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Edited Transcript of GOOD earnings conference call or presentation 3-May-17 12:30pm GMT

Thomson Reuters StreetEvents

Q1 2017 Gladstone Commercial Corp Earnings Call

McLean May 6, 2017 (Thomson StreetEvents) -- Edited Transcript of Gladstone Commercial Corp earnings conference call or presentation Wednesday, May 3, 2017 at 12:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* David J. Gladstone

Gladstone Commercial Corporation - Founder, Chairman and CEO

* Michael B. LiCalsi

Gladstone Commercial Corporation - General Counsel and Secretary

* 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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* Daniel Paul Donlan

Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research

* Lawrence Raiman

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Presentation

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Operator [1]

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Good day, ladies and gentlemen. Welcome to the Gladstone Commercial's First Quarter Earnings Call. (Operator Instructions) As a reminder, today's conference call is being recorded.

I would now like to introduce your first speaker for today, David Gladstone. You have the floor, sir.

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David J. Gladstone, Gladstone Commercial Corporation - Founder, Chairman and CEO [2]

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All right. Thank you very much for that nice introduction, and we thank all of you for calling in. We have great deal of fun with these calls and enjoy doing them. You're ever in this area, we're in a suburb called McLean, Virginia, stop by and say hello, you will see some of the people that are here, there are over 60 members of the team now. And we're over $2 billion in assets under management. Now we'll hear from Michael LiCalsi, he's our General Counsel and Secretary and Michael is also President of Administration, Gladstone Administration. And it's the administrator for all the public funds that we manage. He will make a brief announcement regarding some of the legal regulatory matters. Michael?

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Michael B. LiCalsi, Gladstone Commercial Corporation - General Counsel and Secretary [3]

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Good morning, everyone. The report that you're about to hear may include forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934, including statements with regard to the company's future performance. Forward-looking statements involve certain risks and uncertainties that are based on our current plans, which we believe to be reasonable. There are many factors that may cause our actual results to be materially different from any future results expressed or implied by these forward-looking statements, including all the risk factors included in our forms 10-K and 10-Q that we file with the SEC. Those can be found on our website, gladstonecommercial.com; and on the SEC's website, which is www.sec.gov.

The company undertakes no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. And in our report today, we also plan to talk about funds from operations or FFO. 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 the property, plus depreciation and amortization of real estate assets. The National Association of REITs has endorsed FFO as one of the non-GAAP accounting standards that we can use in discussion of REITs.

Please see our Form 10-Q filed yesterday with the SEC for a detailed description of FFO. And we also plan to discuss core FFO today, which is generally FFO adjusted for certain nonrecurring revenues and expenses. We believe this is a better indication of the operating results of our portfolio and allows better comparability of period-over-period performance. And to stay up to date on our fund and the other Gladstone publicly traded funds, you can sign up on our website to receive email updates on the latest news plus you can follow us on Twitter, the username there is GladstoneComps; and on Facebook, the keyword is the Gladstone Companies.

And finally, you can visit our general website to see more information at www.gladstone.com. And today's presentation is an overview, so we ask that you read our press release issued yesterday and also our Form 10-Q for the quarter ended March 31, 2017, as well as the financial supplement that we prepared. And all these provide further detail on our portfolio and results of operations, these can all be accessed on our website, gladstonecommercial.com. And now we will begin the presentation today by hearing from Gladstone Commercial's President, Bob Cutlip.

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

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Thanks, Mike. Good morning, everyone. During the first order, we completed the lease up of Chicago industrial property and our Minneapolis office property, sold a noncore property in Franklin, New Jersey, with a nice capital gain of $5.9 million, issued $4.6 million of common and preferred equity through our at-the-market programs. We paid $35.4 million of maturing mortgages, continued our investor and investment bank outreach program by visiting with 4 registered investment advisers and 3 investment banks and conducting conference calls with the fund managers to discuss operating results and strategy.

Subsequent to the end of the quarter, we sold a noncore property in Hazelwood, Missouri, completed the construction of the 75,000-square-foot expansion of our industrial property adjacent to the Mercedes-Benz assembly plant in Vance, Alabama. We're selected to acquire 2,000-square-foot multistory offered property in Philadelphia. Commenced activities to expand an existing tenant by 200,000 square feet on adjacent property in Big Flats, New York under a long-term lease, and issued an additional $5.9 million of common and preferred stock under our ATM program.

As you can see from this overview, we had another excellent quarter as we continue to re-lease vacant property and maintain our exceptionally high occupancy. We are 97.9% occupied at March 31. We continue to be pleased with our activity and have a healthy pipeline of acquisition candidates.

As noted during our last quarterly call, overall investment sales volume during 2016 was about 10% below 2015 as reported by national research firms. This lower pace continued through the first quarter. Entering the ninth year of the current cycle, noted researchers have forecast that the market cycle may be peaking. And discussions with brokers at conferences reflect that listings are up, but closings are down.

Whether this leads to some cap rate expansion remains to be seen, as research firms are forecasting that overall investment volume for 2017 will be similar to or maybe a little bit lower as compared to 2016. Regardless, our team will continue to monitor market conditions and actively investigate opportunities and 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 the physical construction on the 75,000-square-foot expansion to our Lear industrial facility in Vance, Alabama. The tenant is now completing the furnishing of the building. The lease term will reset to 10 years on or about June 1. The average cap rate over the new term for the entire 245,000-square-foot, $20 million investment is 10.4%. So very accretive for us. We also began design activities for the development of a 200,000-square-foot industrial facility for a tenant in New York. The new facility scheduled for completion in the second quarter of 2018 will be adjacent to the 120,000-square-foot industrial building that they currently occupy. The estimated total development cost is $12.6 million. Upon completion of the new facility, the leases will reset to 15 years for both buildings.

The average cap rate for the expansion will be about 8.9%, so also very accretive. No properties were acquired during the first quarter. We investigated numerous opportunities in our target markets, but we passed on multiple candidates because either the re-leasing risk was too great due to the tenant credit or building configuration or the estimated deferred maintenance and the near-term capital requirements were excessive. We're rolling into this expansion cycle and some sellers are motivated to take cash off the table and let the buyer assume these potentially near-term risks. That doesn't fit our model.

Now our team continues to have a strong pipeline of acquisition candidates exceeding about $350 million today. 18 properties and 11 of which are industrial where we're placing increased emphasis. We've been selected for one transaction at this time a 60,000-square-foot, $15 million multistory office property in Philadelphia. Now closing on this transaction is not guaranteed, but we're optimistic that it will be added to our portfolio during the June or July time frame. We also have 3 industrial properties in the letter of intent stage, value in excess of $50 million and the balance of the pipeline is under initial review.

As we've noted on our previous calls, the hallmark of our continuing high occupancy remains and will continue to remain thorough tenant credit underwriting and the mission-critical nature of the property. Location and configuration are also important. And over the past year -- 3 years, to promote this aspect of our strategy, we've invested in growth markets, including Phoenix, Salt Lake City twice, Denver 3x, Dallas 4x, Austin, Atlanta twice, South Florida, Philadelphia, Indianapolis and Columbus, Ohio twice. This emphasis on select markets will also improve our overall operating efficiency.

So our strategy is credit emphasis with an added focus on growth market locations.

Our asset management team continued our strong leasing performance. As noted, we leased the remaining space in our office property in Burnsville, Minnesota as well as the balance in a vacant space in our industrial property in Chicago. Both of these leases were for approximately 20,000 square feet and commenced in February. During 2015 and 2016, as I noted in our prior call, we successfully concluded 16 of 18 lease expirations, resulting in over 1 million square feet of leasing activity. Year-to-date, we have renewed 3 of the 5 expiring leases in 2017, representing 75% of expiring rents and have begun discussions with tenants whose leases expire in 2018. We have the three leases expiring in '18 and only two in 2019.

At this time, only 0.5% of our GAAP rents were expiring in '17 and 1.3% of our GAAP rents expire in 2018. Our team is focused on staying ahead the lease expirations and actively managing our properties. We only have one fully vacant property remaining today, and that is the property in Northeast Massachusetts, Newburyport, an 86,000-square-foot freezer/cooler industrial property. We have one full building prospect and one prospect for 50% of the building at this time.

We've also received and signed a letter of intent to sell the property as is. We will see how this unfolds over the next few months and in which direction we will proceed. As part of our portfolio rightsizing efforts to operate in cities we deem to have strong growth prospects, we sold one property during the quarter and one property subsequent to the end of the quarter. The overall capital gain from both transactions was approximately $5.8 million on book value. The initial capital investment was approximately $11.5 million. Both of these assets are considered noncore in our efforts to move out of smaller single-asset market and redeploy the proceeds in our target locations. Since January 2015, we have exited 8 single property markets as part of this capital recycling program.

As we reflect on our recent portfolio efforts, the better long-term news for our overall growth strategy, that only 4% of our forecasted rental income is expiring before 2020. So our cash rents should be stable and growing, and our occupancy should remain high even if economic conditions deteriorate. This is an important fact for our shareholders as the majority of our peers have a minimum of 20% and as high as nearly 50% of their leases expiring during the same period.

The majority of our capital availability will be used to pursue growth opportunity, because we do not anticipate needing significant capital for tenant improvements and leasing commissions to retain tenants and re-lease space or to fund operating deficits. Mike Sodo, our CFO, is going to expand upon our refinancing activities. But I think it's important to note that our refinancings continue to lower our loan-to-value, lower our annual interest cost, and the amount of debt maturing is already reduced significantly through 2017. This combination of our improving capital structure, our lower annual debt cost on our same-store properties, the rightsizing of our portfolio, and the opportunity to emphasize growth, positions us well in the current environment.

So in summary, our first quarter and year-to-date activities continued our leasing and investment success, and we refinanced maturing mortgages at lower interest rates. Our team continues to have a strong pipeline of acquisition candidates and will 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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Good morning. I'll start by reviewing our first quarter 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 was $9.7 million or $0.38 per share for the quarter, while this is a 4% increase totaling approximately 350,000 over the prior quarter, the per share number remains the same. This is a function of the increased common shares outstanding related to our opportunistic $14 million direct placement in December and our continued usage of our ATM program. This dry powder will assist us in funding the acquisition pipeline that was laid out by Bob.

Our first quarter results reflected an increase in total operating revenues to $22.3 million as compared to total operating expenses, excluding impairment charges of $14 million for the period. Net operating expenses at the property level declined by approximately $150,000 from the fourth quarter. In addition, we continue to reduce our interest expense by $100,000 from Q4 due to our gradual deleveraging and efficient loan refinancings.

As Bob mentioned, we did sell one noncore property during the quarter, the sale resulted in a gain of $5.9 million. Now let's look further into our debt activity and capital structure. We continue to have a strong balance sheet as we grow our assets and focus on decreasing our leverage. We've reduced our debt-to-growth assets to 51% from 57% at the beginning of 2016, through refinancing maturing mortgage debt at lower leverage levels and redeeming our Series C Preferred Stock, which was considered debt due to its mandatory redemption date.

We expect to continue to gradually decrease our leverage over the next 18 to 24 months. We continue to use primarily long-term mortgage debt as well as our line of credit to make acquisitions. As we grow through discipline investments, we'll look forward -- look to expand our unsecured property pool with additional good assets.

Over time, this will only increase our funding alternatives. As we managed our balance sheet, we repaid $35.4 million of maturing mortgage debt during the quarter with a combination of borrowings under our line of credit, cash on hand, equity and proceeds from our Franklin, New Jersey asset sale. Over the past 15 months, we repaid $115 million of debt primarily with new variable rate mortgages at interest rates equal to the 1-month LIBOR plus a spread, generally ranging from 2.35% to 2.75%. We've placed interest rate caps on all these new mortgages. We also added some of these properties to our unencumbered pool under our line of credit in an effort to provide more flexibility in the future. Prior to the refinancing, these mortgages had a weighted average interest rate of 6%. Our deleveraging and refinancing efforts have been a tremendous success with first quarter interest expense increasing by approximately 8.5% versus first quarter 2016. On an annual basis, this equates to a $2 million reduction in interest.

Looking at our upcoming maturities, we have only two balloon principal payments of $22.1 million payable during the remainder of 2017. These loans have a weighted average interest rate of 5.4%. We anticipate refinancing these maturities into new long-term debt or adding some of these properties to our asset pool under our line of credit. Either outcome should result in reduction of interest expense.

Long-term mortgage debt continues to be available at slightly higher rates than we've experienced in recent years. Interest rates have been volatile in the past 6 months. This has been a function of global uncertainty, changes in the government, including anticipation of further potential Federal Reserve rate hikes and the unknown future of the U.S. economy.

With all that said, interest rates do still remain retractively low from historical perspective and will continue to actively try to match our acquisitions with cost-effective debt. Depending on several factors, including tenant's credit, property type, location, terms of the lease, leverage, the amount and term of the loan, we're generally seeing interest rates in the 4% to 5% range.

Finally, I'll turn to our equity activity during the first quarter, which I referred to previously. We raised both common and Series D Preferred Equity under our ATM programs during the quarter for combined net proceeds of $4.6 million. We used these funds primarily for deleveraging the balance sheet and tenant improvements at certain of our properties. We continue to view the ATM as the most efficient way to deploy equity. Subsequent to quarter end, we issued another $5.9 million of equity through the collective ATM programs to support the acquisition pipeline.

As of today, our available liquidity is approximately $32.1 million comprised of $7.1 million in cash and an available borrowing capacity of $25 million under the line of credit. With our current availability and access to our ATM programs, we believe that we have enough liquidity to fund our current operations, deals in our pipeline and any known upcoming improvements at our properties. We encourage you to also review our quarterly financial supplement posted on the website, which does provide more detailed financial and portfolio information for quarter. We feel good about executing our business plan for the rest of year as we continue to increase our high-quality asset base and continue to improve our metrics inclusive of leverage. We're focused on maintaining our high occupancy with strong credit and real estate.

Institutional ownership of the stock increased by 13% over the past 15 months to over 53% as of the end of the first quarter. Certainly, some of this is a function of being included in the RMC Index last year. In addition, David, Bob and I have been extremely active in meeting with current potential institutional and retail investors, portfolio managers, investment banks and the like. Through these initiatives, David, Bob and I 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.

And now, I'll turn the program back to David.

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David J. Gladstone, Gladstone Commercial Corporation - Founder, Chairman and CEO [6]

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It was a good report, Mike. Thanks so much. And Bob Cutlip and Mike LiCalsi, good reports as well. Main news, again, is very similar. Raise common and preferred stock for future acquisitions. We have a nice list of potential acquisitions. Leased more vacant space that we have and repaid maturing loans or refinance them at lower interest rates and positioned ourselves for growth.

One item that Bob mentioned, which was the Alabama thing, explains our success in the marketplace and that we're willing to step up and help existing tenants, do most anything, including expanding plants. Obviously, we have to increase the rent we build on to it.

As many of you know, the company didn't cut its monthly cash distributions during the recession, that was quite a success story. We watched many very good REITs cut their distributions, most of them have never recovered, bringing their dividend back to their original level. And we're in a great position not to have a problem if the economy hits the skids again.

Here are some of the things that we're doing today. We need to continue to increase the common stock market place capitalization in order to increase the trading volumes. This will give the institutions who want to buy the stock the ability to do this. The institutions always say the same thing, they want to be able to buy $10 million, $20 million, $30 million worth of our stocks. So we need to be big enough to accommodate that. They also want to, obviously, sell some day, and so they want liquidity.

We continue to grow the company, but consistently, we built our assets and equity base doubling the size in the past 5 years. With this growth, we hope we'll see more buyers coming to the stock. And that should hopefully help increase the price and lower our cost of capital. And as they lower their cost of capital, obviously, we can buy different properties that we're precluded from buying today, because of their low cap rate. We're raising more preferred stock in the Series D, which is a 7% yield. We've a new web page in our website, at www.gladstonecommercial.com, that explains this preferred stock. We can't redeem it for 5 years. So it's very investor friendly. And I think that's the reason most of the institutions have piled into it. We have some very large institutions that have been buying that preferred stock. All of those names would be known to you, if you started to review them.

So we have interest in our company, and I don't think it'd be very long before many of those same institutions will be buying a lot of the common stock as well. We continue to have a promising list of potential quality properties. Doesn't mean we're going to jump on everyone that comes in. We are interested in acquiring even though we didn't acquire any during the quarter. We expect to continue to grow the asset portfolio even more during this year that we're in. With an increase in the portfolio of properties comes greater diversification. We believe that's better for our earnings -- better protection for the earning.

However, please note that the price is a good -- prices today to buy good buildings are very, very difficult, and it takes us a long time to find what we exactly want every time we buy something. We're focusing our efforts finding good properties, obviously, with long-term financing to match long-term leases. And this has been a hallmark of the company from day 1, is matching the long-term leases with long-term debt. And that keeps us out of trouble when banks get in trouble. Being able to lock in those long-term financings, a wonderful force in the future. Between 2017 and 2019, we only have about 4% of the forecasted rents expiring with manageable debt maturities along the way. We're much more optimistic that things are going to be positive for us over the next 4, 5 years. So stay with us. We like having all of our good shareholders ride with us during these times.

Much of the industrial base today is businesses that rent industrial and office properties like our properties, they remain steady. And most of them are paying their rents. So we don't see many defaults out there these days. As you know, we have a terrific credit underwriting group that underwrites each of our tenants. That's the reason we're able to go into some of the transactions that others don't. And considering the track record of our tenants paying their rent, I think it's hard to beat the fact that we do have a very bright future underwriting these tenants that we see.

It's this strong underwriting that kept the company more than 96% occupied from 2003 to today. While, I'm optimistic that our company will be fine in the future, I want to you know that all of us, Bob and I in particular, continue to be very conscious in the acquisitions that we're doing. Just to make sure, we don't have any problems just because we want to be bigger than we're today. We're not going out buying everything that hits the deck here.

We made it through the last recession without cutting the dividend, having a lot of problems from the tenants, and I think if there is another recession lurking on the horizon, portfolio will continue to be stand -- steady and strong as it has in the past. In April, the Board voted to maintain a monthly distribution of $0.125 per common share for April, May and June. That's an annual run rate of $1.50 for year. This is still a very attractive and well managed REIT like ours, that don't come along very everyday. So this is one of the few gems that are out there in the marketplace.

And, yes, I know, you always ask the same question, when are we going to increase the distributions? And all I can say is, at this point the FFO as it increases, we have to look at some small increases over time. We've now paid 147 consecutive common stock cash distributions. And we went through the recessions without missing any of those. It's just a wonderful track record. And because the real estate can be depreciated, all of you know, we're able to shelter the income. Last year, 71% of the payback was from return of capital. So this is a very tax friendly stock.

In my opinion, it's a good place to put in your personal account. You don't need to put it in your IRA or Keogh or any of those. This return on capital is mainly due to the depreciation of the real estate and other items and has caused earnings to remain low after depreciation. That's why we talk about FFO and core FFO, because it adds back the real estate depreciation. Most of you know, depreciation of a building is bit of a fiction anyway since at the end of the depreciation period, the building is usually still standing and still strong and usually rented. So it's a kind of [fictition] that goes on in the tax world. If you own a stock in a nonretirement account as opposed to having it in IRA or retirement plan, you don't pay any taxes on that part, it's sheltered. So the money is coming in, you're able to use it. However, of course, when you sell your stock, you're supposed to reduce your cost basis based on that amount that you got back and pay capital gains on hopefully a larger amount.

On Monday, the stock was about $22.08, distribution yields about 6.8%. Many of the other REITs are trading at much lower yields. The average triple-net REIT that is like us are at 5.6%. So we're way above that in yield. So the stocks trading at a yield -- if the stock was trading at a yield of 5.6%, we'd be at $26.78. That's what we're aiming for, is to get to the average and we're going to push hard to try to get there. In these calls, I've suggested you buy the stock because there was a projection that the company as it gets larger will trade like its peers. Some of the peers and most of the peers are trading at about 5.6%. For those of you who purchased the stock, you've seen the stock price increase, if we paid $150 per year in dividends. Now I'm going to tell you, you ought to go out and buy the stock again, because as we progress and the income increases based on our projections that we're looking at, any increase will put pressure on us to increase the dividend. No guarantee we're going to increase the dividend, but that's the goal. There's simply no reason a company like this REIT trades at such a high yield given the track record since 2003 and the low lease turnover during the next 4 years.

We have a great company. And when we were doing our preferred stock, we asked one of the rating agencies to rate us. And they rated us BBB, and the guy who was doing that said he had never seen a company that had only one bad deal since 2003. I know the analyst will say, you're well managed, but you're externally managed. And that means that you should be, I don't know, they get so upset about external management that they make me angry. Our high occupancy level is a testament to the access we have to these great credit underwriters. We are a REIT that looks first to the tenant to make sure they can pay the rent whereas most REITs look first to the real estate and more and more REITs are externally managed. So we are to get off of that. We also performed an analysis of cost of operating this REIT versus the REITs that are internally managed. And there is really no difference whereas the internally managed or externally managed. And as you know, as we get bigger, we've said that as we approach the $1 billion, we'd adjust the management contract, we did that. The management contract is now lower in terms of fee being paid. I just want to push on one more item of this external management. When the recession came, the internal REITs cut their dividend, we did not. And now because it's externally managed, we can cut the management fee if we need to.

During that period of time, we paid back. We didn't collect $18 million worth of dividends -- worth of fees that we should have collected, that is, we gave it back. And it was very easy to do that. And I just ask how many internally managed REITs had their marriages cut their salary in order to give money to stockholders like we did. My guess is none. So that's just another reason to be externally managed, because at that point, you can -- you can be able to cut your fee pretty easily. So keep in mind that using our ATM program, we're going to continue to grow the company. In the past years, because we're externally managed, we had high flexibility. We gave back $18 million worth about $0.72.

So I know a couple of you've called me and said, what are these articles that are out there? Well, the two articles that are out there from people who are shorting the stock. They're trying to knock down the stock so that they can make money. I would say to all of you, don't listen to the articles there. Making statements that are mostly false, and it just seems to me that anybody who is trying to make money or knocking the price of a share down is not a good person to be listening to. They're just in it for themselves. So now we'll have some questions from our shareholders and analysts, who follow this wonderful company. The operator, please come on, and we'll try to answer some questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) We will be taking our first question from the line of Dan Donlan from Ladenburg Thalmann.

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Daniel Paul Donlan, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research [2]

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David, all the talk in the external management agreement makes you think you must know I was in the queue.

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David J. Gladstone, Gladstone Commercial Corporation - Founder, Chairman and CEO [3]

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We still love you, Dan. Though you don't like external management, but we still love you.

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Daniel Paul Donlan, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research [4]

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Well, to be honest with you, David, at this point in time, given where you're trading at, although there clearly not -- doesn't seem to be an issue for investors. So our issue has always been that externally-advised REITs tend to trade at discounts to NAV and clearly, that's not the case now. Just wanted to move to kind of growth versus deleveraging. You've got a good cost to capital now with your equity, so I'm just curious, how you're looking to manage that? It's oftentimes kind of hard to grow when you're delevering, but given your comments about how far we are out in the recovery, I'm just kind of curious your -- how you weigh the two?

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David J. Gladstone, Gladstone Commercial Corporation - Founder, Chairman and CEO [5]

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Dan, as you know, I'm highly in favor of leverage. I have been in this business. And I think, because we don't have the kind of defaults and problems that others have had, that we've had this over 96% rented REIT for so long, that it's proved that what we're doing is not the high risk proposition that many REITs get into. And I don't disagree with what they're doing. They are going out trying to make a lot of money by building things and changing things. We're just sluggers. We're in there every day, buying companies, buying buildings that have companies that are just solid payers of rents. So we're building ours one brick at a time. And growth for us is dependent on what we see in the marketplace. If we find the right one, we're going to buy it. We are under -- Mike, under 50% levered now?

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Michael B. LiCalsi, Gladstone Commercial Corporation - General Counsel and Secretary [6]

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51% on a book basis.

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David J. Gladstone, Gladstone Commercial Corporation - Founder, Chairman and CEO [7]

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51% on a book basis. That's a nice number for me, Dan. I would like to not knock it down any more than that. As you know, during the last 3 or 4 years, we've been -- every time we refinance something, we borrowed less against the building even though it had probably gone up in value than we had before. So we had to put equity in. I'd like to stop doing that, but I'm going to follow Bob on this. And Bob has to live with his leverage and so do I. But I want to grow, and we're going to grow. It just won't grow as fast as someone would in this position. And I don't really want to delever beyond this, but Bob will probably delever it down in the 40s, so that he looks well when he is talking with people. He's out in the marketplace today. And one of the things people always say is, you are highly leveraged. Well, we're not highly leveraged if you look at the track record of the company. We've been able to pay our dividends. We've been able to do things that others haven't been able to do and given the strength of the portfolio, I just think deleveraging is a mistake. But Bob, you want to answer how you're going to deleverage?

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

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Sure. And Mike can add to this. I think, Mike and I have spoken with a lot of analysts, investment banks, investors, and we think that if we lower the leverage another 5% to 7%, maybe Mike, we think we are where we are. I mean, it's -- I think as David said, and what it's always -- and I had this conversation with you before Dan. What always impressed me when I -- before I joined this company was our ability to acquire properties with people who are long-term rent payers. And I think, our renewal percentage kind of supports that. And so yes, I think we can be a little bit higher leveraged. But for us to get, I think, more institutional coverage and to get even better multiples on our income, we're going to need to lower the bid. So 5% to 7% is where I think we're going to be going, Dan.

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Daniel Paul Donlan, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research [9]

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Okay. I appreciate the comments. And as we look at this kind of shifting to set future financings, how do you feel about unsecured versus secured debt? Lot of the bigger public REITs like to use unsecured, but it kind of does limit their ability to hand back buildings in the event something goes wrong. So just kind of curious how you're viewing that? And if you're going to continue to use more secured debt in order to protect yourself in the event of default or something like that?

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David J. Gladstone, Gladstone Commercial Corporation - Founder, Chairman and CEO [10]

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Yes, thanks, Dan, I will address that. I think, by and large, you will see us predominantly continue to use secured debt candidly. We've been watching the peers, appreciating how other people do use corporate debt, corporate unsecured debt. I would think it would be reasonable over time, as we grow the portfolio and some of those buckets of capital become more viable to a larger company, that you would see some gradual shift in terms of contemplation and execution on the unsecured side. But all of this is just going to be done on an organic level. We're not going to wake up one day and have a dramatically different balance sheet. So by and large, sticking to the Gladstone strategy, but probably with some trending toward being closer to our peer set from a desirable corporate execution.

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Daniel Paul Donlan, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research [11]

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Okay. I appreciate that. And then maybe, Bob, for you. As you look at your portfolio, you definitely seem to shift to more higher growth markets with your acquisitions since you've come on board. Just kind of curious, what percentage of the portfolio you may view as noncore? I mean, you've been an active seller over the last couple of years. When -- does that continue? And how do you see that trending?

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Robert G. Cutlip, Gladstone Commercial Corporation - President [12]

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Well, I think a lot of it's market driven. And there's a couple of factors that we look at. As David indicates, we want to grow the portfolio. Well, we can't go into a wholesale capital recycling program, and we don't need to because these tenants are good rent payers. But when we look at long-term operating efficiencies, we know that we need to reduce the number of markets that we're going to be operating in. Our goal and we stated in our business plan is for us to get down to 30 to 35 markets over time. We're now just under 50 markets. But it's going to be gradual, because we've already gone through renewals with a number of these smaller tenants. But as the opportunities present themselves and we can match acquisitions with the dispositions, we'll continue to slowly leave those markets. But it's going to be gradual. This is a marathon, it's not a sprint. And the team has done a great job of selling assets when it made sense. And we'll continue to do so. But it's not going to be aggressive, Dan, just because the quality of the cash flow is very good. But long term, to be a better operating company, we do need to be in fewer markets, and we will be.

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Daniel Paul Donlan, Ladenburg Thalmann & Co. Inc., Research Division - MD of Equity Research [13]

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Okay. Makes sense. And then just in terms of asset type, sounds like you continue to add to both office and industrial, is there any type of bend towards one or the other? Or it really just simply depends on the tenant credit and I hate to use the word "mission-critical," but maybe the importance of the asset to the tenant's underlying business?

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Robert G. Cutlip, Gladstone Commercial Corporation - President [14]

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Well, as David said, first and foremost, we look at the tenant. We spend a lot of time there, and we look at the mission-critical nature of the property. I mean, as he indicated, we only have 1 [BK] in the entire history of the company, approximately 100 tenants. So that is critical to us. I think from the standpoint of just looking purely real estate, we would like to move more towards industrial. And as I indicated in my comments, we are being able to see -- we are able to see more industrial now just because our cost of capital has dropped. And I would like to move that to more of a higher percentage on the industrial long term. But we're not going to be in a big rush to do it. The majority of our pipeline right now is industrial, because we can't operate in that space. But we will continue to be looking at mission-critical first. And if it's an office property, we will buy it.

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Operator [15]

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Our next question comes from the line of Larry Raiman from LDR Capital Management.

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Lawrence Raiman, [16]

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Nice job on the quarter to the team. Two quick questions. First, with regard to any maintenance capital expenditures in the portfolio. I know so many of your properties are net leased and there's not much lease role. But in terms of maintenance requirements at the company level regarding parking lots or roofs, could you guide folks with regard to how much money you spend in that activity?

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Robert G. Cutlip, Gladstone Commercial Corporation - President [17]

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Yes, this is Bob. And I can give you a macro right now, and Larry, I can give you some more specifics when I have access to it. But this year for both tenant improvements and capital for the buildings themselves, we're looking at about $7 million. And of that, it's about 50-50 with tenant improvements and building improvements. We have probably another $4.5 million of capital we're going to expend during the first half of the year relating to that expansion of the Lear facility. But you can probably anticipate that with the size of this company, our recurring cap improvements for us is probably $3 million to $4 million a year.

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Lawrence Raiman, [18]

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Just $3 million to $4 million a year for just building, maintaining, not reimbursed by the tenants? Is that correct?

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Robert G. Cutlip, Gladstone Commercial Corporation - President [19]

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That is correct. $3 million to $4 million. It's about -- it is probably closer to $3 million because some of our capital requirements on these buildings, we do get amortization of HVAC systems and roofs, depending upon how the lease is structured. Of course, we inherit the lease that is given to us when we buy the property.

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Lawrence Raiman, [20]

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Right. Okay. Thank you for that disclosure. And then one final question. There was a -- I saw on the income statement, that there was about a $3.7 million reserve taken for an asset, could you describe what happened there?

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David J. Gladstone, Gladstone Commercial Corporation - Founder, Chairman and CEO [21]

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Sure. And Larry, it's more further expanded within the footnotes of the financials, the impairment charges of $3.7 million were pertaining to the accounting assessment on two noncore properties within the portfolio. Obviously, appreciating there's an accounting exercise that goes along with that where you probability weight. Your sale scenario as well as the EBIT kind of cash flows for the remaining lease, clearly, within the accounting guidance, you don't get upside on any of you properties within your GAAP income statement. You take the downside. So these will be two properties that as of today we consider noncore. And it's just part of really the quarterly assessment of the entire portfolio.

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Lawrence Raiman, [22]

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And are those assets that are earmarked for sale at some point in the future?

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David J. Gladstone, Gladstone Commercial Corporation - Founder, Chairman and CEO [23]

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I wouldn't say, Bob, can you expand after I speak to it. I don't think that's a probable scenario, it's a possible scenario. But they would be ones that, potentially at the right price, we would certainly consider.

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Operator [24]

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(Operator Instructions) Looks like we have no other questioners in the queue at this time. So I'd like to turn the call back over to Mr. Gladstone for closing comments.

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David J. Gladstone, Gladstone Commercial Corporation - Founder, Chairman and CEO [25]

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All right. Thank you all for all the support you've given us, and just watch, we're going to keep going, keep growing. Thanks again. That's the end of this call.

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Operator [26]

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Ladies and gentlemen, thank you, again, for your participation in today's conference call. This does conclude the program. And you may now disconnect your phones at this time. Everyone, have a great day.