Gladstone Commercial: 8% Yield, 83% Payout, Strategic Portfolio Shift (NASDAQ: GOOD)

Gladstone Commercial Corporation (NASDAQ: GOOD) is a well-managed commercial real estate trust with significant investments in office and industrial properties.

Gladstone Commercial solidly covered its dividend with funds from operations and collected 100% of rent in cash in the second quarter. In my view, it is the industrial angle that makes Gladstone Commercial a promising investment property for passive income investors.

Given Gladstone Commercial’s 83% dividend payout ratio in the second quarter, I see no increased risk to the REIT’s 8% dividend yield.

The stock also sells at a compelling FFO multiple, and Gladstone Commercial’s greater reliance on industrial properties could be a catalyst for FFO growth as well as a greater margin of safety going forward.

My rating history

My last stock rating for Gladstone Commercial was Buy. The trust has solid dividend paying values ​​and is performing quite well in terms of rent collection.

The focus on industrial properties also helps skew the risk/reward relationship in favor of confidence, in my view, and I think the industrial segment is benefiting from industry tailwinds. The 8% dividend yield also looks sustainable for the rest of 2024.

Portfolio and Rent Collection

Gladstone Commercial’s real estate portfolio consists primarily of office and industrial properties, which the company leases to corporations in 27 states (it also owned a small number of properties in the retail and medical office markets).

The real estate investment trust owned 136 properties as of June 30, 2024, reflecting 16.8 million square feet, which were primarily leased to tenants in the automotive, diversified services, real estate and telecommunications industries.

Gladstone Commercial has implemented a strategic policy to increase its industrial real estate footprint (at the expense of offices) amid more positive supply and demand dynamics in the industrial market.

The office real estate market is under considerable pressure, with people’s ability to work from home negatively affecting office occupancy.

Industrial properties, on the other hand, are benefiting from restoration initiatives as well as strong growth driven by the e-commerce industry.

As of June 30, 2024, Gladstone Commercial was producing 62% of annual rent from its industrial real estate portfolio, up 15 percentage points from 2020 when the pandemic hit. The real estate investment trust has set a target of increasing this percentage to 70% in the next 18 months.

As industrial properties are in high demand, Gladstone Commercial could see an acceleration in FFO growth in the coming quarters, which could also improve the trust’s dividend safety margin.

Gladstone Commercial’s second quarter showed a fall in funds from operations on a year-on-year basis, which was due to the real estate investment trust selling non-core real estate properties in an attempt to remove office risks from its portfolio. In 2Q24, core funds from Gladstone Commercial’s operations fell 12% year-over-year to $14.6 million.

In the near term, the real estate investment may continue to sell office properties and invest the proceeds in industrial properties, and therefore passive income investors should anticipate a decline in the trust’s FFO base.

In the long term, however, I think this strategy makes sense for Gladstone Commercial as the office market continues to struggle and the industrial market sees increasing demand for properties.

Dividend coverage

Gladstone Commercial earned $0.36 per share in core funds from operations in the second quarter, down 12% from last year, mainly due to the divestment of non-core office buildings. The business development company paid a stable value of $0.30 per share in T224 (the dividend is paid monthly), which equates to a dividend payout ratio of 83.3%. Dividends, based on current fund operations with rolling rates, are well covered by FFO.

While I don’t see the dividend at risk of being cut based on current dividend payout values, a further shift to industrials could increase the margin of safety for confidence going forward. Industrial real estate is in high demand, particularly from the e-commerce industry, indicating strong asset utilization and positive FFO growth.

Cheap FFO multiple

The commercial real estate investment trust has annualized potential core FFO of $1.39 per share based on LTM funds from operations and $1.44 per share based on 2Q24 operating rate funds.

Given that the stock is currently selling for $14.67, the valuation implies an underlying FFO multiple of 10.3x. STAG Industrial Inc. (STAG)which is a pure-play industrial REIT, sells for 16.2x underlying funds with 2Q24 run rates from operations. STAG is also benefiting from increased real estate investment in warehouses and distribution centers due to the global growth of the e-commerce industry.

From a valuation point of view, I prefer Gladstone Commercial. However, if greater exposure to industrial property is essential to you, STAG Industrial might be the better choice for you.

Why the investment thesis might not pan out

Gladstone Commercial still has office exposure and there is a risk, as we have suggested, that the trust’s funds from operations may continue to fall due to short-term non-core asset sales.

That said, though, I don’t think passive income investors need to lose sleep here over the dividend, which is well covered by FFO and has been so consistent over the past four quarters.

My conclusion

Gladstone Commercial collected 100% of its rent in cash in the second quarter (as well as in July) and had no problem covering its $0.30 per share dividend with funds from operations. Even with a 12% year-over-year decline in core funds from operations, the dividend was well covered.

The trust has also set its sights on growing its industrial holdings at the expense of its office holdings, meaning Gladstone Commercial is more than likely to sell more property, which in the short term may trigger a further decrease in core funds from operations.

In the long run, however, this strategy should pay off as industrial real estate assets are in higher demand and have stronger income potential. Buy.