Gladstone REIT: Monthly 6.9% Yield Worth Considering, +2 Attractive Preferred Series

Gladstone Commercial (GOOD) has been paying attractive monthly dividends for 15 consecutive years, and it also offers two series of compelling preferred shares. The company plans to continue on its path of acquisitive growth and has a pipeline of $260 million for the year 2020. The payout ratio (~95%) combined with slowed FFO per share growth, has fueled some concerns, despite management optimism. This article reviews the health of the business, valuation, risks, dividend safety, and concludes with our opinion about why GOOD may be worth considering if you are an income-focused investor.

Overview:

Gladstone Commercial Corp is a REIT that invests in office and industrial properties globally. The company boasts of a highly diversified portfolio and tenant base. As of February 2020, GOOD owned 122 properties totaling 14.6 million sq. ft. of space across 28 states in the US. The tenants cover a broad cross section of business sectors and range in size from small to very large private and public companies. Its properties are leased to 101 different tenants in 19 industries. Approximately 63% of its tenants have an investment grade or investment grade equivalent credit rating. This is significant as it limits tenant default risk and ensures visibility of rental income for GOOD.

(source: Company The portfolio is typically geared toward long-term agreements as evident from its average remaining lease term of 7.3 years. GOOD enjoys high occupancy rates (currently 97%) and more impressively, the occupancy has never fallen below 96% since the trust’s IPO in 2003.

Dividends –Secure in Near-Term

The company has a solid track record of paying monthly dividends. It has now paid dividends for 180 consecutive months (~15 years). The current dividend yield of ~6.9% is attractive.  In January 2020, GOOD increases the monthly distribution to $0.12515 per share for January, February and March 2020. While this is a modest increase (versus $0.125 earlier), it is noteworthy as this is the first dividend increase in over 10 years. However, we must acknowledge that sustainability and growth of dividends over long-term has been a concern.

Although, GOOD has shown impressive ability to grow its revenues, but the same has not translated into earnings growth. This in our view is the primary reason for concerns around dividend safety in the long-term. Funds from operations (FFO per share) has not seen any meaningful growth since 2014 despite revenues growing significantly (as shown in figure below). After peaking at $1.80 in 2014, FFO per share fell to $1.54 in 2015 and since then has been moving around that range. We view lack of FFO growth partly due to inability to control operating expenses and due to high share dilution to fund its investments.

In 2019, GOOD invested ~$130 million across 14 properties. This is unusually high for a company which generated just ~48 million in LTM FFO (proxy to cash flow). Also, considering the fact that GOOD’s market capitalization is just ~800 million, such high levels of investments have to funded by issuing more shares. This has hindered FFO per share growth.  The company's Q4 funds from operations (FFO) per share were $0.39 while its distributions were $0.375 per share. This suggests a payout ratio of 96% which leaves little room for any dividend growth.

The company on the other hand is optimistic about delivering FFO per share growth from 2020 onwards.  While the management execution on this needs to be closely monitored, we see no reason for any concern around dividends in the near-term.

source: Company data

Solid Balance Sheet

One of the important considerations for investors when buying dividend stocks is balance sheet strength. We are encouraged by GOOD’s deleveraging efforts. Its net debt relative to gross assets was 46.1% as of the end of 2019, compared to 46.8% in 2018, the eighth consecutive year of declining leverage. Nearly 65% of its debt is at a fixed interest rate and further 26% is hedged to fixed via interest rate swaps which limits the exposure to rising interest rates. Looking at the debt profile, 2020 and 2021 loan maturities are very manageable with only $20 million and $27 million coming due, respectively. These could easily be managed via internal cash flow or refinanced. Further, a number of these loans have extension options.

(source: Company Data)

Growth Prospects

GOOD’s management sounds optimistic about its growth prospects mainly driven by solid pipeline of quality properties. The current pipeline of acquisition candidates is approximately $260 million in volume, representing 17 properties, 15 of which are industrial. Of this total, approximately $50 million is either in the letter of intent or due diligence stage, and the balance is under initial review.

“In addition to these accretive deals, our same-store cash rent continues to grow at 2% on an annualized basis. With the number of years of improving the balance sheet behind us, including deleveraging the portfolio, and with substantial acquisitions both at the end of 2019 and early part of 2020, we're excited about the prospects to grow profitability for our shareholders, as well as increasing the industrial allocation of the portfolio. These new investments will provide significant contribution to the Company's performance and aspirations for core FFO growth in 2020 and beyond.”

The higher mix of Industrial allocation will improve property operating efficiencies, reduce capital expenditure levels and potentially result in improved valuation over time. To that end, the industrial allocation was 33% on January 1, 2019 and has increased to 38% by year-end.

Preferred Shares

Apart from common stock, GOOD also has two classes of Preferred units currently outstanding – 7.00% Series D and 6.625% Series E. They’re all cumulative (i.e. if GOOD misses a distribution payment, they are required to make it up later, so long as they do  not go bankrupt). The preferreds are redeemable by the company starting on the dates described in the table below. The fixed rate on both the stocks will continue if GOOD does not redeem them. Neither of them have a stated maturity date and are not subject to mandatory redemption.

(source: QuantumOnline, Blue Harbinger Research

We note that both Series D and Series E preferred shares are trading at premium to par (or liquidation) value – GOODM at $26.37 (~5.5% premium) and GOODN at $26.79 (~7.1% premium). In our view, this premium is acceptable considering the strong monthly income payments. Of the two, we prefer the series D units because of its higher dividend yield at the current price. However, both are attractive, and the dividend payments are even safer than the common dividends (preferred takes priority over common in the capital structure).

Valuation:

GOOD is currently trading at P/FFO LTM multiple of 13.6x. We note that other office REITs such as (Boston Properties and Vornado Realty), are trading in the range of 17-18x, while industrial REITs (such as Duke Realty, Eastgroup Properties, Prologis Inc.) are trading in the range of 25-30x. The company’s lower valuation is partly due to its tight cash flow situation and lack of FFO per growth in recent years. This is also reflected in its relatively higher dividend yield compared to other peers. If FFO growth comes back as stated by the management, we think the valuation gap will narrow and investors can expect solid capital appreciation.

Risks:

Market Cycle sensitivity: GOOD has a higher sensitivity to the market cycle given that it deals in office and industrial properties, which have higher default risk during times of distress. Nonetheless, we note that GOOD was able to maintain its dividend during the last recession of 2008-2009.

Access to capital: The company’s business model is capital heavy and needs significant amount of investments for growth. The current internal cash flows are unable to fund the entire growth and as such GOOD is dependent on easy access to capital markets. If the company is unable to access capital markets, it may severely impact its growth prospects.

Interest rate risk: Even though we expect interest rates to remain relatively tame, dramatically rising rates could create challenges. As REITs are often seen as an alternative to bonds, higher interest rates could mean decreased demand for REITs, thereby causing a decline in the share price.

Conclusion:

Gladstone is an attractive REIT with a fairly secure high-dividend yield supported in the near-term and mid-term by its cash flow (FFO) generation. There are some concerns given its high payout ratio (~95% in 2019), however these uncertainties appear already reflected in the share price given the relatively lower price-to-FFO versus peers. Also somewhat reassuring, it has now paid its dividend for 180 consecutive months (~15 years) and announced a modest increase in January 2020 for the first time in over 10 years. We believe the positives outweigh the negatives and the stock offers an attractive opportunity for investors to generate solid monthly income within a prudently diversified investment portfolio. And if you cannot get comfortable with the common shares, the preferreds also pay monthly, they offer an almost equally attractive yield, and they are safer (considering they’re higher in the capital structure). If you are an income-focused investor, Gladstone is worth considering.