Summary
- Redeploying proceeds from the sale of office properties with expiring leases into sale leasebacks on industrial properties will likely dilute earnings.
- Refinancing of a $29.3 million mortgage secured by the leased, but largely vacant Austin Office Property in August of this year likely will be extremely challenging.
- The involvement of a receiver on the Columbia, South Carolina asset means it will likely be sold for less than its mortgage.
- Management’s confusing answers on capex on the conference call should make investors nervous about the level of capex in 2023.
Since Gladstone Commercial ( GOOD ) always sold itself as the REIT that never cut its dividend, the first earnings call after it announced a dividend cut promised to be interesting. Investors or research analysts hoping for a mea culpa from management and some acknowledgement that they had been overly optimistic in assuming they could maintain their dividend in the face of a worsening office market and increasing interest rates were disappointed. This may explain the more aggressive line of questioning during the call by the research analysts who no doubt had been embarrassed in front of their accounts by not predicting the dividend cut or the FFO miss. Instead of beginning the call by focusing on issues with their own capital structure or lease expirations, management discussed the war in Ukraine. I am sure investors hearing that GOOD collected 100% of their contractual rents, but still needed to cut the dividend were left scratching their heads wondering how Ukraine is part of the story.
GOOD may very well collect 100% of its contractual rents in 2023, however, I think the pain is just beginning. As I pointed out in ( Gladstone Commercial Beats Estimates on $4.3 Million In Non-Recurring Accelerated Rents ) 1Q23 will be the first quarter where GOOD feels the full quarter impact of the expiration of its lease with Verizon at its property in Columbia, SC which expired in October. On the earnings call management mentioned that the property is now being handled by a receiver which indicates it is likely to be sold for less than the value of its mortgage. This means the revenue (and interest payments) from the property will move off of GOOD’s books, but they will receive nothing for the property. Their equity has been reduced to zero. The property is valued on their balance sheet at $3 million (GOOD 10-K 2022, p. 76) against a mortgage of $9 million. (GOOD 10-K 2022, p. 88.) They are lucky this is a non-recourse mortgage.
Office Lease Expirations
The challenges of lease expirations will not end for GOOD with the new year. In 2023 GOOD has 7.1% of its annual straight-line rent expiring or $8.8 million. (GOOD 4Q22 Financial Supplement, p.19) When queried for details about its 2023 lease expirations on its earnings call, management mentioned that two of the office lease expirations are under purchase agreement and out for execution. A few things investors should keep in mind:
- The only property that is listed as Held for Sale in its 10-K is the vacant Columbia, SC property. This means the auditors (and GOOD) likely have some doubts as to whether or not these sales will close. The PSA’s have not been executed.
- If GOOD does sell these properties I think it will almost certainly be at a very high cap rate based on 2022 NOI as the market for office properties with no tenants is terrible. As I mentioned in my last article ( Gladstone Commercial's Dividend Cut Announcement: A Signal on Office Lease Expirations in 2023 ) a couple of their office properties with expiring leases are currently listed for sale. Two of them are Class B office properties per the brokers’ marketing material. ( 250 E Arapaho, 7450 Huntington Park Drive ) Vacant suburban Class B office is not drawing much interest from buyers right now due to the imbalance of demand and supply in the office market as well as the lack of financing for office properties generally. This was discussed by the Wall Street Journal in their February 21st article Office Landlord Defaults Are Escalating as Lenders Brace for More Distress . As investors saw on GOOD’s asset in Columbia, SC when a tenant leaves an office building vacant it no longer trades off a cap rate. The current fair value of the Columbia, SC asset is $3 million. (GOOD 10-K 2022, p.76) Last year its budgeted NOI was $3.6 million (GOOD August 18, 2022 8-K. Schedule 6.25) which implies a cap rate of over 100%. I think similar markdowns may emerge on the vacant office properties GOOD is trying to sell this year.
- Assuming GOOD follows through on its plan to reinvest the proceeds in Industrial Properties with long-term leases, I think these transactions will be very dilutive as they will not come close to replacing the lost income from the expiring office leases.
Maturing Mortgages and Debt Amortization
Maturing mortgages and debt amortization payments will also need to be addressed in 2023. In 2023 GOOD has $58.3 million in balloon maturities as shown in the chart below from their 4Q22 Investor Presentation.
The majority of GOOD’s 2023 mortgages maturities are secured by office properties with tenants on short-term leases of 3 years or less as shown below.
2023 Mortgage Maturities - Office (GOOD's August 18, 2023 8-K, Schedule 6.25 and Schedule III of GOOD's 2022 10-K)
I think this will make things particularly difficult for GOOD. As the Wall Street Journal highlighted in their article on distress in the office sector on February 21st loan officers are avoiding just the types of buildings GOOD is looking to refinance.
Loan Officers Avoid Office (Wall Street Journal - Feb 21, 2023)
While all of these properties will be difficult to refinance, I think the $29.3 million loan on the Austin property presents the biggest challenge for GOOD. Although GM is still on the lease for over half of the building through 2026, it has already vacated the property. JLL is currently marketing the sublease space. I think it is doubtful that any lender would consider this property acceptable collateral for a loan.
When pressed on plans for refinancing management’s answers do not inspire confidence. Below is management’s response.
Question on Debt Maturities (GOOD 4Q22 Earnings Call)
Management did not answer the analyst’s question on the rate they expected on the refinancings, and each of the options management suggests for accessing capital has some negative implications for GOOD. Refinancing properties with long-term leases that are currently collateral for the line that would be attractive to banks and then using the properties with maturing mortgages as collateral for the line would not only infuriate their line lenders, it would also bring down the average lease term for properties securing the line. GOOD’s overall weighted average lease term is 7 years. (Page 4 Investors Presentation.) The line requires an average weighted lease term of 5 years for the unencumbered pool of assets supporting the Credit Facility. (§9.3 of 4 th Amended and Restated Credit Agreement filed as an 8-K on August 18 th , 2023.) I think GOOD will only be able to move a limited number of properties to line without tripping this covenant and the Austin property is large enough that it would move the needle.
I think just drawing off the line is not really an option for GOOD. They have $86 million available, but they will need to acquire assets to continue bringing up their weighted average lease term and continue their shift to industrial properties. Once again, I think their lenders would make life tough for GOOD if they simply tried to push borrowing on the line to the maximum level without acquiring new properties.
Additionally, they will need to use $9 million of line capacity simply to keep up with the amortization on their existing debt. As detailed in their 10-K on p. 79 their principal debt payments due in 2023 are $67.3 million. The $58.3 million mentioned on their earnings call and shown in their Investor Presentation simply reflects the balloon payments that are due. The $9 million difference represents amortization payments. The funds for these payments will need to come from somewhere.
I think the idea of issuing stock through the ATM to pay off the maturing mortgages would make GOOD’s lenders happy, however, it would be incredibly dilutive to FFO. The interest rate on the maturing debt is in the 4.8% range. At GOOD’s current stock price of $14.37, assuming a run rate FFO of $0.34/quarter GOOD’s FFO multiple is 10.6x or a FFO yield of 9.5%. In short GOOD’s 2023 mortgage maturities have put them between a rock and a hard place.
Capex Funding
Finally, funding increasing capex may be another drain on the line’s capacity in the coming year. In Q4 capex jumped to $4.4 million. If GOOD used an AFFO calculation this would have dinged their AFFO/share by $0.11. Management’s response to an analyst’s question on the future trend of capex leaves much unanswered and many investors wondering what other surprises may be in store for them. No one answered the question as to why capex went up in 4Q22. You have one executive saying office properties are more expensive from a capex perspective and another saying industrial are the issue. Based on the marketing materials from 717 Parmer in Austin, I suspect some of the work they are doing on the property caused capex to spike. I have no idea if that work is complete or on-going. The exchange with the analyst is below.
Capex Question (GOOD 4Q22 Earnings Call)
In summary it was an ugly quarter for GOOD and its analysts as everyone had to face the music of office lease expirations in a historically bad office market along with rising rates. In my view, management didn't rise to the occasion nor inspire any confidence that they will be able to navigate the challenges of the year ahead. Blaming the year-old war in Ukraine and rising rates, when several months ago management told investors everything was fine has to rub people the wrong way. It is possible that management really did think they would be able to maintain the dividend, but this simply suggests to me that they are quite disconnected from the reality of their business. Nothing illustrates the Advisor’s lack of attention to this externally managed REIT better than David Gladstone’s comments on the dividend.
David Gladstone Comments (GOOD 4Q22 Earnings Call)
The chairman does not remember which company he is talk about. Investors should remember that as some try to take solace in claims that everything will be OK in a year and we will be increasing the dividend.
Risks to Shorting GOOD
It is important for readers to understand that despite the problems I believe GOOD faces in 2023, the stock is very volatile as its investor base turns over. This means any number of things could cause the stock spike price to spike temporarily. A short seller without sufficient capital could be forced to liquidate their position at a loss in this scenario. It is easy to envision circumstances where GOOD’s stock price rises rapidly on perceived good news, For example, GOOD could report the sale of an asset at a substantial gain or they could use accelerated rents or termination fees to exceed analysts’ estimates like they did in Q322 as was discussed in my earlier piece on GOOD. Alternatively, they could announce an arrangement with their line lenders that the market views as a benefit. Additionally, GOOD will likely continue to pay its reduced dividend until its lenders tell them they need to stop. Not only does the dividend represent a cost to a short seller, I believe the dividend will put a floor on the stock price for some time as there will always be investors who are seeking yield. My assumption is that lenders will wait until the last possible moment to ask GOOD for an additional reduction to its dividend. In the interim, they will simply pressure GOOD to raise more equity to help their position in the capital stack. In other words, I believe someone shorting GOOD needs to have the patience and capital to wait until the market has a clear and informed view of GOOD's projected 2023 and possibly 2024 FFO/share.
Additionally, short-sellers need to be prepared for the possibility that if GOOD successfully leases some of their vacant office space at attractive rates the stock could move upward.
For further details see:
Gladstone Commercial: The Pain Is Likely Just Beginning