Gladstone Commercial Corp Q1 FY2024 Earnings Call

Greetings, and welcome to the Gladstone Commercial conference call for the quarter ending March 31, 2024. This conference is being recorded. It is now my pleasure to introduce your host, David Gladstone, Chief Executive Officer. Please proceed.

Well, thank you, Latonia. Again, you do a nice introduction, and we thank all of you for calling in this morning to hear what we've been doing. We enjoy the time we have with you and wish we had a lot more time to talk back and forth, but we don't. First, we're going to hear from Erich Hellmold, and he's our Deputy General Counsel, to give you the legal and regulatory matters concerning the call and report today. Erich?

Thank you, and good morning. Today's report may include forward-looking statements under the Securities Act of 1933 and the Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties that are based upon 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 risk factors in our Forms 10-Q, 10-K and other documents we file with the SEC. Those can be found on our website, www.gladstonecommercial.com, specifically the Investors section, or on 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. FFO is a non-GAAP accounting term defined as net income, excluding the 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 nonrecurring revenues and expenses. We believe these metrics are a better indication of our operating results and allow better comparability of our period-over-period performance. Please visit our website, www.gladstonecommercial.com and sign up for our email notification service. You can also find us on Facebook. The keyword there is the Gladstone Companies, and Twitter @GladstoneComps. Today's call is an overview of our results, so we ask that you review our press release and Form 10-Q issued yesterday for more detailed information. Now I'll turn it over to Gladstone Commercial's President, Buzz Cooper.

Thank you, Erich, and thanks to everyone for joining us today. We will be discussing our operations and key topics of concern. Interest rates continue to significantly affect capital markets and real estate. Last quarter, we observed that the 10-year U.S. Treasury yield dropped from 5% in October 2023 to 4.3% in February 2024. However, it rose nearly to 4.7% by April 2024 and closed yesterday at 4.49%. This volatility has affected net lease investment volume across the industry. According to CBRE, net lease investment volume decreased by 51% year-over-year for the entire year of 2023, and total commercial real estate volume declined by 52%. Sale leasebacks, which are central to our value proposition focusing on tenant credit, performed relatively better than traditional third-party acquisitions. While total commercial real estate volume fell by 52%, sale-leaseback volume only dropped by 21% in 2023, based on CBRE data. We intend to continue utilizing our credit underwriting expertise to take advantage of sale-leaseback opportunities throughout the rest of 2024. In terms of asset classes, industrial real estate remains strong and now makes up 60% of our annualized straight-line rent. CBRE reports that average industrial asking rents in Q4 2023 increased by 6% year-over-year, with the industrial vacancy rate at 4.8% at year-end. The manufacturing sector, in particular, shows strong demand driven by near-shoring and reshoring trends, as well as tenant loyalty. Any challenges in industrial fundamentals stem from unprecedented leases to large distribution centers, a sub-asset class we generally avoid. Moving to the office sector, the broader market is still struggling, showing early signs of stabilization. JLL noted that office groundbreaking in Q1 2024 fell to below 300,000 square feet, marking the lowest recorded volume. We made significant strides in 2023 by executing our core strategies, which included divesting from noncore office assets, acquiring mission-critical industrial assets in growth areas, renewing expiring leases, and carefully evaluating our tenants' credit. We exited seven noncore markets and properties, completed nearly $30 million in new acquisitions, and increased our portfolio's industrial concentration from 56% to 60% as of December 2023. Currently, we have several actionable opportunities in the pipeline, including one under contract for closing this month. These prospects involve lease renewals with increased rent and added terms, as well as potential dispositions. We remain disciplined, especially concerning tenant credit, as we believe many credits represent too great a risk in the current economic climate. Alongside new acquisitions, our asset management team managed over 1.4 million square feet of leases, achieving a more than $1.26 million, or 13%, net increase in same-store GAAP rent. The annualized straight-line rent from these transactions totaled $10.7 million in 2023. In Q1 2024, we continued to reposition our portfolio through the sale of three noncore office properties and also sold an additional noncore property shortly after the quarter ended. Additionally, we renewed three leases with an average term of 6.4 years, adding $681,000 in straight-line rent. Although we cannot control the Federal Reserve or precisely predict interest rate movements, we are confident that our developments have better positioned our portfolio for 2024 and beyond. Our portfolio occupancy stood at 98.9% as of March 31, 2024, and we have collected 100% of cash-based rents since February 2022. This reflects the critical nature of our assets and the quality of our tenants, positioning us well to withstand any economic challenges. Moreover, we see additional opportunities that remain untapped. Most of our industrial assets have fixed annual escalations in the range of 1.5% to 3.5%. Industrial rent growth has outpaced these escalation rates in recent years, leading to rents that are currently below market value and will be advantageous at lease renewal. Our balance sheet is robust and flexible, allowing us to continue investing in industrial deals at favorable cap rates as seller expectations readjust. Since January 1, 2022, we have reduced our mortgage debt by a net $174 million and expanded our unencumbered asset base by over 60%. Only six office mortgages are remaining, with the first maturing in 2026. We also have $56.1 million in available liquidity through our revolving credit facility and cash reserves, maintaining a leverage ratio below 50% as of March 31, 2024. While short-term interest rate movements are unpredictable, we anticipate some normalization over time. As this occurs, we expect to be well-positioned to seize advantageous new opportunities, with sale leasebacks particularly anticipated to be a primary source of new deals. These arrangements offer additional credit scrutiny and extended terms, both key aspects of our value proposition. Our balance sheet's flexibility, strengthened by the $174 million reduction in net mortgage debt since January 2022, along with our liquidity of more than $56 million, enables us to continue expanding our industrial base. Since 2019, our industrial concentration as a percentage of annualized straight-line rent has risen from 32% to 60%, and we aim to increase this further in the coming 6 to 12 months.

Thank you, Buzz. I will begin my comments about our financial results by discussing our operating results for the first quarter of 2024. All per-share figures mentioned are based on fully diluted weighted average common shares. FFO and core FFO per share available to common stockholders were both $0.34 for the quarter. For the fourth quarter and the first quarter of 2023, both FFO and core FFO available to common stockholders were $0.37 per share. The decline in FFO per share in Q1 2024 compared to Q1 2023 was due to decreased revenues in Q1 2024, caused by leases expiring before Q1 2024 and higher expenses because of rising interest rates. Our same-store cash rent in the first quarter of 2024 increased by 0.8% compared to the same period in 2023, primarily from increased rental rates from leasing activities following Q1 2023. Our first-quarter results showed total operating revenues of $35.7 million against operating expenses of $23.3 million, compared to operating revenues of $36.6 million and operating expenses of $34.7 million for the same quarter in 2023. Regarding our debt profile, 38% is fixed rate, 51% is hedged floating rate, and 11% is floating rate, which corresponds to the amount drawn on our revolving credit facility. As of March 31, our effective average SOFR was 5.34%. Our outstanding bank term loans are hedged with $310 million in interest rate swaps and the remainder with interest rate caps. We are closely monitoring interest rates and adjusting our hedging strategy as necessary. Currently, our 2024 loan maturities are manageable, with $7.4 million due, which involves one property held for sale. At the end of the quarter, we had $75.9 million in outstanding revolver borrowings. We did not conduct any common stock sales this quarter. We received net proceeds of $200,000 from sales of our Series preferred F stock. We are managing our equity activities to maintain adequate liquidity for future capital needs and new acquisitions. Currently, we have three properties held for sale. As of today, we have around $56 million in cash and available credit. We also encourage you to review our quarterly financial supplement posted in the Investors section of our website for more detailed financial and portfolio information for the quarter. Our common stock dividend is $0.30 per share per quarter, equating to $1.20 per year.

Okay. Thank you. That was a good report, Gary, and a good one from Buzz. Our team has really performed very well. Overall, a very nice quarter, and we see this as continuing to add to our records of doing good things for our shareholders. During the first quarter, as you heard, we sold 3 office properties. So we're out of those. Subsequent to the end of the quarter, we sold an additional office property and renewed 3 leases while we're working on that. And since January of 2023, we've sold 11 office properties and presently have just 2 for sale. We have become an industrial real estate company. We're away from the office properties that we had. We sold most of those and are still working those off. The commercial team is growing the real estate we own at a good pace, and the team is doing a great job managing the properties we own. Somebody asked me if the Fed was going to cut interest rates this year, and I said it doesn't make much difference if they cut a quarter in July, what's that going to do for us? Not much. So our team is strong professionals. They continue to pursue properties that fit into what we're looking for, which is industrial properties. Our acquisition team is seeking strong credit tenants. So we're doing a good job there. So rather than me continuing to talk, let's get the operator on and get some great questions from the people who follow our company. Latonya?

I wanted to ask you on the transaction market hoping to get some more color on your acquisition pipeline and what kind of cap rates you're seeing in the market?

We are observing some deal activity in the market, and it's clear that brokers are handling numerous broker opinion of values. However, when we review the financials of these opportunities, specifically within the industrial sector, they currently do not align with our credit profile to the extent we would prefer. Given the current economic conditions, we are carefully evaluating to ensure that tenants can reliably pay their rent both now and in the future. Despite this, we do see many promising opportunities and have a few in the pipeline that we intend to pursue. One opportunity is expected to close this month. While we anticipate higher volumes, we need seller expectations to align with our criteria to secure beneficial deals. Additionally, this will depend on our borrowing costs; generally, we are focusing on deals that yield an accretive basis with a cap rate of around 8.5 or higher.

Okay. Second question I wanted to ask you was on the incentive fee. There was an incentive fee recorded in this quarter, but there was also an incentive fee giver and I just wanted to get some clarification on what we should expect going forward?

Relative to the incentive fee, after discussions between management and the Board, the decision was made to begin receiving part of the incentive fee at a reduced capacity. At this point in time, I'm not going to comment on where we might be going forward due to the fact that, obviously, at the end of the quarter here, we will make that determination with the Board at the end of the next quarter.

Can you talk a little bit about the market for well-occupied office assets in your portfolio, if it's got a good tenant and some decent lease term left? And what your thoughts are on accelerating the level of office dispositions in order to redeploy into industrial or reduced leverage, etc. these days?

Sure. And as mentioned, we do have 2 held for sale that obviously are office, Rob. We are taking a very disciplined approach as it relates to moving assets, looking at the market. Some are more frothy than others as it relates to opportunities. That being said, we have more opportunities with some of our office buildings just as we see in the industrial side in the South, and we are evaluating those. But as it relates to an overall theme within the portfolio, we are being disciplined because, of course, we also want to match up sales with new acquisitions in our recycling program.

No, I would say this is a pretty clean quarter. This is, yes, absolutely.

Just hoping to ask, you're seeing really strong numbers in occupancy rates and same-store numbers. How much ability do you have to continue to push rents?

We have a couple of upcoming renewal opportunities that will allow for adjustments. Most of our deals have fixed increases, but during renewals, there is a chance to discuss improvements or business expansions with the tenant. This gives us the chance to renegotiate the lease. As noted in our report, the current industrial rates compared to a few years ago provide us an opportunity to raise those rates above the contractual rent.

Very helpful. And then just in the acquisition environment, you mentioned credit quality a couple of times. Just trying to get a sense of what the delta is between what you're seeing in the market and what your preferred credit quality rate would be? Just to try to get a sense of how close those two might be converging.

As it relates to that on the credit side, and we do evaluate every credit separately, we have to make sure that it passes our muster first, and if we could get the pricing to offset some of that risk, we would do so. Otherwise, we are going to pass on an opportunity. But we take into consideration all of the factors, both location, building type functionality and, of course, the credit. I'm not sure if I specifically answered your question. So if you need to follow up, please.

And just to follow up on what Dave is asking about. The group has a long history of underwriting small and mid-sized businesses, which it turns out are often the people who are renting our properties. Many times, they're doing it because they want to raise some money to buy something else, not another location, but equipment or just raise money in order not to have so much debt on their balance sheet. We're very mindful of that. And it sounds like a good thing to do when you sell your property and pay off debt, but let's face it, when you enter into a lease, it's almost the same thing as owing money to a bank. So from my standpoint, we're still underwriting these things. Buzz has been doing underwriting of smaller businesses for a long, long time and so have I. I grew up in that part of the business. So we feel comfortable going after some of these businesses, but I'm going to tell you it's still an interesting thing going on in the marketplace. I really don't expect us to go back anytime soon to really cheap interest rates. We lived for probably 7 years with wonderful low interest rates. May not be that way now because the government continues to spend so much money there, pushing up everything that's tied to any kind of interest rates. So as we look at the world going forward, I think we can continue just to go along like this. Hopefully, we can increase our dividend at some point. But it's not dependent on interest rates coming back to where they were. We've got a strong balance sheet, and we've got a good producing income. So hopefully, it just continues on this way and then go into a bust kind of atmosphere. So Latonya, we have anyone else who wants to ask a question.

Can you just provide any update on re-leasing outlook for the 3 leases that are expiring over the remainder of 2024?

We are currently in deep discussions regarding one lease that is expected to provide significant benefits, representing about 3% of the 4.6 million square feet we have expiring. We anticipate having this resolved soon. There is another lease for 6,000 square feet that is not a major concern, and we are optimistic that the current tenant will renew. Additionally, we are in talks regarding another lease. Overall, we feel comfortable managing these leases, and there is one other small vacancy of 3,000 square feet. We are hopeful to have announcements about positive developments and long-term leases in the near future.

Okay. Can you explain how the size of the incentive fee credits for the quarter was determined? I'm trying to understand why that specific amount was credited back.

In our discussions, we believed it was the right decision, as we are in agreement with the shareholders and also considering the well-being of our employees. This approach kept us in line with shareholder interests, and we felt that it was a necessary step to take for the benefit of our staff and the shareholders.

Is it based on like a percentage of the incentive fee in the quarter or a gross number? I'm just trying to think of why $700,000-something versus the whole amount, half of it, etc.?

John, this is Gary. We aim to activate the incentive fee, but not to a level that would greatly impact income and FFO. While we'll assess how much we can take over the next few quarters, it will be at a lower level, as mentioned by Buzz. The intention is to take some amount that does not affect FFO, as we want to remain aligned with our shareholders. We can't specify an exact figure. Frankly, it's not a precise calculation. This time, we took about one-third, which is a significant reduction. I would expect a similar approach in the next quarter as well.

Okay. That's very helpful. And then lastly, I know you talked a little bit about dispositions and the ability of some office properties. Maybe looking back on the dispositions that were completed, in the first quarter and quarter-to-date, I mean who is maybe the buyer for these assets? Is it more of a redevelopment play? Is it financial owners? Just trying to get a little color on who's the other counterparty in that market today.

Sure. They don't need to inform us right away, but in general, what we've observed and heard is that, yes, they are being redeveloped. Some are being transformed into multifamily apartments. We've seen at least one instance where an office building is set to become a pickleball facility. It's varied across the board. There is definitely a value-add opportunity for them. However, as long as they can achieve performance, we are not as concerned about what they plan to do with the property.

John, some of these people are the tenant, and they're buying the building and getting control of rents for the future. We're happy to do that, of course.

There are no further questions in queue at this time. I'll turn it back to you, Mr. Gladstone, for closing comments.

Oh, shucks, we wanted some more questions. We're having fun when we come to these meetings because we have such good shareholders, and we enjoy talking to them as well as the analysts. That is the end of this, and thank you all for calling in.

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.