properties; that is they have a rated number of AAA or BBB ratings. And these are well-located properties with well-located -- with great tenants.

And these are high quality real estate, and they are being sought out by the very large real estate investment trusts, a lot of the insurance companies and pension funds. The cap rates, though, the yield on these have risen some, but they're still not in any range that we can pay. They are still much too low for us to consider in this category of real estate.

There are others in this category with lower ratings, and we've purchased a few of these properties over the years, but generally speaking, we are not in that category.

There is another category called small real estate properties, like fast food locations and pharmacy chains. These are being purchased by individual investors at cap rates that yield about 7%, 7.5%, sometimes a little higher, if the property is outside the general, large area and a more difficult area.

And all of these people are buying it just for income. They do it instead of buying the bonds of, say, CVS Pharmacy, they go out and buy the real estate and hold the real estate rather than the bond.

This area is the still in flux. There is not a lot of people in this marketplace today. And we do see some of it coming back, but it is still not coming our way. The cap rates haven't raised -- the interest rate on these have not raised high enough for us to look at them.

So that leaves us with a third area, our investment space, is the middle-market, where we see non-rated tenants; these are small- and medium-size businesses in commercial office and industrial properties. We like the medical and retail area also in this area, but we haven't been able to do much of that, because the retail business has been so difficult to analyze.

Our competitive advantage in this area is that we have expertise to underwrite the non-rated business tenants in conjunction with the real estate. As you know, in our other businesses, we do make loans and investments in small businesses, so we are well-qualified to underwrite these small businesses and make sure that we are going to get paid.

The cap rates, or the yields, in this group are in the 9% to 13% range. We are very focused on those now, and working very hard to make sure that we can wrap up some of those during the coming year.

We are trying to do this -- and we do this each time, and I think this separates us from a lot of the folks that are out there -- at the same time that we make these acquisitions, we are also trying to lock in long-term financing and have that in place, so that those two are locked in and we live on the difference between what we are able to borrow on the mortgage side and what we've actually paid for the property and getting in terms of yield on the rent. And so while we proceed cautiously here, we are expecting some really good transactions in the near-term.

Much of the industrial base in the United States today, especially the rents on industrial and commercial properties, remains pretty steady. Most of them are paying their rents, they are paying as agreed, and the marketplace just needs to come back in terms of mortgages.

There are some that are having problems, and usually even if you go into the bankruptcy, they keep paying, simply because the building is something that they really need as part of their operation.

However, we don't expect significant growth in the base during 2010. We don't have much left. I think we will close one loan, maybe two -- one loan -- one purchase with a loan on it in place, and maybe another purchase before the end of the year. But I don't see 2010 being a big bang-up year for us. It is more steady as she goes, rather than growth.

But I do see 2011 as a big year for growth for this REIT. I think we've positioned ourselves so that we are in great shape now. Stock price has come back, and I think this is an indication that the marketplace understands that we are getting ready to grow the asset base pretty significantly.

As I mentioned before, at this point in time, I am very optimistic that our Company will be fine in the future. We all have to worry about the future, but we will be cautious in our acquisitions.

We are looking at a number of ways to grow. First, we are talking to some of the local banks to provide mortgages on the properties that we have. We have a number of local banks that have issued a couple of term sheets that we are looking at now.

We do have $80 million of properties that don't have a mortgage on them, and we are working with these to get them mortgages. Obviously, if we could free up $40 million, we could use that $40 million to buy new properties that would increase our income. And if we can find some good mortgages for these properties, it will free up enough money to give us growth and hopefully we can, at the same time, find additional debt equity for -- debt and equity for our Company.

We are looking for ways to raise some equity, too. As I mentioned, we are looking at various forms of preferred stock. We may be able to issue some preferred stock at reasonable rates in the next 12 months. I am hopeful that we can raise some funds with preferred stock. As you know, our preferred stock is now trading just about at par, so it is yielding what we issued it at now for those that are buying it, and I am hopeful that we can issue some more of that kind of preferred stock.

We are also seeking to raise some money in the Reg D offering. That was great for accredited investors. Unfortunately, the government changed the definition of accredited investors and made it very difficult for us to sell that issue, so we had to terminate that issue.

We are working on a potential registered non-traded offering, and this would allow anyone who wants to buy the stock -- they don't have to be accredited -- to buy the issue. I'm not sure whether we will issue that or not. We are going through some discussions now, and it will take us at least a couple of months to come back and make that decision.

We are looking for other ways to raise money, but right now, it is very hard to sell any kind of security. The marketplace is very jaundiced right now. So stay tuned, and we will have some announcements in the near future about what we are trying to do.

In October, the Board declared a monthly distribution of $0.125 on the common shares for October, November and December, or $1.50 per year. This is a nice rate for such a good REIT. As we look at the triple nets, we are trading at a higher yield than all of them. We should be trading at like a 5% yield; instead, it is more like an 8% yield.

Because the real estate can be depreciated -- and I go through this every time and I want you all to understand it, because it is very important -- because the real estate can be depreciated, we are able to shelter the income of the Company. And the distributions, for example, in 2009 were about 94% of return of capital. And that, of course, is tax-free.

It will be somewhat less this year because we have additional income from the repayment of our mortgage, with all the income that came along with that repayment. So this is a great stock to hold in your personal account because it is so tax-friendly.

And just to mention this again, because I've gotten several shareholders' calls, this return of capital is due to the depreciation of the real estate asset. As you all know, it is a bit of a fiction, because the buildings are still there after you depreciate them over 20, 25 years. And that is why we talk about FFO, because it is adding back the real estate depreciation. And the depreciation of the building at the end of the day is fiction for tax purposes. The great thing is that if you own the stock personally, you don't pay any taxes on that part that is sheltered by the depreciation shield, because it is a return of capital.

However, this return of capital does reduce your cost basis in the stock, which may result in a larger capital gain -- hopefully, a very large capital gain somewhere down the road.

Stock's now trading at about $18.70 a share. This is about an 8% yield, based on the $1.50. Many of the REITs, as I mentioned before, are trading at much lower yields. In fact, the whole REIT universe is trading at about a 4.3% yield. So we are a very nice product to buy if you are looking for REITs. I am hopeful that we will trade up in terms of price and the yield will go down.

We will be declaring the next monthly distribution in January for the months of January, February and March. And I am hopeful that sometime during 2011, we will be able to increase our dividends.

Now, we'll have some questions from our loyal shareholders and some of the analysts that follow us and the wonderful REIT world. So I will turn it back over to the operator for the questions.

(Operator Instructions) John Roberts, Hilliard Lyons.

Question on the $1.6 million charge. It seems like a rather large charge, in light of only raising $800,000 in capital. Could you discuss that -- exactly where that came from and what it consisted of?

Well, we could break it out, but it is primarily lawyers and underwriters. We fronted the underwriting cost on that. We were supposed to raise $50 million, which we hoped would be even more than that. We thought we might be able to go up to as much as $100 million.

So there were a lot of front-end costs, a lot of printing costs, and unfortunately, it turned out to be very negative.

Okay. So legal -- a lot of legal?

It was a lot of legal, it was a lot of investment bankers helping us out in the marketplace, talked to the market. We had to sign up a number of underwriters that were selling the stock. And it was just -- unfortunately, it was very expensive.

It was a great learning lesson for us. We've learned about the non-traded market place very well now. And that is why I want to explore it one more time -- and it certainly won't cost that kind of money to do it. hopefully -- but looking at the registered side of that business, where we actually register the stock, but it doesn't trade.

Like all these non-traded public -- non-public REITs, in other words?

Exactly where we are. We are right in that marketplace, and we were well-received until the government made some very substantial changes, and I think cut back. You also should know that FINRA has come out very strong in terms of auditing a lot of the underwriters on their Reg D offerings. Reg D has become a sort of bad word over at FINRA.

So we are unfortunate we got caught in that transition, and it is unfortunate for our shareholders. But I think it is going to pay off in the long term. We do understand that marketplace now. We know how to sell to it.

Okay, well, just a heads up, keep in mind those same issues with the new public-traded -- or private REIT offerings as well. You might hit those same things with FINRA.

They seem to be better, John. We talked with FINRA -- as you know FINRA dominates that area, and we talk with them often and they seem to be not as adamant that the registered shares are as bad as the Reg D shares.

Okay. How much -- you've got two properties that you've lost. What was the exact rental income that you lost on those two properties?

Yes, the number -- what was it?

About $1 million a year.

About $1 million a year.

Okay. And you lost another $290,000 from the bankrupt tenant, so you basically lost (multiple speakers).

That tenant is still paying. We don't expect them to confirm the lease, but there is usually a 12-month pickup on that. So we may lose some. That tenant was due to vacate the building in about 14, 15 months from now anyway.

All right. So you expect to get that -- even with them in bankruptcy, you expect to get the rent for the next year?

We probably will get about 12 months of rent. That's our guess.

Okay. And was that from a reserve or --?

No, that is the way the bankruptcy court handles leases now.

Okay. So you did say you expect them to -- you expect the tenet to accept the lease, not reject it?

Well, they may accept the lease. I don't expect them to do that. But they've got to pay you something for throwing your lease out.

Well, do they have the capital to do that, I guess would be the question (multiple speakers).

They do.

Okay, they've got the capital.

They do. It is a very large transaction that was done by a very well-known LBO fund. And unfortunately, they stacked a bit too much debt on it.

Okay, so the annual rent you're losing, not including that $290,000, is about $1 million?

It is about $1 million. And if you think about it, it really comes out of the incentive fee. The incentive fee gets hit first.

That's all the questions I've got. Thanks, David.

Chris Lucas, Robert Baird.

Sorry about that, David. Can you hear me okay?

I can now. Go ahead, Chris.

Great. Sorry about that. Just a follow-up to John's question. On the asset in Hazelwood, did that tenant -- did that declare a Chapter 11 or Chapter 7?

It is an 11.

It's an ll. Okay. And then on the line commitment that you have signed, can you give us an update on that status? I missed the beginning of the call. I apologize if you've already reviewed it. But can you give us a sense as to where that stands and the size of it relative to the current balance outstanding?

It's $50 million, so it's the same size as the line that we have today. And it is -- what we've done is we have a term sheet; it is signed. We are in draft now of legal documents; I think we are in version two or three. And hopefully, we will sign in the month of November.

Okay. And then just on the acquisitions front, in terms of just the volume of deals that you are looking at, can you give us some sense as to how that has changed in terms of pricing and in terms of just the pure volume of transactions you are reviewing?

The backlog is still very strong. We are known in the marketplace, and we told everybody that we are close to turning on the spigot in terms of our ability to buy. So we are seeing deals now.

As I mentioned somewhere in the presentation, we've got one transaction in which we are buying with mortgage in place that looks like it will close in November; maybe it gets pushed to December. That will be a nice transaction and it will be a pickup in earnings because the yield on the equity that we will be putting up is very substantial. No guarantee, of course, that we close anything, but that one does look like it is getting close to closing.

We have a couple more in the pipeline, similar strategy, in which we've got a tenant that is well-known, and we think we can get a pretty good mortgage on that property with some of the banks in that area.

But we are just now beginning to push through, now that we've gotten our line of credit in place, and we are starting to see the marketplace respect our stock a little bit more and are starting to push forward and do some transactions.

In terms of yields, the return on equity, if you assume even the higher-priced mortgages today, for us are going to be substantial. I think you are talking about a minimum of 11% and probably much higher than that in terms of all-in returns.

And then on the vacated assets, the two properties, any prospects on re-tenanting those at this point?

The one in Richmond seems like it is coming along. We've got -- people continue to walk through the place. We continue to work with the locals. Unfortunately, the Richmond marketplace was damaged more than perhaps any other marketplace around the country in terms of its industrial real estate and office real estate.

And so we are working with the locals in the area that have some prospects, and I am hopeful that in the next six months we will have a new tenant. We will have to spend some dollars, of course, to put in some tenant improvements. But my belief is that one will get leased.

The property in Massachusetts is more problematic. It is in a much higher-scale area. It lends itself to a redevelopment, rather than renting out as warehouse/industrial kind of space. We are going through the process of reconfiguring that into a -- I won't mention what it is until we get the zoning done. If we get the zoning done, we will upscale that by putting a substantial amount of money in it and turning it into a very handsome return for us.

So your plan there is to do a redevelopment that you will do, as opposed to selling it and letting somebody else do?

We are going to redo it, but we have our joint venture partner that we will operate it for.

That's all I have, David. Thanks.

(Operator Instructions) Sir, I am showing no questions at this time.

All right. Thank you all for calling in. We will conclude this, and again, we will see you next quarter. That is the end of this conference call.

Thank you, sir. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your line.