David Gladstone, chairman of the eponymous Gladstone Commercial (GOOD), claimed in the first quarter conference call on May first that GOOD should trade at $26.00 if it were trading at a comparable yield to the rest of the triple net lease REITs. With a recent market price of $16.95, there is a clear disparity between actual price and his projected trading value. Through investigating the true intrinsic value of GOOD we can get a better idea as to potential reasons for this disparity.
Gladstone Commercial is a rather small triple net lease REIT with a market capitalization of $186.4mm. Its FFO from 1Q12 was $4.2mm up 9.2% from 1Q11. However, the FFO decreased on a per share basis over this same period from $0.41 to $0.38 largely due to issuance of new common stock. This company has some very interesting aspects to consider as it has outlying characteristics which differentiate it from other REITS. We will start by analyzing the strengths.
GOOD utilizes a unique property acquisition process through which it can adeptly review unrated, small business tenants, to ascertain their suitability for the company. This allows GOOD to opportunistically acquire properties that are essentially unavailable to most other REITs. While it may seem risky to take on these smaller tenants, the success of this strategy is apparent with occupancy of 98.7% as measured by square footage and strong tenant compliance with rental agreements.
Gladstone Commercial has demonstrated impressive stability making it through the recession of 2008-2010 without losing FFO or decreasing dividends. In fact, GOOD has paid out 93 consecutive monthly dividends. Much of this can be attributed to the matching of leases with long term fixed rate mortgages to lock in cash flows. Additionally, being a triple net lease REIT reduces the potential for unexpected expenditures associated with building maintenance.
While the preferreds are unremarkable, offering average yields and mostly trading above par, the common yield is significantly higher than the rest of the sector.
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The already phenomenal dividend on the common is accentuated by the fact that most of it comes tax deferred as a return of capital. The percentage can vary, but in 2011 83.374% of the $1.50 dividend was deemed return of capital with the rest considered ordinary income. Despite the already strong dividend, David Gladstone seems inclined to raise it further as he stated in the aforementioned conference call "I think this year might be a good chance for us to raise the dividend". He did stipulate that a necessary condition was an increased FFO which he felt was likely to occur as the recent acquisitions kick in.
The advantages of investing in GOOD are certainly enough to pique an investor's interest, so we can continue our analysis with the company's deficiencies.
Poor availability of funds
The unrated tenants as well as small overall size of the company make it difficult to obtain loans/mortgages of sufficient amount or with desirable rates. Consequently, the company has had to issue new equity to fund acquisitions. On June 9th 2011 Gladstone announced the issuance of additional common stock. 1,200,000 shares of common stock were sold by Underwriters at a public offering price of $17.55 per share. The underwriters were initially sold the common stock at $16.59 per share. When the market closed on 6/9/11, GOOD sold at $18.45 per share as compared to a $17.48 close on 6/10/11. In addition to reducing the market pricing of common shares by over 4%, GOOD only received $16.59 per share sold due to underwriting fees. While GOOD may have had a valid reason to quickly raise capital, other approaches could have been more efficient. For example, by using an at-the-market offering, GOOD could have forgone the costly underwriter's fee as well as avoided selling well below the stock's current price. On the positive side, Gladstone Commercial may be better prepared for similar situations in the future having recently expanded its line of credit from $15mm to $75mm.
FFO barely covering dividend
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.
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 (National Retail Properties, Realty Income Corp.)? Three large contributing factors are cost of capital, market capitalization, and Price to FFO.
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National Retail Properties (NNN)
Realty Income Corp. (O)
Cost of capital
National Retail Properties and Realty Income Corp. can attach capital at a much lower cost than GOOD because of their market capitalization and the associated institutional following. While GOOD is sometimes forced to generate their own costly capital through common and preferred stock offerings, the larger companies have extensive lines of credit at lower rates. In fact, Realty Income recently expanded its line of credit from $425mm to $1.0B at a rate just over LIBOR.
In addition to the effects company size has on cost of capital, it affects the pool of investors which can invest in any given company. With a market capitalization of only $186.4mm many institutional investors are restricted from investing in GOOD so its pool of potential buyers is limited to smaller funds and individuals. In contrast, the massive sizes of NNN and O allow full investment from any institution while still providing opportunity to individuals.
Among all equity REITs, the average estimated price/FFO is 15.4, so the higher price to FFO ratios of NNN and O suggest that investors have confidence in these companies. At only 10.8 Price/FFO, GOOD seems to have not yet fully earned the trust of investors which in my opinion provides huge opportunity. Having just been birthed in 2003 Gladstone Commercial is still in the process of establishment. It already has a strong business model and has the potential to become a very successful company.
For an institutional investor GOOD lacks liquidity and the trading volume to provide sufficient opportunities for purchase, but the incredibly high yield combined with stability and opportunities for growth make it worth looking into for the individual investor. While its small size prevents GOOD from trading at prices comparable to the bigger triple net lease REITs, David Gladstone just might see that goal reached as this company matures.
Disclosure: 2nd Market Capital and its affiliated accounts are long GOOD