Gladstone Commercial: Stick To The Preferred Shares

Summary

• Despite how cheap the common shares are, the level of risk is still high.
• Preferred shares have excellent FFO coverage and the risk of being suspended is low.
• Preferred shares look undervalued when compared to the US High Yield B Effective Yield.
• Preferred shares of 9.80% plus look like a huge mispricing in the preferred space and look like a low-risk play to pocket double-digit returns.

wellesenterprises

Introduction

Gladstone Commercial Corporation (NASDAQ:GOOD) is a Maryland-based REIT that owns industrial and office properties. GOOD has historically entered into, and intends in the future to enter into, purchase agreements for real estate having net leases with terms of approximately 7-15 years with built-in rental rate increases. The REIT invests in single-tenant and anchored multi-tenant net leased assets, with an industrial product emphasis. They are net lease, which is my favourite type of lease, as the tenant is required to pay most or all operating, maintenance, repair, and insurance costs and real estate taxes.

As of February 2023, GOOD owned 137 properties totalling 17.2 million square feet of rentable space, located in 27 states with an occupancy of ~96%, and a weighted average lease term of ~7 years. 59% of rent comes from industrial space, 39% from office, 3% in retail, and 1% in medical offices. The largest tenants include General Motors (GM), Kane Is Able Inc., ADP (ADP), and Morgan Stanley (MS). In fact, 50% of their rent is from investment grade (or equivalent if private) companies.

Q1 2023 Investor Presentation (Gladstone Commercial)

Q1 2023 Investor Presentation (Gladstone Commercial)

The common stock has fallen 44% over the past 10 months and now trades at ~10 FFO, which may seem like a steal for a REIT that is predominantly in the desirable industrial space, but as we will see this low valuation may in fact be warranted.

Data by YCharts

Data by YCharts

First of all, the REIT has managed to grow the revenues and assets YoY over the last eight years, but FFO remains flat. This is in part because of management and incentive fees paid under their advisory agreement which rise in line with increases in their asset base for finding, evaluating contracts, and assisting in the negotiating to purchase real estate on GOOD's behalf. The management fee is 1.5% of equity and the incentive fee is based on core FFO exceeding 2.0% quarterly, or 8.0% annualized, which is the hurdle rate. The Adviser will receive 15.0% of the amount of GOOD's pre-incentive fee Core FFO that exceeds the new hurdle rates. The incentive fee has been eliminated for the first two quarters of 2023, however.

Q1 2023 Investor Presentation (Gladstone Commercial)

Second, interest expense has risen steadily since 2020 as a result of rising interest rates 19% YoY as a result of rate increases. As far as leverage goes, the REIT isn't in the worst possible position, with 45% debt-gross book value and only 7% of debt coming due in 2023. In addition, the rates are predominantly fixed or at least hedged, with a weighted average rate of 5.33%. The majority of GOOD’s 2023 mortgage maturities are secured by office properties with tenants on short-term leases of three years or less, which is an asset class banks have been shying away from unless long-term leases are in place. This is because office space has become the most dreaded asset class as the work-from-home era has kicked into gear.

2022 FYE Results (Gladstone Commercial)

Q1 2023 Investor Presentation (Gladstone Commercial)

Q1 2023 Results (Gladstone Commercial)

While interest rates have been rising on their fixed rate debt refinancing, the cap rates on their acquisitions have not kept up as per below, which is not a recipe for FFO growth. According to management:

The demand for industrial space has continued due to the continuing growth of e-commerce and recent trend of manufacturing onshoring, which appears to have partially rebounded from the adverse effects of COVID-19 on the commercial real estate industry in 2020, 2021, and early 2022. However, the increased cost of construction materials and product delivery delays caused by supply chain disruption and related inventory management issues, and the apparent labor shortage we are facing nationally, have resulted in inflation and higher costs for both industrial and office construction projects. Further, a tightening of available financing due primarily to higher interest rates has caused a slowdown in new construction starts throughout the fourth quarter of 2022, as compared to the record breaking third quarter of 2022, which should lead to lowered deliveries into 2024.

Source: 2022 Annual Report

Q1 2023 Investor Presentation (Gladstone Commercial)

Q1 2023 Investor Presentation (Gladstone Commercial)

Now sure, they will be able to realize strong leasing spreads on their expiring leases, but unfortunately only four leases expire in 2023 and eight in 2024, which combined accounts for only 7% of rental income. Unfortunately, two of the leases expiring in 2023 are office properties which are now held for sale.

Q1 2023 Investor Presentation (Gladstone Commercial)

All of this has culminated into a multi-year FFO payout ratio of over 100% as management kept raising the dividend on a YoY basis despite little growth in FFO/share. At the end of 2022 management finally decided to cut the monthly payment dropped from $0.1254 per share to $0.10, a painful 20% haircut. This is a major red flag on management capabilities, considering they collected 100% of contractual rent throughout the year. Even that may not be enough with the payout ratio at 81% based on run-rate FFO.

The Preferred Shares

Now let me change the tone of this article from the negative to the positive. Just because the common shares show signs of being speculative does not mean the preferred offerings have to.

Gladstone is after all well onside with its credit covenants. It is unlikely they would have to suspend preferred dividend payments to be granted forbearance from their operating banks.

Q1 2023 Results (Gladstone Commercial)

Q1 2023 FFO was $14,847,000 or $0.37/share which annualized is $59,388,000 or $1.48/share (without the incentive fee however). This is FFO available to common shares relative to $3,002,000 in payments to preferred shareholders. That is coverage of almost 20x. The preferred shares may be 89% of book equity, but real estate is likely as little as $280 Million undervalued using a conservative 6% cap rate and a run-rate of $94 Million in NOI. Class B industrial space gets cap rates of 4-5% while class B office gets 6-7% in most US markets at this time.

Q1 2023 Results (Gladstone Commercial)

There are three preferred share issuances available, with the Class F being recently issued. 22,256 Class F shares were issued for net proceeds of $0.5 Million. Only the 6.625% Series E (NASDAQ:GOODN) and the 6.00% Series G (NASDAQ:GOODO) are publicly traded and are summarized below. Both issues have been beaten down over 30% since September 2022. Both issues are cumulative, meaning the common share dividend must be cut before the preferred share dividend can be and all preferred share payments must be paid in full before common dividends can be resumed. Both issues have similar current yields at 9.81-9.90% and upside to call which is over 24%. GOODO has the longer dated call date, so the high yield can be locked in for longer.

Gladstone Preferred Shares (Google Finance)

Issue	Ticker	Monthly Dividend	Market Price	Yield	YTC	Call Date
Gladstone Commercial 6% Series G	(GOODO)	$0.125	$15.18	9.90%	24.22%	06/21/2021
Gladstone Commercial 6.625% Series E	(GOODN)	$0.138	$16.63	9.81%	25.28%	10/04/2024

Click to enlarge

The debt does not seem to be rated by any of the major ratings agencies (Fitch, S&P, Moody's). The REIT is still well onside with debt covenants but has a negative outlook, anything less than upper speculative grade (BB) seems unfair. I would argue Necessity Retail REIT (RTL) debt which I wrote on last week is hardly any less risky and is rated upper speculative. The US High Yield B Effective Yield is currently 8.61% meaning these preferred shares are trading at a 121-129 bps premium, indicating a huge mispricing.

US High Yield B Effective Yield (Interactive Brokers)

If you are in agreement with my fair yield methodology, these preferred shares should trade closer to $17.42 and $19.23/share, respectively.

Verdict

Q1 2023 results discussed some positives that have transpired between January and the end of April. Most notably the acquisition of a 76,089 square foot industrial property for $5.3 million at a cap rate of 9.70%, which is leased to one tenant on a 20-year lease. This should add half a million to NOI on an annual basis and was badly needed to keep pace with rate increases. They also collected 100% of the first quarter's cash rents and 100% of April cash rents. They have listed their vacant office properties for sale at $17.5 Million and 158,501 square feet. Whether they can fully pay down the encumbrances is another matter.

The outlook does not look promising for the common stock and given the repositioning required to deleverage, I would not be surprised to see another dividend cut. The coverage on the preferred shares is still more than adequate, and the risk of these dividend payments getting cut is fairly low.

These preferred shares offer a low risk play to pocket double-digit returns in the preferred space.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of GOODO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[Bluegrassriver]

The preferred shares look solid. I like the revenue increasing for seven years in a row and they keep reducing leverage. If the offices will be renovated into condos or apartments it would be a big win. New housing is certainly needed in those two locations.

[brettalex]

I can’t tell from the article or maybe I missed it, but is the dividend qualified?

[ethel65]

@brettalex no

[ethel65]

Well, shoot. the price is getting run up today.

[Eileen Dover]

@ethel65 I'll wait for the drop back down.

[Rob G. in Vegas]

"Q1 2023 FFO was $14,847,000 or $0.37/share which annualized is $59,388,000 or $1.48/share (without the incentive fee however). This is FFO available to common shares relative to $3,002,000 in payments to preferred shareholders. That is coverage of almost 20x."

Not quite 20X. The preferred dividend payments for GOOD are $3.002 Million per quarter. $12M in annual preferred payments.

So that knocks down coverage on FFO/preferred dividends to 4.95X. Still good.

[SummitNJ]

@Rob G. in Vegas Hi Rob, the coverage on the preferred is fine, but the common seems to be in danger. From Brant's article above, the credit line conditions state that the maximum dividends/FFO ratio is 96%. Brant notes that the annualized FFO in 1Q is $1.48/share, but the annual dividends are $1.20 for common shares and preferred dividends of $.30 per common share ($12 million/40 million common shares), for a total of $1.50, annualized. Trailing 12-month isn't as bad (91.8% ratio), but it seems as if the company needs capital gains or lower interest rates in order to keep paying $.10 per month on the common. Reinstating the incentive pay would lower FFO and force another dividend cut. The removal of incentive pay might not be as "voluntary" as it appeared.

[Rob G. in Vegas]

@SummitNJ I'm thinking there will another dividend cut for GOOD common at year end or in early 2024. I hope I'm wrong.

[CincinnatiRick]

@Rob G. in Vegas We can say "it's priced in" but you know that there will be another lurch downward when it happens. Buying opportunity?

[SummitNJ]

My own opinion (not a fact) is that Gladstone is far from a quality company.
Look at its Shareholders Equity. $726 million raised from stock issues, $543 million returned to shareholders as dividends in excess of earnings (your money), $6 million in AOCI, $189 million left. It calls selling stock and giving you a dividend as "a return."
It will borrow more money from its line of credit in the near term. My opinion is that it's not paying dividends from value it created. That's what it's equity says, at least.

[Sma lenn]

@SummitNJ wouldn’t dividends in excess of earnings include depreciation? Wouldn’t you use dividends in excess of FFO?

[Rob G. in Vegas]

@SummitNJ It is paying dividends from free cash flow. Here is what I commented when GOOD released EPS for 1Q 2023:

"FCF for the quarter fell to $13M, down from $16.2M during 1Q 2022. Why?

Big 34% jump in interest expenses and an additional $1M spent on cap-ex.

With $15M spent on common and preferred distributions, the common dividend still seems too high. They should have cut it more.

But plenty of coverage for the $3M they spend/quarter on the preferred dividends."

It was a mediocre quarter at best for GOOD, even with the waived incentive fee (which was $1.34M during 1Q 2022).

[Eileen Dover]

@Rob G. in Vegas Are you long either N or O ? Would you choose one over the other? Thanks

[arcticfoxman]

Yes, I've looked at swapping over but I think my traditional broker's costs are too expensive to bother as fundamentally Gladstone is solid as a rock. However your article has prompted to buy a small dip into the Series E (GOODN). Who knows, if interest rates don't go up, or even drop a notch in the next 12 months I may get called for a nice capital gain.
Just clicked to Follow you. 👍

[Eileen Dover]

@arcticfoxman Why N over O , the earlier possible call date ? Both yield 9.9%, but the O has a call date to 2026 as opposed to 2024 for N, so you would get the high yield for 2 years longer (should there not be a suspension of the common which might hit the Pref).

[ethel65]

@arcticfoxman I don't think they're going to have the funds to call the preferreds.. which suits me just fine

[SummitNJ]

@Eileen Dover
GOODN has a 6.625% coupon while GOODO has a 6% coupon. If the yield on the preferreds from to 6.25%, for example, GOOD has the incentive to call the N series, but won’t call the O series. Having said that, the O series trades better.

[arcticfoxman]

You're showing a call date of June 2021 for GoodO, that can't be relevant. Do u have an update?

[Brant Munro, CFA]

@arcticfoxman geez loaded with typos here. Its 2026 i believe.

[PickleNick]

@arcticfoxman correct, 6/28/2026

[jumby]

@Brant Munro, CFA measure twice, cut once.

[Eileen Dover]

"...meaning the common share dividend must be cut before the preferred share dividend can be". Of course you mean the common dividends must be suspended, not cut as they already have been this year from $1.50/sh to $1.20/sh.

[Brant Munro, CFA]

@Eileen Dover Haha yes typo.

[toomuchgas]

@Eileen Dover It could be cut further without being suspended.

[arcticfoxman]

@toomuchgas . In my experience of preferreds & bonds, companies still pay even if they've suspended the divi on the common stock.
The only times they've not is when they've gone bust, and it would be a very cold day for Gladstone to go bust. They're very solid.