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Gladstone Commercial Corporation (NASDAQ:GOOD)

Q3 2012 Earnings Call

November 2, 2012 8:30 AM ET

Executives

David Gladstone – Chairman and CEO

Bob Cutlip – President

Danielle Jones – CFO

Analysts

Elizabeth Bland – Janney Montgomery Scott

Operator

Good morning, and welcome to the Gladstone Commercial Corporation Third Quarter Ended September 30, 2012 Conference Call. All participants will be in a listen-only mode. (Operator Instructions) Please note, this event is being recorded.

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

David Gladstone

Thank you, Emily for that good introduction, and thanks to all of you for calling in. This is David Gladstone, and this is the Gladstone Commercial Call for the quarter ending September 30. And I say this each time but it’s true, we enjoy these times that we have with all of you on the phone and I wish there were other times to talk to you, maybe we’ll startup something in mid quarter to talk to you, we’ll come back to that at some point in time. If you’ve been in this area, in the Washington, D.C. area, we’re located in the suburb called McLean, Virginia and you have an open invitation to stop by say hello. You’ll see a great team at work here. There are 57 members of the team now so we’re no longer a small group and we have a couple of puppy dogs that come in every day and we enjoy that as well.

Now about the forward-looking statements. This report that I’m about to give, that we’re all about to give includes 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 and they 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 the future results expressed or implied by these forward-looking statements, including those factors listed under the caption "Risk Factors" of our company’s 10-K and 10-Q filings and also filed with the Securities and Exchange Commission. Those 10-Ks and 10-Qs can be found on our website at www.gladstonecommercial.com and on the SEC website. The company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future results or otherwise.

In our talk today, we plan to talk about funds from operation or FFO. And since FFO is a non-GAAP accounting term, I need to define FFO is net income, excluding the gains or losses from the sales of real estate, plus depreciation and amortization of real estate assets. The National Association of Real Estate Investment Trusts or NAREIT has endorsed FFO as one of those non-accounting standards that we can use in discussing our REIT and all REITs for that matter. Please see our 10-Q filed yesterday with the SEC and our financial statements for a detailed description of FFO.

All right, now we’ll begin the call today by hearing from our President, Bob Cutlip. Bob, go ahead.

Bob Cutlip

Thank you, David. Good morning, everyone. During the quarter, we acquired one additional property, issued a long-term debt on three of our properties and extended the term on four of our upcoming expiring leases. Our pipeline remains robust and we hope to announce additional acquisitions in the near future.

Now for some details. As of today, all but two of our buildings continue to be occupied and all of the occupied buildings continue to pay as agreed. The two empty buildings constitute about 1.9% of our stabilized gross portfolio of income and about 1.2% of the total square feet of space we own. We continue to take the appropriate action to re-tenant these properties.

The new office property we acquired this quarter has 60,000 square feet and was purchased for $15.5 million. This property is located in a master plant mixed Jews community in Jupiter, Florida. Jupiter is on the Southeastern Coast of the state. We funded this acquisition through a combination of cash on hand and the assumption of $10.8 million of mortgage debt on the property. This facility serves as the headquarters for the North American subsidiary of G4S Worldwide, one of the largest providers of security solutions with operations in 125 countries. G4S Secure Solutions USA has leased the property for 10.5 years and has two options to renew the lease for additional periods of five years each.

Switching to mortgages, the market for long-term mortgages has improved. Mid to long-term, that is five to 10-year mortgages are becoming much more obtainable. The collateralized mortgage-backed securities or CMBS market has made a comeback in recent months, but it is more conservative than it was prior to the credit crisis and the market remains somewhat volatile. Consequently, we also look to regional banks, insurance companies and other non-bank lenders as an alternative to finance our real estate activities.

During the quarter, we issued or assumed three new mortgages for $23.5 million. Two of these mortgages were issued by insurance companies and the remaining mortgage was from the regional bank. The three mortgages were collateralized by three of our properties at a weighted average interest rate of 5.6% and a weighted average loan-to-value obtained was 72%. Depending on several factors including the tenant credit rating, location of the building, and the terms of the loan, we’re seeing interest rates in the marketplace today ranging anywhere from 4.5% to 5.5%, historically low rates. Because we were able to obtain long-term debt during the quarter, we continue to have available equity to fund additional purchases of real estate in our pipeline.

Now let’s address equity. As we reported yesterday, we extended the term of our At the Market Program or ATM program and anticipate issuing a small amount of common stock under this program during the fourth quarter. This equity will give us additional liquidity to fund additional acquisitions. Our stock price has been high over the past several months, so this is a great opportunity for us to issue a small amount of equity to reduce our leverage without damaging our stock price.

Despite the continued challenges in the marketplace, we’ve been successful during 2012 in raising cost-effective equity and issuing additional preferred stock to grow our portfolio from properties. While we are seeing signs of improvement in both the equity and debt capital markets, we believe these markets will remain somewhat challenging during the remainder of 2012 and into 2013, as we adjust to the new terms available in these markets. The upcoming election will likely have an impact on these markets.

We continue to only use our line of credit to make acquisitions that we believe can be financed with longer-term mortgage debt. As you may recall, our customer business model calls for us initially to borrow from the line to buy the properties. We then obtain longer-term fixed-rate mortgages as soon as we can. By doing this, we are then able to secure the difference or spread between the rent coming in and the mortgage payments going out, thus locking in the profit for 5 to 10 years or in some cases, even longer.

From a liquidity perspective, the proceeds from the mortgages then pay down our line of credit, thus making the line available for the purchase of our next property. We expanded our line from $50 million to $75 million this past January to give us more room to acquire additional properties. We also had one additional bank join the bank syndication group.

With the turmoil on the credit and equity markets over the past few years, our business model adjusted so that we’re matching as closely as possible, long-term leases with longer term credit. And if we do not believe we’ll be able source attractive debt on new acquisitions, then we’ll only buy properties that already have long-term mortgages on them.

Our current availability under the line of credit is $25.8 million. In addition, we currently have approximately $3.7 million of cash on hand. Assuming we can obtain 65% loan-to-value on new acquisitions, we have enough liquidity available to acquire the additional properties in our pipeline for 2012.

Turning to our tenants, we continued to improve the value of our existing portfolio of properties by reviewing and renegotiating existing leases, and performing improvements at our properties. To this end, we are actively working with our existing tenants who have leases expiring in 2013 to renegotiate and extend the terms of their leases. During the past quarter, we extended the term on four of our leases that will expire in 2012 and 2013. We currently have three remaining leases that expire in 2013 or about 5% of our rent.

We are close to extending two of these leases and are actively working the other lease. Locating new tenants and signing leases with existing tenants for these buildings, they require some significant capital outlay for tenant improvements and leasing commissions.

In summary, at quarter end, all of our existing tenants are paying as agreed and our portfolio was 98% leased. We have two buildings without tenants and are aggressively pursuing client prospects for each. To this end, we are negotiating with the tenant for our vacant building located in Saint Louis, Missouri. We continue to look for new tenants for our Richmond, Virginia property and to that end have hired a new broker in an effort to revitalize the re-leasing effort. Signing new leases in these properties will require some capital outlay for leasing commissions, and tenant allowances. Our pipeline of possible acquisitions is strong today, and we hope to close on more properties in the upcoming months. So stay tuned.

And now let’s turn it back to David.

David Gladstone

All right, thank you Bob. Good presentation. Now, let’s turn to our Chief Financial Officer and Treasurer, Danielle Jones, for a report on the financial results during the quarter.

Danielle Jones

Good morning. Our quarterly results are positive and reflect our growth in our recent acquisitions. At quarter end, our total assets increased to $526 million, up 23% from one year ago. The amounts outstanding under long-term mortgages in our line of credit increased to $343.4 million, which is a 24.8% increase from last year. In addition, our stockholders’ equity, including our term preferred stock, increased by 16.7% to $162.5 million from our preferred equity offering earlier this year.

As we discussed previously, we completed a public offering of about 1.5 million shares of Series C term preferred stock at a price of $25 per share, resulting in gross proceeds of $38.5 million in January of this year. We used the proceeds from the offering to repay the outstanding balance on our line of credit. Due to its mandatory redemption feature, the preferred stock is classified as a liability on our balance sheet and the costs incurred related to this offering are recorded in deferred offering costs and will amortize over the redemption period which ends in January of 2017.

We have mortgage debt in the aggregate principal amount of $1.4 million payable during the remainder of 2012. The mortgage payments due in 2012 are only principal amortization payments and we have sufficient cash or borrowing capacity under our line to pay these amounts. We were able to refinance our largest mortgage with $45.2 million GE Mortgage that originally matured in 2012 with KeyBank which closed on October 1. The KeyBank Mortgage was a $34 million 10-year mortgage on seven of the nine properties that has been originally financed under the GE Mortgage.

We placed the remaining two properties in our borrowing base on our line of credit. We funded the difference between the KeyBank Mortgage and the GE payoff with existing cash on hand. We have $14.2 million of mortgage debt payable during 2013 and of this principal payable in 2013, $8.7 million is a balloon principal payment not due until the fourth quarter of 2013. We currently anticipate being able to extend the maturity dates or alternatively refinance its mortgage with the new lender. Currently the weighted average interest rate of our existing mortgages is 5.7%.

Because we were able to obtain a significant amount of long-term debt during the quarter, we do not need to draw from a line of credit to fund our $15.5 million acquisition during the quarter. However we did draw a $5.5 million at the end of the quarter in order to repay the GE Mortgage discussed earlier. Our debt to equity ratio at the end of the quarter, excluding our new tranche of term preferred stock was 2.7 to 1.

Our sources of liquidity continue to include the cash flows generated from operations, existing cash on hand, availability under our line of credit, and obtaining mortgages on our remaining unencumbered properties and issuing additional equity securities. Our current available liquidity is approximately $29.5 million, which is comprised of $3.7 million of cash and an available borrowing capacity of $25.8 million under our line of credit.

The borrowing capacity on our line of credit is limited to a percentage of the value of properties pledged as collateral to the line, with the amount outstanding under our line and outstanding letters of credit. With the capacity under our line and our current cash flows from operations, we have sufficient liquidity to acquire the remaining properties in our pipeline for 2012, new operations and service or debt this year, and perform any capital improvements to properties and maintain our distributions to our common shareholders.

In addition, we continue to have the ability to raise $218 million of additional preferred or common stock equities in the sale of securities that are registered under our shelf registration statement in one or more future public offerings. Of the approximately $218 million of available capacity under our shelf, approximately $22 million of common stock is reserved for additional sales under our open market sales agreement which as mentioned above, we intend to issue shares from the ATM program during the fourth quarter.

And now, I’ll discuss the operating results. First please note that per share numbers referenced are fully diluted weighted average common shares. FFO available to common stockholders for the quarter was approximately $4.2 million or $0.38 per share, which was a slight decrease from compared to the same period last year. FFO decreased primarily because of 16% increase in operating revenues derived from the 11 properties acquired subsequent to September 30, 2011 was offset by a 23% increase in interest expense due to the mortgage debt issued during the last quarter of 2011 and during 2012, coupled with dividends we paid on the recently issued term preferred stock, which was not outstanding in 2011, and an increase in property operating expenses during the quarter.

Property operating expenses increased because of ground lease [ph] payments we are now responsible for at two of our properties acquired subsequent at September 30, 2011. FFO for the nine months was approximately $12.2 million or $1.10 per share, which is a 1.9% increase over FFO from the prior period. The increase in FFO for the nine months was a result of the increase in operating revenues during 2012 from new acquisitions coupled with the smaller increase in interest expense for the nine months ended September 30, 2012, as compared to the three months ended September 30, 2012 due to the fact of the long-term debt with only outstanding part of 2012.

We paid out 42.3 % of the incentive fee during the quarter and 31.4% of the incentive fee for the nine months. This amount increased over the second quarter, however it’s still limited because of the additional preferred equity rates in January and debt issued in the second and third quarters which was not deployed until late in both the second and third quarters. We expect this percentage to increase next quarter with the full quarter of earnings from our most recent acquisitions coupled with our strong pipeline. We continued to build our portfolio, we will be able to consistently pay out a greater percentage of the incentive fee earned so we will be able to grow our FFO.

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

David Gladstone

All right, that was a good report, Danielle. We encourage all of the listeners to read our press release and the quarterly report that was filed yesterday with the SEC called Form 10-Q. There is a lot of good material in those documents and you can find them on our website at www.gladstonecommercial.com and also on the SEC website.

To stay up-to-date in the latest news involving Gladstone Commercial and our other public companies, please follow us on Twitter, under the name, "GladstoneComps," C-O-M-P-S, and on Facebook, keyword, "The Gladstone Companies," and you can go to our general website to see more information about all of our funds at www.gladstone.com.

The main news to report for this quarter seems to me is we are able to acquire an additional property. We issued some long-term debt to fund this acquisition, and on acquisitions from the second quarter and extend four leases that were coming due in 2012 and 2013. I think all of this is great positive news for our shareholders. We’ve built up a nice pipeline of potential properties that we’re interested in acquiring and we are in due diligence phase on most of those. And because of the pipeline, we are able to grow the asset base again during the last quarter of 2012 and increase the portfolio of properties coming means greater diversification and also better earnings.

We’re still selling some of our senior common stock. We sold over $1.3 million to-date. I think the company is a great position to increase its assets and to increase the income from those assets. And we keep issuing some common stock which seems to be accreted to our current shareholders. So we’re excited about the remainder of this year and 2013. I think it’s going to be a stellar year for this company.

On another note, we’ve been able to find some attractive long-term mortgages to finance our unencumbered properties since the mortgage marketplace from banks is getting much better, but still not as robust as four or five years ago but we do have long-term mortgages now on 69 of the 78 properties we have, the remaining properties are pledged as collateral on our line of credit and it provides us with additional liquidity.

We also continued to look at properties with mortgages on them that we can assume or secure financing close to simultaneous with the acquisition of the properties as we did with three properties during 2011 and thus far in 2012. We don’t close debt simultaneously, so afterwards we are very successful in obtaining debt on the properties in a few months after our closing.

The marketplace for real estate as I keep telling it each time is divided into three big areas, tenants that have AAA or BBB ratings, that are well located in high-quality real estate are being sought after by large real estate investment trusts, some insurance companies and pension funds. And the cap rates on those continues to move around and has moved down even since the last time we talked to you. There is still very low for us to consider as a category for real estate, so we’re not in that area.

Small real estate properties like fast food locations or pharmacy chains locations are being purchased by individual investors at cap rates between 6.5% and 7%. They do this for income rather than buying bonds and we purchased two of these last year in the last years and we’re somewhat out of the normal marketplace at the time that we purchased them and so we got them at very good rates but that’s also a marketplace it’s difficult for us to invest in.

The area we most like and where we shine is the middle market, where we see non-rated tenants and small and medium-sized businesses in commercial and office and industrial properties, as well as a few medical properties. Our competitive advantage in this area is the expertise we have in underwriting non-rated business tenants in conjunction with the acquisition of the real estate. So we have the experts in the real estate area here but as you know, we’re in the business of lending and investing in small businesses, so we take those individuals that are part of our business and they underwrite the tenants so we have a competitive advantage there. We’re in a good position to see a lot of opportunities here. Cap rates for these groups are in the 8% to 9% range. And the leverage rate can be as high as 11% to 15% after we put the lower cost leverage on those.

We’re focusing our efforts on finding good properties in long-term financing to match the long-term leases and being able to lock in that long-term financing would be good for us in the future as you know, we’re much more optimistic now that things are going to be positive for us in the next year. So while we proceed cautiously, we’re expecting some beneficial transactions in the near term and certainly for 2013.

Much of the industrial base that rents industrial and commercial properties, which is our main stay remains steady. Most of them are paying their rents. There are still some businesses that are having problems in the economy and still not in good shape. However, we expect good growth for the rest of 2012 and certainly for 2013 for this real estate investment trust.

And while I’m optimistic that the company will be trying in the future, nevertheless, we continue to be cautious on our acquisitions as we’ve done in the past years. We made it through the last recession without cutting our dividends and having a lot of problems from tenants. And if there is another recession looking on horizon, I think our portfolio will continue to stand the test against that.

We were successful in raising common equity twice in 2011 and some preferred stock once in 2012. We used the new equity to fund acquisitions there in the past year and we’re in the marketplace of course to raise a small amount of common equity with our ATM program. We should raise a little bit in the fourth quarter unlike we raised further equity in parts of 2013 as we continue to fund some of our pipeline.

In October 2012, the Board voted to maintain the monthly distribution of $0.125 per common share for the months of October, November and December. The monthly dividend payer and that run rate is $1.50 per year, a very attractive rate for such a well-managed real estate investment trust. We now have paid 99 consecutive common stock dividends since inception and we went through the recession as I mentioned without cutting that dividend.

Because the real estate can be depreciated, and I mention this every time, we are able to shelter the income, the distributions in 2012 were 83% of return on capital. That is they are tax-free. This is a tax-friendly stock and in my opinion it’s a great one for your personal accounts for income.

This return on capital is due to the depreciation of the real estate which is the fiction in the tax code and it causes earnings to remain low after depreciation but when you add back that depreciation that gives us funds from operation or FFO. And that’s why we talk about FFO because it’s adding back all of that real estate depreciation and it’s just a fiction in the first place that those building’s are depreciating at that rate.

If you own stock in a non-retirement account as opposed to having an IRA or REIT or a retirement plan, you don’t pay any taxes in that part that’s sheltered by the depreciation as its considered a return on capital. However, you do have to note that return on capital does reduce your cost basis on the stock which may result in a larger capital gain when the stock is sold.

With the stock price at $18.55 as it was yesterday at the close, the distributions of $1.50 that’s about an 8.1% return. I’ll note that the industrial marketplace which we have a lot of industrial properties those REITs are trading at 3.7%. The office marketplace we have some office properties obviously the 3.3% and the whole triple-net marketplace is trading at 5.46%.

If we were trading at that REIT universe which is at 3.9% today, that would mean our stock would trade at $38 a share, so there is a lot of room for us to move up in terms of price and still be within trading areas of other REITs in this marketplace in terms of the yield. And then triple-net REITs are trading at about 5.4% today and if we were trading at a 5.4% yield that would be $28 per share. We believe that we should be trading there and as we get bigger and stronger, obviously more people will look at us favorably and we’ll move up in prices at least that’s my belief.

In the past we have traded at over $20 a share and I think we will certainly make that in the near term. We will vote early in January during our regular scheduled quarterly Board meetings on declaration of the monthly distribution for January, February and March. And the outlook is very positive there.

And now, I’ll stop and stop selling stock and answer some questions from our loyal shareholders as well as analysts who follow this wonderful league. Would the operator please come on and help us answer – ask some questions.

Question-and-Answer Session

Operator

We will now begin the question and answer session. (Operator Instructions) At this time, we will pause momentarily to assemble our roster. And our first question will come from Dan Donlan of Janney Capital. Please go ahead.

Elizabeth Bland – Janney Montgomery Scott

Good morning. It’s Elizabeth Bland here with Dan. Can you just talk about your Roseville, Minnesota property and your plans for the remaining space, are there any updates there?

David Gladstone

Sure. Bob, why don’t you update us on Roseville?

Bob Cutlip

Certainly. We have hired a very good local real estate company broker who is helping us reposition the property. Our plans are to release the property, the balance of the property about two-thirds of the space to primarily office users although because of the power availability that we have there, we have interest from data centers. At this time we do have two office prospects that are between 80,000 and 100,000 square feet and one data center prospect, but our expectation is that probably the majority of that space will be for Class A minus to Class B plus office.

So it works well for call centers. It works well for state users and two of those users are in that category right now. It’s a challenging market, we know that, but the facility is set up to accommodate these large users. And yes, we’re hopeful and we’re confident that we’re going to be able to go for positively with the project.

Elizabeth Bland – Janney Montgomery Scott

Okay, thanks. That’s helpful. Do you expect to leave that vacant for any period of time or do you think it will be a smooth transition from when the current tenant stops paying rent at the remaining space?

Bob Cutlip

Well right now we think we have not forecasted – we’re going to lease the entire balance of the space next year because it is a challenging market but because we’re receiving some fairly strong prospects with the large floor plate requirements, we’re confident that we’re going to be successful next year, but I certainly can’t go (inaudible) we’re going to release the entire building within the next 12 months.

David Gladstone

You remember of course that we do – the existing tenant has been reduced down to one-third of the building and they are paying about one half of the rent that they used to pay. So we’re in good shape there in terms of current income that won’t change that much but at the same time, just as Bob mentioned, we love to get the rest it rented out because it would bring in more rent than we have gotten in the past.

Elizabeth Bland – Janney Montgomery Scott

Right. And then on the Saint Louis property, I know you are still in negotiations, but are you able to give any idea of when a new lease would come online there?

David Gladstone

No, I certainly can’t say that, I mean we’re encouraged about it because it’s an excellent industrial building distribution facility with rail service. The prospect is extremely interested in it and we’re encouraged about getting something across the go line here shortly.

Elizabeth Bland – Janney Montgomery Scott

Okay, thanks.

David Gladstone

We’ll go to the next question please.

Operator

(Operator Instructions) And at this time, I am not showing any questions, so this does conclude our question and answer session. I’d like to turn the conference back over to Mr. Gladstone for any closing remarks.

David Gladstone

I know sometimes some of you get your fingers a little bit tangled up and don’t hit the phone in time. So if you have well one quick question, let’s jump on the phone please. No questions? All right, well thank you all, this makes the question and answer session kind of short but we appreciate all the things that you do for us out there in selling the stock and this will end our conversation now.

Operator

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.

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