Earnings Call Transcript - GOOD Q3 2021

Operator, Operator

Greetings and welcome to Gladstone Commercial's Third Quarter Earnings Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I'd now like to turn the conference over to your host, Mr. David Gladstone, Chairman and Chief Executive Officer. Thank you, sir. Please, proceed.

David Gladstone, Chairman and CEO

Thank you, Latanya. That was a nice introduction and thanks to all of you for calling in. As I mentioned every time, we enjoy these times with you and have a chance for you to ask questions. I wish we had more time to talk with you, but we only do it once a quarter. Now, we'll start out by hearing from Michael LiCalsi, he is our General Counsel and Secretary. He'll give you the legal and regulatory matters concerning the call report. Michael?

Michael LiCalsi, General Counsel and Secretary

Thanks, David. Good morning, everybody. Today's call may include forward-looking statements under the Securities Act of 1933 and the Securities Exchange Act of 1934, including those regarding our future performance. Now 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 Risk Factors in our Forms 10-Q, 10-K and other documents we file with the SEC. You can find them on our website www.gladstonecommercial.com specifically go to the Investors page, or on the SEC's website, that's 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. Now, today, we will focus…

Bob Cutlip, President

Thank you, Mike. Good morning, everyone. During the third quarter, we continued our focus on industrial acquisitions and increasing occupancy. We acquired an 80,600 square foot industrial facility and product storage yard in St. Louis, Missouri, for $22 million with 17.4 years of remaining lease term and a GAAP cap rate of 7.5%. Acquired an 81,700 square foot industrial facility in Peru, Illinois, which is just West of Chicago for $4.7 million with 15 years of remaining lease term and a GAAP cap rate of 7.6%. We leased 176,000 square feet at our Austin Texas property through 2026 to a rated investment grade tenant. Commenced the 12.5 year lease of our 238,000 square foot industrial facility at the Tulsa Port of Catoosa, renewed a lease of a 60,000 square foot flex office building in San Antonio, Texas through November of 2031, and collected 100% of cash-based rents during the third quarter, and 100% of October scheduled rents. Our recent investments further reinforce our strategy to increase our portfolio's industrial allocation. The acquisition volume since 2019 is approaching $350 million and all assets have been industrial in nature. Our industrial allocation has increased from 33% to within striking distance of 50% today. Our near term objective is to reach 60% within the next 12 plus months. And our long-term objective is to reach 70% to 75% within the next two plus years. Our success has been with acquisition candidates in the 50,000 to 300,000 square foot range and we expect to continue this size focus. On the personnel front, we hired Ryan Carter, as an Executive Vice President to lead our Midwest and West regions. Ryan possesses over 20 years of experience as a principal acquiring and developing commercial properties and as a senior investment sales professional. He has a long prior history with our company having sold several properties to us through the years and has a strong familiarity with our investment strategy. We're extremely excited that Ryan has agreed to join the team. Our asset management team continued to deliver improving our same-store operations. Year-to-date ending September 30th, the team extended, expanded and/or leased 1.4 million square feet covering 13 tenants with an average weighted lease term of 7.5 years and a tenant improvement allowance of just $2.99 per square foot. The annualized straight-line rent of these transactions totaled $12.8 million. As noted in the introduction, the releasing of our 238,000 square foot industrial facility in Tulsa, and the 176,000 square foot lease in Austin are two very positive outcomes for the quarter. These leases not only increased our straight-line lease payments by over $5 million per year, but the increased occupancy also reduced our vacancy rate by 2.6%, and will result in a very positive impact on same-store performance going forward. Anticipating that many on the call are interested in lease expirations through 2022, I wanted to summarize the team's thoughts and activities. We have about 4.5% of our leases expiring in 2022 and the expiration dates are at the end of June, end of July, and end of October. So future expirations should be quite manageable, and we'll be able to continue our emphasis on top-line rent growth through the expansion of our portfolio. As you all know, the Austin office vacancy has been our largest and our team has achieved excellent recent lease success. As noted in the introduction, we leased approximately 176,000 square feet, or nearly 55% of the building. The end result of that transaction alone is that we have replaced approximately 95% of the former straight-line rent when the property was 100% occupied by GM. Since the property was completely vacant from September 2020 until September 15th of this year, this transaction will have a sizeable positive impact on same-store performance going forward. And with Austin leasing activity increasing since the second quarter, we have additional prospects for the balance of the space, and we therefore expect final straight-line rents at this property to be considerably higher than with the prior occupant. Market conditions are worthy of comment, particularly with the adverse effects from the onset of the COVID-19 virus. A review of research reports relating to industrial and office statistics for the third quarter reflects both improvements and some continued challenges. Investment sales volume for all product types exceeded $450 billion during the first three quarters and is the highest for the first nine months of any year since 2007. Prices for all property types increased by about 16% according to Real Capital Analytics. Industrial overall activity continues to be strong, with vacancy at about the 4% level, net absorption exceeding 100 million square feet for the fourth straight quarter, and over 500 million square feet under construction. Although supply chain disruption is creating challenges for all product sectors, e-commerce and logistics demand continue to drive the industrial sector. Office vacancy, on the other hand, increased as negative absorption was estimated to be about 10 million square feet according to JLL Research. This figure, however, is an improvement over the prior three quarters, which witnessed negative absorption of approximately 20 million square feet per quarter. And the vacancy level does not include over 150 million square feet of sublease space available on a national basis. New supply activity continues for office products as over 100 million square feet are currently under construction. And as it relates to growth opportunities, we're seeing increased investment sales listings. Our current pipeline of acquisition candidates is approximately $350 million in volume, representing 18 properties, one of which is an office and the balance are industrial. Of the 18 properties, three properties are in due diligence totaling about $54 million; three properties are in the letter of intent stage, exceeding $60 million; and the balance are under initial review. Our team is staying actively engaged in our target markets as we believe acquisition opportunities will continue to arise that we can and we will pursue. In summary, our third Quarter activities reflected strong leasing and rental collection success, continued active engagement to identify and close industrial acquisitions, and collectively positions us well to pursue growth opportunities. Now, I'd like to turn it over to Gary for a report on the financial results, including our capital markets activities.

Gary Gerson, CFO

Thank you, Bob, and good morning, everyone. I'll start my remarks by reviewing our operating results for the third quarter. All per share numbers I referenced are based on fully diluted weighted average common shares. FFO and core FFO available to common shareholders were $0.44 and $0.39 per share for the quarter respectively. FFO and core FFO available to common stock shareholders during the third quarter of 2020 were $0.39 and $0.40 per share respectively. FFO adjusted for comparability and core FFO available to common shareholders for the first nine months of 2021 were $1.20 and $1.17 respectively. FFO and core FFO adjusted for comparability available to common shareholders during the first nine months of 2020 were $1.19 and $1.20 per share respectively. Our same-store cash rent in the third quarter grew at 2.2% over the third quarter of 2020 and for the first nine months of 2021, it grew at 3.4% over the first nine months of 2020. Our third quarter results reflected total operating revenues of $34.3 million with operating expenses of $25.5 million as compared to operating revenues of $33.1 million and operating expenses of $25.3 million for the same period in 2020. We continued to enhance our strong balance sheet, as we grow our assets and continue to focus on reducing our leverage. We have reduced our debt to gross assets over the past six years to 44.8% through refinancing maturing debt, and financing new acquisitions at lower leverage levels. We believe we're between 1% and 2% away from our target leverage level. We continue to primarily use long-term mortgage debt to make acquisitions. 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 options. Looking at our debt profile, 63% is fixed rate, 34.5% is hedged floating rate, and 2.5% is floating rate. As of today, our 2021 and 2022 loan maturities are manageable with $7.5 million due in 2021 and $96 million coming due in 2022. We will finance these amounts at the appropriate time. We upsized our credit facility in the first quarter of 2021, which consisted of a $65 million term loan with a $15 million delayed draw component. This quarter we drew down the remaining $15 million. The proceeds were utilized to acquire accretive properties. As of the end of the quarter, we had $2.1 million of revolver borrowings outstanding. While entering the third quarter with sufficient liquidity, we've been active in issuing equity through our ATM program. During the nine months ended September 30, 2021, and net of issuance costs, we raised $24.1 million through common stock sales. We continue to manage our equity actively to ensure that we have sufficient liquidity for upcoming capital investments. As of today, we have approximately $84 million in cash and $36.5 million of availability under our line of credit. With our current availability, the strong performance of our portfolio and access to our ATM program, we believe that 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 51.5%. 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 grows. We have raised our common stock dividend to $37.5825 per share per quarter, or $1.5033 per year. We have not cut or suspended the dividend since our IPO in 2003. Our common stock closed yesterday at $22. The distribution yield on our stock is at 6.83%. And now I'll turn the program back to David.

David Gladstone, Chairman and CEO

Thank you very much. That was a good report Gary and a good one from Bob Cutlip and Michael LiCalsi too. The team has performed very well this quarter and we've not incurred much by the various government reactions to the virus. So we ended up with a very nice quarter. You've heard a lot today on the numbers of new transactions and new leases and the quarter was impressive. The team collected 100% of the cash-based rents during the quarter and the team also acquired the two industrial assets during the quarter and leased over half of our Austin property. That was one that had dragged us down for quite a while and now it's back paying and we're in good shape. That led us to thinking about increasing the dividend which we did. Including the Austin property, the team executed 13 lease transactions year-to-date, ending September 30, and represents about $12.8 million in annualized straight-line rents. Our commercial team is growing the real estate we own at a really good pace and the team is doing a great job managing the properties we already own, especially during the pandemic. This team has a strong professional group and continues to pursue quality properties on the list of acquisitions they are reviewing. The acquisition team is seeking strong credit tenants; we look at the credit first and the real estate second. They know that quality tenants and real estate make excellent investments. The asset managers that we have are very active managing the properties that the company owns to maximize their value. It's a different environment we're in today, but the team has been up to the challenges and has done a great job. The outlook, well we're in the middle market business like many of our tenants, we've been challenged with previous government restrictions related to the virus. Our tenants continue to pay their rents, and these times we are in have never been seen before and there will be future challenges, I'm sure, but our first-class team is doing a fantastic job. Okay, let's stop here and have our operator come on and help our listeners ask a few questions.

Operator, Operator

Thank you. At this time, we will conduct a question-and-answer session. Our first question comes from Craig Kucera with B. Riley Securities. Please proceed.

Craig Kucera, Analyst

Yes, hey good morning, guys. I just want to make sure I'm connecting the dots here and thinking about Austin, which I think is a big part of the story here this quarter. So GM shows back up as your top tenant. It looks like you leased about half of the building but at pretty close to the same total rent; should we infer from that, that that whereas before they were paying $14, $15, you thought you could get close to $20, but that was actually closer to maybe the high 20s? And how to think about what the rent might be at that building, or I guess just additional color on that building would be great.

Bob Cutlip, President

Sure, Craig. And as I've indicated, we’ve got a non-disclosure and a confidentiality agreement with the tenant. So I can't disclose specific numbers. But if you look at the last couple of quarters where I indicated that rents, new asking rents, which of course are less than straight-line, but new asking rents were in the low to mid-20s, we ended up at that location. And we feel very, very good about it and it probably relates to the balance of the building. We think that we're going to still be in that price range. So since we've got 45% of the building still to lease, we're very excited about what the ultimate outcome will be with that building and activity has picked up. We have one RFP out right now for a tenant. So we're just going to see how things unfold. But we're definitely encouraged because the activity in Austin has, in fact, picked up and when you see some of the research reports that have just recently been released, CBRE indicates that tech leasing comprises over a fourth of all leases that were done in the third quarter and Austin was singled out as one of the strongest markets. So we're encouraged, of course, we participated in that third quarter with us leasing that property. But we think going forward; it still is going to be very, very strong for us.

Craig Kucera, Analyst

Got it. And of course recognizing that there is a non-disclosure agreement here, but can you give us additional color as far as maybe a period of free rent or at what point that tenant might take occupancy and start paying rent, and it starts to hit your income statement?

Bob Cutlip, President

All I can say is it was minimal, and our tenant improvements were very low. So we're very excited about the outcome. The team did an absolutely phenomenal job in the negotiations, and we're encouraged about this new tenant who we believe could be in there for a long time.

Craig Kucera, Analyst

And one more for me on the same topic, over the past years that building has been those assets have been vacant. You've contemplated leasing it up or selling it, and you've leased up about half of it. Are you thinking once that those assets are leased up that they were going to be long-term holds or is that still potentially something you might sell down those down the line which you get it all leased up?

Bob Cutlip, President

Well, all the options are on the table. I think right now our objective is to lease the balance of the building. And then, at that point, I think David and I and Gary will make a decision as to whether or not we want to exit that property and redeploy it into industrial assets. I'm more of an industrial player, as you know, and so long-term, I think as I indicated, our goal is to get to 75% on the industrial side. This could be a very, very huge sale for us that could be redeployed into another industrial portfolio, which from an operating efficiency standpoint, as we all know, industrial leasing is much less expensive compared to office leasing.

Craig Kucera, Analyst

Got it. And then one more for me, sorry, just thinking about acquisitions for 2021, kind of where are you thinking you're going to settle in as far as cumulative closings for the year versus where we were kind of your thoughts last quarter or so?

Bob Cutlip, President

We've been maintaining our expectation of reaching between $100 million and $120 million this year, despite the disruptions we encountered at the start. The team has bounced back strongly. Currently, we have $54 million in the bond and another $63 million under letter of intent, which should come together by the end of January or early February. While we might not exceed $100 million by the end of this year, we are beginning 2022 in a strong position, especially with several properties set to close in the first two months of the year.

Craig Kucera, Analyst

Okay. Thanks. That's it.

Bob Cutlip, President

And we're seeing a lot more listings. I mean the team is staying extremely focused on our target markets. We're staying within our $5 million to $20 million range and are successful. We do participate a lot on sale lease backs. As you saw, those two leases that we did were in excess of, well, one was 17 and one was 15 years. We like that. We like that middle market kind of non-traded company that we can underwrite the credit and work with private equity companies to offload those assets so they can put the money into the operating business.

David Gladstone, Chairman and CEO

Other questions?

Operator, Operator

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

John Massocca, Analyst

Good morning.

Bob Cutlip, President

Good morning, John. How are you doing?

John Massocca, Analyst

Not bad. So on the lease expiration front, I know you touched a bit on 2022, but there's still a little left for 2021. Can you maybe just give any color on how that is progressing and maybe what that's composed of?

Bob Cutlip, President

Yes. We have an 86,000 square foot office property in Salt Lake City occupied by a strong tenant. They are going to move. Right now we have a prospect for a third of the building. And then the other property is it's like a 16,000 square foot tenant in Tampa, Florida. And we're talking to the lead tenant in that building to take the balance of the space, which we're somewhat encouraged about. But until we get it across the goal line, as you know, it's not done. But I still feel very good about what we have done so far. Those two leases, John, expire at the very end of December. So we've got a little bit of headway yet, but we don't have it across the goal line. The next year we have just three leases that are expiring, as I indicated in June, July and October. One of which we are already in conversations, the tenant is moving out. But we have another tenant that we're in final negotiations that they would move in actually before that tenant moves out in July. So somewhat encouraged about what's going on there.

John Massocca, Analyst

Okay. And then, obviously, we kind of talked about a little bit with Austin specifically, but what's kind of the bigger appetite for maybe recycling out of office properties and redeploying that capital into industrial? And I guess how do you balance maybe what could potentially be a headwind from the cap rate environment for office versus industrial versus that desire to get to 75% or more industrial exposure in a couple of years?

Bob Cutlip, President

Certainly. Recently, we have sold our last six properties, all of which were single-story office spaces, something our team is well aware that I don't favor, which is why we decided to sell them. We plan to keep this strategy moving forward. Gary and I have evaluated the situation, and I’m still keen on suburban office spaces within mixed-use settings as a solid long-term investment, particularly for the kind of mission-critical assets we acquire. We will persist in selling off the single-story office properties due to the high re-leasing costs per square foot. We expect to divest between $15 million and $20 million per year, with most of those sales being properties valued under $10 million. Once we sell these properties, we will reinvest the capital. While we might face some cap rate discrepancies, if we maintain the divestiture to $15 million to $20 million, it shouldn't significantly affect us. My focus is on a long-term strategy that involves acquiring properties with superior operating efficiencies and lower renewal costs, as well as more stable products. We are shifting our focus towards the industrial sector.

John Massocca, Analyst

Okay. And I guess today is in kind of the specific areas you look at, what's maybe the cap rate mixed between industrial, some of the office that looks attractive to you, and then some of the office that you might potentially be looking to capital recycle out of?

Bob Cutlip, President

Well, I would say that on the industrial side, where we're seeing deals that make sense for us are in the mid-5s to low-6s going in. You saw the two that we bought this last quarter were higher than that. We were fortunate. But that's really what we're seeing in our target markets. As you know, there's a lot of cap rate compression completely across the country on the industrial side, but we can still find deals that are between 5.5, and let's say 6 in a quarter that suit our needs. You can look at the office product that we're looking at is probably 50 to 75 basis points higher. We're not really finding much that makes any sense. The people who are selling office product are smart. There's CapEx requirements. We're not into a bunch of HVAC replacement, roof replacement, parking replacement, redoing lobbies, and quite frankly, the smart office sellers are selling assets that are like that. As you can tell, we have one out of 18 office products, and that's kind of the way I think we're going to see it going forward. It's going to be less than 20% of our total pipeline, let's say. The arbitrage, I do think that the arbitrage is probably going to be 50 basis points anyhow, maybe 75, but I still look at it long-term and since we're talking about $15 million to $20 million per year, I don't think it's a significant impact on our same-store performance and going forward FFO per share.

John Massocca, Analyst

Okay, understood. Thanks for taking the questions. That's it for me.

Bob Cutlip, President

Thanks.

David Gladstone, Chairman and CEO

Next question, please.

Operator, Operator

Our next question comes from Brian Hollenden with Aegis. Please proceed.

Brian Hollenden, Analyst

How much does the Austin asset 55% still impact the same-store revenue? I know that your same-store revenue was 2.2% in the quarter. What would that have been had the Austin asset been leased for the full quarter?

Bob Cutlip, President

It could have been significant. I might have to share that, but for the full quarter, we're discussing...

Gary Gerson, CFO

About a 1.5 million.

Bob Cutlip, President

About a 1.5 million of rent and 1.5 million of rent, and we've got 38 million shares. So you can probably do the calculation on that. But it was only really participating about 15 days because they moved in September 15th.

Brian Hollenden, Analyst

Okay. And then year-to-date about 13 lease transactions, and how much of an increase are you getting for industrial versus office when you exclude that Austin asset?

Bob Cutlip, President

I don't have the specifics. All I can tell you is that through September of the 13 assets that were done, five of them were office and the balance were industrial. Our overall straight-line rent on that was in excess of 11% through September. We did another lease at the end of October, which we had a roll down in the rent down there. And so that reduced our straight-line rent increase to the high-single-digit. That was an industrial property, but it was cold storage. There was a big roll-down. We bought that property back in 2007, so the rents were well over market. The key for us is that we got the tenant in there for another 10 years. I'm going to get 2% to 3% increases in the rents every year.

Brian Hollenden, Analyst

Thank you. And then maybe last one for me, can you just talk a little bit about what you're seeing on the acquisition front this quarter, maybe in the last couple of quarters, it does look like, was that three assets in due diligence and three LOI that you have quite a pipeline coming over the next few months?

Bob Cutlip, President

Yes. What we're seeing is a combination of quasi-manufacturing and quasi-distribution, and in our secondary growth markets, that is playing well for us with 18 properties in due diligence. Our history has been that if we get something into the letter of intent stage, we typically close on about a third of those for sure, at the bottom side. I expect that we're going to continue to see that amount of velocity. As I indicated, we average anywhere, we average really between $16 million and $18 million per copy on our acquisitions over the last couple of years. I think that's going to continue. If we stay at that level, then we're not competing against, I would say, the larger peers, and we're much more competitive there. I still think that we'll have the opportunity to have a pipeline in excess of $300 million and our expectations, Gary's and my expectation is for us to grow the portfolio by $120 million to $150 million a year going forward.

Brian Hollenden, Analyst

Thank you.

David Gladstone, Chairman and CEO

Next question?

Operator, Operator

We have a follow-up question from Craig Kucera with B. Riley. Please proceed.

Craig Kucera, Analyst

Hey, guys, just one more for me. Just going through Q, you did have a $2.4 million legal settlements that kind of booked in other income. And I'm just curious, do you have any other lawsuits out there? Are there any other potential legal settlements that might close over the next quarter or two? Or was that really sort of a unique situation?

Bob Cutlip, President

That was a very unique situation, non-recurring one-time. So no, we don't have anything else like that coming up.

Craig Kucera, Analyst

Okay, thanks. Appreciate it.

David Gladstone, Chairman and CEO

Next question?

Operator, Operator

Mr. Gladstone, we have no further questions in queue. At this time, I would like to turn it back over to you for closing comments, please.

David Gladstone, Chairman and CEO

Well, thank you all for calling in and asking good questions. Please ask a lot more next time we meet, because we only meet once a quarter and we'd love to hear from all of you and your concerns. You bring up some good questions. So that's the end of this. Thank you for calling in.

Operator, Operator

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