Gladstone Commercial Corp Q1 FY2023 Earnings Call

Greetings and welcome to the Gladstone Commercial Corporation First Quarter Earnings Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, David Gladstone, Chief Executive Officer. Please proceed.

Well, thank you, Latoya. This is a nice introduction that you do each time. Thanks to all of you for calling in this morning. It's a chilly day here in McLean, Virginia, just outside of Washington, D.C., and we'll warm you up with some good news in a minute. We enjoy this time we have with you on the phone and wish we had more time to talk with you. Now we'll hear from Michael LiCalsi, our General Counsel and Secretary, to give us legal and regulatory matters concerning our reports.

Thanks, David. Good morning, everybody. Today's report may include forward-looking statements under the Securities Act of 1933 and 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, and many factors may cause our actual results to be materially different from any future results expressed or implied in these statements, including all risk factors in our Forms 10-Q, 10-K, and other documents that we filed with the SEC. You can find these on our website, gladstonecommercial.com, specifically on the Investors page or the SEC's website at www.sec.gov. 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 will discuss FFO, which is funds from operations. Now FFO is 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, generally FFO adjusted for certain other non-recurring revenues and expenses. We believe these metrics are a better indication of our operating results and allow for better comparability of our period-over-period performance. We ask everyone to visit our website, once again, gladstonecommercial.com, to sign up for our email notification service. You can also find us on Facebook; the keyword there is the Gladstone Companies, and our Twitter handle is @gladstonecomps. Today's call is an overview of our results, so we had to review our press release and Form 10-Q, both issued yesterday for more detailed information. Now I'll hand it over to Gladstone Commercial's President, Buzz Cooper.

Thank you, Michael, and thank you all for calling in. Today, we will discuss economic and portfolio topics that are top of mind. The country is going through a rough patch economically, which has affected the commercial property market. Although remote work and lingering effects of the pandemic have weakened the office property market, the industrial property markets remain strong. We continue to pivot to a higher percentage of industrial assets by divesting from non-core assets, and we are lowering our exposure to the office market and de-risking our portfolio. I'd like to highlight several positive developments. Our overall portfolio remains stable, and we continue to see attractive acquisition candidates. Further, we continue to have success with retenanting and capital recycling into industrial assets. With these facts in mind, let me move on to a discussion covering the results 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, our CFO, to review our financial results for the period and our capital and liquidity positions. I would add that I've asked EJ Wislar, the company's CIO, to join us here in the room today to address specific market questions. During the first quarter of 2023, we continued our focus on industrial acquisitions and improving operations. We collected 100% of cash-based rents during the first quarter, extended the lease of 352,860 square feet of industrial property in Ottumwa, Iowa, for an additional five years, and extended the lease on 3,546 square feet of office space for an additional five years. Our investments, dispositions, and re-leasing activities further reinforce our strategy to increase our portfolio's industrial allocation and improve property operations. The acquisition volume since 2019 has exceeded $470 million, and all assets have been industrial in nature. Our industrial allocation has increased from 32% to 59% during this period, while our pure office allocation has been reduced to 37%. The team's near-term objective is to reach an industrial allocation of over 60% in the next 6 to 12 months. We have had success in acquisitions in the 50,000 to 300,000 square foot range, with most being long-term sale-leasebacks, and we expect this trend to continue. Now I'd like to comment on the portfolio. Our asset management team continued to deliver on improving our same-store operations. For Q1 2023 compared to Q1 2022, same-store lease revenues increased by 5.8%. We are also continuing our capital recycling efforts to redeploy sales proceeds into industrial assets. Our rent collection experience continues to be strong, with 100% of cash rents collected through April. We are very pleased with our portfolio and with our tenants' performance during these challenging times for all industries. It is appropriate to mention that for the quarter, the average GAAP cap rates on our $114.4 million of 2022 acquisitions was 7.12%. Our transactions in due diligence currently scheduled to close within the next 45 days are above 7.5%, which we expect will be very accretive to our shareholders. With the higher interest rates and the limited availability of credit, transaction volumes are down by over 50% year-over-year, and there continues to be a disconnect between buyers and sellers as it relates to pricing expectations. However, the industrial sector continues to outperform other asset classes, accounting for roughly 25% of all commercial property sales. Furthermore, the increase in cost to high-yield debt leverage loans has made sale-leasebacks an attractive source of capital for private equity firms, and an increasing number of firms are exploring it as a financing alternative. Return to office efforts are beginning to progress across the United States as the labor market softens and companies focus on efficiency and productivity. Major employers in key industries have announced reversals of remote work policies or increased frequency of hybrid working, most of which will take effect midyear. In April, the White House released new guidelines for federal employees to significantly increase office work. Although remote work remains elevated and the office market faces cyclical challenges, there are promising signs from corporate tenants pushing towards an increase in in-person work. As for our acquisition opportunities, we see a reduction in sales listing activities, and investment sales brokers are indicating that the number of acquisition candidates on a per-property basis has declined. We have seen cap rate expansion in the market due to the continued rise in interest rates and cost of debt, with new sponsors exploring sale-leasebacks. Our current pipeline of acquisition candidates is approximately $408 million in volume, representing 25 properties, all of which are industrial. Of the 25 properties, three are in due diligence, totaling $25.5 million; one is in staging for another $8.5 million, and the balance are under review. Our team is actively engaged in our markets, as we believe acquisition opportunities will continue to arise, and we can and will pursue them. In summary, our first quarter activities reflected continued strong leasing and rental collection success, continued active engagement to identify industrial acquisition opportunities, and have collectively positioned us well to pursue growth. Now let's turn it over to Gary, our CFO, for a report on the 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 first quarter of 2023. All per share numbers referenced are based on fully diluted weighted average common shares. FFO and core FFO per share available to common stockholders were both $0.37 per share for the quarter. FFO and core FFO available to common stockholders during the first quarter of 2022 were $0.39 and $0.40 per share, respectively. Our same-store cash rent in the first quarter of 2023 increased by 5.8% over the same period in 2022. Our first quarter results reflect total operating revenues of $36.6 million with operating expenses of $25.4 million, as compared to operating revenues of $35.5 million and operating expenses of $25.7 million for the same period in 2022. Moving on to the balance sheet, we had no acquisitions or dispositions this quarter. We continue to reduce our debt to gross assets, which are now down to 45.2% as of the end of the quarter. Looking at our debt profile, 47.4% is fixed rate, 49.1% is hedged floating rate, and 3.5% 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 hedging costs. As of March 31, our effective average SOFR was 4.87%. Our outstanding bank term loans are hedged with $210 million of interest rate swaps and the remainder with interest rate caps. In addition, we have $100 million of forward-starting swaps to replace maturing caps in mid-2023. We continue to monitor interest rates closely and update our hedging strategy as needed. As of today, our 2023 and 2024 loan maturities are manageable, with $54.8 million due in 2023 and $11.2 million coming due in 2024. As of the end of the quarter, we had $26.25 million of revolver borrowings outstanding. We've had minimal activity in issuing equity through our aftermarket or ATM program. During the first quarter of 2023 and net of issuance costs, we raised $4 million through common stock sales. We also raised net proceeds of $0.5 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. Presently, we have three office properties held for sale, two scheduled to close in June with signed PSAs, and negotiations ongoing for a sale of our Columbia, South Carolina asset, with the current lessee. As of today, we have approximately $7.4 million in cash and $75 million of availability under our line of credit. We encourage you to also review our core financial supplement posted on our website, which provides more detailed financial and portfolio information for the quarter. Our common stock dividend is $0.30 per share per quarter, or $1.20 per year. And now, I'll turn it back to David.

All right. Thank you very much. Wonderful yield on the stock at 10% or so. We are all happy that things are going well here. It was a really good report you did, Gary, and a good one from Buzz and Michael too. The team has performed very well and reacted admirably to various challenges. Overall, it's been a nice quarter. The commercial team is growing the real estate we own at a good pace, and the team is doing a great job of managing the properties we own. Our team of strong professionals continues to pursue potential quality properties from the acquisitions that they are reviewing. Our acquisition team is seeking strong credit tenants. They recognize that the quality of the tenant and the real estate make for excellent investments. Our asset managers are actively managing the properties that the company owns in order to maximize value. I'm going to stop here, Latoya, if you will come on and see if we have some questions from some of the good analysts that follow our company.

Our first question comes from Gaurav Mehta with EF Hutton.

My first question is on the vacancy in the portfolio. Can you provide some color on your expectations to fill some of the vacancies that you have?

Certainly, Gaurav, thank you. We are aggressively looking to sell the office assets that do have vacancies. As referenced in the report, we have several that are either due to close under PSAs. We had one that came about at the end of January that we also have been able to gain a signed LOI upon a larger transaction that we have a PSA out on. From a square footage basis, it was $165,000, all office. So we feel very good about those that are fortunately in the portfolio currently, and we will continue that capital recycling. I hope that answers your question regarding that, and I'm happy to delve deeper if needed.

No, that's helpful. Second question, I was hoping you could address debt maturities for 2023 of $54.8 million. How do you plan to refinance that debt? And if you do, where do you think the rates are today to refinance it?

Well, those are all mortgage maturities, and we are working on those; our treasurer is in contact with potential lenders. It depends. I mean, the majority of that is office, and rates on those are relatively high, but we think we can get them all done. I can't really say more than that. The spreads are higher than 200 to 300 basis points over the 10-year. So unfortunately, the cost of those mortgages could be more than if they were fixed, but we can also get variable rate mortgages and swap those out at a probably lower rate.

Our next question comes from Rob Stevenson with Janney Montgomery Scott.

Sorry if I missed it, but what's the rough dollar amount on the 7.5 cap rate assets that you expect to acquire in the next 45 days? Is that the $25.5 million that you spoke of, or does that 25.5 include deals that are further out than the next 45 days?

No, sir. That's the $25.5 million.

Okay, perfect. And then, how should we be thinking about dispositions over the remainder of '23 beyond the three office assets? And where is pricing for those types of office assets today?

Obviously, it depends on the location, and we have good quality real estate in our office, but they are in areas that have been hit across the country. To give you an idea of the value, we look to get out a whole, if I can call it that way, relative to both debt and/or value on our books. In some cases, we might be selling over our cost and acquisition price, but in other cases not. I think we have it very manageable, especially with the three I mentioned that will, in the not-too-distant future, be off our books. We are also continuing to address another specific office property that matures at the end of the year, looking to dispose of that property because it's in a very tough market and somebody needs to come in and redevelop it. Obviously, that is not our business model. It's very manageable; the three properties I referenced constitute about 1.85% of the portfolio rent that we're missing, if you will. So I think it's very manageable, and again, the team has really done a great job of moving properties, and we continue to focus on that.

Okay. And then I guess given those comments and given how difficult the market is in valuing office assets and cash flows relative to industrial, is there any compelling reason why you guys would buy an office asset over the next 12 to 18 months? Or is whatever capital you're going to deploy 100% going to be industrial?

I would say it's going to be 100% industrial. Office is just too unknown at this point in time for us to take that risk. So I would leave it at that. We are fully focused on our industrial acquisitions versus office.

Okay. And then last one for me. Can you just talk about the markets, given where interest rates are for the preferred right now that you guys have offered a little bit of that in both the first quarter and thus far in the second quarter. Where is that having to price in order to go? Is that being priced at a discount to the $25 par? Or at the $25 par? Is there a deep market for that given where rates are? Can you just talk a little bit about the environment there?

The Series F preferred is non-traded, and it's not sold through the public markets. We are not selling it at a discount.

Next question comes from John Massocca with Ladenburg Thalmann.

I know it's still early days and still very much ongoing, but are you seeing any impacts, both in terms of deal flow and financing on your end from some of the stress we've seen in the regional banking market?

I'll let EJ address the deal standpoint. With the rise in interest rates, some lenders have been less willing to lend than others. Our Treasurer and Gary have established a good stable of lenders that we can go to, and we have commitments from some on our acquisitions. I would say it's a difficult market, but it's a market where we are still able to acquire and place mortgages on. If you want to have a shot at what the current purchase market looks like, it remains active.

Yes, absolutely. When we look at our debt, we operate with lower leverage than many buyers in the private space, which is advantageous for us when we look to place mortgages on assets. More generally, year-over-year, we have seen a material slowdown in active listings from the brokerage community, as well as off-market transactions. There has been a slight slowdown in the sale-leaseback market, certainly not as much as in the third-party space. This is driven by a weaker backdrop for the private equity M&A environment. That being said, we are seeing a number of attractive sale-leaseback opportunities, as Buzz alluded to. It is an attractive source of capital for sponsor-backed businesses in a tight credit condition environment. Broadly speaking, you are probably looking at a 50% to 70% drop across the industry in transaction volume. You could look at the earnings of some of the major brokerage houses for insight on that. For us, having a longer focus on the sale-leaseback world, we're seeing some lower transactional activity but are being very discerning with what we are looking at.

In terms of cap rate expansion, what are you seeing today? Is that 9.7% that was kind of posted on the subsequent-to-quarter-end acquisition typical, or was that very bespoke to that particular transaction?

It's a mix. I would say that one was maybe a bit higher than some of what we're seeing, given how we were able to find that deal. Broadly marketed deals are going to be a bit inside that. We're also using some of our proprietary sources, where you'd be a little higher. But I'd say that's fairly representative of what you might see, maybe just a bit inside that.

And John, if I could add, we are also able to achieve a little higher cap rates. This company is known in the market for doing what we say we are going to do. As a result, the seller wants to have the comfort that we will execute and close. So that certainty of closure is very important today in the marketplace.

As we think about the incentive fee waiver, any update on whether that would be potentially extended deeper into 2023? Or just your thoughts there?

I would let Gary take that question as well as David. Obviously, our Board makes that decision at the time when they next meet and onward. So I don't have much to say about that at this point.

I really don't have anything to add to that. I mean, the first two quarters were contractually waived, and our Board will decide ongoing if they want to continue that, partially waive it, or not waive it at all.

If you remember, the reason we reduced that amount or stopped that amount and may use the same logic going forward is that we want to make our dividend and ensure that we're strong in that area. So the goal is to keep going. I've cut dividends twice in my life, and I don't like either of those periods. We'll be fine. We'll do what's necessary to make sure that the dividend keeps going to shareholders.

Our next question comes from Timothy Hertz, a private investor.

Congratulations on the sale of some of the properties. How much capital do you expect to be able to recycle from the sale of those properties? And just roughly, I'm not looking for precision.

I would say approximately, as I look at it and what's on the horizon, somewhere in the $20 million range.

Okay, good. That will be able to fund most of the acquisitions that you have then. You mentioned that one of the interest rate caps is going to expire midyear. What increase in interest expense might we see from the expiration of that cap?

All in, probably that cap obviously is at an older cap. It's at a lower rate than our swap. You'll probably see interest rates increase. I think it's about 1 point over that for the $100 million. So it's about $1 million a year.

Are there any other caps expiring in 2023 or '24?

Yes. We have about $60 million in caps expiring in the first quarter of 2024. Those are hedging the $60 million term B loan, which matures in 2026. We are looking now at potentially swapping that out, and we're going to watch the markets to monitor pricing on that swap rate as we move forward.

On the credit agreement, when will the properties that collateralize that agreement be next reevaluated?

In terms of the valuation on that, if you look at what's publicly available, it's based on a trailing 12-month income for the valuation component. So it's done on a quarterly basis.

It's done off income rather than property assessment value?

Yes.

Are there any provisions in the credit agreement that you're watching more carefully than others to ensure that you don't violate?

No. We're in a pretty good position right now. I don't think there's anything we're really bumping up against, so I would answer no to that.

At this time, there are no further questions in queue. I'd like to turn the call back over to Mr. David Gladstone for closing comments.

Thank you very much. We appreciate all those nice questions. We like it when you give us questions. I think one of the things that didn't come up is that we saw some relief coming in a quick-moving increase in the Fed's rate. The Fed seems to be, although they don't say it the same way everyone is saying now, they seem to be in a pause mode. Maybe we can hold them at 5% in our projections going forward. If so, I think we'll be in very nice shape. We do appreciate the Fed backing off where they were. If there are no final questions, I'm going to say goodbye to you folks and see you next quarter.

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