2023-08-17 10:50:01 ET
Summary
- FFO beat versus consensus was entirely due to a non-recurring termination fee.
- Rarely used accounting methodology led to accounting errors that required revisions to 2021, 2022 and 1Q23 earnings.
- Non-cash items such as straight-line rents and the amortization of tenant funded improvements are elevating FFO.
- Operating cash flow does appear to support GOOD's dividends.
- Rising office vacancies and increasing interest rates will put increased pressure on GOOD's FFO.
Gladstone Commercial's (GOOD) share price rose by 4.4% the day after it announced FFO of $0.41 per share for 2Q23 versus consensus estimates of $0.36 per share. The beat was entirely due to accelerated rents, aka a termination fee, of $2.045 million or $0.05 per share. (GOOD 10Q 2Q23 p. 37) Past readers of my work will recall in 3Q22 results were similarly augmented by one-time termination fees, which I explained in Gladstone Commercial Beats Estimates On $4.3 Million In Non-Recurring Accelerated Rent. The day after GOOD reported its 4Q22 results, which did not include the one-time benefit, the stock fell 4.9%.
While GOOD's headlines numbers were driven by the termination fee, the rest of its earnings report paints a dismal picture of the current state of their business. GOOD's unusual policy of treating tenant funded improvements as assets, which I discussed in May in Gladstone Commercial Hits Numbers With Rarely Used Accounting, While A Debt Maturity Looms , has led to accounting errors. ( GOOD 10Q 2Q23 p. 8 ) Although the impact of the errors is fairly small on GOOD's bottom-line results, the added disclosure allows readers of the financial statements to see the overall impact of the policy. Additionally, the $6.8 million impairment charge recorded during the quarter confirms GOOD's on-going difficulty addressing challenges in its office portfolio. At the same time the $7.3 million it spent on leasing commissions and capital expenditures (GOOD Financial Supplement 2Q23 p. 6) call into question the economics of the leasing accomplishments that GOOD touted on its earnings call. As GOOD's 2Q23 cash flow statement shows paying tenants to move into your space is not a sustainable strategy in the long run. Nonetheless, I think the biggest take away from the quarter is that GOOD was not able to replace its $28.9 million mortgage on 717 Parmer in Austin, TX and simply used the line to pay off the mortgage which will increase the interest rate by 2% and reduce the availability on GOOD's credit facility. (GOOD 10Q 2Q23 p. 33)
Rent Acceleration/Termination Fee
GOOD recorded accelerated rents of $2.045 million or $0.05 per share in 2Q23. (GOOD 10Q 2Q23 p. 37) As described on GOOD's quarterly conference call this fee was a result of Citrix terminating their lease for a building in Fort Lauderdale that they had already vacated and were subleasing. GOOD is going direct with the current sublessee. When GOOD originally acquired the property in 2016 Citrix was a Fortune 1000 company . The new tenant, Moss Construction, is a privately held construction company with headquarters elsewhere in Fort Lauderdale. Signing a direct lease is clearly a positive for GOOD, relative to the building sitting empty. However, based on GOOD's disclosure investors have no idea as to whether the rental income from the building will increase or decrease when compared to the old lease or what was spent on tenant improvements and leasing commissions to get Moss to sign a long-term lease.
Accounting Errors/Revenue from Tenant Funded Impairments
In 1Q23 GOOD disclosed that its same store revenue growth was partially due to revenue recognized from tenant funded improvements. I fully discussed why investors should discount this revenue in my last article on GOOD, Gladstone Commercial Hits Numbers With Rarely Used Accounting, While A Debt Maturity Looms. Interestingly, this quarter GOOD did not change its policy, but it did disclose errors in its calculations related to this accounting method. (GOOD 10Q 2Q23 p. 8) When a novel accounting theory is used, there is not a lot of precedent for management or its auditors to draw on. This means errors can be made in the related calculations. This appears to have happened to GOOD. Hence, it was required to revise its past earnings for 2021, 2022 and the 1st quarter of 2023. While the amounts involved are small investors, should be questioning the quality of GOOD's earnings. By treating improvements tenants make to their own space as assets (and therefore earnings/FFO) on their own books, GOOD is booking non-cash revenue. This of course cannot be used to pay down debt or fund dividends.
While GOOD's disclosure makes it impossible to tell how much revenue they are recognizing from tenant funded improvements, we can estimate the size of issue based on GOOD's disclosure on its same store results. GOOD's same store (occupied properties) lease revenue increased by $3.66 million in the quarter year over year. GOOD provides three items that drove the increase in its same store revenue in its 10Q: accelerated rents, revenue from tenant funded improvements and increases in operating expenses which are recovered from its tenants (GOOD 10Q 2Q23 p. 45) GOOD discloses its termination fees so the increase due to this item can be calculated. If one assumes that 100% of the increase in same store expenses are passed through to tenants, the remaining unexplained difference in increased same store revenue is likely due to revenue that is being recognized from tenant funded improvements - see the below calculations.
Assuming the above math is correct, this means GOOD is recognizing almost $2 million a quarter or $0.05/share in revenue from the tenant funded improvements. On the cash flow statement this would show up in the amortization of deferred rent asset and liability, net line item. This math basically matches what is shown on the face of the cash flow statement for the six months ended 2Q23. GOOD shows $4.13 million in amortized deferred rent assets and liability, net. Last year at the end of the second quarter GOOD's cash flow statement only had $1.194 million in this line item. As I will discuss in more detail later, recognizing non-cash items as FFO can help in the current quarter, but the gap between cash flow and FFO needs to be plugged with either debt, equity or asset sales and this causes future dilution.
The Office Woes Continue
As most investors now know, office valuations have plummeted in the last couple of years as the work from home trend has endured even as the COVID pandemic has receded and a new normal has taken hold. Tenants that are in the market for space have lots of options, and know they can drive very attractive terms from landlords desperate to fill vacancies. GOOD's portfolio has performed particularly poorly over the last year and half. They have had impairment charges of $18.9 million driven almost entirely by office properties where tenants did not renew leases. (GOOD 2022 10K, 2Q23 10Q) GOOD's two remaining expirations for 2023 are properties that are currently vacant. (GOOD 8-K 8/18/22 Schedule 6.25/GOOD 2Q23 Investor Presentation p. 19) One is an office building in Columbus, GA that was occupied by the University of Phoenix, which has closed almost all of its physical campuses . The other was occupied by a childcare facility in Columbus, OH and has been vacant for over a year. CBRE is currently marketing the property for sale or lease . Together these leases provide $1.868 million in straight-line rents. (GOOD 2Q23 Investor Presentation p. 19) When they expire it will hit GOOD's FFO by almost $0.05/share in 2024.
Balance on the Revolver Keeps Growing As Does the Interest Expense
On earnings calls early this year when analysts ask management how they planned to deal with upcoming debt maturities this year they were told not to worry about it. Management said they had lots of options. Below are their responses to questions on refinancings from their February and May earnings calls.
GOOD 4Q22 Conference Call 1Q23 GOOD Conference Call
As I pointed out in my last piece on GOOD, Gladstone Commercial Hits Numbers With Rarely Used Accounting, While A Debt Maturity Looms , management would have to come up with an answer by August of 2023 due to the maturity dates of the loans. It turns out GOOD was forced to simply use its line of credit to pay off the two mortgages with a combined balance of $35.7 million and weighted average interest rate of 4.85%. (GOOD 2Q23 10Q. p.33) This creates two major issues for GOOD. One, their interest costs will continue to go up as they are replacing 4.85% debt with variable rate debt that based on the current SOFR rate of 5.3% and a 1.5% spread (GOOD Investor Presentation 2Q23 p. 13) is 6.8%. This will increase interest expense and reduce FFO by $700,000 a year. More importantly, GOOD is running out of capacity on its line of credit. It currently only has $44.1 million available against $28.7 million of maturing debt before the end of 2024. (GOOD 2Q23 Earnings Conference Call.) Given that GOOD is overpaying its dividend based on its cash flow statement as I will discuss, it will have to find solutions outside of just paying off mortgages by using its line of credit. Furthermore, GOOD's interest expense is likely to continue to climb as its interest rate caps burn off and its swaps expire. GOOD no longer provides adequate disclosure to model the precise impact of its interest rate hedging strategy. However, we do know that they have a forward swap that will replace an expiring cap in the 3rd quarter. (2Q23 Earnings Conference Call) Given that GOOD's LIBOR caps range from 1.49% to 2.50% (GOOD 10Q 2Q23 p. 19) and they only started using swaps after interest rates began moving up, it is safe to assume the hedge replacing the cap will be at a much higher rate.
Conclusion
Cash Flow Statement Shows GOOD's Business Is Trouble
GOOD's FFO/share YTD is $0.78, and it has paid out $0.60/share in dividends. This indicates a payout ratio of 77% and would imply GOOD has about $7.3 million to pay down debt or invest in new properties. (GOOD Investor Presentation 2Q23 p. 9) I believe many research analyst models and investor expectations are driven off of this math.
If you ask an accountant (as opposed to a Wall Street research analyst) what is their favorite statement, 99 out of 100 times you will hear them say the cash flow statement. Assumptions can change how income or equity is presented, let alone a non-GAAP number like FFO. However, change in cash year to date is an absolute fixed number. GOOD's cash flow statement for the first six months of the year shows a very different story from FFO. Operating cash flow is $30.7 million. Despite the fact that this amount includes a $1.2 million benefit from accounts payable and accrued expenses increasing, it almost matches the distributions it paid for dividends to preferred and common equity holders which were at $30.3 million. This means the $7.3 million cushion mentioned above does not really exist. (If you adjust for the increasing payables and accrued expenses GOOD's operating cash flow did not even cover its distributions.) The difference between FFO and operating cash flow is being driven primarily by the amortization of deferred rent asset and liability, net (which as I discussed early is the result of very creative accounting) of $4.1 million and a decrease in deferred rent receivable of $1.5 million. Deferred rent receivables arise from straight-lining leases with rent escalations as required by GAAP. I have no issue with GOOD's accounting of deferred rent receivables. However, it indicates GOOD is signing new leases with steep rent escalations to book current earnings even if the tenant is not paying high cash rents in the current period. With GOOD's average lease term at 18.7 years in the first 6 months of 2023 (GOOD 10Q 2Q23 p. 36) it is possible that GOOD's new leases are paying very low rents currently but are scheduled to pay high rents over a decade from now. While the GAAP accounting and FFO averages (straight-lines) these rents, straight-line rents cannot pay interest or dividends. Interestingly, last year GOOD recorded only $57,000 in deferred rent receivables through the first 6 months of the year. These long-term leases with steep increases seem to be a new strategy for GOOD. The final major item driving the difference between operating cash flow and FFO is leasing commissions of $1.3 million which GOOD needed to pay brokers to fill its office vacancies and retain its tenants generally.
Most REITs since the turn of the century have reported an AFFO number which adjusts FFO for straight-line rents, leasing commissions, and capital expenditures (which were $6 million for GOOD through the first 6 months of the year (GOOD Investors Presentation 2Q23 p.6) This provides investors with a much clearer view of a REIT's ability to fund its dividend, but GOOD marches to its own drummer.
As my calculations below illustrate if GOOD calculated AFFO like most REITs its monthly AFFO would be $0.077/share. With a payout ratio of 70% the dividend would be about $0.05 per month or half of GOOD's current dividend. This calculation looks at historical numbers and does not adjust for increasing interest rates or expiring leases becoming vacant properties.
In conclusion, while GOOD would like investors to view its dividend as well covered by its operating business, I believe its current cash flow and dividend level are on an unsustainable course. Despite receiving a $2 million termination fee, selling $4.6 million worth of real estate, raising $7.8 million of equity (after adjusting for the buy back) and having FFO exceed its common dividend by $7.3 million in the first 6 months of the year, GOOD's net debt basically stayed flat.
I think investors should also be questioning the wisdom of GOOD paying high leasing commissions and capital expenditures to fill their office properties with tenants that have long-term leases where the initial rents are low but escalate over many years. While this strategy helps FFO, it hurts GOOD's ability to cover its dividend.
I believe as GOOD continues to sell properties, office leases expire without being renewed and interest rates continue to climb GOOD will find it harder and harder to present numbers that allow investors to feel confident that their current dividend is covered in the long run and once again the dividend will need to be reduced.
Risks to Shorting GOOD
It is important for readers to understand that despite the problems I believe GOOD faces going forward, 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 this quarter. 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 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 Tops Consensus With Non-Recurring Termination Fees, While Financial Statement Errors Highlight Its Unusual Accounting