alvarez
Gladstone Commercial (NASDAQ:GOOD) has been faced with the difficult task of transitioning from a 60% office portfolio into better property types, and they have had to do it at a time when interest rates are rising. It was a daunting task and much of the market thought they would fail either through debt piling up or substantial loss in FFO/share.
As data comes out, GOOD is making it further and further through the transition while maintaining FFO. Results coming in well above expectations have led to GOOD dramatically outperforming peers with a total return of 39% over the past 52 weeks compared to the popular triple net REIT, Realty Income (O), which came in at -7%.
S&P Global Market Intelligence
In this article, I will discuss the advantages and skills GOOD has deployed to offset its substantial challenges. As GOOD completes its transition, the difficulties will fade, but its advantages are enduring. I think GOOD will be a long-term outperformer.
A difficult transition filled with headwinds
Gladstone Commercial is a well-seasoned company. Back when it was buying the bulk of its portfolio, office was broadly considered a premier asset class. GOOD was always choosy about what they bought, having proprietary underwriting procedures and leaning toward high cap rates. Through its asset selection process, it ended up buying about 60% of its portfolio into office, with the rest primarily industrial.
As the pandemic hit, office went from a respected asset class to the pariah of real estate. Vacancy in the sector soared as demand plummeted. Everyone wanted to sell office, and few if any wanted to buy.
GOOD was in a tight spot with a 60% office portfolio and relatively high leverage. 6 aspects made transitioning away from office difficult to execute and likely to come with FFO/share dilution.
- Low transaction volume
- High vacancy in the office sector
- High office cap rates
- Low industrial cap rates
- High cost of equity capital
- High cost of debt capital
With its stock price cratered and interest rates high, accessing fresh capital to fund a transition was largely out of the question. GOOD had to find a way to do it on a capital neutral basis. The way to transition without new capital would be to sell office properties and use the proceeds to buy industrial.
Office has been going for cap rates often north of 10% while industrial cap rates are still fairly low at maybe 6% for most transactions. Thus, even if GOOD was able to sell its office assets, it would come at a steep loss of NOI. With those cap rates, every $100 of office NOI lost would only produce $60 of industrial NOI.
Many companies just swallowed hard and took the NOI loss because they felt pressured to get out of office ASAP. Indeed, we saw a similar transition for Mack Cali as it moved from office to apartments and lost a massive chunk of its FFO. Lexington Properties (LXP) did the office to industrial transition a few years earlier and also lost a large portion of its FFO.
With so much precedence for FFO loss in this sort of transition along with the challenging office environment, the market thought GOOD would lose a substantial amount of earnings.
What the market missed is that GOOD is a different sort of company.
Advantages
- Strong underwriting
- Mission-critical properties such that renewal rates are higher
- Long lease terms allow staggering of dispositions
David Gladstone’s (chairman and CEO) background is in credit underwriting of small businesses. Buzz Cooper (president) also has a background in credit underwriting.
This different sort of skill set allowed GOOD to go after different acquisitions than peers. While everyone else was bidding up sale leaseback transactions with investment grade tenants, GOOD was looking at properties with unrated tenants.
Other bidders just assumed unrated tenants were bad credit, but many of them were the equivalent of investment grade and just were too small to want to bear the expense of getting an official credit rating.
By doing the credit underwriting themselves, not only was GOOD able to buy properties with strong credit tenants, but the cap rates were 100 to 200 basis points higher because other bidders did not know the tenants were investment grade equivalent.
The strength of GOOD’s underwriting really showed itself in the pandemic, as many other triple nets had a few percentage points of tenants who refused to pay rent (some of the non-payers were investment grade). GOOD had 100% rent collection.
Its tenants paid rent because the facilities which they are renting from GOOD were critical to their operations. This full rent collection in addition to long WALT (weighted average remaining lease term) provided GOOD with an extended window in which to complete its transition. Each year, only a small percentage of leases expired, which meant only a few properties at a time had to be dealt with.
Even among the leases expiring, GOOD was able to re-lease many at higher rents, particularly the industrial properties. Leases so far in 2024 have been re-signed at 13% increases to rent, per Buzz Cooper on the conference call:
“Our asset management team led more than 1.4 million square feet of leases, resulting in a more than $1.26 million or 13% net increase in same-store GAAP rent”
With strong leasing and 100% rent collection, dispositions were opportunistic in nature, allowing reasonable proceeds from sale.
GOOD has been reinvesting office sale proceeds into industrial but has managed to make it less dilutive by getting unusually large cap rates. For example, on May 8th, 2024 GOOD announced the purchase of an $11.7M warehouse at a 12.3% cap rate. It is a 25-year triple net lease and follows GOOD’s typical acquisition style – a small tenant that GOOD independently underwrote and believes to be reliable.
With its much higher acquisition cap rates along with favorable leasing spreads, GOOD has been able to complete a large chunk of the transition away from office without losing much FFO. As of the end of 1Q24, GOOD is down to 36% office.
GOOD
FFO is still at a $1.36 run rate, comfortably covering their over 8% dividend yield.
Shareholder aligned culture
Over the years, I have been very impressed by the culture David Gladstone has instilled in his companies. They understand that investors are their bosses and are one of the few management teams that have voluntarily taken pay cuts to ensure earnings stability.
During the financial crisis, management waived a substantial portion of their fees so as to keep FFO at a level that could cover the dividend. GOOD was one of the few triple nets that did not cut its dividend during the GFC.
As discussed above, COVID and GOOD’s heavily office portfolio made the last few years another challenging period for the company. Once again, management voluntarily waived a large portion of their fees so as to maintain earnings.
Every company experiences vicissitudes, but GOOD’s culture is such that management compensation takes the first hit before shareholder earnings.
Going forward
I suspect FFO will be fairly flat for the next few years as GOOD completes its office dispositions.
The headwinds of lost NOI from property sales can largely be offset by recycling the proceeds into high cap rate industrial acquisitions. The 12.3% cap rate acquisition discussed above is unusual, even for GOOD, but they can consistently source deals in the 8s and 9s.
The rest of the NOI offset is likely to come from organic rent growth in 2 forms:
- Escalators built into leases
- Positive rent rolls on lease turnover. With 60% industrial, the majority of their portfolio rent is below market rates.
Once the transition is complete, I think FFO/share will begin to grow at a moderate pace.
In my opinion, 3 years of flat FFO followed by moderate growth should trade at about a 12X-13X multiple. GOOD is presently valued at 10.7X run rate FFO, so I think it is significantly undervalued.
Gladstone Commercial Debt Profile
GOOD’s debt is 89% fixed rate with a weighted average rate of 4.16%. There are minimal maturities until 2026.
GOOD
Over the past 12 years, GOOD has reduced leverage from 63% of gross assets to 46%
GOOD
That is a level of debt slightly higher than peer average, but not alarming.
Risks to thesis
The macro risks for GOOD are similar to triple net peers. It does not require rapid GDP growth, but avoiding recession would be preferable. The rest of GOOD’s transition will go more smoothly if the economy holds up.
Interest rates are fine for GOOD where they are, but a few Fed cuts over the next year or so would save a few pennies per share in interest expense.
A risk more specific to GOOD would be David Gladstone moving away from the company. Over the past year or so, Buzz Cooper has been taking on increased responsibility, and I suspect he will eventually replace Gladstone as CEO. I’ve met with Cooper and think he is a worthy replacement, so I have no concerns about him as a potential future CEO. The risk, in my opinion, is on the cultural side, as I think David Gladstone is the driving force behind the shareholder first mentality. David looks healthy and sounds healthy, but he is 81 years old, so retirement is likely coming at some point.
The bottom line
Gladstone Commercial is well positioned to provide investors with steady dividend income. Over time, I think FFO/share growth will resume, which could unlock significant capital appreciation as well.
