Gladstone Commercial Corp Q3 FY2022 Earnings Call

Greetings and welcome to the Gladstone Commercial Corporation Third Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, David Gladstone, CEO. Thank you, sir, you may begin.

Thank you, Latoya. That was a nice introduction, and thanks to all of you for calling in. We appreciate this time we have with you on the phone; I wish we had more time to talk with you to make sure you understand what we're up to. Now, we'll hear from Michael LiCalsi, our General Counsel and Secretary, to give legal and regulatory matters concerning this call and the report.

Thanks, David. Good morning, everybody. Today’s report may include forward-looking statements under the Securities Act of 1933, the Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties that are based on our current plans, which we believe to be reasonable. Many factors may cause our actual results to be materially different from any future results expressed or implied by these forward-looking statements, including all the risk factors listed in our Forms 10-Q and 10-K and the other documents we filed with the SEC. You can find them on our website, specifically the Investors page, or on the SEC's website. We undertake no obligation to publicly update or revise any of these forward-looking statements, whether as a result of new information, future events, or otherwise, except as required by law. Today, we'll discuss FFO, which is funds from operations, a non-GAAP accounting term defined as net income, excluding gains or losses from the sale of real estate and any impairment losses on property, plus depreciation and amortization of real estate assets. We'll also discuss core FFO, which is generally FFO adjusted for certain other non-recurring revenue and expenses. We believe these metrics are a better indication of our operating results and allow better comparability of our period-over-period performance. We ask everybody to take the opportunity to visit our website, sign up for our email notification service. You can also find us on Facebook and Twitter. Today's call is an overview of our results, so we ask that you review our press release and Form 10-Q, both issued yesterday for more detailed information. I'll now hand the baton over to Gladstone Commercial's President, Buzz Cooper.

Thank you, Michael. Good morning, everyone, and thank you for dialing in. I will cover the highlights for the last quarter and provide some comments on the state of the portfolio and market outlook before turning the call over to Gary Gerson, Gladstone Commercial's CFO, to review our financial results and our capital and liquidity position. During the third quarter of 2022, we continued our focus on industrial acquisitions and improving operations. We amended, extended, and upsized our syndicated revolving credit and term loan facility from $325 million to $495 million. We used the net proceeds to pay down mortgage loans and borrowings under our revolving credit facility. We acquired a 246,000 square foot industrial portfolio located in Vineland, New Jersey, and Brighton, New Jersey, for $32.5 million and a 15-year sale-leaseback transaction. We acquired a 67,000 square foot industrial building in Jacksonville, Florida, for $8 million and a 20-year sale-leaseback transaction. We acquired a 49,000 square foot industrial building in Fort Payne, Alabama, for $5.6 million in an UPREIT transaction. We sold our Jupiter, Florida office property for $19 million, resulting in a gain on sale of $8 million and a levered IRR of approximately 18%. We sold a 60,000 square foot office property in Parsippany, New Jersey, for a 15% levered IRR, and we sold a 25,000 square foot office property in Boston Heights, Ohio. We leased 41,225 square feet at our Parmer Austin, Texas office building to Cognizant Technology Solutions for a 5.7-year term at market rates. We leased and renewed 120,000 square feet at our Horsehead, New York industrial building for a five-year term at market rates. We leased 47,566 square feet at our Fort Lauderdale, Florida office building to Moss & Associates for a 5.3-year term at market rates. Subsequent to the end of the quarter, we acquired a 69,000 square foot industrial office building in Denver, Colorado, for $12 million and a 20-year sale-leaseback transaction with a GAAP cap rate of 8.8%. We sold our 31,000 square foot office building in Columbus, Ohio. Lastly, we leased 20,682 square feet of our Mason, Ohio office property for seven years and four months, bringing the property to full occupancy. These investments, dispositions, and re-leasing activity further reinforce our strategy to increase our portfolio's industrial allocation and improve property operations. Acquisition activity since July 2021 has been steady and consistent, despite the uncertain market conditions driven by rising inflation, the war in Europe, and pandemic challenges. The team averages $11.9 million of investments per month, with a strong average GAAP cap rate of 6.9%. The acquisition volume since 2019 has exceeded $450 million, and all assets have been industrial in nature. Our industrial allocation has increased from 32% to 54% during this period, while pure office allocation has been reduced to 42%. The team's near-term objective is to reach an industrial allocation of 60% within the next 12 to 18 months. Our success has been with acquisition candidates in the 50,000 to 300,000 square foot range, with the predominance of sale-leaseback transactions, and we expect to continue this focus. Now I'd like to comment on the portfolio. Our asset management team continued to deliver on improving our same-store opportunities. Year-to-date through September 30, the team leased, renewed, and extended 501,501 square feet covering nine tenants, with a weighted average lease term of 8.1 years. The annualized straight rent totaled $5.7 million. We are also continuing our capital recycling efforts to redeploy sale proceeds into industrial assets. These transactions will benefit our 2022 operating performance and in the out years as well. Our rent collection experience continues to be strong with 100% of cash rents collected through October 31. We are very pleased with our portfolio and our tenants' performance during these challenging times for all industries. On the personnel side, we continue to grow our talent pool, both in size and experience. Judy Carter has joined the company as a Senior VP of Asset Management. In the third quarter, we closed three transactions for a total of $46.1 million. The first was a two-property portfolio located in Vineland, New Jersey, and Bridgeton, New Jersey, with a purchase price of $32.5 million and a GAAP cap rate of 7.17%. The second closing was in Jacksonville, Florida, with a purchase price of $8 million and a GAAP cap rate of 7.92. The final closing was in Fort Payne, Alabama, with a purchase price of $5.6 million and a GAAP cap rate of 6.76, in an UPREIT transaction. It's important to mention that since January 2022, the average GAAP cap rate on our $97.5 million of acquisitions has been 6.88%. These transactions and due diligence are currently scheduled to close within the next 45 days and are above 7%, which we expect will be very accretive to our shareholders. Market conditions are worthy of comment, particularly with the continued effects of COVID-19, rising inflation, supply chain challenges, rapid and consistent interest rate increases, and the war in Europe. A review of research reports relating to industrial and office statistics for the third quarter reflects both improvements and continued challenges. Most industrial property types continued to outperform expectations, and the fundamentals remained strong despite the economic volatility, creating a disconnect between the property markets and capital markets. While investors are beginning to take a risk-off approach, long-term quality real estate investment opportunities remain. Despite headwinds indicating an economic slowdown, the national industrial market remains resilient, albeit with slightly slowing fundamentals. Per Cushman & Wakefield, net absorption exceeded 100 million square feet for the eighth straight quarter, driving vacancy down to 3.2%. Demand continues to outpace deliveries, and rising construction costs are driving the average industrial asking rates to new heights, up 22% year-over-year, the strongest growth rate ever recorded. National rents are poised to continue growing ahead of inflation over the next several months given the record low vacancy rate. Deliveries picked up in the third quarter, as nearly 150 million square feet was delivered, the highest quarterly total on record. Despite these record deliveries, the construction pipeline continued to increase dramatically, with 760 million square feet in the third quarter, as developers remain bullish on the industrial market. Supply chain, labor, and inflationary pressures have delayed development schedules, contributing to a record high construction pipeline. The industrial market is expected to remain robust. The office market has continued to evolve and gradually recover from the pandemic. Per Cushman & Wakefield, third quarter office absorption continued to be negative, the ninth negative of the past 10 dating back to Q2 2020. In Q3 2022, there was a net negative absorption of 18.5 million square feet across the United States. According to JLL, leasing activity slightly decreased during Q3, with approximately 45 million square feet leased, a 3.6% decrease from Q2. After lengthening for several quarters, the average lease terms are again beginning to decline as companies reconsider short-term space needs, with the average lease term decreasing to just 6.2 years. The office sector recorded 11.8 million square feet of new deliveries for the third quarter, bringing year-to-date completions to 38.3 million square feet, marking a slight decline from the previous year. As it relates to our growth opportunities, we have recently seen a reduction in sales listing activity, and the investment sales brokers indicate that the number of acquisition candidates on a per-property basis has been reduced. We are slowly beginning to see cap rate expansion in the market due to the continued rise in interest rates and cost of debt. The current pipeline of acquisition candidates is approximately $300 million in volume, representing 20 properties, all of which are industrial. Of the 20 properties, one property is in due diligence, totaling $5.5 million; three properties are in the letter of intent stage totaling $68 million, and the balance are under initial review. Our team is staying actively engaged in our markets as we believe acquisition opportunities will continue to arise that we can and will pursue. In summary, our third quarter activities reflected continued strong leasing and rent collection success, continued active engagement to identify industrial acquisition opportunities, and have collectively positioned us well to pursue growth opportunities. Now let's turn it over to Gary, our CFO, who will report financial results, including our capital market activities.

Thank you, Buzz. Good morning, everyone. I'll start my remarks regarding our financial results this morning by reviewing our operating results for the third quarter of 2022. All per share numbers I reference are based on fully diluted average common shares. FFO available to common stockholders was $0.23 per share, and core FFO available to common stockholders was $0.44 per share for the quarter, respectively. FFO adjusted for comparability and core FFO available to common stockholders during the third quarter of 2021 were $0.44 and $0.39 per share, respectively. FFO available to common stockholders for the three quarters ended September 30, 2022, was $1.21, and core FFO available to common stockholders for the same period was $1.22. FFO adjusted for comparability and core FFO for the three quarters ended September 30, 2021, were $1.20 and $1.17, respectively. Our same-store cash rent in the first three quarters of 2022 increased by 0.2% over the first three quarters of 2021. Our third quarter results reflected total operating revenues of $39.8 million, with operating expenses of $37.4 million, including an impairment charge of $10.7 million on our Columbia, South Carolina office property, as compared to operating revenues of $34.3 million and operating expenses of $25.5 million for the same period in 2021. Moving on to the balance sheet, we continue to grow our assets and focus on reducing our leverage. In the third quarter, we increased total assets by approximately $16.3 million. We continue to reduce our debt to gross assets and are now down to 44.8% as of the end of the quarter. We believe we are 1% to 2% away from our target leverage level. During the third quarter, we amended, extended, and upsized our syndicated credit facility. We increased term loans from $225 million to $370 million and increased our revolving credit facility commitment from $100 million to $125 million. Net proceeds were used to retire maturing mortgages and fund acquisitions. We want to thank our lenders for making this upsized credit facility a success, which include Key Bank, Bank of America, Huntington National Bank, Fifth Third Bank, United Bank, Synovus Bank, First Financial Bank, and S&T Bank. As we grow through disciplined investments, we also continue to expand our unsecured property pool with additional high-quality assets. Over time, we expect this will increase our debt financing offers. Looking at our debt profile, 49.5% is fixed rate, 49.5% is hedged floating rate, and 1% is floating rate, which is the amount drawn on our revolving credit facility. We have seen increased expenses this quarter due to the rise in interest rates and the expensing of deferred financing costs associated with the amended credit facility. As of September 30, our effective average SOFR rate was 2.98%. Our outstanding bank debt is hedged with $210 million of interest rate swaps and the remainder with interest rate caps. We continue to monitor interest rates closely and update our hedging strategy as needed. As of today, our 2022 and 2023 loan maturities are manageable with $16 million due in 2022 and $66.1 million coming due in 2023. We have several options and will refinance these amounts at the appropriate time. As of the end of the quarter, we had $7.8 million of revolving borrowings outstanding. While entering the fourth quarter with sufficient liquidity, we've been active in issuing equity through our at-the-market program. During the third quarter of 2022, net of issuance costs, we raised $8.9 million through common stock sales. We also raised net proceeds of $0.9 million from sales of our Series F preferred stock. We continue to manage our equity activity to ensure that we have sufficient liquidity for upcoming capital requirements. As of today, we have approximately $6.6 million in cash and $30.6 million of availability under our line of credit. With our current availability, the strong performance of our portfolio, and access to the ATM program, we believe we have significant incremental flexibility to fund our current operations near and long term. We encourage you to also review our quarterly financial supplement posted on our website, which provides more detailed financial and portfolio information for the quarter. Institutional ownership of our stock has increased over time to 46.6% as of September 30, which is a significant increase over the last eight years. We continue to be very active in meeting with current and potential investors, portfolio managers, coverage analysts, and investment banks. We look forward to establishing new relationships as the company continues to grow. Our common stock dividend is $0.3762 per share per quarter or $1.548 per year, with our common stock closing yesterday at $17.33. The distribution yield on our stock is 8.68%. And now, I'll turn the program back over to David.

Well, that was a good report, Gary, and a good one from Buzz and Michael, too. The team has performed very well and reacted admirably to all the various changes presented by the pandemic and the economy. Overall, given all of these changes that are going on, I think we have had a very nice quarter and look forward to a good quarter going forward. You heard a lot today about the numbers of new transactions, new leases, and the quarterly numbers are impressive. The team amended and extended our credit facility, which was coming due anyway, and they've done a great job of pushing it on up to $495 million. We collected all of our cash rents that we're accruing, and so the team also acquired four industrial assets during the quarter for a total investment of $46.1 million and sold three office buildings. Again, that's our goal—to push out our office properties. So we sold three during the quarter. Also, lease renewals totaled 208,791 square feet, which is part of a total of 501,501 in lease renewals to date. Subsequent to the end of the quarter, the team acquired industrial properties for about $12 million and sold an additional office property. So we're continuing to roll over and become almost purely operational-oriented toward the industrial or commercial side. The commercial team continues to grow its real estate holdings at a good pace. I’m very happy to say that the company is in great shape. As all of you know, we're in the middle market. Most of our tenants are middle-market companies; that's where we perform best. Our other funds have always been oriented toward the middle market. Like many of our tenants, we are being challenged now with inflation, which is pretty brutal when they move the inflation rate up so quickly by spending so much money. Rising interest rates are a big threat to everyone in this business that's doing real estate transactions. The recession, while it might be categorized as a light recession, is still present, and the supply chain disruptions seem to be getting better, but it's still a challenge. I'm really proud to say that our tenants continue to pay their rents. These are times that have never been seen before, and there will be future challenges. But we have a first-class team, and I'm glad to say that they are up to the challenge. I have been around long enough to witness seven or eight of these recessions, so I think we will make it through this one as well. I'm going to stop now and let Latoya explain how people can ask us some questions, and we'll try to give better answers to the questions that come up. First question?

Thank you. We will now conduct a question-and-answer session. Our first question comes from Gaurav Mehta, EF Hutton. Please proceed.

Thanks. Good morning. First question on your lease expirations. Can you provide some color on the lease that you have expiring in 4Q and then maybe some early color on the leases expiring in 2023?

Yes, Gaurav, I'm happy to do that. We are actively managing the leases that are coming due. We have one property in South Carolina where the lease is expiring, and we are aggressively working to re-lease it. We've had a couple of interested parties, although they have not come through. They are government in nature, which means the process is slow. With that property, we're looking to see what other alternatives we have. That being said, it's going to be a challenge for us, but we are working through it, monitoring it closely and trying to affect a change with that property, potentially through sale or occupancy. In 2023, we believe several of the leases that are coming due will either be sold or actively occupied. Specifically, in Texas, we have one or two properties that we are holding for sale currently, and another one we are looking to exit. We believe the total we have is manageable. The team has done a great job historically managing these vacancies and problem properties as well.

Yes. One more, if I could. On the acquisitions, I look at the cap rate for 3Q at 7.2%. In 4Q, you acquired another property at an 8.1% cap rate. Is the higher cap rate on the 4Q acquisition specific to that property, or does it reflect where market cap rates are moving with higher interest rates?

You are correct with that statement. It was honestly a function of the team doing a great job of negotiating with the seller in light of the high interest rate costs since our initial commitment to them. We discussed this with the sellers to improve and maintain our economics, ensuring the deal remains as accretive as possible. We are seeing some capital expansion as well. We hope that sellers realize this sooner rather than later, but we will maintain our discipline with regards to our underwriting and ensure our deals are accretive. The team has had a couple of instances where we've had to adjust terms, and we'll continue to do so when necessary.

Okay. Thank you. That’s all I had.

Okay, next question, please.

Our next question comes from John Massocca with Ladenburg Thalmann. Please proceed.

Good morning.

Good morning, John.

So maybe sticking with the acquisition line of questioning, what are you seeing in terms of deal volume as we approach the busy season in 4Q? We've heard from some peers that the moves in interest rates have created a buyer-seller disconnect. Is that what you're experiencing? What expectations do you have for 4Q, either for properties under PSA and LOI, just kind of broader expectations? And then how are you looking at 2023 at this point?

So John, I agree with what you said about the marketplace. We are seeing a slowdown of opportunities. However, the team has been very successful over the last 18 to 24 months with what I'll call off-market sale-leaseback transactions, and we are continuing to focus on that. We hope sellers will understand that cap rates have to rise due to the cost of borrowing and the transactions themselves. Deal volume is present, although, again, we are seeing a slowdown in opportunities. Deals typically come out toward the end of the year after the summer into fall, but we are pursuing some off-market opportunities primarily focused on sale-leaseback transactions. In this environment, we have companies looking to sell their properties to generate cash to reinvest in their businesses. Our underwriting accounts for where that cash is being allocated. As we move into 2023, I believe we will be more discerning on the acquisition side, waiting for sellers to adjust their expectations.

Okay. And regarding your balance sheet, what are you thinking about in terms of cost of debt right now? In 2023, it looks like it could be a busy year for refinancing. What are your expectations for the cost of that debt versus what you currently have in place?

Well, I think we have swapped a fair amount of our term loans. We continue to look at doing some more of that. Overall, right now, everybody expects short-term rates to increase. I'm looking at the forward curve right now, and it shows getting as high as 5.1%. We're seeing mortgages in the sixes, so yes, we expect interest rates to go up. If we were to use mortgage debt, it would need to be for a property with a high enough cap rate to offset that mortgage debt. Through our hedging strategy, we're managing any of these interest rate increases, but we expect costs to rise. We anticipate that, if expenses increase, we should have revenue to offset that.

John, I think we've locked ourselves into a good term on the interest rates we are paying on the debt, which aligns with our long-term strategy. The mortgages we have in place are in good shape to support us over the next couple of years. Right now, we are focused on new deals, and as you heard from Buzz, talking to some of these sellers is challenging because many of them are still fixated on prices from six months ago. This disconnect between our borrowing ability and what sellers expect to get for their properties is significant. It will take time for this to work its way through the market, so we are remaining steady and optimistic for this quarter. Where we will be in 2023 is anyone's guess, but I think we will be in a similar position.

Okay. Moving over to the in-place portfolio, apologies if I missed this earlier in the call, but any update on the lease-up situation in Austin? How is that looking? And what's the outlook for that property? If it gets closer to being fully leased, will it become a candidate for disposition given the interest rate environment?

We do have a couple of prospects related to the remaining square footage of approximately $100,000 in that building. The cash flow on that building is now positive compared to what it was when GM occupied the full building. As it relates to Austin, there has been a slowdown there, both in terms of residential space and a lot of subleased space on the market, which creates a drag for us with prime spaces. That said, we are having discussions internally about that building, making some assumptions and projections for going forward into 2023. While we value the cash flow from that building, if we can increase its value, we may look at repositioning it to allow us to acquire more industrial product.

Is there still a market to recycle out of that asset, given the current interest rates?

Yes, I believe there is. Honestly, we would like to have that second floor occupied to increase its value even more; however, given the interest rate costs, we are actively evaluating our options. I believe it is well-positioned within the farmer space as swing space for ongoing development around it.

All right. That was all for me. Thank you very much.

Thank you. Okay. Next question?

Our next question comes from Craig Kucera with B. Riley. Please proceed.

Yes. Hi. Good morning, guys. Just one for me. Given your unique viewpoint into the middle market, much of which is manufactured based in your portfolio, are you seeing any signs of stress among your tenants, particularly in categories where their input costs are outpacing their ability to raise prices? Does that give you any pause on acquiring assets in any particular categories?

I think cash flows, generally speaking, are in pretty good shape for us. We've chosen tenants that are stronger than most in the market, so I believe we are in a good position. There's no doubt that interest rate hikes impact everyone in this business; it limits our ability to pursue new transactions. While there are plenty of transactions available, there remains a disconnect between what we can afford due to higher interest rates and what tenants are prepared to pay. We are moving cautiously but are well-positioned to handle whatever challenges come our way. We have strong banking relationships and a diversified portfolio, both geographically and in terms of manufacturing types. This approach relates back to our strategy of supporting small businesses, focusing on the credit quality of the tenant. Overall, we're in a solid position.

Okay. Thank you.

Are there any other questions?

There are no further questions at this time. I would like to turn it back to you, Mr. Gladstone, for closing comments.

We thank all of you for calling in. It has been a pleasure to spend this time with you. I hope in January, during our next call, you have many more questions for us. We appreciate the inquiries. That concludes this call. Thank you, Latoya.

This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a great day.