Gladstone Commercial Corporation Annual report pursuant to Section 13 and 15(d)

Annual report pursuant to Section 13 and 15(d)

Real Estate and Intangible Assets

Real Estate and Intangible Assets

12 Months Ended

Dec. 31, 2016

Real Estate

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



	December 31, 2016			December 31, 2015
Real estate:
Land	$	104,719		$	97,117
Building and improvements	662,661			635,728
Tenant improvements	54,369			47,532
Accumulated depreciation	(131,661		)	(112,243		)
Real estate, net	$	690,088		$	668,134

Real estate depreciation expense on building and tenant improvements was $24.1 million, $22.2 million, and $18.8 million for the years ended December 31, 2016, 2015, and 2014 respectively.

Acquisitions

Certain acquisitions during the year ended December 31, 2016, were accounted for as business combinations in accordance with Accounting Standards Codification ("ASC") 805, as there was a prior leasing history on the property. The fair value of all assets acquired and liabilities assumed were determined in accordance with ASC 805, and all acquisition-related costs were expensed as incurred. Commencing in the fourth quarter of 2016, we early adopted ASU 2017-01 "Clarifying the Definition of a Business," which narrows the scope of transactions that would be accounted under ASC 805 Business Combinations. Under ASU 2017-01, if substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single identifiable asset or a group of similar identifiable assets, the grouping is not a business, and rather an asset acquisition. Our fourth quarter 2016 acquisition has been deemed an asset acquisition when evaluated under the new guidance, and all acquisition-related costs have been capitalized.

During the year ended December 31, 2016 and 2015 we acquired three and six properties, respectively, which are summarized below (dollars in thousands):



Year Ended		Aggregate Square Footage	Weighted Average Lease Term	Aggregate Purchase Price		Acquisition Costs		Aggregate Annualized GAAP Rent		Aggregate Debt Issued
December 31, 2016	(1)	329,620	10.5 Years	$	66,570	$	179	$	5,589	$	38,800
December 31, 2015	(2)	520,053	9.9 Years	$	77,798	$	586	$	7,984	$	43,379

(1) On May 26, 2016 we acquired a 107,062 square foot property in Salt Lake City, UT for $17.0 million. We borrowed $9.9 million to fund the acquisition. The annualized GAAP rent on the 6 years lease is $1.4 million. On September 12, 2016 we acquired a 119,224 square foot property in Fort Lauderdale, FL for $23.9 million. We borrowed $14.1 million to fund the acquisition. The annualized GAAP rent on the 9 years lease is $2.0 million. On December 14, 2016 we acquired a 103,334 square foot property in King of Prussia, PA for $25.7 million, including $0.2 million of acquisition-related costs that were allocated among the identifiable assets acquired. These acquisition-related costs are not included in the aggregated costs in the table above. We borrowed $14.8 million to fund the acquisition. The annualized GAAP rent on the 15 years lease is $2.2 million. Our King of Prussia, PA acquisition in the fourth quarter was accounted for as an asset acquisition under ASC 360.

(2) On March 6, 2015 we acquired a 155,984 square foot property in Richardson, TX for $24.7 million. We borrowed $14.6 million to fund the acquisition. The annualized GAAP rent on the 9.5 years lease is $2.7 million. On March 20, 2015 we acquired a 30,850 square foot property in Birmingham, AL for $3.6 million. The annualized GAAP rent on the 8.5 years lease is $0.3 million. On May 28, 2015 we acquired a 78,033 square foot property in Columbus, OH for $7.7 million. We borrowed $4.5 million to fund the acquisition. The annualized GAAP rent on the 15 years lease is $0.6 million. On May 29, 2015 we acquired a 86,409 square foot property in Salt Lake City, UT for $22.2 million. We borrowed $13.0 million to fund the acquisition. The annualized GAAP rent on the 6.5 years lease is $2.4 million. On July 15, 2015 we acquired a 78,151 square foot property in Atlanta, GA for $13.0 million. We borrowed $7.5 million to fund the acquisition. The property is fully leased to one tenant through two leases, with 30% of the building leased for 15 years and the remainder leased for 7 years. The annualized GAAP rent on the leases is $1.3 million. On October 20, 2015 we acquired a 90,626 square foot property in Villa Rica, GA for $6.6 million. We borrowed $3.8 million to fund the acquisition. The annualized GAAP rent on the 18 years lease is $0.6 million.

We determined the fair value of assets acquired and liabilities assumed related to the properties acquired during the year ended December 31, 2016 and 2015, respectively, as follows (dollars in thousands):



Business Combinations
	Year ended December 31, 2016			Year ended December 31, 2015
Acquired assets and liabilities	Purchase price			Purchase price
Land	$	7,125		$	10,528
Building and improvements	22,934			42,652
Tenant Improvements	3,240			6,996
In-place Leases	3,355			7,410
Leasing Costs	1,437			4,338
Customer Relationships	3,090			5,408
Above Market Leases	—			1,712
Below Market Leases	(281		)	(1,246		)
Total Purchase Price	$	40,900		$	77,798

Asset Acquisitions
	Year ended December 31, 2016			Year ended December 31, 2015
Acquired assets and liabilities	Purchase price			Purchase price
Land	$	3,681		$	—
Building and improvements	11,682			—
Tenant Improvements	4,057			—
In-place Leases	2,669			—
Leasing Costs	1,987			—
Customer Relationships	1,406			—
Above Market Leases	188			—
Total Purchase Price	$	25,670		$	—

Total Purchase Price on all Acquisitions	$	66,570		$	77,798

Below is a summary of the total revenue and earnings recognized on the 2, 6 and 11 asset acquisitions treated as business combinations completed during the years ended December 31, 2016, 2015, and 2014 respectively (dollars in thousands):



	For the year ended December 31, 2016			For the year ended December 31, 2015			For the year ended December 31, 2014
Rental Revenue	$	1,462		$	4,919		$	5,605
Earnings	(162		)	(63		)	36

Pro Forma

The following table reflects pro-forma consolidated statements of operations as if the business combinations acquired through December 31, 2016, were acquired as of January 1, 2015, and the properties acquired during 2015, were acquired as of January 1, 2014. The pro-forma earnings for the years ended December 31, 2016, 2015 and 2014 were adjusted to assume that the acquisition-related costs were incurred as of the beginning of the comparative period (dollars in thousands, except per share amounts):



	For the year ended December 31,
	(unaudited)
	2016			2015			2014
Operating Data:
Total operating revenue	$	88,304		$	89,720		$	87,439
Total operating expenses	(56,697		)	(54,480		)	(66,052		)
Other expenses	(27,429		)	(31,014		)	(26,014		)
Net income (loss)	4,178			4,226			(4,627		)
Dividends attributable to preferred and senior common stock	(7,656		)	(5,101		)	(4,636		)
Net loss attributable to common stockholders	$	(3,478	)	$	(875	)	$	(9,263	)
Share and Per Share Data:
Basic and diluted loss per share of common stock - pro forma	$	(0.15	)	$	(0.04	)	$	(0.54	)
Basic and diluted loss per share of common stock - actual	$	(0.16	)	$	(0.07	)	$	(0.61	)
Weighted average shares outstanding-basic and diluted	23,193,962			21,159,597			17,253,503

Significant Real Estate Activity on Existing Assets

During the year ended December 31, 2016 and 2015, we executed 9 and 15 leases, respectively, which are aggregated below (dollars in thousands):



Year Ended	Aggregate Square Footage	Weighted Average Lease Term		Aggregate Annualized GAAP Rent		Aggregate Tenant Improvement		Aggregate Leasing Commissions
December 31, 2016	551,335	3.9 Years	(1)	$	2,478	$	1,244	$	436
December 31, 2015	890,092	7.3 Years	(2)	$	7,514	$	2,881	$	1,925


(1)	Weighted average lease term is weighted according to the annualized GAAP rent earned by each lease. Our leases have terms ranging from 1 year to 7.7 years.


(2)	Weighted average lease term is weighted according to the annualized GAAP rent earned by each lease. Our leases have terms ranging from 1 year to 12.4 years.

On May 31, 2016, we reached a legal settlement with the previous tenant on one property to compensate us for deferred capital obligations and repairs they were required to perform during their tenancy. We recognized $0.3 million, recorded in other income on the consolidated statement of operations, related to reimbursed deferred capital obligations, and received $0.9 million as a reimbursement of repairs incurred during the year ended December 31, 2016 in connection with the legal settlement received, which was recorded net against operating expenses on the consolidated statement of operations.

Future Lease Payments

Future operating lease payments from tenants under non-cancelable leases, excluding tenant reimbursement of expenses and excluding real estate held for sale as of December 31, 2016, for each of the five succeeding fiscal years and thereafter is as follows (dollars in thousands):



Year	Tenant Lease Payments
2017	$	84,787
2018	85,509
2019	86,273
2020	78,683
2021	69,827
Thereafter	275,938
	$	681,017

In accordance with the lease terms, substantially all operating expenses are required to be paid by the tenant; however, we would be required to pay operating expenses on the respective properties in the event the tenants fail to pay them.

Intangible Assets

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



	December 31, 2016						December 31, 2015
	Lease Intangibles			Accumulated Amortization			Lease Intangibles			Accumulated Amortization
In-place leases	$	71,482		$	(28,182	)	$	66,244		$	(22,679	)
Leasing costs	48,000			(18,599		)	44,360			(14,774		)
Customer relationships	50,252			(17,400		)	46,485			(14,722		)
	$	169,734		$	(64,181	)	$	157,089		$	(52,175	)
	Deferred Rent Receivable/(Liability)			Accumulated (Amortization)/Accretion			Deferred Rent Receivable/(Liability)			Accumulated (Amortization)/Accretion
Above market leases	$	10,479		$	(7,296	)	$	10,176		$	(6,818	)
Below market leases and deferred revenue	(21,606		)	8,959			(17,951		)	8,294
	$	(11,127	)	$	1,663		$	(7,775	)	$	1,476

Total amortization expense related to in-place leases, leasing costs and customer relationship lease intangible assets was $13.4 million, $13.1 million, and $10.1 million for the years ended December 31, 2016, 2015, and 2014, respectively, and is included in depreciation and amortization expense in the consolidated statement of operations.

Total amortization related to above-market lease values was $0.5 million, $0.4 million, and $0.3 million for the years ended December 31, 2016, 2015, and 2014, respectively, and is included in rental revenue in the consolidated statement of operations.

Total amortization related to below-market lease values was $1.2 million, $0.9 million, and $0.7 million for the years ended December 31, 2016, 2015, and 2014, respectively, and is included in rental revenue in the consolidated statement of operations.

The weighted average amortization periods in years for the intangible assets acquired and liabilities assumed during the years ended December 31, 2016 and 2015, respectively, were as follows:



Intangible Assets & Liabilities	2016	2015
In-place leases	11.5	13.0
Leasing costs	11.5	13.0
Customer relationships	15.8	17.5
Above market leases	5.2	18.6
Below market leases	7.9	13.5
All intangible assets & liabilities	12.5	14.3

The estimated aggregate amortization expense to be recorded for in-place leases, leasing costs and customer relationships for each of the five succeeding fiscal years and thereafter is as follows, excluding real estate held for sale as of December 31, 2016 (dollars in thousands):



Year	Estimated Amortization Expense of In-Place Leases, Leasing Costs and Customer Relationships
2017	$	15,522
2018	15,459
2019	15,451
2020	13,827
2021	11,879
Thereafter	33,415
	$	105,553

The estimated aggregate rental income to be recorded for the amortization of both above and below market leases for each of the five succeeding fiscal years and thereafter is as follows, excluding real estate held for sale as of December 31, 2016 (dollars in thousands):



Year	Net Increase to Rental Income Related to Above and Below Market Leases
2017	$	743
2018	743
2019	743
2020	797
2021	705
Thereafter	5,594
	$	9,325

(1) Does not include ground lease amortization of $139.