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Over the last few weeks, I have been writing on several of the small-cap Triple Net Lease REITs. Yesterday, I wrote an article on Chambers Street (CSG), and last week, I wrote about Monmouth REIT (MNR). The previous week, I wrote about STAG Industrial (STAG), and before that, I wrote on National Retail Properties (NNN).
I have also been actively following the merger between American Realty Capital Properties (ARCP) and Cole Real Estate Investments (COLE). Late last year, I wrote an article on Lexington Realty Trust (LXP) and I described the New York-based REIT as my dark horse for 2014.
I have also been watching W.P. Carey (WPC) and the merger with related CPA:16 that closed yesterday. As suspected, some of the non-traded REIT investors (and their advisors) sold out of Carey yesterday and the price of the shares closed down around 4% (closed at $57.87). If you haven't dipped your toe in yet, it may now be the time.
I'm currently writing an article on Realty Income (O) for my newsletter subscribers (see website here), and I have been more than pleased with the performance of Gramercy Property Trust (GPT). On December 13th (2013), I declared that the $545 million (total capitalization) REIT was my best pick in 2013, returning a whopping 92% (year-over-year).
A few other Triple Net REITs that I cover are Spirit Realty Capital (SRC) - see article here - Agree Realty (ADC) - see article here - One Liberty Properties (OLP) - see article here - and EPR Properties (EPR) - see article here.
In fact, I have just about covered every Triple Net REIT on the planet; that is, except Gladstone Commercial (GOOD). I have not intentionally avoided GOOD, it's just that I have been way too busy writing. However, this week I decided that I would complete the circle and become the first Seeking Alpha writer to cover - soup to nuts - the entire Triple Net REIT sector.
Gladstone Commercial Corporation
Gladstone Commercial is a small-cap Triple Net REIT that listed on NASDAQ in July 2004 (almost 10 years ago). The company is externally advised by Gladstone Management Corporation, an affiliated adviser with around $1 billion of funds under management. GOOD is one of a family of funds (managed by Gladstone Management), and other affiliated companies include Gladstone Capital Corporation (GLAD), a business development company (or BDC) that invest in small and medium private businesses; Gladstone Investment Corporation (GAIN), a BDC that operates primarily as a buyout fund that also invests in small and medium businesses; and Gladstone Land Corporation (LAND), a REIT that invests in farmland located in major agricultural markets across the US.
The common denominator for all of the above referenced Gladstone businesses is David Gladstone, who serves as chairman and CEO of Gladstone Management. The senior Gladstone is also chairman and CEO of all four Gladstone public companies, and he is past chairman of Allied Capital Commercial (a former REIT) and a past board member of Capital Automotive (formerly a publicly traded REIT on NASDAQ through December of 2005, when it completed a privatization with DRA Advisors LLC). The external management team at Gladstone Management includes a veteran team of employees, but there appears to be considerable conflicts of interest in the duties, responsibilities, and compensation associated with the various entities.
Notably, I find GOOD's Management Services Agreement with its Adviser to be riddled with risk. For example, in the 2012 10-K, the "Advisory Agreement provides for an annual base management fee equal to 2.0% of total stockholders equity less the recorded value of any preferred stock and an incentive fee based on FF0".
The Adviser does not charge acquisition or disposition fees when acquiring or disposing of properties and there are no fees charged when the Adviser "secures long or short-term credit or arranges mortgage loans on properties". But here is where I break out in hives:
Our Adviser may earn fee income from our borrowers tenants or other sources. This fee income earned by our Adviser or portion thereof may at the sole discretion of the Board of Directors be credited against our base management fee as rebate to the base management fee.
Ok. So let me get this straight. GOOD leases a building to XYZ tenant and GOOD's adviser can "earn fee income" from GOOD's tenants. The 10-K goes on to read:
The incentive fee would reward our Adviser if our quarterly FF0 before giving effect to any incentive fee or pre-incentive fee FF0 exceeds 1.75% or the hurdle rate of total stockholders equity less the recorded value of any preferred stock. We pay our Adviser an incentive fee with respect to our pre-incentive fee FF0 quarterly.
OK. This is more complex than most Triple Net REITs. Why would the Adviser be getting compensated a 2% management fee that is already on the high side and additional earned fees from GOOD's borrowers tenants or other sources. Let's take a closer look at GOOD's tenants.
The Good, the Bad, and the Ugly
In GOOD's 10-K, the company's tenant risks are explained as follows:
Highly leveraged tenants and borrowers may be unable to pay rent or make mortgage payments which could adversely affect our cash available to make distributions to our stockholders. Some of our tenants and borrowers may have recently been either restructured using leverage or acquired in leveraged transactions. Tenants and borrowers that are subject to significant debt obligations may be unable to make their rent or mortgage payments if there are adverse changes to their businesses or because of the impact of the recent recession.
Tenants that have experienced leveraged restructurings or acquisitions will generally have substantially greater debt and substantially lower net worth than they had prior to the leveraged transaction In addition the payment of rent and debt service may reduce the working capital available to leveraged entities and prevent them from devoting the resources necessary to remain competitive in their industries.
Now here is the kicker:
These companies generally are more vulnerable to adverse economic and business conditions and increases in interest rates. Leveraged tenants and borrowers are more susceptible to bankruptcy than unleveraged tenants. Bankruptcy of tenant or borrower could cause (1) the loss of lease or mortgage payments to us, (2) an increase in the costs we incur to carry the property occupied by such tenant, (3) reduction in the value of our securities or, (4) decrease in distributions to our stockholders.
So I looked up the latest Investor Presentation to see exactly what tenants were leasing from GOOD. Based upon my source (SNL Financial), GOOD owns 87 properties, primarily on the East Coast.
Here is a snapshot of the number of properties from 2008 through Q3-2013:
GOOD has around $666 million in assets (as of Q3-2013), and here is a snapshot of historical growth:
According to the latest Investor Presentation, GOOD has a diversified portfolio consisting of a variety of categories. The largest sector is telecommunications (16.8%), followed by healthcare (12.8%), electronics (8.3%), and automobile (7.9%).
Now here is where I get confused, or better yet, nervous. Within GOOD's Investor Presentation, the company lists the largest tenants as "Company A", "Company B", etc… There is no specific name mentioned for any of the 85 properties owned.
So now, I must dig deeper. By surfing the net, I was able to come up with a random sample of properties owned by GOOD. The first address is Catoosa, OK (population 8,155). Here is a picture of a 238,310-square foot property that was acquired by GOOD at a cost of $66.52 per square foot:
Now on to Montgomery, AL. Here is a 29,472 building owned by GOOD that was built in 1962:
Now take a look at this property located in Menominee Falls, WI (population 35,681). This is a 125,692-square foot building that was acquired for around $8 million:
Although the tenant level transparency for GOOD's portfolio was weak, the company did provide a chart of lease expirations (below). Also, the presentation states that the "typical lease is 10 to 15 years", with "most leases due after 2019". Also, the company states that its "weighted average cap rate" on its properties is 8.8%. Clearly, the lack of transparency in GOOD's lease portfolio means that many of the tenants are sub-investment grade credits and pose significant risks as referenced above.
GOOD's Investor Presentation does a thorough job explaining what a Triple Net Lease is; however, I believe the presentation does little to protect the average investor. Notably, the presentation states the obvious that one must "diversify by industry, geography, and tenant" and "focus on recession resistant businesses and seek long term leases". The presentation goes into great detail explaining that GOOD underwrites and conducts due diligence on its real estate; however, it does not steer investors toward a mindset of conducting their own due diligence - I'm glad I wrote this article.
Dig Deeper into the Debt
GOOD operates with considerably more debt than the Triple Net REIT peers. In the Investor Presentation, GOOD states that its "asset coverage ratio of its mortgages is 56% of gross real estate" and that's "outstanding". Furthermore, the presentation boasts that the company has "bankruptcy remote" debt and it has "only guaranteed $2 million of mortgages".
First off, GOOD has over 90% in secured debt. That means that the company is a long way from getting an Investment Grade debt rating (currently, there are no ratings on GOOD). Compare that with Realty Income that has only 17% in secured debt (S&P BBB+) or National Retail Properties with less than 1 percent in secured debt (S&P BBB).
Second, GOOD utilizes non-recourse property-level debt, meaning that if a lease is terminated, GOOD has the option to hand the keys back to the lender. Sounds good, right?
Wrong. As mentioned above, GOOD has 56% mortgage to assets, and that means that there is 44% of equity (per asset). So if GOOD has a few tenants that file BK (bankruptcy) and the company elects to "hand back the keys", equity is diluted (lost). Furthermore, it's just not prudent business to mortgage-up your portfolio, as that restricts flexibility in negotiating leases (expansions or relocations). Simply said, there is considerably less risk in owning a portfolio of mortgage-free assets like National Retail Properties. It goes back to the "golden rule" - he who has the gold, makes the rules.
In addition, I'm not overly excited about the debt maturities. There are some sizable mortgage bullets coming up in 2016 and 2017. Remember, interest rates are going to rise and GOOD loses leverage in that game.
Dig Deeper into Earnings
GOOD's Investor Presentation provides the following Funds from Operations (or FFO) chart:
However, this chart I provided below is more relevant. It's the FFO/Share chart:
Interesting - it looks like GOOD has seen very little growth over the previous three years. In fact, GOOD has achieved negative growth (FFO/share fell from $1.53 to $1.50) and the numbers look downright weak. As evidenced by the FAST GRAPH below, GOOD looks rather pathetic:
Compared with the peer group, GOOD appears to be trading at a discount - shares are trading at $18.65, with a Price to Funds from Operations (or P/FFO) of 12.5x.
Also remember that GOOD is considered a small-cap REIT so it has very little Institutional support, and given the low quality of real estate owned, it's very unlikely that GOOD will be a candidate for a REIT merger.
The biggest thing going for GOOD is the high dividend yield. As evidenced by the snapshot below, GOOD pays the highest dividend of the broader Net Lease sector. The yield is 8.04%.
During the most recent earnings call, David Gladstone, CEO, said:
As you know, one of my hallmarks of running these companies is never cut the dividend. And so our goal is to make sure we never put ourselves in a position of having to cut the dividend, so we like to be very strong in terms of earnings before we phase the dividend.
Back in May (2012) and in a Seeking Alpha article, Dane Bowler touched on the dividend coverage. He said:
With 1Q12 FFO totaling $0.38 per share and distributions of $0.375 per share, the dividend is barely covered. Some of the decreased coverage can be attributed to the one-time costs associated with its recent acquisitions and the timing of the acquisitions which causes only a partial quarter of revenue from the new properties to show up on the report. While in reality the dividend coverage is better than the numbers from the first quarter report would suggest, it still makes me skeptical as to the plausibility of the dividend increase that David Gladstone seems to anticipate.
Bowler went on to say:
So with the massive dividend and reasonably strong first quarter performance, why does GOOD trade at such a discount compared to other triple net lease companies?
Bowler was "spot on". GOOD pays a monthly dividend of $.125 per share that translates into an annual dividend of $1.50. GOOD's FFO/share is around $1.51. This is thin margin bet. Simply said:
The thrill of victory is not worth the agony of defeat.
I believe that GOOD is a BAD investment. Currently (as of Q3-13), the company has 2 ½ vacant buildings, and although that puts occupancy at 96.7%, I'm concerned that GOOD has the most exposure to rising interest rates. I'm not concerned as much about the debt costs at GOOD in so much as the debt costs of GOOD's tenants.
As we have seen, a majority of GOOD's tenants are non-investment grade and that means that their cost of capital will have a much more dramatic impact on their maturities. Let's face it. The US economy is still operating in a recovery mode and the balance sheet for the average business has not improved drastically. There is simply no way to compare GOOD's operating platform with most of the other Triple Net REITs.
I'll sum it up with the title for the article - It's Too GOOD to be True. I'll pass. Remember what Frank J. Williams wrote in the classic book, If You Must Speculate, Learn the Rules:
People of the dupe type are hypnotized by the glare of gold. They stare so long at glistening fortune that their minds are brought under subjection to one of nature's strongest passions- greed. They will listen to any tip, however wild and ridiculous, and impulsively act on any suggestion.
Source: SNL Financial, FAST Graphs, GOOD Investor Presentation.
Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.