UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549 

FORM 10-Q

(Mark One)

 

 

GLADSTONE COMMERCIAL CORPORATION

FORM 10-Q FOR THE QUARTER ENDED

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

Gladstone Commercial Corporation

Condensed Consolidated Balance Sheets

(Dollars in Thousands, Except Share and Per Share Data)

(Unaudited) 

Gladstone Commercial Corporation

Condensed Consolidated Statements of Operations

(Dollars in Thousands, Except Share and Per Share Data)

(Unaudited) 

 

Gladstone Commercial Corporation

Condensed Consolidated Statements of Cash Flows

(Dollars in Thousands)

(Unaudited)

Gladstone Commercial Corporation

Notes to Condensed Consolidated Financial Statements (Unaudited)

1. Organization, Basis of Presentation and Significant Accounting Policies

Gladstone Commercial Corporation is a real estate investment trust or REIT,("REIT") that was incorporated under the General Corporation Law of the State of Maryland on February 14, 2003. We focus on acquiring, owning and managing primarily office and industrial properties. On a selective basis, we may make long term industrial and commercial mortgage loans; however, we do not have any mortgage loans currently outstanding. Subject to certain restrictions and limitations, our business is managed by Gladstone Management Corporation, a Delaware corporation, or the Adviser, and administrative services are provided by Gladstone Administration, LLC, a Delaware limited liability company, or the Administrator, each pursuant to a contractual arrangement with us. Our Adviser and Administrator collectively employ all of our personnel and pay their salaries, benefits, and general expenses directly. Gladstone Commercial Corporation conducts substantially all of its operations through a subsidiary, Gladstone Commercial Limited Partnership, a Delaware limited partnership, or the Operating Partnership.

All further references herein to “we,” “our,” “us” and the “Company”“us” mean Gladstone Commercial Corporation and its consolidated subsidiaries, except where it is made clear that the term means only Gladstone Commercial Corporation.

Interim Financial Information

Our interim financial statements are prepared in accordance with U.S. generally accepted accounting principles or GAAP,("GAAP") for interim financial information and pursuant to the requirements for reporting on Form 10-Q and in accordance with Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying annual financial statements prepared in accordance with GAAP are omitted. The year-end balance sheet data presented herein was derived from audited financial statements, but does not include all disclosures required by GAAP. In the opinion of our management, all adjustments, consisting solely of normal recurring accruals, necessary for the fair presentationstatement of financial statements for the interim period, have been included. The interim financial statements and notes thereto should be read in conjunction with the financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2015,2016, as filed with the U.S. Securities and Exchange Commission on February 17, 2016.15, 2017. The results of operations for the three and nine months ended September 30, 2016March 31, 2017 are not necessarily indicative of the results that may be expected for other interim periods or for the full fiscal year.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could materially differ from those estimates.

Critical Accounting Policies

The preparation of our financial statements in accordance with GAAP requires management to make judgments that are subjective in nature in order to make certain estimates and assumptions. Application of these accounting policies involves the exercise of judgment regarding the use of assumptions as to future uncertainties, and as a result, actual results could materially differ from these estimates. A summary of all of our significant accounting policies is provided in Note 1 to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2015.2016. There were no material changes to our critical accounting policies during the ninethree months ended September 30, 2016; however we issued mezzanine equity duringMarch 31, 2017.

Certain items on condensed consolidated statement of operations for the ninethree months ended September 30,March 31, 2016 which is further describedhave been reclassified to conform to the current period's presentation. These reclassifications had no impact on previously-reported equity, net loss, or net change in Note 10.cash and cash equivalents.

Recently Issued Accounting Pronouncements

In February 2016,2017, the FASB issued Accounting Standards Update 2017-05 ("ASU 2016-02, “Leases: Amendments2017-05") to provide guidance for recognizing gains and losses from the transfer of nonfinancial assets and in-substance non-financial assets in contracts with non-customers, unless other specific guidance applies. The standard requires a company to derecognize nonfinancial assets once it transfers control of a distinct nonfinancial asset or distinct in substance nonfinancial asset. Additionally, when a company transfers its controlling interest in a nonfinancial asset, but retains a noncontrolling ownership interest, the company is required to measure any non-controlling interest it receives or retains at fair value. The guidance requires companies to recognize a full gain or loss on the transaction. As a result of the new guidance, the guidance specific to real estate sales in ASC 360-20 will be eliminated, and partial sales of real estate assets will now be subject to the FASB Accounting Standards Codification” (“ASU 2016-02”),same derecognition model as all other nonfinancial assets. The amendments to the nonfinancial asset guidance are effective at the same time an entity adopts the new standard requires lessees to apply a dual approach, classifying leases as either finance or operating leases basedrevenue guidance. We are in the process of evaluating the impact of this new guidance on the principle of whether or not the lease is effectively a financed purchase by the lessee. This classification will determine whether lease expense is recognized based on an effective interest method or on a straight line basis over the term of the lease, respectively. A lessee is also required to record a right-of-use asset and a lease liability for all leases with a term of greater than 12 months regardless of their classification. Leases with a term of 12 months or less will be accounted for similar to existing guidance for operating leases today. The new standard requires lessors to account for leases using an approach that is substantially equivalent to existing guidance for sales-type leases, direct financing leases and operating leases. ASU 2016-02 is expected to minimally impact our consolidated financial statements as we currently have four operating ground lease arrangements for which we are the lessee. We also expect our legal expense to increase as the new standard requires us to expense indirect leasing costs that were previously capitalized to leasing commissions. ASC 2016-02 supersedes the previous leases standard, ASC 840 Leases.statements. The standard is effective on January 1, 2019, with early adoption permitted. 

2. Related-Party Transactions

Gladstone Management and Gladstone Administration

We are externally managed pursuant to contractual arrangements with our Adviser and our Administrator, which collectively employ all of our personnel and pay their salaries, benefits, and general expenses directly. Both our Adviser and Administrator are affiliates of ours, as their parent company is owned and controlled by Mr. David Gladstone, our chairman and chief executive officer. Two of our executive officers, Mr. Gladstone and Mr. Terry Brubaker (our vice chairman and chief operating officer) serve as directors and executive officers of our Adviser and our Administrator. Our president, Mr. Robert Cutlip, is an executive managing director of our Adviser. Mr. Michael LiCalsi, our general counsel and secretary, serves as our Administrator’s president.president, general counsel and secretary. We have an advisory agreementAdvisory Agreement (as defined below) with our Adviser and an administration agreement with our Administrator, or the Administration Agreement. The services and fees under the advisory agreementAdvisory Agreement and Administration Agreement are described below. At September 30, 2016March 31, 2017 and December 31, 2015, $2.02016, $2.1 million and $1.9$2.1 million, respectively, was collectively due to our Adviser and Administrator.

Base Management Fee

As a result of the July 1, 2015 amendment, the calculation of the annual base management fee equals 1.5% of our adjusted total stockholders’ equity, which is our total stockholders’ equity (before giving effect to the base management fee and incentive fee), adjusted to exclude the effect of any unrealized gains or losses that do not affect realized net income (including impairment charges) and adjusted for any one-time events and certain non-cash items (the later to occur for a given quarter only upon the approval of our Compensation Committee). The fee is calculated and accrued quarterly as 0.375% per quarter of such adjusted total stockholders’ equity figure. EffectiveAs a result of the July 1, 2016 amendment, the definition of adjusted total stockholders' equity in the calculation of the base management fee and the incentive fee (described below) includes total mezzanine equity. AllOur Adviser does not charge acquisition or disposition fees when we acquire or dispose of properties, as is common in other provisions remained unchanged.

For the three and nine months ended September 30,March 31, 2017 and 2016, we recorded a base management fee of $1.1$1.2 million, and $2.8 million, respectively, and for the three and nine months ended September 30, 2015, we recorded a base management fee of $0.9 million, and $2.6 million, respectively.

Incentive Fee

As a result of the July 1, 2015 amendment, the calculation of the incentive fee was revised to reward the Adviser in circumstances where our quarterly Core FFO (defined at the end of this paragraph), before giving effect to any incentive fee, or pre-incentive fee Core FFO, exceeds 2.0% quarterly, or 8.0% annualized, of adjusted total stockholders’ equity (after giving effect to the base management fee but before giving effect to the incentive fee), orfee, and which, as a result of the hurdle amount. Effective July 1, 2016 amendment to the definition of adjusted total stockholders' equityAdvisory Agreement, now includes total mezzanine equity.equity). We refer to this as the new hurdle rate. The Adviser will receive 15.0% of the amount of our pre-incentive fee Core FFO that exceeds the new hurdle amount.rate. However, in no event shall the incentive fee for a particular quarter exceed by 15.0% (the cap) the average quarterly incentive fee paid by us for the previous four quarters (excluding quarters for which no incentive fee was paid). Core FFO (as defined in the Advisory Agreement) is GAAP net income (loss) available to common stockholders, excluding the incentive fee, depreciation and amortization, any realized and unrealized gains, losses or other non-cash items recorded in net income (loss) available to common stockholders for the period, and one-time events pursuant to changes in GAAP.

The incentive fee prior to the July 1, 2015 our then-existing advisory agerementamendment rewarded the Adviser in circumstances where our quarterly funds from operations, or FFO, before giving effect to any incentive fee, or pre-incentive fee FFO, exceeded 1.75%, or 7.0% annualized, or the hurdle rate, of common stockholders’ equity. Funds from operations, or FFO, included any realized capital gains and capital losses, less any distributions paid on preferred stock and Senior Common Stock, but FFO did not include any unrealized capital gains or losses (including impairment charges). The Adviser received 100.0% of the amount of the pre-incentive fee FFO that exceeded the hurdle rate, but was less than 2.1875% of our common stockholders’ equity. The Adviser also received an incentive fee of 20.0% of the amount of our pre-incentive fee FFO that exceeded 2.1875% of common stockholders’ equity.

Capital Gain Fee

Under the Advisory Agreement, as amended in July 2015, we will pay to the Adviser a capital gains-based incentive fee that will be calculated and payable in arrears as of the end of each fiscal year (or upon termination of the agreement)Advisory Agreement). In determining the capital gain fee, we will calculate aggregate realized capital gains and aggregate realized capital losses for the applicable time period. For this purpose, aggregate realized capital gains and losses, if any, equals the realized gain or loss calculated by the difference between the sales price of the property, less any costs to sell the property and the current gross value of the property (which is calculated as the original acquisition price plus any subsequent non-reimbursed capital improvements). At the end of the fiscal year, if this number is positive, then the capital gain fee payable for such time period shall equal 15.0% of such amount. No capital gain fee was recognized during the three and nine months ended September 30, 2016March 31, 2017 or 2015.2016.

Termination Fee

As a result of the July 2015 amendment, the Advisory Agreement includes a termination fee whereby, in the event of our termination of the agreementthereof without cause (with 120 days’ prior written notice and the vote of at least two-thirds of our independent directors), a termination fee would be payable to the Adviser equal to two times the sum of the average annual base management fee and incentive fee earned by the Adviser during the 24-month period prior to such termination. A termination fee is also payable if the Adviser terminates the agreementAdvisory Agreement after the Company haswe have defaulted and applicable cure periods have expired. The agreementAdvisory Agreement may also be terminated for cause by us (with 30 days’ prior written notice and the vote of at least two-thirds of our independent directors), with no termination fee payable. Cause is defined in the agreement to include if the Adviser breaches any material provisions of the agreement,thereof, the bankruptcy or insolvency of the Adviser, dissolution of the Adviser and fraud or misappropriation of funds.

Administration Agreement

Under the terms of the Administration Agreement, we pay separately for our allocable portion of the Administrator’s overhead expenses in performing servicesits obligations to us including, but not limited to, rent and our allocable portion of the salaries and benefits expenses of its personnel,our Administrator's employees, including, but not limited to, our chief financial officer, treasurer, chief compliance officer, general counsel and secretary (who also serves as our Administrator’s president)president, general counsel and secretary), and their respective staffs. Our allocable portion of the Administrator’s expenses isare generally derived by multiplying our Administrator’sAdministrator's total expenses by the approximate percentage of time the Administrator’sAdministrator's employees perform services for us in relation to their time spent performing services for all companies serviced by our Administrator under contractual agreements. For the three and nine months ended September 30,March 31, 2017 and 2016, we recorded an administration fee of $0.3$0.4 million and $1.1$0.4 million, respectively, and for the three and nine months ended September 30, 2015, we recorded an administration fee of $0.3 million and $1.1 million, respectively. Our Board of Directors reviews and considers approving or renewing the agreement with our Administrator each July.

Gladstone Securities

Gladstone Securities, LLC, or Gladstone Securities, is a privately held broker dealer registered with the Financial Industry Regulatory Authority and insured by the Securities Investor Protection Corporation. Gladstone Securities is an affiliate of ours, as its parent company is owned and controlled by Mr. David Gladstone, our chairman and chief executive officer. Mr. Gladstone also serves on the board of managers of Gladstone Securities.

We entered into an agreement with Gladstone Securities, effective June 18, 2013, for it to act as our non-exclusive agent to assist us with arranging mortgage financing for properties we own. In connection with this engagement, Gladstone Securities maywill, from time to time, continue to solicit the interest of various commercial real estate lenders or recommend to us third party lenders offering credit products or packages that are responsive to our needs. We pay Gladstone Securities a financing fee in connection with the services it provides to us for securing mortgage financing on any of our properties. The amount of these financing fees, which are payable upon closing of the financing, are based on a percentage of the amount of the mortgage, generally ranging from 0.15% to a maximum of 1.0% of the mortgage obtained. The amount of the financing fees may be reduced or eliminated, as determined by us and Gladstone Securities, after taking into consideration various factors, including, but not limited to, the involvement of any third party brokers and market conditions. We paiddid not pay financing fees to Gladstone Securities of $0.05 million and $0.2during the three months ended March 31, 2017 but paid Gladstone Securities $0.08 million during the three and nine months ended September 30,March 31, 2016, respectively, which are included in mortgage notes payable, net, in the condensed consolidated balance sheets, or 0.28% and 0.36%0.43% of total mortgagesmortgage principal secured. We paid financing fees to Gladstone Securities of $0.02 million and $0.2 million during the three and nine months ended September 30, 2015, respectively, which are included in mortgage notes payable, net, in the condensed consolidated balance sheets, or 0.3% of total mortgages secured in each period. Our Board of Directors renewed the agreement for an additional year, through August 31, 2017, at its July 2016 meeting.

3. LossEarnings per Share of Common Stock

The following tables set forth the computation of basic and diluted lossearnings (loss) per share of common stock for the three and nine months ended September 30,March 31, 2017 and 2016, and 2015, respectively. We computed basic lossearnings (loss) per share for the three and nine months ended September 30,March 31, 2017 and 2016, and 2015, respectively, using the weighted average number of shares outstanding during the periods. Diluted lossearnings (loss) per share for the three and nine months ended September 30,March 31, 2017 and 2016, and 2015, reflects additional shares of common stock related to our convertible senior common stockSenior Common Stock (if the effect would be dilutive), that would have been outstanding if dilutive potential shares of common stock had been issued, as well as an adjustment to net income available to common stockholders as applicable to common stockholders that would result from their assumed issuance (dollars in thousands, except per share amounts).

 

4. Real Estate and Intangible Assets

Real Estate

The following table sets forth the components of our investments in real estate as of September 30, 2016March 31, 2017 and December 31, 2015,2016, respectively, excluding real estate held for sale as of September 30, 2016March 31, 2017 and December 31, 2015,2016, respectively (dollars in thousands):

 

Real estate depreciation expense on building and tenant improvements was $6.1$6.4 million and $17.9$5.9 million for the three and nine months ended September 30,March 31, 2017 and 2016, respectively, and $5.7 million and $16.4 million for the three and nine months ended September 30, 2015, respectively.

Significant Real Estate Activity on Existing Assets

During the ninethree months ended September 30,March 31, 2017 and 2016, we executed seven leases,zero and one lease, respectively, which are summarizedis aggregated below (dollars in thousands):

 

 

The following table summarizes the carrying value of intangible assets, liabilities and the accumulated amortization for each intangible asset and liability class as of September 30, 2016March 31, 2017 and December 31, 2015,2016, excluding real estate held for sale as of September 30, 2016March 31, 2017 and December 31, 2015,2016, respectively (in thousands):

Total amortization expense related to in-place leases, leasing costs and customer relationship lease intangible assets was $3.4$3.5 million and $9.9$3.3 million for the three and nine months ended September 30,March 31, 2017 and 2016, respectively, and $3.3 million and $9.7 million for the three and nine months ended September 30, 2015, respectively, and is included in depreciation and amortization expense in the condensed consolidated statement of operations.

Total amortization related to above-market lease values was $0.1 million and $0.4 million for both the three and nine months ended September 30,March 31, 2017 and 2016, respectively, and $0.1 million and $0.3 million for the three and nine months ended September 30, 2015, respectively, and is included in rental revenue in the condensed consolidated statement of operations. Total amortization related to below-market lease values was $0.3 million and $0.7$0.2 million for the three and nine months ended September 30,March 31, 2017 and 2016, respectively, and $0.2 million and $0.7 million for the three and nine months ended September 30, 2015, respectively, and is included in rental revenue in the condensed consolidated statement of operations.

5. Real Estate Dispositions, Held for Sale and Impairment Charges

Real Estate Dispositions

During the three months ended March 31, 2017, we completed the salecontinued to execute our capital recycling program, whereby we opportunistically sold properties outside of our Dayton, Ohio property for $0.2 million. There was no gain or loss recognized on this sale. We considered this office asset to be non-core to our long term strategy,core markets and we re-deployed theredeployed proceeds to pay downfund property acquisitions in our target secondary growth markets, as well as repay outstanding debt. During the three months ended March 31, 2017, we sold one non-core property, which is summarized below (dollars in thousands):

Our disposition during the sale of our property located in Rock Falls, Illinois, and our two properties located in Angola, Indiana for an aggregate of $3.0 million and recognized a loss of $0.02 million. We considered these industrial assets to be non-core to our long term strategy, and we re-deployed the proceeds to pay down outstanding debt.

The table below summarizes the components of operating income from the real estate and related assets disposed of during the three and nine months ended September 30,March 31, 2017, and 2016, and 2015, respectively (dollars in thousands):

(1) Includes a $0.6$5.9 million impairment chargegain on sale of our Dayton, OhioFranklin, New Jersey property.

Real Estate Held for Sale

During the three months ended March 31, 2017, we had one property classified five properties (located in Montgomery, Alabama, Hazelwood, Missouri, Syracuse, New York, Toledo, Ohio and South Hadley, Massachusetts)as held for sale. We considered the property classified as held for sale underduring the provisionsthree months ended March 31, 2017 to be non-core to our long term strategy. The one property classified as held for sale during the three months ended March 31, 2017 was sold subsequent to the end of ASC 360-10, “Property, Plant,the quarter, and Equipment.” ASC 360-10 requires that thewe recognized a loss of $0.1 million. The assets and liabilities of any such properties, bethe one property classified as held for sale are presented separately in our condensed consolidated balance sheet in the current period presented, and that we cease recording depreciation and amortization expense. We consider all fiveas of these assets to be non-core to our long term strategy. We have executed sales agreements for the Montgomery, Alabama, Hazelwood, Missouri, and Toledo, Ohio properties, and are actively looking for buyers for the Syracuse, New York and South Hadley, Massachusetts properties. We anticipate the Hazelwood, Missouri property sale will close during second quarter 2017, and we currently anticipate the remaining four properties to sell during the fourth quarter 2016.March 31, 2017.

Our assets classified as held for sale during the three months ended March 31, 2017 were not classified as discontinued operations because they do not represent a strategic shift in our operations, nor will they have a major effect on our operations and financial results.

The table below summarizes the components of income from real estate and related assets held for sale (dollars in thousands):

 

The table below summarizes the components of the assets and liabilities held for sale reflected on the accompanying condensed consolidated balance sheet (dollars in thousands):

 

Impairment Charges

We performed an evaluation and analysis of our entire portfolio to determine if any of our held and used assets were impaired during the three months ended March 31, 2017 and identified two held and used assets which potentially were impaired during March 2017. For these properties, during March 2017, we received unsolicited interest from potential buyers, and as a result, we included a sale scenario and shortened our hold period when comparing the undiscounted cash flows against the respective carrying values. Based upon our analysis, we concluded that the undiscounted cash flows for these properties were below their respective carrying values indicating that these assets were impaired as of March 31, 2017. Therefore we recorded $3.7 million in impairment charges to adjust the carrying value for both assets to fair market value. We evaluated both properties for held for sale classification, and concluded that these assets did not qualify, and both properties were classified as held and used assets as of March 31, 2017.

Fair market value for these assets was calculated using Level 3 inputs, which were determined using comparable asset sale data from the respective asset locations. We continue to evaluate our properties on a quarterly basis for changes that could create the need to record impairment. Future impairment losses may result, and could be significant, should market conditions deteriorate in the markets in which we hold our assets or we are unable to secure leases at terms that are favorable to us, which could impact the estimated cash flow of our properties over the period in which we plan to hold our properties. Additionally, changes in management's decisions to either long-term own and lease or sell a particular asset will have an impact on this analysis.

As part of our held for sale process, we perform an analysis of all properties and recorded impairment charges of $1.8 million and $2.0 millionclassified as held for sale during the three and nine months ended September 30, 2016,March 31, 2017, and $0.6 millioncompare the fair market value of the asset less selling costs against the carrying value of assets available for bothsale. We did not record any impairment related to our held for sale assets during the three and nine months ended September 30, 2015, respectively. March 31, 2017.

We recognized impairment charges of $0.04 million on our Dayton, Ohio property and $0.02 million on our Angola, Indiana and Rock Falls, Illinois properties, which were sold during the nine months ended September 30, 2016. We also recognized $0.2 million, $0.7 million and $1.1$0.4 million of impairment charges on our Montgomery, Alabama, Hazelwood, Missouri and South Hadley, Massachusetts properties, respectively, which are allone property during the three months ended March 31, 2016. This property was classified as held for sale in the accompanying condensed consolidated balance sheet, during the ninethree months ended September 30, 2016. We recognized impairment on these assets as the hold period for these assets was shortened when they met the definition ofMarch 31, 2016, and through our held for sale.

The fair values for the above properties wereheld for sale property was calculated using Level 3 inputs which were calculated using an estimated sales price, less estimated costs to sell. The estimated sales price was determined using an executed purchase and sale agreement, auction house price ranges and real estate broker guidance.agreement.

6. Mortgage Note Receivable

On July 25, 2014, we closed a $5.6 million second mortgage development loan for the construction of an 81,371 square foot, build-to-suit transitional care facility located on a major hospital campus in Phoenix, Arizona. Subsequently, on April 14, 2015, we closed an additional $0.3 million interim financing loan for the development of the Phoenix, Arizona property. Construction was completed in July 2015 and we earned 9.0% interest, paid currently in cash, on the loan during construction and through maturity. Prior to completion of the facility, we were granted a right of first offer to purchase the property at fair value. We elected not to purchase the property, and received an exit fee upon maturity of the loan in an amount sufficient for us to earn an internal rate of return of 22.0% on the second mortgage development loan, inclusive of interest earned. The principal balance of the loans and all associated interest income and exit fee revenue was received in January 2016. We recognized no interest income or exit fee revenue during the three months ended March 31, 2017. We recognized $0.4 million in both cash interest income and exit fee revenue during the ninethree months ended September 30, 2016. We recognized $0.3 million and $0.8 million, respectively, in both cash interest income and exit fee revenue during the three and nine months ended September 30, 2015, respectively. The principal balance of the loans and all associated interest and exit fee revenue was received in JanuaryMarch 31, 2016. We currently have no mortgage notes receivable outstanding.

7. Mortgage Notes Payable Line ofand Credit and Term Loan Facility

Our mortgage notes payable and line of creditCredit Facility as of September 30, 2016March 31, 2017 and December 31, 20152016 are summarized below (dollars in thousands):