Summary
Triple net REITs are traded in direct proportion to their leverage.
While the market is correct to take leverage into account, it is ignoring other factors such as organic growth rate.
GOOD’s industrial focus bodes well for future growth and it should trade at a higher multiple.
This idea was discussed in more depth with members of my private investing community, Portfolio Income Solutions. Learn More »
imaginima/E+ via Getty Images The Buy Thesis
Gladstone Commercial ( GOOD ) has materially improved its quality in terms of balance sheet, property type, growth, and dividend coverage, yet it still trades at discounted valuation relative to peers. GOOD is now positioned for stability and growth which I believe warrants a significantly higher multiple than the 13.5X at which it trades. Reasonably flat pricing
Over the past 10 years, GOOD has returned 202%, but the majority of that has been the dividend. Source: SNL Financial
The market price went from $17.01 to $23.31, so just 37% of that 202% was from price appreciation. This relative lack of price growth in a market that has been up materially has left GOOD’s multiple behind a bit. Source: SNL Financial
The bars above are quarterly snapshots of P/FFO. It stands today at 13.5X.
Prima facie, the lack of multiple growth is justified by the lack of FFO/share growth. Source: SNL Financial
GOOD appears to have been fundamentally stagnant for the last 10 years and it would be correct to trade a stagnant company at approximately 13.5X.
I would posit, however, that GOOD has been improving markedly. It has gone through a metamorphosis changing from a struggling overleveraged REIT barely covering its dividend to a strong REIT positioned for growth.
This quality improvement just hasn’t shown up in the headline numbers….. yet. From struggle to prosperity
FFO/share is a great metric, but it is only comparable when looking at the same quality of FFO.
FFO generated by properties that are going to grow net operating income in the future is functionally worth more than the same amount of FFO from properties that are not growing or will require capex.
Similarly, a company can generate more FFO/share by operating at high leverage. However, since that comes with more risk, each dollar of FFO should be valued lower.
These sorts of quality changes within a REIT often go unnoticed because they are masked by the headline number.
If we look at just FFO/share, GOOD has been stagnant for 10 years, but if we dig a bit deeper, it is clear that GOOD has improved quality across the board. Specifically, I want to touch on 3 areas: > Balance sheet Property type Forward organic growth rate To see the improvement, it helps to know where it started.Gladstone Commercial was far too levered heading into the financial crisis. Many of the REITs that entered the crisis at 70%-80% debt+preferred to enterprise value did not make it out and most certainly did not maintain their dividend.It was only by extremely strong tenant selection that GOOD was able to make it through. Occupancy remained remarkably high and tenants paid rent consistently. I attribute this resilience in the face of overleverage and a brutal crisis to the proprietary credit underwriting of the Gladstone Management team.Even with strong property level performance, they were not out of the woods when the crisis ended.Debt was still too high and the dividend was barely covered by FFO. To make matters worse, leases were starting to expire in droves and office properties do not re-lease well. They often require massive amounts of capex and tenants have negotiating power on lease terms.Factoring in leasing capex, the dividend was not covered for a few years exiting the crisis.Most management teams/boards would have cut the dividend, but David Gladstone is a different kind of man. He holds the dividend as sacred. He chose to maintain the dividend even as the financial crisis gave the world’s best excuse to cut it.He was also averse to the idea of paying an uncovered dividend, so to make up the difference between AFFO and the $1.50 dividend, management voluntarily waived a significant portion of their paycheck. This still stands out in my mind as one of the greatest acts of alignment between management and shareholders. (And it came from an externally managed REIT!)At first, they had to forgo a significant amount of compensation to keep FFO/share at $1.50, but as economic fundamentals improved, they waived less and less until the company could still earn $1.50 with normal G&A expense.Beyond the […]
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