Gladstone Commercial Corporation (GOOD) is an externally-advised REIT that owns triple-net leased industrial, commercial, medical and other types of real estate properties. The Company's assets are typically leased to private middle-market companies, some of which have been financed by buy-out funds and venture capital firms.

In a nutshell, the short story on GOOD is that it is a highly-levered, low-quality REIT with many cash flow obligations senior to the common stock dividend and whose largest tenant will be vacating most of the premises at the end of 2012 (and in my view, has a low likelihood of getting a replacement). Management also appears to have a checkered past.

Despite this, GOOD trades at an enormous premium to its intrinsic value, is expensive relative to its comparable publicly-traded peers, and generally carries more risk than other net-lease REITs with better balance sheets, lower lease rollover schedules, and higher quality tenants. A realistic view of value is between $6-8 per share (trades at ~$17), the company is levered 9.6x debt + preferred to EBITDA, has low underlying credit quality (less than half of the tenants have a credit rating, no disclosure on what is actually investment grade), and the company is currently not able to earn its dividend.

I would encourage readers to flip through the attached slides (    https://docs.google.com/open?id=0B4hgVZQCkTN1NXBwQVRMTEVpYUE), which provides a comprehensive review of the valuation, capital structure, cash flow sensitivity, market comparables and several notable inconsistencies throughout the company’s February presentation (http://gladstonecommercial.investorroom.com/index.php?s=97). The slides also are presented with sensitivity tables, so you can pick your own assumptions and come to your own conclusion. This brief write up will focus on what I perceive to be the likely catalyst for the short, as well as the variant view.

Beginning with the lease rollover schedule:

2012 - 9.8% of rent 
2013 - 8.5% of rent 
2014 - 7.1% of rent 
2015 - 15.7% of rent

This compares to net lease companies Realty Income Corporation (O) and National Retail Properties (NNN), both mature portfolios and considered best-in-class, who generally have 3-4% annually.

Regarding 2012, their largest tenant (Unisys) located in their Roseville, MN facility (360,000 square feet) representing 7% of total rent revenue, expires at the end of the year at an average rent of $8.43 per square foot. It has renewed for only a portion of the building leaving 4% of existing rent exposed to the market once the lease expires. Multiple calls into real estate agents in the market have confirmed that the area surrounding the Roseville, MN facility has very high vacancy rates for both office and industrial. The GOOD facility has an industrial building’s exterior, but its interior is built-out with office finish (otherwise known as “flex” space), has no dock doors (where trucks would normally access the warehouse) and was specifically built and tailored for Unisys. Converting it back to industrial would cost capital GOOD barely has and in any case would result in much lower rent. The likelihood of getting an office tenant also seems slim, as one would presume that most office tenants would prefer to be in normal office buildings.

This event is perilous for current equity shareholders as GOOD is already stretching above 100% AFFO to pay their $1.50 dividend to common. As an externally-advised, highly-levered REIT, GOOD not only is obligated to pay interest/principal to mortgage and preferred holders, but carries a 2/20 compensation structure payable to Gladstone Management (the advisor to GOOD, helmed by executives with an unsavory past, see slides) .

This is a summary of the December quarter cash flow (millions, except per share):

Revenue - $11.5 
(-) Operating Costs/GA - $1.3 
(-) Management/Incentive Fees - $1.3 
(-) Interest Expense on Mortgage - $4.5 
(-) Preferred Payout - $1.0 
(+) Add back Incentive Fee Given Up (to service common stock) - $.4 
(-) Amortization of deferred rent asset and liability, net -$.1 
AFFO - $3.6 
Shares Outstanding - 10.9M 
AFFO/Share - $.33 
Dividend Policy - $.375 
AFFO Payout Ratio - 113%

GOOD's credit facility limits dividend payouts to 95% of FFO (according to covenants that allow certain add backs), hence GOOD waived a portion of their incentive management fee to maintain compliance with this covenant. They are not required to do so and may not do so in the future. Even with this incentive fee add-back, GOOD has been maintaining the current dividend of $1.50 a share by the skin of their teeth. It seems inevitable that with the high financial leverage baked into the business, any shortfall in current rent will force a cut in the dividend. Note that Gladstone’s ability to collect an incentive fee is based on an FFO yield relative to book equity hence a reduction in the dividend would not impact their ability to earn the incentive fee! There is precedent for this as well: Gladstone cut dividends at two other externally advised vehicles, GAIN and GLAD (two other companies they manage).

Currently the company trades at an implied cap rate of 8.2% on in-place cash flow. While this seems optically high, it is actually a premium to its most comparable peer, STAG Industrial (STAG). STAG owns industrial net-lease properties (less specialized product, a relative strength for STAG) with similar weighted average lease term remaining (6 years vs. GOOD at 7 years), and slightly lower leverage at 7.9x debt + preferred to EBITDA. STAG is internally managed and does not have a 2/20 incentive compensation structure. Despite the relative strength of STAG vs. GOOD, STAG trades at an implied cap rate of 8.8%. STAG is broadly viewed to trade roughly in-line with NAV. STAG also continues to buy assets at a 9-10% cap rate, validating the multiple.

My estimate of GOOD NAV incorporates a 5% decline in revenue (whether it be lost revenue from Unisys or other rollover transpiring this year) and applies a 10% cap rate, resulting in a value of $6.37 per share. I view the 120 basis point spread to STAG as appropriate given the more specialized nature of the asset and the credit profile of the underlying tenants. As a proxy, depreciated book value is $7.45 per share. Contrary to the belief that “real estate appreciates over time”, I believe that highly specialized real estate in tertiary locations do not appreciate. The value is in the current cash flow and remaining term, and as it burns off, the uncertainty surrounding the value of the building at the end of the lease draws near. $6 to $8 per share seems to be about right from an intrinsic value perspective.

I have not heard a credible variant view, but that is probably because nobody is paying attention to it. This company does not have institutional investor base. The company only shows 53% of shares outstanding are filed with the SEC (per Bloomberg), which implies that most of the investors are retail oriented. As you flip through the list of who does show up, it feels like most of these investors are driven entirely by yield, which seems to be supporting the stock at these levels. I can talk about the reasons why it is over valued until the cows come home, but the retail investor will probably hold onto it until the dividend is cut. With the line of credit limiting future dividend payments to 95% of cash flow and a sizeable amount of rent about to disappear, the odds seem to favor a short position.

Some might argue that the dividend yield is too high to short. I will concede that it is expensive at 8.7% yield, and would offer Select Income REIT (SIR) as a pair. I have not done extensive work on this name, but it just spun out from Commonwealth REIT in early March, has strong asset quality, low leverage, and will be paying a well-covered dividend (estimated to be $1.60 per share, on a $22.91 share price, ~7% yield) that can offset most of the carry cost of shorting GOOD. It is an externally advised vehicle with a promote structure, which is not ideal, but it does pair off well against GOOD and isolates the event.

I’ll finish this the same way I finished the presentation:

WEAK ASSETS 
OVER LEVERED 
UNSUSTAINABLE DIVIDEND 
QUESTIONABLE SPONSORSHIP 
OVER VALUED