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Edited Transcript of GOOD earnings conference call or presentation 15-Feb-18 1:30pm GMT

Q4 2017 Gladstone Commercial Corp Earnings Call

McLean Oct 11, 2018 (Thomson StreetEvents) -- Edited Transcript of Gladstone Commercial Corp earnings conference call or presentation Thursday, February 15, 2018 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* David John Gladstone

Gladstone Commercial Corporation - Founder, Chairman & CEO

* Erich Hellmold

* Michael J. Sodo

Gladstone Commercial Corporation - CFO

* Robert G. Cutlip

Gladstone Commercial Corporation - President

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Conference Call Participants

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* David Steven Corak

B. Riley FBR, Inc., Research Division - Analyst

* Jeffrey David Rudner

UBS Investment Bank, Research Division - Analyst

* John James Massocca

Ladenburg Thalmann & Co. Inc., Research Division - Associate

* Laura Shelmire Engel

Stonegate Capital Markets, Inc., Research Division - Senior Research Analyst

* Rick Murray

* Robert Chapman Stevenson

Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst

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Presentation

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Operator [1]

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Good day, ladies and gentlemen, and welcome to the Gladstone Commercial Corporation Fourth Quarter and Year Ended December 31, 2017, Earnings Call and Webcast. (Operator Instructions) As a reminder, this conference call may be recorded. It is now my pleasure to hand the conference over to Mr. David Gladstone. Sir, you may begin.

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [2]

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All right. Thank you, Brian. Nice introduction, and thanks to all of you for calling in. We always, as we mention every time, enjoy these calls and hope we can have more of them. Please come and visit us if you're in the Washington, D.C., area. We're located in the suburb called McLean, Virginia, and you have an open invitation to stop by and see us if you're in this area. You'll see a great team at work. As mentioned before, we still have over 60 members of the team here. Now you're going to hear from -- well, before we begin, just wanted to say how saddened we are all about the shootings in South Florida. We have properties in Florida and wish all those people well, it just breaks our heart to see such events. So now we'll hear from Erich Hellmold. He is our #2 lawyer. He works with Michael LiCalsi and he is General Counsel for us. And he's going to give us a brief announcement regarding some of the legal and regulatory matters concerning the call and report today.

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Erich Hellmold, [3]

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Thanks, David. Good morning, everybody. Today's report may include forward-looking statements under the Securities Act of 1933 and the Securities Exchange Act of 1934, including those regarding our future performance. These forward-looking statements involve certain risks and uncertainties that are based upon our current plans, which we believe to be reasonable.

Many factors may cause our actual results to be materially different from any future results expressed or implied by these forward-looking statements, including all risk factors in our Forms 10-Q, 10-K, and other documents we file with the SEC. Those can be found on our website, www.gladstonecommercial.com, specifically the Investor Relations page, or on the SEC's website, www.sec.gov.

We undertake no obligation to publicly update or revise any of these forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. Today, we will discuss FFO, which is funds from operations. FFO is a non-GAAP accounting term defined as net income, excluding the gains or losses from the sale of real estate and any impairment losses from property, plus depreciation and amortization of real estate assets.

We'll also discuss core FFO, which is generally FFO adjusted for certain other nonrecurring revenues and expenses. We believe this is a better indication of our operating results and allows better comparability of our period-over-period performance. Please take the opportunity to visit our website, www.gladstonecommercial.com and sign up for our e-mail notification service. You can also find us on Facebook, keyword the Gladstone Companies. And we even have our own Twitter handle, @GladstoneComps. Today's call is an overview of our results, so we ask that you please review our press release and Form 10-K issued yesterday for more detailed information. Again, those can be found on the Investor Relations page of our website. Now over to Gladstone Commercial's President, Bob Cutlip.

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Robert G. Cutlip, Gladstone Commercial Corporation - President [4]

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Thanks, Erich. Good morning, everyone. During the fourth quarter, we acquired a $17.2 million office property in Columbus, Ohio; acquired a $20.4 million office property in Salt Lake City, Utah; executed an agreement to sell our property in Tewksbury, Massachusetts, for $5.5 million; executed an agreement to sell our property in Arlington, Texas, for $5.6 million; issued $16.2 million of common stock and preferred stock under our ATM programs; and extended and expanded the line of credit and term loan resulting in increased capacity, significantly extended maturities and a lower borrowing cost.

Subsequent to the end of the quarter, we executed an agreement to acquire a $14 million industrial property adjacent to the Mercedes-Benz assembly plant in Vance, Alabama. We leased 35,000 square feet in our Maple Heights, Ohio, industrial property, effective January 1. We repaid a maturing $6.7 million mortgage note and conducted multiple nondeal roadshows, including 2 held in Boston and Los Angeles that were hosted by research analysts that recently initiated coverage.

For the full year ended December 31, some noted investment capital and asset management highlights worthy of note include that we invested $138 million in 7 property acquisitions and 1 expansion project, at an average yield to us or average cap rate over the term of 8.2%. The impact of these accretive acquisitions is expected to be fully felt in 2018, as the timing of these transactions resulted in only 3 to 4 months of income contribution during 2017. We exited 4 noncore single property markets. We completed the lease-up of an industrial property in Raleigh, North Carolina, and an office property in Houston, Texas. We renewed and extended the leases of 5 tenants, at a GAAP rental rate per square foot increase of 6.9%, recast and extended our revolver in term loan at lower cost, and refinanced $49.2 million of maturing mortgages at lower leverage at interest rates. As you can see from this overview, every team member across all functions contributed to a successful 2017.

As of year-end, our properties were 98% occupied. We continue to be pleased with our activity and have a healthy pipeline of acquisition properties. As noted during our last quarterly call, overall investment sales volume for the year was trending lower than for 2016. The most recent published reports reflect overall sales volume reducing by somewhere between 8% and 10% as compared to 2016.

Completing the 9th year of the current cycle, noted researchers in the industry have forecast that the market cycle may be peaking from a volume standpoint. Prices continue to rise for most product types, but at a much slower rate with maybe the exception of industrial properties. Investment sales listing started the year at a much slower pace than normal. However, research firms are forecasting that overall investment volume for 2018 could be similar to 2017.

Our team will monitor -- continue to monitor market conditions and actively investigate opportunities, and we will acquire properties when the tenant credit, location and asset returns are accretive and promote our measured growth strategy.

Now for some company-specific details. We completed 2 acquisitions during the quarter. These acquisitions said a lot about our team approach to transactions and our broker relationships, as the acquisitions were with the same investment-grade tenant, the same seller, located in 2 of our targeted markets and closed on the same day, December 1. To briefly summarize these transactions, the multistory office properties are in Columbus, Ohio and Salt Lake City, Utah.

The tenant is Morgan Stanley Wealth Management, who has been in both properties since 2007 and has personally invested $20 million in building improvements at each location. There is also a regional bank occupying approximately 15% of the Columbus property. The investment in the Columbus, Ohio, property is $17.2 million and the Salt Lake City investment is $20.4 million. The average unexpired lease term is 8.6 years, and the average yield to us or the average cap rate is 9 points -- 9%, excuse me.

A desired requirement of the seller was to complete the sale prior to year-end. With our knowledge of the markets, the properties, the tenant credit and possessing significant availability of capital, we executed the purchase and sale agreement in November, and closed the transaction on December 1.

Matt Tucker, who leads our Midwest region and Andrew White, who leads our West region, their teams worked diligently with their counterparts at both the listing agent and the seller, and created a win-win transaction for all. We executed an agreement to acquire our second industrial property adjacent to the Mercedes-Benz assembly plant in Vance, Alabama. We are currently in the due diligence phase with an expected closing in March. The property was recently constructed and the lease term is 10 years.

The acquisition price $14.2 million, and the average cap rate of the lease term is 7.6%. The tenant has invested $25 million in an automated assembly system for this just-in-time manufacturing facility.

Closing this transaction will promote our strategy of increasing our allocation to industrial buildings over the next few years, of course, market conditions permitting.

Our team continues to have a strong pipeline of acquisition candidates exceeding $305 million in volume in 18 properties, 7 of which are industrial. Of this total, $14.2 million is in the due diligence stage, $61 million is in the letter of intent stage and the balance is under initial review.

Our asset management team has continued managing our portfolio to ensure strong performance. As noted earlier, 2 of our partially vacant properties in Raleigh and Houston, Texas, are now fully occupied as of January 1, and we leased 35,000 square feet in our Maple Heights, Ohio, property. Our only fully vacant property in Tewksbury, Massachusetts, is currently under contract, with an expected sale date before the end of March. We recognized a $2.8 million impairment on this property in the fourth quarter. That's due to what we believe are inferior market characteristics and determined the better strategy was to sell this asset and redeploy the proceeds in our target markets.

The better news for 2018 is that we have no further lease expirations for the balance of the year. Of the 3 expirations that were scheduled for 2018, 1 tenant renewed, 1 tenant elected to acquire the property with an expected closing date before the end of the first quarter, and one 8,000-square-foot tenant vacated at the end of January.

Our team is already engaging tenants with expiring leases in 2019, and those leases represent just 4% of our contractual rent as of the end of 2017.

This is an important fact for our shareholders as the majority of our peers have approximately 15% or more of their leases expiring during the same period. The majority of our capital availability will be used to pursue growth opportunities, because we do not anticipate needing significant capital for either tenant improvements or leasing commissions to retain tenants and release vacant space, or to fund operating deficits.

I think it's important to note that from a capital structure standpoint, our refinancings continue to lower our loan-to-value and lower our annual costs, and the amount of debt maturing in the years ahead is at a very manageable level. This combination of limited lease expirations and improving capital structure, lower annual debt costs on our properties and the selective sale of noncore properties and redeployment of those proceeds gives us more opportunities to emphasize growth.

So in summary, our fourth quarter and year-to-date activities continued our acquisition and leasing success, extended our credit facility and refinanced maturing loans. Our team continues to have a strong pipeline of acquisition candidates and we'll adhere to our strategy of only acquiring properties with creditworthy tenants in growth markets that are accretive to our operations.

Now let's turn it over to Mike for a report on the financial results.

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [5]

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Thanks, Bob. Good morning. I'll start by reviewing our fourth quarter and full year operating results. All per-share numbers I reference are based on fully diluted weighted average common shares.

FFO and core FFO available to common stockholders were $10.9 million and $11 million, respectively, or $0.381 and $0.384, respectively, per share for the quarter. On a core FFO basis, this is over a 3% increase totaling approximately $336,000 from the prior quarter. FFO and core FFO available to common stockholders were $41.7 million and $41.2 million, or $1.54 to $1.52 per share, respectively, for the year. On a core FFO basis, this is an 11% increase, totaling approximately $4.1 million from the prior year. We acquired 2 office properties in December, as Bob mentioned. The rents from these properties as well as the 5 other property acquisitions completed between the latter half of the second quarter and at the end of the third quarter contributed to the growth of core FFO, and are anticipated to help us increase profitability going forward, given their full year participation and earnings for 2018.

Our fourth quarter results reflected an increase in total operating revenues to $25.3 million, as compared to total operating expenses, excluding impairment losses of $17.6 million for the period.

Now let's take a look at our debt activity and capital structure. We continue to enhance our strong balance sheet as we grow our assets and focus on decreasing our leverage. We've reduced our debt to gross assets by 10% to 47% since the beginning of 2016, generally through refinancing maturing debt and financing new acquisitions at lower leverage levels. We expect to continue to gradually decrease our leverage over the next 18 to 24 months.

As we discussed this with various analysts, investors and lenders, we believe this will put us at the proper leverage level going forward long term. We continue to primarily use long-term mortgage debt to make acquisitions. As we grow through disciplined investments, we'll look to expand our unsecured property pool with additional high-quality assets as well. Over time, this will increase our funding alternatives.

As we manage our balance sheet, we have repaid $129 million of debt over the past 24 months, primarily with new long-term variable rate mortgages at interest rates equal to the 1 month LIBOR, plus a spread ranging from 2.35% to 2.75%. We placed interest rate caps on all of these loans. We also added some of these properties to our unencumbered pool under our line of credit, whether an advanced permanent debt placement, disposition or an effort to provide more flexibility in the future. The prospects for doing this were further enhanced through our refinance of our credit facility in October, which I'll discuss further.

Prior to the refinancing, these mortgages had a weighted average interest rate of 6%. And our deleveraging and refinancing efforts have been a tremendous success with 2017 interest expense decreasing by approximately 5% versus 2016.

We did amend, extend and upsize our combined credit facility in October. The new facility has $85 million of revolving credit capacity as well as an upsized term loan totaling $75 million, which is $50 million larger than the prior term loan. At close, we termed out all previous combined borrowings, leaving us with a fully undrawn revolving credit facility. The revolving credit facility was extended for a new 4-year term through October 2021, with the term loan extended through October 2022. We have interest rate caps in place in all the outstanding term debt.

In addition to successfully upsizing the facility as well as significantly extending the maturity profile, we also improved pricing on both the revolving credit facility and the term loan by 25 basis points.

We believe its execution was important as we continue to prudently address our maturing debt, pursue opportunities to improve pricing, increase our unencumbered asset pool over time and provide the necessary liquidity to operate the business. Looking at our debt profile after this important refinance, 2018 loan maturities are very manageable with only $38 million of debt coming due. Further, we have less than $50 million of mortgages maturing in each of the next 4 years.

From a long-term mortgage debt perspective, issuances continue to be available, but at higher rates than we've experienced in recent years. Interest rates have been very volatile this year, particularly with the recent rise in the interest rates on U.S. Treasuries. With that said, interest rates still remain attractively low from a historical perspective, and we'll continue to actively try to match our acquisitions with cost effective debt. Depending on several factors, including the tenant's credit, property type, location, terms of the lease, leverage, and the amount and term of the loan, we're generally seeing all-in rates in the 4% to high-4% range. In 2017, the rate on the 10-year fixed-rate loans related to our acquisitions range from 3.5% to 3.9%.

We continue to minimize our exposure to rising interest rates with 70% of our existing debt being fixed rate and an additional 26% being hedged through interest rate swaps and caps. We've remained active in issuing both our common stock and our Series D preferred stock using our ATM programs. During the fourth quarter in net-of-issuance costs, we raised $14.7 million of common stock and $1.5 million of Series D preferred stock. We continue to view the ATM as an efficient -- extremely efficient way to raise equity and fund attractive acquisitions.

As of today, we have $4 million in cash and $43.2 million of availability under our line of credit. With our current ability and access to our ATM programs, we believe that we have enough liquidity to fund our current operations, properties we are reviewing and any known upcoming improvements at our properties.

We continue to also encourage you to review our quarterly financial supplement posted on our website, which provides more detailed financial and portfolio information for the quarter. We feel good about executing our business plan during 2018, as we continue to increase our high-quality asset base and continue to improve our metrics, including leverage.

We're focused on maintaining our high occupancy with strong credit and real estate. Institutional ownership of our stock has increased by 15% in the past 24 months to over 55% as of year-end. Certainly, some of this is a function of being included in the RMZ Index in December of '16, but Bob and I have been very active in meeting with current and potential institutional investors, portfolio managers, investment banks and the like. We look forward to further engaging with not only our existing investor base, lenders and coverage analysts, but also establishing new relationships as the company moves forward to its next chapter.

Now I'll turn it back to David.

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [6]

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That was a good report, Mike, and good ones from Bob and Erich as well. All you can say about the last 3 months as well as the year is, wow, everything is clicking right along, making good progress in building the assets and keeping ourselves occupied. Both the -- we bought 2 high-quality office buildings during the last 3 months. And that's in place and should add a good amount of money to the bottom line as we go forward. We sold the -- over $16.2 million of combined new preferred and common, so there is your equity that's going to help us build up. We executed lease extensions on up to 2 of our buildings that are now 100% leased that weren't before, executed sales agreements on 2 noncore assets during the first quarter of 2018. That's a total of 4 for the year. So everything is falling into place. They got a great team working there and this should position the company for continued growth.

As many of you know, the company didn't cut its monthly cash distributions during the recession and I bring that up each time because people keep talking about things are going to get worse, and all I can say is, I think our balance sheet and P&L is going to be able to go through any kind of recession. That was quite a success story when we went through the last one, and what some of our very good companies that we compete with, cut their distributions, and most of them have never recovered to bring their dividend back to the original level. And we're in a great position not to have to substantial -- have substantial problems if the economy hits the skids again. We are in a good position today because we do not have many leases coming due until 2020. We expect low spending on tenant improvements, we continue to refinance loans that are coming due and most of these are going into really long-term debt with fixed rates that match up with our buildings that have long-term leases at fixed rates.

We're now building up the asset base with new purchases and have more to come. I think our balance sheet is strong. It's really battle-ready if there is a recession or problem in the marketplace. We built our assets and our equity base, doubling the size over the last 5 years, which I think is a very strong indication of what a great team is here. With the growth that we see, we hope to see the buyers coming to the stock and should hopefully help increase the price of the stock. It's extremely low right now. We're raising more preferred stock in the Series D, which is a 7% yield. People who want a yield and very safe stock, I think that's one of the best. We do have a new webpage on our website, www.gladstonecommercial.com, that explains the preferred stock. We cannot redeem this for another, I think, about 3 years. So it's very investor friendly, nothing. We normally even consider removing some of our preferred stock from our balance sheet.

We continue to have a promising list of potential quality properties that we're interested in acquiring. We expect to continue to grow the portfolio even more in 2018. With the increase in the portfolio of properties comes greater diversification, and we believe more predictable earnings. However, please note that prices for good buildings with good tenants is very high and yields are relatively low. So we have to shop around and we can't just go out and buy half a dozen buildings this afternoon. We have to make sure that the tenants and the buildings fit our mode of operation. Much of the industrial base of businesses that rent industrial and office properties like the ones we have remain very steady. As you know, we have a terrific credit underwriting group that underwrites our tenants, and considering the track record of tenants paying their rents, I think the future is bright. It's a strong underwriting and has kept this company more than 96% occupied since 2003.

While I'm optimistic of our company and its fine future, Bob and his team will continue to be cautious of the acquisitions as they've done in past years. Now the fun part, in December, the Board voted to maintain the monthly distribution of $0.125 per common share for January, February and March. This is an annual run rate of $1.50 per year. It's a very attractive rate for a well-managed REIT like ours, which we believe is, well, perfect for individuals that want monthly income. And yes, I know, you want to know, when we're going to increase the distribution amount, and all I can say is take a look at the FFO as it increases, we'll have to look at some small increases in dividends. We need to keep the dividend ahead of inflation, so our stockholders do not have a reduction in their buying power of their dividends they are receiving and we're working on that now.

We now have paid 156 consecutive common stock cash distributions, that's more than 13 years. I think it's just a wonderful track record and speaks volumes about how strong this company is. Because the real estate can be depreciated, here is another one, we are able to shelter the income of the company. The return of capital was about 60% for the common stock in 2017. This is a tax-friendly stock that, in my good opinion, is one that's wonderful for personal accounts. And I like it in my personal account because I don't pay taxes on the 60.4% that is sheltered.

The return of capital, as you all know, is mainly due to the depreciation of real estate assets and other items, and it's caused earnings to remain low after depreciation. And that's why we talk about FFO and core FFO because this adds back the real estate depreciation. Depreciation of a building has always, in my mind, been a fiction since at the end of the depreciation period the building is still standing and usually has a tenant in it. So it's a nonevent. The stock is a non-retirement accounts as opposed to having an IRA or retirement plan. That means you don't pay taxes on the part that's sheltered by depreciation, as it's considered a return to capital. However, when you sell the stock, you do have a lower cost basis, so you may have to pay some taxes, but looks like the new tax laws will give us some benefit there as well.

Stock closed on Monday at -- not Monday, closed yesterday at $17.28. The distribution yield on our stock is now about 8.68%. Many REITs are trading at much lower yields. This recent down draft in the equity markets has created a great time to buy some of our stock. I hope you will all call your brokers after this and get some stock purchases. The NNN REIT Index is generally trading about 6.61% yield. So if our stock was trading at that today, price would be about $24.60. So there's a lot of room for expansion of the stock price to be closer to the industry stock like ours, and that's about a 70% -- 30% discount, about 70% of the average that's out there today.

My guess is that as investors continue to discover and familiarize themselves with our company, we'll see the price of the stock increase and bring the yield in line with the other REITs that are like us. There's simply no reason for this REIT to trade at such a high yield given the track record and the low lease turnover for the next 2 years.

I always complain about being criticized for being externally managed, but folks, being externally managed allows us to access the team of credit underwriters unlike any other internally managed REIT. Our high occupancy level is a testament to this access that we have. We also are a REIT that looks first at the tenant, makes sure they can pay the rent, whereas many of the REITs always look at the real estate and talk about location, location, location, we're always talking about tenant, tenant, tenant, just to make sure that we're going to get our paid rent.

In addition, while the salaries are paid by the external adviser, many of the resources, such as Bob and Mike are solely dedicated to Gladstone Commercial, and we have a whole team of people that do nothing but work on this REIT every day. We've also performed an analysis on cost of operating of REITs not higher than ours. We look at the internally managed REITs and we put the numbers together and we published some of this over time, and I know when Bob and Mike get on the road and they're asked that question, they pull out the slides and show people that we are right in line with many of the people that are out there doing exactly what we are.

We have been methodically decreasing our leverage every quarter. We get criticized for being a little heavily leveraged. We are not anymore. We've been putting up more equity when we refinance our mortgages. This allows us, obviously, to get lower cost capital. But we are near the end of using our equity to lower our debt amounts, and current level of leverage is quite conservative. Equity will be used to buy more new properties. So we'll always have to raise money to buy these new properties. But raising money to pay down the debt so that our debt equity ratio, that's not something that I want to see us spend a lot of money doing that.

So at this point, let's get some questions from our shareholders and some of the analysts out there, who follow this wonderful company. Would Brian come on please and help us get through some of these questions?

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question will come from the line of Rob Stevenson with Janney.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [2]

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When you think about financing acquisitions in a $17 stock world, obviously, there's some balance sheet capacity left, which you guys have. But is it preferred that you guys look at, once that's exhausted, how do you guys think about that? Is it asset sales and trying to basically call the bottom end of the portfolio and redeploy into higher growth assets? Just curious how you guys are thinking about that if the current REIT environment persists?

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [3]

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Yes. It's always a problem of trying to figure out how you're going to finance the company in a falling stock price, because quite frankly, all the REITs are down, as you know, Rob, in terms of price. So what we look at first, of course, is how many of our existing portfolio are we going to sell. And as we sell those off, we want to redeploy the money into something that we think is going to be a better fit for us long term. So that's the first order of business. Second order of business, of course, is to look at the ATM program for our preferred stock and see if we can sell some more preferred stock. We didn't sell much last quarter. It's about $2 million worth of preferred sold. So that's not going to help us that much. But that's the first 2 orders of business. And then we have to look at, okay, we're going to sell some stock at $17? If we are, that means, when we go out to buy a piece of property, we've got to get a much lower price for the property and higher yield in order to make up for that loss in stock price. So Rob, we just need you to keep writing buy recommendations and we'll be all right, I think.

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [4]

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Sorry, just to expand on that a little bit, I mean, and just to David's point on the modest amount of ATM activity. We do obviously look at the dividend yields on the common and the preferreds. To the end, that we're seeding deals with common, it does put a stress on the weighted average cost of capital today with the [8 -- 7] dividend yield on the common. So potentially could issue more preferred, I would say more so really the down draft and the stock price has not been why we have not issued meaningful amounts of equity within the ATM program year-to-date. Bob mentioned an individual property for $14 million being in due diligence phase. With $43 million availability in the line and $4 million of cash, there just hasn't been a liquidity requirement. So we will watch the trading and pivot if necessary to -- whether it's common or pref. But the deal team really just needs to stick to their knitting in terms of the spreads we need to obtain over that weighted average cost of capital to do accretive deals.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [5]

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Okay. And then if your deal size level -- what are you guys seeing out there in terms of volume of properties for sale. I mean, is it -- has the 50 basis points moved in the 10 year or the likelihood that you're going to get another fed rate increase here in March, started to weave its way and less product being up for sale, as people try to figure out where cap rates settle out in that type of environment? Has there been sort of any noticeable change for you guys over the last, call it, 60, 90 days in terms of product out there over in the market, even stuff that -- beyond the stuff that you guys are looking at?

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Robert G. Cutlip, Gladstone Commercial Corporation - President [6]

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Rob, as I kind of indicated, the year started off slow. And I think it's started off slow for a number of reasons. A lot of people are talking about buyer/seller disconnects, which I think is happening, because smarter buyers are saying, well, we know rates are rising, and so why would we be in that same very low cap rate environment that we've been over the last 2 to 3 years. So I think that's one item. And it's amazing that the brokers have been telling us that they started off the year slower, but now they're starting to see a lot of more BOVs, Broker's Opinion of Values being requested. So I think that the market is going to come back to where there is more activity. I mean, although I would say, if I compared this year to the last 3, our activity is probably off somewhere between 25 and maybe 1/3, but still with the activity that we have, we're seeing a little bit of movement in the cap rates, primarily in the Midwest, not in the West yet and a little bit in the mid-Atlantic. But I think it's just going to be a challenge because it's -- as what happened in '15 and '16, if you recall, our stock prices hit dramatically as was the majority of the REITs. And so we were prudent. We still bought in the mid-8s from an average cap standpoint. Last year our cap rate -- average cap rate was 8.2%. And I think, unfortunately, we're going to have to probably be in that general range until, I think, the market wakes up and recognizes business hasn't changed. We still have the same margins we've had before, and we've got stability in our portfolio and our cash flow. So we just have to be patient, persistent, and as -- I think some of my colleagues say, you just have to be opportunistic, Cutlip, and that's what we will be.

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [7]

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So Rob, just to add on to that, remember what marketplace we are in, we're not up there competing with the guys who have big tenants like IBM, and those kind of properties where there is almost 100% certainty that, if you buy anything with those names on it, you're going to get paid. So those trade at relatively low yields. We're in the marketplace where we are doing the underwriting that would've been done by S&P or somebody else. We pride ourselves on being able to take on a middle market company that doesn't have the kind of ratings that you'd see in some of the other REITs. And I know people get little bit nervous about that, but, gosh, 13 years doing this now, you ought to wake up and say, I think these guys know what they're underwriting in terms of the tenant. And obviously, we underwrite the real estate the way everybody does. So we're in a different marketplace. We should be able to find transactions that will give us the same kind of yields that we've gotten before. Our real challenge now is where we're going to get the equity, at what price, in order to make these transactions happen. Right now, we got plenty of money. We can do what we want to do. I think when we talk to you guys at the end of the next quarter, we'll have to answer this question again.

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Robert G. Cutlip, Gladstone Commercial Corporation - President [8]

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Yes. And one last comment, Rob, talking about size. In our letter of intent stage, right now, nearly every deal is between $5 million and let's say $18 million or $19 million. So it's not in the $25 million to $40 million range. And I think, as David alluded, those -- a lot are the middle market non-rated companies in our secondary growth markets, but they are ones that have been in the property a long time, and we think we can underwrite them well and we can get a little bit better cap rate.

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Robert Chapman Stevenson, Janney Montgomery Scott LLC, Research Division - MD, Head of Real Estate Research & Senior Research Analyst [9]

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Okay. And then last one for me. Mike, given where lease roles look to be in '18 versus '17, you talked just briefly about where you see the sort of overall level of tenant improvements, CapEx and leasing commissions being in order to maintain the occupancy in '18 versus '17?

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [10]

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Sure. To your point, we have very little role in '18. As we guide towards ballpark numbers, I would say, from a CapEx perspective, we're looking at a number roughly in the $2.5 million to $3 million range for 2018, and then combine TIs and LCs on top of that in the $1.5 million to $2.5 million range. So for 2017, Rob, CapEx, when you stripped out the Lear improvements, which were income-producing improvements and extension of that lease, '17 was like a $3.5 million to $3.7 million number. We probably will roughly be on top of that on the low end of the range.

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Operator [11]

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Our next question will come from the line of David Corak with B. Riley FBR.

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David Steven Corak, B. Riley FBR, Inc., Research Division - Analyst [12]

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I just want to start with operating expense, a little bit higher than we had anticipated this quarter. I was wondering, how much was kind of onetime items? What those items were? And -- or if it's just mainly related to less triple-net exposure? And then, Mike, what's a good run rate leakage number to model going forward?

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [13]

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Sure. So Dave, I appreciate the question. I think generically as you guys look at tenant recovery revenue as compared to the property operating expense line items. It needs to be -- we'll delve a little further in that. What's happening is, as we're doing less triple-net deals and we're doing more base year leases, particularly, as an example of the Maitland acquisition we did in July of last year, being the anchored multi-tenant with ADP taking up 72% of the space.

There is recovery revenue pertaining to that property, but it actually is coming in, in the form of what's being recorded as rental income. So as I look at run rate, if you just truly took the property operating expenses per the income statement less tenant recovery revenue, Q1 through Q3, the run rate there was about a $1.3 million per quarter number. Just doing the mathematical exercise and it went up to about $1.9 million for Q4, that's $600,000 of increase. The vast majority of that actually was recovered, but it was recovered in the form of what was defined as rental income. GAAP's getting pretty particular in the next 2 years in terms of how your income statement's actually going to be presented in 2019 as a revenue recognition concept that's coming out, that actually is going to split out that component of what is now being recorded to rental income to your actual tenant recovery line item. So it's not an exact science, it's just taking the delta between the 2 and saying that's leakage. That absolutely is not our leakage number, we'd be crucified if that was. I need to get back to you in terms of what the specific run rate number is for absolute leakage in '18. So I apologize I do not have that in front of me, but I'll get back to you in short order on that.

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [14]

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Why don't we put that on our website under Question-and-Answer, so everybody can get to that number?

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [15]

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Great idea. Will do.

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [16]

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David, you have another question?

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David Steven Corak, B. Riley FBR, Inc., Research Division - Analyst [17]

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How much of the portfolio...

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [18]

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Go ahead.

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David Steven Corak, B. Riley FBR, Inc., Research Division - Analyst [19]

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Okay. How much of the portfolio is your kind of triple-net at this point?

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [20]

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At least 2/3 of it.

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David Steven Corak, B. Riley FBR, Inc., Research Division - Analyst [21]

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Okay, fair enough. And then just following up on Rob's question about kind of the releasing spreads. Specifically, with kind of the office portfolio, some of the stuff you transacted this year, and I think there were maybe 2 assets, pair of assets this quarter, can you just talk about the kind of releasing activity and the spreads you're getting there and where that is kind of compared to market?

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [22]

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Dave, I'm not -- I'm trying to understand, during this quarter, the 1 lease that we did was an industrial lease in Maple Heights, Ohio. It's a 350,000-square-foot industrial lease. So we did not do one that -- the most recent one is a, believe it or not, a small lease of 2,900-square-foot lease in our Indianapolis property, and that one went up a little bit, just -- by less than 5%, but that's directly related to the tenants who moved into that space, is our anchor tenant in that building. And so they just assumed the same -- continuation of the same rental rate. So I would say, globally we're looking at no more than 2% to 3% increases cash-wise on office, just because the office market, I think for the most part, is starting to get a little bit, not dicey, but it's getting to where a little bit more is under construction as compared to what absorption is, based on the research reports I'm reading. So going forward, I think there's going to be a much lower increase in rental rates. We don't have anything this year that is rolling now. The one lease that just expired, the -- well, the tenant left the 8,000 square feet that I mentioned, we expect that one to come probably in line with the current rental rate. So it'll probably be flat.

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David Steven Corak, B. Riley FBR, Inc., Research Division - Analyst [23]

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Okay, fair enough. And the last one for me. David, you talked a little bit about the dividend and how it relates to FFO, core FFO. Obviously, an attractive yield today with an 8-handle, but do you have kind of a target payout or coverage ratio that you'd like to get to down the road? Just some color on how you think about that big picture?

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [24]

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I'll tackle it. I mean, Bob and I and David obviously have been -- led various REITs throughout our tenures here. I think the peer set probably ranges from generically 65% to 85% on an AFFO basis payout ratio. I mean, we're encouraged that as we look out into '18 that on a run rate basis towards the end of '18, we'll be at a point where on a cash available for distribution, the way I think you would look at it, Dave, will be covering the dividend, and FFO payout ratio will probably be in the low 90s at that point. We don't think we need to really get to midpoint of peer set, but I would say we need to work for our cash available for distribution to at least be in the low 90s or better before we are in a good state to pragmatically do those ratable increases in the dividend that David alluded to.

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Operator [25]

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Our next question will come from the line of Laura Engel with Stonegate Capital.

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Laura Shelmire Engel, Stonegate Capital Markets, Inc., Research Division - Senior Research Analyst [26]

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A lot of my questions have been answered. Just curious, could you summarize with the 2 -- looks like 2 properties held for sale at year-end under contract to close first quarter. You mentioned, I think, an impairment on one. Can you just summarize how that will play out as far as the contract value versus what they're being carried out versus, I think, the impairment charge you took?

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [27]

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As -- and I can get you -- I can't get you the exact number right now, but as David indicated, we'll get that and put it on the Q&A. But it's going to be pretty flat with what the impairment was. The impairment was $2.8 million and we're going to be right on that revised number with the sale of the property. On the other property, we are expecting a capital gain on that asset in Arlington, Texas. The impaired property is the only fully vacant store in the portfolio.

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Operator [28]

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(Operator Instructions) And our next question will come from the line of John Massocca with Ladenburg Thalmann.

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John James Massocca, Ladenburg Thalmann & Co. Inc., Research Division - Associate [29]

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So you guys kind of mentioned that after you have used up the available liquidity maybe to invest at the next, kind of, primary lever to pool in terms of raising the proceeds to invest would be capital recycling? How deep do you think your disposition pipeline is in terms of the noncore assets you'd be looking to sell?

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Robert G. Cutlip, Gladstone Commercial Corporation - President [30]

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John, at this point, with our tenants paying extremely well, even though they are in the smaller markets and we've been through renewals with each one of them. I'm in no big rush to be truthful with you. I think, though, as we have indicated in our prior presentations and when Mike and I are on the road, we want to selectively move out of those markets, and then we're going to match it with opportunistic buy to that particular point, which we've done in the past. I mean, so if I -- I can't tell you what the magic wand would be on it. But if I look globally in macro -- from a macro standpoint, we are probably looking at just a few assets a year over the next 2 to 3 years. It's just -- it's going to depend on what type of, let's say, opportunities we have to redeploy the capital. There's no reason for us to sell just for the sake of selling.

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John James Massocca, Ladenburg Thalmann & Co. Inc., Research Division - Associate [31]

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Understood. So it's more kind of -- in some ways, if you find a good use of the proceeds, given what you could sell it for and what you could buy, it's going to be opportunistic in that? That kind of means rather than let's go out and sell a bunch of assets so we can have some dry powder on hand to do deals?

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Robert G. Cutlip, Gladstone Commercial Corporation - President [32]

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That's exactly right. That's exactly right.

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John James Massocca, Ladenburg Thalmann & Co. Inc., Research Division - Associate [33]

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And I think kind of more from the acquisition side, you guys kind of mentioned that the pipelines still -- maybe what would be kind of smaller deals, $15 million to $18 million. I mean, do you think that's just because that's what's transacting in the marketplace right now? Or is that you have yields on those assets kind of moved up quicker in line with the changes in interest rates, and therefore, they are more attractive?

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Robert G. Cutlip, Gladstone Commercial Corporation - President [34]

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I would say that it's what you -- the latter -- is that it's -- at the lower end of the size, the yields are a bit more attractive for us right now. And as I alluded to before, in '15 and '16, it was the same way. Prior to that, we were buying $20 million to $30 million assets. And then when our stock price dropped, we were able to be a lot more competitive in the $10 million to $20 million range. And that's what the team is doing right now. And I think doing a very good job. With the $60 million that we have in letter of intent, I mean, that's actually 6 properties. So it's really where the opportunity for us to get the margins we require. So the team has adjusted very well.

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John James Massocca, Ladenburg Thalmann & Co. Inc., Research Division - Associate [35]

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Makes sense. And then kind of on a more financial side, you guys mentioned the 26% of debt was swapped and capped. What's the split between that? How much is swapped and how much of that is capped?

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [36]

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Yes. In round numbers, John, I would say about 20% of it is capped and the remaining 6% is swapped.

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John James Massocca, Ladenburg Thalmann & Co. Inc., Research Division - Associate [37]

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Okay. So if there is a 50 basis point move in LIBOR, it probably won't have that much of an effect, ballpark numbers?

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [38]

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That's right. That's right.

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Operator [39]

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Our next question will come from the line of Jeff Rudner with UBS.

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Jeffrey David Rudner, UBS Investment Bank, Research Division - Analyst [40]

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I missed part of the reference you made earlier in your presentation at the end regarding Blackstone Commercial. Could you comment on that a little bit further?

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [41]

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You mean Gladstone Commercial?

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Jeffrey David Rudner, UBS Investment Bank, Research Division - Analyst [42]

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Gladstone Commercial, yes.

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [43]

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Oh, good. I didn't want to...

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Jeffrey David Rudner, UBS Investment Bank, Research Division - Analyst [44]

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No, no, I understand, right.

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [45]

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I don't know. Gladstone Commercial, it seems to me has a wonderful opportunity because people are not going out and jumping on these middle market tenants. We love them. And we built this business around that whole area. We are not -- I don't even know what the number is today, but it's relatively small compared to the rest of the world in terms of how many of our tenants are rated by big firms like S&P or Moody's. And so when you look at what we do, we do the same underwriting and I think actually we do it better than some of the people inside Moody's, for example. And so I think we've done a good job, Jeff, picking out good small businesses. Do you know, we have 2 other companies that are business development companies and we are always underwriting small companies. And so whether we are underwriting and do a probability of default on their loan or the investments we've made, or underwriting and when to do the probability of default on their lease, it's a very similar process. And having been in this business for the last 40 years, it seems to me, maybe even longer, I don't even know now, I've gotten -- been here so long...

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Jeffrey David Rudner, UBS Investment Bank, Research Division - Analyst [46]

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Go back to the days of Allied Capital, goes back a long way.

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [47]

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Yes. Our underwriting skills are really strong. And I think that differentiates us substantially from all the other people out there. And I know a lot of the institutions will come in and say, you're paying out too much of your income and you got to get it way down. I just don't follow that logic. If you got something that pays and pays and pays and never drops below 96% occupied. We're going to pay out a larger percentage of that than say somebody who's going out and doing development deals or they're buying empty buildings, refurbishing and then leasing them up. It's just a different business. And it's more predictable. It's every year. We seem to get better at growing our asset base and our dividends. So from my standpoint, I think Gladstone Commercial is just very strong in that area.

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Jeffrey David Rudner, UBS Investment Bank, Research Division - Analyst [48]

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Well, I certainly appreciate that. And I think 2 comments you made also, which are very important, is, one, even during the financial crisis, the dividend was never cut, you were able to maintain that $1.50 annual dividend. And secondly, in making your loans, you look more at the ability of the tenant to pay their rent as opposed to location, location, location, what the property might be worth?

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [49]

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That is the way we run the business. We look at the tenant first and say, if we don't believe in the tenant, why bother even looking at the real estate.

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Operator [50]

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(Operator Instructions) And now our next question will come from the line of Rick Murray with Sorin Capital.

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Rick Murray, [51]

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You guys have made good progress over the last couple of years in bringing down the leverage. But I wanted to follow-up on David Corak's question, because I was a little bit surprised to see the gap between your cash flow from operations and the dividend kind of widen out again this year after some improvement the year before. So what is causing that to happen? Why is the dividend growing more than the cash flow from operations? And what are the steps that you have in your plan to narrow that gap?

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [52]

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Thanks for the question, Rick. We don't look at it at the exact same way. The dividend hasn't grown, obviously, from of a per share level, obviously, as we've issued incremental shares, there's been incremental need from a notional to pay the dividend. But our core FFO per share and while it's not a disclosed number, but AFFO as a form of cash available for distribution has improved every single year. So as we see it, we're actually getting in a better spot in terms of, either if it's on a core FFO basis, improving that payout ratio for something that has been in the 99% range to something that I believe is around 95% range right now. And on a cash available for distribution, that has been something historically that had run at a payout ratio of 125 and north. And as I mentioned, I think, in my comments today, we think by the end of '18, we'll be at a place where, more or less, AFFO/CAD will actually be covering the dividend. So we may be looking at little bit different things, but we think the per-share earnings has improved quarter-over-quarter and year-over-year, while the dividends remained constant.

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Rick Murray, [53]

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Right. But I mean, if I look at your cash flow statement, the cash flow from operations in '17 was $47 million, your dividend a little over $50 million. So there is that gap before any CapEx. So I guess I'm trying to understand why that gap has widened. Is it because you're doing deals at lower cap rates that you needed to? Or is it timing differences? Or -- just -- and what are the steps that are going to get us to bridge that gap?

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Michael J. Sodo, Gladstone Commercial Corporation - CFO [54]

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I understand on a 2017 basis what you're doing from an analysis perspective, 47 versus the 50 number, and that correlates directly to what I made mention to in terms of AFFO or cash available for distribution, really now being at a point at which it's about 110% payout ratio. I don't -- haven't done it with those metrics. Historically, the way we look at it is that, that ratio has improved over time. I would say, we'd expect it to continue to improve over time doing $140 million of acquisitions back-end loaded in '17 at a weighted 8.2 cap based upon our balance sheet structure, should only improve that comparison as we look into 18. So -- sorry, I haven't gone back and looked at it from a cash flow statement for '16 and beyond -- behind that. But, I think, your '17 numbers for a static point in time line up with the way we look at it as we compare it to AFFO or CAD.

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Robert G. Cutlip, Gladstone Commercial Corporation - President [55]

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One other item, too, on that, Rick. And thanks for the question here. We -- as you recall and I think Dave's mentioned it in prior calls, we've doubled the asset base since 2012. And if you think about what's transpired with GAAP rent versus cash rent, we now are now going to get the benefit from 12 and 13 every year, crossing over that threshold to where our cash rent's going to be greater than our GAAP rent. And so that cash positive is going to, I think, benefit us year-over-year as we go forward, just because of the increase in the AUM. So -- assets under management. So we probably need to do that calculation. And if we do, we'll put it up on the Q&A as well, so that people can see the benefit going forward to our operation.

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Operator [56]

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There are no further questions in the queue at this time, sir. I'd now like to hand the call back over to Mr. David Gladstone for some closing comments.

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David John Gladstone, Gladstone Commercial Corporation - Founder, Chairman & CEO [57]

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All right. Thank you all for calling in. We really enjoy this time together and love the questions that we get. So see you next quarter. That's the end of this call.

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Operator [58]

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Thank you, sir. Ladies and gentlemen, this does conclude our conference. Thank you very much for your participation. We hope you have a wonderful day.