e10vq
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER: 0-50363
GLADSTONE COMMERCIAL CORPORATION
(Exact name of registrant as specified in its charter)
     
MARYLAND   02-0681276
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer Identification No.)
1521 WESTBRANCH DRIVE, SUITE 200
MCLEAN, VIRGINIA 22102

(Address of principal executive office)
(703) 287-5800
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes þ  No o.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
             
Large accelerated filer o    Accelerated filer þ    Non-accelerated filer   o
(Do not check if a smaller reporting company)
  Smaller reporting company o 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No þ .
The number of shares of the registrant’s Common Stock, $0.001 par value, outstanding as of October 31, 2008 was 8,565,264.
 
 

 


 

GLADSTONE COMMERCIAL CORPORATION
TABLE OF CONTENTS
         
    PAGE  
PART I   FINANCIAL INFORMATION
       
 
       
Item 1. Financial Statements (Unaudited)
       
 
       
Consolidated Balance Sheets as of September 30, 2008 and December 31, 2007
    3  
 
       
Consolidated Statements of Operations for the three and nine months ended September 30, 2008 and 2007
    4  
 
       
Consolidated Statements of Cash Flows for the nine months ended September 30, 2008 and 2007
    5  
 
       
Notes to Consolidated Financial Statements
    6  
 
       
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
    22  
 
       
Item 3. Quantitative and Qualitative Disclosures about Market Risk
    33  
 
       
Item 4. Controls and Procedures
    34  
 
       
PART II OTHER INFORMATION
       
 
       
Item 1. Legal Proceeding
    35  
 
       
Item 1A. Risk Factors
    35  
 
       
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    36  
 
       
Item 3. Defaults Upon Senior Securities
    36  
 
       
Item 4. Submission of Matters to a Vote of Security Holders
    36  
 
       
Item 5. Other Information
    36  
 
       
Item 6. Exhibits
    36  
 
       
SIGNATURES
    38  

2


 

GLADSTONE COMMERCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS
(Unaudited)
                 
    September 30, 2008     December 31, 2007  
ASSETS
               
Real estate, net
  $ 367,715,344     $ 324,761,772  
Lease intangibles, net
    32,467,191       28,989,556  
Mortgage notes receivable
    10,000,000       10,000,000  
Cash and cash equivalents
    3,064,675       1,356,408  
Restricted cash
    2,637,531       1,914,067  
Funds held in escrow
    1,988,558       1,401,695  
Deferred rent receivable
    6,667,829       5,094,799  
Deferred financing costs, net
    4,752,282       4,405,129  
Prepaid expenses and other assets
    989,645       979,263  
 
           
 
               
TOTAL ASSETS
  $ 430,283,055     $ 378,902,689  
 
           
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
 
               
LIABILITIES
               
Mortgage notes payable
  $ 255,425,225     $ 202,120,471  
Short-term loan and borrowings under line of credit
    30,200,000       24,400,000  
Deferred rent liability
    3,343,863       3,933,035  
Asset retirement obligation liability
    2,155,341       1,811,752  
Accounts payable and accrued expenses
    514,222       778,949  
Due to adviser (Refer to Note 2)
    1,231,722       784,301  
Obligation under capital lease
    232,301        
Rent received in advance, security deposits and funds held in escrow
    3,600,768       2,706,113  
 
           
 
               
Total Liabilities
    296,703,442       236,534,621  
 
           
 
               
STOCKHOLDERS’ EQUITY
               
Redeemable preferred stock, $0.001 par value; $25 liquidation preference; 2,300,000 shares authorized and 2,150,000 shares issued and outstanding
    2,150       2,150  
Common stock, $0.001 par value, 47,700,000 shares authorized and 8,565,264 shares issued and outstanding
    8,565       8,565  
Additional paid in capital
    170,640,979       170,640,979  
Notes receivable — employees
    (2,629,846 )     (2,769,923 )
Distributions in excess of accumulated earnings
    (34,442,235 )     (25,513,703 )
 
           
 
               
Total Stockholders’ Equity
    133,579,613       142,368,068  
 
           
 
               
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
  $ 430,283,055     $ 378,902,689  
 
           
The accompanying notes are an integral part of these consolidated financial statements.

3


 

GLADSTONE COMMERCIAL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
                                 
    For the three months ended September 30,     For the nine months ended September 30,  
    2008     2007     2008     2007  
Operating revenues
                               
Rental income
  $ 10,157,553     $ 8,024,305     $ 29,269,036     $ 22,834,663  
Interest income from mortgage notes receivable
    216,446       255,555       673,548       758,333  
Tenant recovery revenue
    83,144       80,648       253,495       230,851  
 
                       
Total operating revenues
    10,457,143       8,360,508       30,196,079       23,823,847  
 
                       
 
                               
Operating expenses
                               
Depreciation and amortization
    3,262,903       2,668,383       9,435,690       7,722,349  
Property operating expenses
    225,020       204,972       670,442       597,273  
Base management fee (Refer to Note 2)
    404,108       459,202       1,255,833       1,412,337  
Incentive fee (Refer to Note 2)
    793,787       677,104       2,300,286       1,896,677  
Administration fee (Refer to Note 2)
    238,241       175,852       724,978       592,996  
Professional fees
    117,857       118,371       362,584       442,479  
Insurance
    43,354       53,943       126,947       171,275  
Directors fees
    54,702       66,250       161,202       174,750  
Stockholder related expenses
    42,232       40,991       271,430       215,969  
Asset retirement obligation expense
    35,157       29,440       98,394       86,542  
General and administrative
    105,999       17,452       139,151       79,119  
 
                       
Total operating expenses before credit from Adviser
    5,323,360       4,511,960       15,546,937       13,391,766  
 
                       
 
                               
Credit to incentive fee (Refer to Note 2)
    (205,876 )     (526,991 )     (941,928 )     (1,746,564 )
 
                       
Total operating expenses
    5,117,484       3,984,969       14,605,009       11,645,202  
 
                       
 
                               
Other income (expense)
                               
Interest income from temporary investments
    4,559       33,105       20,796       325,390  
Interest income — employee loans
    49,624       52,728       152,620       169,608  
Other income
    7,500       9,896       56,493       28,127  
Interest expense
    (4,258,461 )     (2,920,270 )     (12,008,316 )     (8,137,343 )
 
                       
Total other expense
    (4,196,778 )     (2,824,541 )     (11,778,407 )     (7,614,218 )
 
                       
 
                               
Income from continuing operations
    1,142,881       1,550,998       3,812,663       4,564,427  
 
                       
 
                               
Discontinued operations
                               
(Loss) income from discontinued operations
    (1,322 )     5,975       (34,956 )     471  
Net realized income from foreign currency transactions
          33,487             33,550  
Taxes refunded on sale of real estate
                      78,667  
 
                       
Total discontinued operations
    (1,322 )     39,462       (34,956 )     112,688  
 
                       
 
                               
Net income
    1,141,559       1,590,460       3,777,707       4,677,115  
 
                       
 
                               
Dividends attributable to preferred stock
    (1,023,437 )     (1,023,438 )     (3,070,312 )     (3,070,312 )
 
                       
 
                               
Net income available to common stockholders
  $ 118,122     $ 567,022     $ 707,395     $ 1,606,803  
 
                       
 
                               
Earnings per weighted average common share — basic & diluted
                               
Income from continuing operations (net of dividends attributable to preferred stock)
  $ 0.01     $ 0.07     $ 0.08     $ 0.18  
Discontinued operations
    0.00       0.00       0.00       0.01  
 
                       
 
                               
Net income available to common stockholders
  $ 0.01     $ 0.07     $ 0.08     $ 0.19  
 
                       
Weighted average shares outstanding- basic & diluted
    8,565,264       8,565,264       8,565,264       8,565,264  
 
                       
The accompanying notes are an integral part of these consolidated financial statements.

4


 

GLADSTONE COMMERCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
                 
    For the nine months ended September 30,  
    2008     2007  
Cash flows from operating activities:
               
Net income
  $ 3,777,707     $ 4,677,115  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    9,435,690       7,722,349  
Amortization of deferred financing costs
    806,075       509,990  
Amortization of deferred rent asset and liability, net
    (399,049 )     (399,051 )
Accretion of obligation under capital lease
    7,234        
Asset retirement obligation expense
    98,394       86,542  
Decrease (increase) in prepaid expenses
    (110,382 )     28,815  
Increase in deferred rent receivable
    (1,763,153 )     (1,247,345 )
Increase in accounts payable, accrued expenses, and amount due adviser
    182,694       516,996  
Increase in rent received in advance
    171,191       137,534  
 
           
Net cash provided by operating activities
    12,206,401       12,032,945  
 
           
 
               
Cash flows from investing activities:
               
Real estate investments
    (48,935,032 )     (85,742,539 )
Receipts from lenders for reserves held in escrow
    630,033       1,007,684  
Payments to lenders for reserves held in escrow
    (1,216,896 )     (1,010,385 )
Increase in restricted cash
    (723,464 )     (275,696 )
Deposits on future acquisitions
    (1,650,000 )     (1,310,000 )
Deposits applied against real estate investments
    1,750,000       1,610,000  
 
           
Net cash used in investing activities
    (50,145,359 )     (85,720,936 )
 
           
 
Cash flows from financing activities:
               
Borrowings under mortgage notes payable
    48,015,000       32,521,691  
Principal repayments on mortgage notes payable
    (1,171,849 )     (599,328 )
Principal repayments on employee notes receivable from sale of common stock
    140,077       400,598  
Borrowings from line of credit
    62,600,000       24,200,000  
Repayments on line of credit
    (56,800,000 )     (4,200,000 )
Receipts from tenants from reserves
    1,746,804       1,446,577  
Payments to tenants from reserves
    (1,555,146 )     (1,311,406 )
Increase in security deposits
    531,806       140,525  
Payments for deferred financing costs
    (1,153,228 )     (770,761 )
Dividends paid for common and preferred
    (12,706,239 )     (12,320,797 )
 
           
Net cash provided by financing activities
    39,647,225       39,507,099  
 
           
 
Net increase (decrease) in cash and cash equivalents
    1,708,267       (34,180,892 )
 
Cash and cash equivalents, beginning of period
    1,356,408       36,005,686  
 
 
           
Cash and cash equivalents, end of period
  $ 3,064,675     $ 1,824,794  
 
           
 
NON-CASH OPERATING, INVESTING AND FINANCING INFORMATION
               
 
Additions to real estate included in accounts payable, accrued expenses, and amount due adviser
  $     $ 409,000  
 
           
 
Increase in asset retirement obligation
  $ 245,195     $ 150,523  
 
           
 
Fixed rate debt assumed in connection with acquisitions
  $ 6,461,603     $ 4,506,689  
 
           
The accompanying notes are an integral part of these consolidated financial statements.

5


 

GLADSTONE COMMERCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Organization and Significant Accounting Policies
Gladstone Commercial Corporation (the “Company”) is a Maryland corporation that operates in a manner so as to qualify as a real estate investment trust (“REIT”) for federal income tax purposes and was incorporated on February 14, 2003 under the General Corporation Law of Maryland, primarily for the purpose of engaging in the business of investing in real estate properties net leased to creditworthy entities and making mortgage loans to creditworthy entities. Subject to certain restrictions and limitations, the business of the Company is managed by Gladstone Management Corporation, a Delaware corporation (the “Adviser”).
Subsidiaries
The Company conducts substantially all of its operations through a subsidiary, Gladstone Commercial Limited Partnership, a Delaware limited partnership, (the “Operating Partnership”). As the Company currently owns all of the general and limited partnership interests of the Operating Partnership through GCLP Business Trust I and II as disclosed below, the financial position and results of operations of the Operating Partnership are consolidated with those of the Company.
Gladstone Commercial Partners, LLC, a Delaware limited liability company (“Commercial Partners”) and a subsidiary of the Company, was organized to engage in any lawful act or activity for which a limited liability company may be organized in Delaware. Commercial Partners has the power to make and perform all contracts and to engage in all activities to carry out the purposes of the Company, and all other powers available to it as a limited liability company. As the Company currently owns all of the membership interests of Commercial Partners, the financial position and results of operations of Commercial Partners are consolidated with those of the Company.
Gladstone Lending, LLC, a Delaware limited liability company (“Gladstone Lending”), and a subsidiary of the Company, was created to conduct all operations related to real estate mortgage loans of the Company. As the Operating Partnership currently owns all of the membership interests of Gladstone Lending, the financial position and results of operations of Gladstone Lending are consolidated with those of the Company.
Gladstone Commercial Advisers, Inc., a Delaware corporation (“Commercial Advisers”) and a subsidiary of the Company, is a taxable REIT subsidiary (“TRS”), which was created to collect all non-qualifying income related to the Company’s real estate portfolio. It is currently anticipated that this income will predominately consist of fees received by the Company related to the leasing of real estate. There have been no such fees earned to date. Since the Company owns 100% of the voting securities of Commercial Advisers, the financial position and results of operations of Commercial Advisers are consolidated with those of the Company.
GCLP Business Trust I and GCLP Business Trust II, subsidiaries of the Company, each are business trusts formed under the laws of the Commonwealth of Massachusetts on December 28, 2005. The Company transferred its 99% limited partnership interest in the Operating Partnership to GCLP Business Trust I in exchange for 100 trust shares. Commercial Partners transferred its 1% general partnership interest in the Operating Partnership to GCLP Business Trust II in exchange for 100 trust shares.

6


 

Interim financial information
Interim financial statements of the Company are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying annual financial statements prepared in accordance with GAAP are omitted. In the opinion of management, all adjustments, consisting solely of normal recurring accruals, necessary for the fair statement of financial statements for the interim period have been included.
Investments in real estate
The Company records investments in real estate at cost and capitalizes improvements and replacements when they extend the useful life or improve the efficiency of the asset. The Company expenses costs of repairs and maintenance as incurred. The Company computes depreciation using the straight-line method over the estimated useful life of 39 years for buildings and improvements, five to seven years for equipment and fixtures and the shorter of the useful life or the remaining lease term for tenant improvements and leasehold interests.
The Company accounts for its acquisitions of real estate in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations,” which requires the purchase price of real estate to be allocated to the acquired tangible assets and liabilities, consisting of land, building, tenant improvements, long-term debt and identified intangible assets and liabilities, consisting of the value of above-market and below-market leases, the value of in-place leases, the value of unamortized lease origination costs, the value of tenant relationships and the value of capital lease obligations, based in each case on their fair values.
Management’s estimates of value are made using methods similar to those used by independent appraisers (e.g., discounted cash flow analysis). Factors considered by management in its analysis include an estimate of carrying costs during hypothetical expected lease-up periods considering current market conditions, and costs to execute similar leases. The Company also considers information obtained about each property as a result of its pre-acquisition due diligence, marketing and leasing activities in estimating the fair value of the tangible and intangible assets and liabilities acquired. In estimating carrying costs, management also includes real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, which primarily range from nine to eighteen months, depending on specific local market conditions. Management also estimates costs to execute similar leases, including leasing commissions, legal and other related expenses to the extent that such costs are not already incurred in connection with a new lease origination as part of the transaction.
The Company allocates purchase price to the fair value of the tangible assets of an acquired property by valuing the property as if it were vacant. The “as-if-vacant” value is allocated to land, building, and tenant improvements based on management’s determination of the relative fair values of these assets. Real estate depreciation expense on these tangible assets was approximately $2.3 million and $6.7 million for the three and nine months ended September 30, 2008, respectively, and approximately $1.8 million and $5.2 million for the three and nine months ended September 30, 2007, respectively.
Above-market and below-market in-place lease values for owned properties are recorded based on the present value (using an interest rate which reflects the risks associated with the leases acquired) of the difference between (i) the contractual amounts to be paid pursuant to the in-place leases and (ii) management’s estimate of fair market lease rates for the corresponding in-place leases, measured over a period equal to the remaining non-cancelable term of the lease. The capitalized above-market lease values, included in the accompanying balance sheet as part of deferred rent receivable, are amortized as a reduction of rental income over the remaining non-cancelable terms of the respective leases. Total amortization related to above-market lease values was $63,374 and $190,123 for the three and nine months ended September 30, 2008 and 2007, respectively. The capitalized below-market lease values, included in the accompanying balance sheet as deferred rent liability, are amortized as an increase to rental income over the remaining non-cancelable terms of the respective leases. Total amortization related to below-market lease values was $196,391 and $589,173 for the three and nine months ended September 30, 2008 and 2007, respectively.

7


 

The total amount of the remaining intangible assets acquired, which consist of in-place lease values, unamortized lease origination costs, and customer relationship intangible values, are allocated based on management’s evaluation of the specific characteristics of each tenant’s lease and the Company’s overall relationship with that respective tenant. Characteristics to be considered by management in allocating these values include the nature and extent of our existing business relationships with the tenant, growth prospects for developing new business with the tenant, the tenant’s credit quality and expectations of lease renewals (including those existing under the terms of the lease agreement), among other factors.
The value of in-place leases and unamortized lease origination costs are amortized to expense over the remaining term of the respective leases, which generally range from 10 to 15 years. The value of customer relationship intangibles, which is the benefit to the Company resulting from the likelihood of an existing tenant renewing its lease, are amortized to expense over the remaining term and any anticipated renewal periods in the respective leases, but in no event does the amortization period for intangible assets exceed the remaining depreciable life of the building. Should a tenant terminate its lease, the unamortized portion of the above-market and below-market lease values, in-place lease values, unamortized lease origination costs and customer relationship intangibles will be charged to expense. Total amortization expense related to these intangible assets was approximately $0.9 million and $2.8 million for the three and nine months ended September 30, 2008, respectively, and approximately $0.8 million and $2.5 million for the three and nine months ended September 30, 2007, respectively.
Impairment
Investments in Real Estate
The Company accounts for the impairment of real estate in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which requires that the Company periodically review the carrying value of each property to determine if circumstances that indicate impairment in the carrying value of the investment exist or that depreciation periods should be modified. If circumstances support the possibility of impairment, the Company prepares a projection of the undiscounted future cash flows, without interest charges, of the specific property and determines if the investment in such property is recoverable. If impairment is indicated, the carrying value of the property would be written down to its estimated fair value based on the Company’s best estimate of the property’s discounted future cash flows. There have been no impairments recognized on real estate assets in the Company’s history.
Provision for Loan Losses
The Company’s accounting policies require that it reflect in its financial statements an allowance for estimated credit losses with respect to mortgage loans it has made based upon its evaluation of known and inherent risks associated with its private lending assets. Management reflects provisions for loan losses based upon its assessment of general market conditions, its internal risk management policies and credit risk rating system, industry loss experience, its assessment of the likelihood of delinquencies or defaults, and the value of the collateral underlying its investments. Actual losses, if any, could ultimately differ from these estimates. There have been no provisions for loan losses in the Company’s history.
Cash and cash equivalents
The Company considers all short-term, highly liquid investments that are both readily convertible to cash and have a maturity of three months or less at the time of purchase to be cash equivalents; except that any such investments purchased with funds held in escrow or similar accounts are classified as restricted cash. Items classified as cash equivalents include money-market deposit accounts. All of the Company’s cash and cash equivalents at September 30, 2008 were held in the custody of one financial institution, and the Company’s balance at times may exceed federally insurable limits. The Company mitigates this risk by depositing funds with major financial institutions.

8


 

Restricted cash
Restricted cash consists of security deposits and funds held in escrow for certain tenants. The funds held in escrow are for capital improvements, taxes, insurance and other replacement reserves for certain of our tenants. These funds will be released to the tenants upon completion of agreed upon tasks as specified in the lease agreements, mainly consisting of maintenance and repairs on the buildings, and when evidence of insurance and tax payments has been submitted to the Company.
Funds held in escrow
Funds held in escrow consist of funds held by certain of the Company’s lenders for properties held as collateral by these lenders. These funds consist of replacement reserves for capital improvements, repairs and maintenance, insurance and taxes. These funds will be released to the Company upon completion of agreed upon tasks as specified in the mortgage agreements, mainly consisting of maintenance and repairs on the buildings, and when evidence of insurance and tax payments has been submitted to the lenders.
Deferred financing costs
Deferred financing costs consist of costs incurred to obtain financing, including legal fees, origination fees, and administrative fees. The costs are deferred and amortized using the straight-line method, which approximates the effective interest method over the term of the financing secured. The Company made payments of $1,096,766 and $1,153,228 for deferred financing costs during the three and nine months ended September 30, 2008, respectively, and $82,736 and $770,761 for the three and nine months ended September 30, 2007, respectively. Total amortization expense related to deferred financing costs was $300,318 and $806,075 for the three and nine months ended September 30, 2008, respectively, and $176,817 and $509,990 for the three and nine months ended September 30, 2007, respectively. Accumulated amortization was $2,990,567 and $2,184,492 as of September 30, 2008 and December 31, 2007, respectively.
Prepaid expenses and other assets
Prepaid expenses and other assets consist of accounts receivable, interest receivable, prepaid assets and deposits on real estate.
Obligation under capital lease
In conjunction with the Company’s acquisition of a building in Fridley, Minnesota on February 26, 2008, it was assigned a ground lease on the parking lot of the building at the time of closing, which had a purchase obligation to acquire the land under the ground lease at the end of the term, April 1, 2014. In accordance with SFAS No. 13 “Accounting for Leases,” the Company accounted for the ground lease as a capital lease and recorded the corresponding obligation under the capital lease.
Revenue recognition
Rental revenue includes rents that each tenant pays in accordance with the terms of its respective lease reported evenly over the non-cancelable term of the lease. Certain of the Company’s leases currently contain rental increases at specified intervals. We recognize such revenues on a straight-line basis by averaging the non-cancelable rental revenues over the lease terms. Deferred rent receivable in the accompanying balance sheet includes the cumulative difference between rental revenue as recorded on a straight line basis and rents received from the tenants in accordance with the lease terms, along with the capitalized above-market lease values of certain acquired properties. Accordingly, the Company determines, in its judgment, to what extent the deferred rent receivable applicable to each specific tenant is collectible. The Company reviews deferred rent receivable, as it relates to straight line rents, on a quarterly basis and takes into consideration the tenant’s payment history, the financial condition of the tenant, business conditions in the industry in which the tenant operates and economic conditions in the area in which the property is located. In the event that the collectibility of deferred rent with respect to any given tenant is in doubt, the Company records an increase in the allowance for uncollectible accounts or records a direct write-off of the specific rent receivable, which would have an adverse effect on the net income for the year in which the reserve is increased or the direct write-off is recorded and would decrease total assets and stockholders’ equity. No such reserves have been recorded as of September 30, 2008.

9


 

Management considers its loans and other lending investments to be held-for-investment. The Company reflects held-for-investment investments at amortized cost, less allowance for loan losses, acquisition premiums or discounts, and deferred loan fees. On occasion, the Company may acquire loans at small premiums or discounts based on the credit characteristics of such loans. These premiums or discounts are recognized as yield adjustments over the lives of the related loans. Loan origination fees, as well as direct loan origination costs, are also deferred and recognized over the lives of the related loans as yield adjustments. If loans with premiums, discounts, or loan origination fees are prepaid, the Company immediately recognizes the unamortized portion as a decrease or increase in the prepayment gain or loss. Interest income is recognized using the effective interest method applied on a loan-by-loan basis. Prepayment penalties or yield maintenance payments from borrowers are recognized as additional income when received.
Certain of the Company’s mortgage loans and leases have embedded derivatives in the form of interest rate floors and ceilings. These embedded derivatives do not require separate accounting under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”
Income taxes
The Company has operated and intends to continue to operate in a manner that will allow it to qualify as a REIT under the Internal Revenue Code of 1986, as amended, and accordingly will not be subject to federal income taxes on amounts distributed to stockholders (except income from foreclosure property), provided it distributes at least 90% of its REIT taxable income to its stockholders and meets certain other conditions. To the extent that the Company satisfies the distribution requirement but distributes less than 100% of its taxable income, the Company will be subject to federal corporate income tax on its undistributed income.
Commercial Advisers is a wholly-owned TRS that is subject to federal and state income taxes. Though Commercial Advisers has had no activity to date, the Company would account for any future income taxes in accordance with the provisions of SFAS No. 109, “Accounting for Income Taxes.” Under SFAS No. 109, the Company accounts for income taxes using the asset and liability method under which deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.
Segment information
SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” provides standards for public companies relating to the reporting of financial and descriptive information about their operating segments in financial statements. Operating segments are defined as components of an enterprise for which separate financial information is available and is evaluated regularly by the chief operating decision maker or decision making group in determining how to allocate resources and in assessing performance. Company management is the chief decision making group. As discussed in Note 9, the Company’s operations are derived from two operating segments, one segment purchases real estate (land, buildings and other improvements), which is simultaneously leased to existing users, and the other segment originates mortgage loans and collects principal and interest payments.
Foreign currency transactions
The Company purchased two properties in Canada in October 2004. These properties were classified as held for sale as of June 30, 2006, and were sold in July 2006. All gains and losses from foreign currency transactions are reflected in discontinued operations in the Company’s consolidated financial statements. The Company had a bank account in Canada, which was closed in December 2007. The cash account was re-valued at each balance sheet date to reflect the then current exchange rate. The gains or losses from the valuation of the cash were recorded on the income statement as a realized gain or loss. Realized foreign currency gains of $33,487 and $33,550 were recorded for the three and nine months ended September 30, 2007, respectively. There were no realized foreign currency gains or losses recorded for the three and nine months ended September 30, 2008 since the account was closed in December 2007.

10


 

Asset retirement obligations
In March 2005, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”).  FIN 47 requires an entity to recognize a liability for a conditional asset retirement obligation when incurred if the liability can be reasonably estimated.  FIN 47 clarifies that the term “Conditional Asset Retirement Obligation” refers to a legal obligation (pursuant to existing laws or by contract) to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity.  FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. The Company has accrued a liability and corresponding increase to the cost of the related properties for disposal related to all properties constructed prior to 1985 that have, or may have, asbestos present in the building. The Company accrued a liability during the nine months ended September 30, 2008 of $245,195 related to properties acquired during the period. The Company also recorded expense of $35,157 and $98,394 for the three and nine months ended September 30, 2008, respectively, and $29,440 and $86,542 for the three and nine months ended September 30, 2007, respectively, related to the cumulative accretion of the obligation.
Real estate held for sale and discontinued operations
SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” requires that the results of operations of any properties which have been sold, or are held for sale, be presented as discontinued operations in the Company’s consolidated financial statements in both current and prior periods presented. Income items related to held for sale properties are listed separately on the Company’s consolidated income statement. Real estate assets held for sale are measured at the lower of the carrying amount or the fair value, less the cost to sell, and are listed separately on the Company’s consolidated balance sheet. Once properties are listed as held for sale, no further depreciation is recorded.
Recently Issued Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in GAAP and expands disclosures about fair value measurements.  SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years.  The Company has only partially adopted the provisions of SFAS 157 because of the issuance of FSP SFAS 157-2 (the “FSP”), which allows companies to delay the effective date of SFAS 157 for non-financial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis. The partial adoption had no impact on the Company’s results of operations.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 allows entities to measure at fair value many financial instruments and certain other assets and liabilities that are not otherwise required to be measured at fair value. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company adopted SFAS 159 effective for the fiscal year beginning January 1, 2008, and the adoption had no impact on the Company’s results of operations.
In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations,” SFAS No. 141(R), which replaces SFAS No. 141, “Business Combinations” (“SFAS 141R”). SFAS 141R significantly changes the accounting for acquisitions involving business combinations, as it requires that the assets and liabilities of all business combinations be recorded at fair value, with limited exceptions. SFAS 141R also requires that all expenses related to the acquisition be expensed as incurred, rather than capitalized into the cost of the acquisition as had been the previous accounting under SFAS No. 141. SFAS 141R is effective on a prospective basis for all business combinations for which the acquisition date is on or after the beginning of the first annual period subsequent to December 15, 2008.  If SFAS 141R had been in effect as of January 1, 2008, the Company would have expensed approximately $0.73 million of transaction costs related to the six acquisitions completed during the nine months ended September 30, 2008, or approximately 1.4% of the total purchase price of the acquired properties, which would have resulted in a decrease in funds from operations (“FFO”) of approximately 7.2%. The impact on the Company’s results of operations could differ significantly when the pronouncement is adopted on January 1, 2009.

11


 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”). SFAS 160 requires all entities to report noncontrolling (minority) interests in subsidiaries in the same way as equity in the consolidated financial statements. SFAS 160 is effective for fiscal years beginning after December 15, 2008. The Company does not believe the adoption of this pronouncement will have a material impact on its results of operations.
In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”), which is intended to help investors better understand how derivative instruments and hedging activities affect an entity’s financial position, financial performance and cash flows through enhanced disclosure requirements. The enhanced disclosures primarily surround disclosing the objectives and strategies for using derivative instruments by their underlying risk as well as a tabular format of the fair values of the derivative instruments and their gains and losses. SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008.
In April 2008, the FASB issued FASB Staff Position No. 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP SFAS 142-3”), which amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No. 142 “Goodwill and Other Intangible Assets” (“SFAS 142”). FSP SFAS 142-3 is intended to improve the consistency between the useful life of a recognized intangible asset under SFAS 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS 141R. FSP SFAS No. 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008, as well as interim periods within those fiscal years, and must be applied prospectively to intangible assets acquired after the effective date. The Company is currently evaluating the impact the adoption of the pronouncement will have on its results of operations.
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 period. Actual results could materially differ from those estimates.
Reclassifications
Certain amounts from prior years’ financial statements have been reclassified to conform to the current presentation. These reclassifications had no effect on previously reported net income or stockholders’ equity.

12


 

2. Management Advisory Fee
The Company has been externally managed pursuant to a contractual investment advisory arrangement with its Adviser, under which its Adviser has directly employed all of the Company’s personnel and paid its payroll, benefits, and general expenses directly. The Company’s initial investment advisory agreement with its Adviser was in place from August 12, 2003 through December 31, 2006 (the “Initial Advisory Agreement”). On January 1, 2007, the Company entered into an amended and restated investment advisory agreement with its Adviser (the “Amended Advisory Agreement”) and an administration agreement (the “Administration Agreement”) with a wholly-owned subsidiary of the Adviser, Gladstone Administration, LLC (the “Administrator”). The management services and fees in effect under the Amended Advisory and Administration Agreements are described below.
Amended Advisory Agreement
The Amended Advisory Agreement provides for an annual base management fee equal to 2% of the Company’s total stockholders’ equity, less the recorded value of any preferred stock, and an incentive fee based on FFO. For the three and nine months ended September 30, 2008, the Company recorded a base management fee of $404,108 and $1,255,833, respectively, and for the three and nine months ended September 30, 2007, the Company recorded a base management fee of $459,202 and $1,412,337, respectively. For purposes of calculating the incentive fee, FFO includes any realized capital gains and capital losses, less any dividends paid on preferred stock, but FFO does not include any unrealized capital gains or losses. The incentive fee rewards the Adviser if the Company’s quarterly FFO, before giving effect to any incentive fee (“pre-incentive fee FFO”), exceeds 1.75%, or 7% annualized, (the “hurdle rate”) of total stockholders’ equity, less the recorded value of any preferred stock. The Adviser receives 100% of the amount of the pre-incentive fee FFO that exceeds the hurdle rate, but is less than 2.1875% of the Company’s pre-incentive fee FFO. The Adviser also receives an incentive fee of 20% of the amount of the Company’s pre-incentive fee FFO that exceeds 2.1875%.
For the three and nine months ended September 30, 2008, the Company recorded an incentive fee of $793,787 and $2,300,286, respectively, offset by a credit related to an unconditional and irrevocable voluntary waiver issued by the Adviser of $205,876 and $941,928, respectively, for a net incentive fee for the three and nine months ended September 30, 2008 of $587,911 and $1,358,358, respectively. For the three and nine months ended September 30, 2007, the Company recorded an incentive fee of $677,104 and $1,896,677, respectively, offset by a credit related to an unconditional and irrevocable voluntary waiver issued by the Adviser of $526,991 and $1,746,564, respectively, for a net incentive fee for the three and nine months ended September 30, 2007 of $150,113. The board of directors of the Company accepted the Adviser’s offer to unconditionally, irrevocably and voluntarily waive a portion of the incentive fee for the three and nine months ended September 30, 2008 and 2007, in order to maintain the current level of distributions to the Company’s stockholders.
Administration Agreement
Under the Administration Agreement, the Company pays separately for its allocable portion of the Administrator’s overhead expenses in performing its obligations including, but not limited to, rent for employees of the Administrator, and its allocable portion of the salaries and benefits expenses of its chief financial officer, chief compliance officer, controller, treasurer and their respective staffs. The Company’s allocable portion of expenses is derived by multiplying the Administrator’s total allocable expenses by the percentage of the Company’s average total assets (the total assets at the beginning and end of each quarter) in comparison to the average total assets of all companies managed by the Adviser under similar agreements. For the three and nine months ended September 30, 2008, the Company recorded an administration fee of $238,241 and $724,978, respectively, and for the three and nine months ended September 30, 2007, the Company recorded an administration fee of $175,852 and $592,996, respectively.

13


 

3. Earnings per Common Share
The following tables set forth the computation of basic and diluted earnings per share for the three and nine months ended September 30, 2008 and 2007:
                                 
    For the three months ended September 30,     For the nine months ended September 30,  
    2008     2007     2008     2007  
Net income available to common stockholders
  $ 118,122     $ 567,022     $ 707,395     $ 1,606,803  
 
                               
Denominator for basic & diluted weighted average shares
    8,565,264       8,565,264       8,565,264       8,565,264  
 
                       
 
                               
Basic & diluted earnings per common share
  $ 0.01     $ 0.07     $ 0.08     $ 0.19  
 
                       
4. Real Estate and Intangible Assets
Real Estate
The following table sets forth the components of the Company’s investments in real estate, including capitalized leases, as of September 30, 2008 and December 31, 2007:
                 
    September 30, 2008     December 31, 2007  
Real estate:
               
Land
  $ 55,226,042  (1)   $ 48,867,482  
Building
    325,090,570       283,829,987  
Tenant improvements
    9,820,706       7,802,937  
Accumulated depreciation
    (22,421,974 )     (15,738,634 )
 
           
Real estate, net
  $ 367,715,344     $ 324,761,772  
 
           
 
(1)   Includes land held under a capital lease carried at approximately $1.1 million.
 
During the nine months ended September 30, 2008, the Company acquired six properties, which are summarized below:
 
(1)   On January 29, 2008, the Company acquired a 42,900 square foot industrial building in Reading, Pennsylvania for approximately $7.2 million, including transaction costs. At closing, the Company extended a 20 year triple net lease with the sole tenant, and the tenant has four options to extend the lease for additional periods of five years each. The lease provides for prescribed rent escalations over the life of the lease, with annualized straight line rents of approximately $0.72 million.
 
(2)   On February 26, 2008, the Company acquired a 74,160 square foot office building in Fridley, Minnesota for approximately $10.6 million, including transaction costs. At closing, the Company was assigned the previously existing triple net lease with the sole tenant, which had a remaining term of approximately five years. The tenant has two options to extend the lease for additional periods of five years each. The lease provides for prescribed rent escalations over the life of the lease, with annualized straight line rents of approximately $0.95 million. The Company was also assigned a ground lease on the parking lot at the time of closing, which has a remaining term of approximately six years. At the end of the term, the Company is required to purchase the land. The rent due under the ground lease had been prepaid by the previous owner through the end of the term.
 
(3)   On March 31, 2008, the Company acquired a 273,300 square foot industrial building in Concord Township, Ohio for approximately $15.3 million, including transaction costs. At closing, the Company extended a 20 year triple net lease with the sole tenant, and the tenant has three options to extend the lease for additional periods of five years each. The lease provides for prescribed rent escalations over the life of the lease, with annualized straight line rents of approximately $1.72 million.

14


 

(4)   On April 30, 2008, the Company acquired a 74,950 square foot industrial building in Pineville, North Carolina for approximately $3.9 million, including transaction costs. At closing, the Company extended a 20 year triple net lease with the sole tenant, and the tenant has three options to extend the lease for additional periods of five years each. The lease provides for prescribed rent escalations over the life of the lease, with annualized straight line rents of approximately $0.43 million.
 
(5)   On August 29, 2008, the Company acquired a 223,458 square foot industrial building in Marietta, Ohio for approximately $8.1 million, including transaction costs.  At closing, the Company extended a 20 year triple net lease with the sole tenant, and the tenant has two options to extend the lease for additional periods of ten years each. The lease provides for prescribed rent escalations over the life of the lease, with annualized straight line rents of approximately $0.90 million.
 
(6)   On August 29, 2008, the Company acquired a 67,200 square foot office building in Chalfont, Pennsylvania for approximately $8.4 million, including transaction costs, which was funded by a combination of cash on hand, and the assumption of approximately $6.5 million of financing on the property.  At closing, the Company was assigned the previously existing triple net lease with the sole tenant, which had a remaining term of approximately 7 years. The tenant has two options to extend the lease for additional periods of five years each.  The lease provides for prescribed rent escalations over the life of the lease, with annualized straight line rents of approximately $0.76 million.
In accordance with SFAS No. 141, “Business Combinations,” the Company allocated the purchase price of the properties acquired during the nine months ended September 30, 2008 as follows:
                                                                 
                    Tenant                     Customer             Total Purchase  
    Land     Building     Improvements     In-place Leases     Leasing Costs     Relationships     Obligations     Price  
Reading, Pennsylvania
  $ 490,646     $ 6,188,168     $ 14,208     $ 362,479     $ 1,786     $ 141,232     $     $ 7,198,519  
Fridley, Minnesota
    1,354,233       7,454,098       619,428       452,414       171,005       807,950       (225,067 )     10,634,061  
Concord Township, Ohio
    1,796,467       10,254,003       900,120       1,702,792       5,102       917,661       (245,198 )     15,330,947  
Pineville, North Carolina
    669,025       2,930,295       98,025       151,426       2,218       93,080             3,944,069  
Marietta, Ohio
    829,014       6,537,796       69,469       479,124       3,268       179,014             8,097,685  
Chalfont, Pennsylvania
    1,249,415       6,105,819       316,519       172,278       189,326       397,841             8,431,198  
                 
 
  $ 6,388,800     $ 39,470,179     $ 2,017,769     $ 3,320,513     $ 372,705     $ 2,536,778     $ (470,265 )   $ 53,636,479  
                 
Intangible Assets
The weighted average amortization period for the intangible assets acquired during the nine months ended September 30, 2008, were as follows:
         
Intangible assets   Years
In-place leases
    16.8  
Leasing costs
    18.2  
Customer relationships
    22.7  
All intangible assets
    16.7  
There were no allocations to above or below market lease intangibles for the six acquisitions during the nine months ended September 30, 2008.

15


 

Future operating lease payments from tenants under non-cancelable leases, excluding tenant reimbursement of expenses, in effect at September 30, 2008, were as follows:
         
    Tenant
    Lease Payments
Three months ending December 31, 2008
  $ 9,922,367  
Year ending December 31, 2009
    38,749,365  
2010
    38,743,925  
2011
    38,352,963  
2012
    38,056,061  
2013
    32,691,790  
Thereafter
    184,282,955  
In accordance with the lease terms, substantially all tenant expenses are required to be paid by the tenant; however, the Company would be required to pay property taxes on the respective properties, and ground lease payments on the property located in Tulsa, Oklahoma, in the event the tenant fails to pay them. The total annualized property taxes for all properties held by the Company at September 30, 2008 was approximately $5.5 million, and the total annual ground lease payments on the Tulsa, Oklahoma property was approximately $134,000.
The following table summarizes the net value of other intangible assets and the accumulated amortization for each intangible asset class:
                                 
    September 30, 2008     December 31, 2007  
            Accumulated             Accumulated  
    Lease Intangibles     Amortization     Lease Intangibles     Amortization  
In-place leases
  $ 15,981,245     $ (4,661,864 )   $ 12,660,732     $ (3,414,868 )
Leasing costs
    9,662,731       (2,769,660 )     9,290,026       (2,114,233 )
Customer relationships
    17,136,501       (2,881,762 )     14,599,726       (2,031,827 )
 
 
                       
 
  $ 42,780,477     $ (10,313,286 )   $ 36,550,484     $ (7,560,928 )
 
                       
The estimated aggregate amortization expense for the remainder of the current and each of the five succeeding fiscal years is as follows:
         
    Estimated Aggregate
    Amortization Expense
Three months ending December 31, 2008
  $ 688,090  
Year ending December 31, 2009
    2,687,299  
2010
    2,623,713  
2011
    2,480,618  
2012
    2,190,906  
2013
    1,312,252  
Thereafter
    6,319,267  
5. Discontinued Operations
On July 21, 2006, the Company sold its two Canadian properties for approximately $6.9 million, for a gain on the sale of approximately $1.4 million. The Company incurred approximately $315,000 in taxes related to the gain on the sale in 2006. The 2006 tax returns were subsequently filed in March of 2007, and the amount owed was approximately $236,000. The Company received a refund in 2007 in the amount of approximately $79,000, which is reflected in the accompanying statement of operations in discontinued operations under taxes refunded on sale of real estate. The operating expenses recorded during the three and nine months ended September 30, 2008 are legal fees related to the Canadian entities which have been dissolved.

16


 

The Company classified its two Canadian properties as discontinued operations, in accordance with the provisions of SFAS 144. The table below summarizes the components of income (loss) from discontinued operations:
                                 
    For the three months ended September 30,     For the nine months ended September 30,  
    2008     2007     2008     2007  
Operating (expense) income
  $ (1,322 )   $ 5,975     $ (34,956 )   $ 471  
 
                               
Net realized income from foreign currency transactions
          33,487             33,550  
 
                               
Taxes refunded on sale of real estate
                      78,667  
 
                       
 
(Loss) income from discontinued operations
  $ (1,322 )   $ 39,462     $ (34,956 )   $ 112,688  
 
                       
6. Mortgage Note Receivable
On April 15, 2005, the Company originated a mortgage loan in the amount of $10.0 million, collateralized by an office building in McLean, Virginia, where the Company’s Adviser and Administrator are subtenants in the building. This 12 year mortgage loan accrues interest at the greater of 7.5% per year or the one month London Interbank Offered Rate (“LIBOR”) rate plus 6.0% per year, with a ceiling of 10.0%. The mortgage loan is interest only for the first nine years of the term, with payments of principal commencing after the initial period. The balance of the principal and all interest remaining is due at the end of the 12 year term. At September 30, 2008, the interest rate was 8.5%.
7. Mortgage Notes Payable, Line of Credit and Short-Term Loan
The Company’s mortgage notes payable, line of credit and short-term loan as of September 30, 2008 and December 31, 2007 are summarized below:
                                         
    Date of Issuance/     Principal Maturity     Stated Interest Rate at     Principal Balance Outstanding  
    Assumption     Date     September 30, 2008 (1)     September 30, 2008     December 31, 2007  
Fixed-Rate Mortgage Notes Payable:
                                       
 
    3/16/2005       4/1/2030       6.33 %   $ 2,958,913     $ 3,003,582  
 
    8/25/2005       9/1/2015       5.33 %     21,448,474       21,664,476  
 
    9/12/2005       9/1/2015       5.21 %     12,588,000       12,588,000  
 
    12/21/2005       12/8/2015       5.71 %     19,280,744       19,456,000  
 
    2/21/2006       12/1/2013       5.91 %     9,369,889       9,480,063  
 
    2/21/2006       6/30/2014       5.20 %     19,529,866       19,782,270  
 
    3/29/2006       4/1/2016       5.92 %     17,000,000       17,000,000  
 
    4/27/2006       5/5/2016       6.58 %     14,324,718       14,514,214  
 
    11/22/2006       12/1/2016       5.76 %     14,309,000       14,309,000  
 
    12/22/2006       1/1/2017       5.79 %     21,846,000       21,846,000  
 
    2/8/2007       3/1/2017       6.00 %     13,775,000       13,775,000  
 
    6/5/2007       6/8/2017       6.11 %     14,240,000       14,240,000  
 
    9/6/2007       12/11/2015       5.81 %     4,442,289       4,487,205  
 
    10/15/2007       11/8/2017       6.63 %     15,855,560       15,974,661  
 
    8/29/2008       6/1/2016       6.80 %     6,441,772        
 
    9/15/2008       10/1/2010       6.85 %     48,015,000        
 
Total Fixed-Rate Mortgage Notes Payable:
                            255,425,225       202,120,471  
 
                                   
 
                                       
Variable-Rate Line of Credit:
    12/29/2006       12/29/2009  (2)   LIBOR + 1.9 %     10,200,000       4,400,000  
 
                                   
 
                                       
Variable-Rate Short-Term Loan:
    12/21/2007       12/21/2008  (3)   LIBOR + 2.75 %     20,000,000       20,000,000  
 
                                   
 
 
                                   
Total Mortgage Notes Payable, Line of Credit and Short-Term Loan
                          $ 285,625,225     $ 226,520,471  
 
                                   
 
(1)   The weighted average interest rate on all debt outstanding at September 30, 2008 was approximately 5.92%.
 
(2)   The line of credit may be extended for a one-year period at the Company’s option, subject to certain conditions.
 
(3)   The short-term loan may be extended for a six-month period at the Company’s option, subject to certain conditions.

17


 

Mortgage Notes Payable
As of September 30, 2008 the Company had 16 fixed-rate mortgage notes payable, collateralized by a total of 55 properties. The obligor under each of these notes is a wholly-owned separate borrowing entity, which owns the real estate collateral. The Company is not a co-borrower but has limited recourse liabilities that could result from: a borrower voluntarily filing for bankruptcy, improper conveyance of a property, fraud or material misrepresentation, misapplication or misappropriation of rents, security deposits, insurance proceeds or condemnation proceeds, and physical waste or damage to the property resulting from a borrower’s gross negligence or willful misconduct.  The Company also indemnifies lenders against claims resulting from the presence of hazardous substances or activity involving hazardous substances in violation of environmental laws on a property.  The weighted-average interest rate on the mortgage notes payable as of September 30, 2008 was approximately 6.0%.
The fair market value of all fixed-rate mortgage notes payable outstanding as of September 30, 2008 was approximately $231.4 million, as compared to the carrying value stated above of approximately $255.4 million. The fair market value is calculated based on a discounted cash flow analysis, using interest rates based on management’s estimate of interest rates on long-term debt with comparable terms.
On August 29, 2008, the Company assumed approximately $6.4 million of indebtedness pursuant to a long-term note payable from GE Commercial Mortgage Financial Corporation (“GE”), in connection with the Company’s acquisition, on the same date, of a property located in Chalfont, Pennsylvania. The note accrues interest at a rate of 6.8% per year, and the Company may not repay this note prior to maturity, or the Company may be subject to a substantial prepayment penalty. The note matures on June 1, 2016.
On September 15, 2008, through wholly-owned subsidiaries, the Company borrowed approximately $48.0 million pursuant to a long-term note payable from GE, which is collateralized by security interests in 15 properties. The note accrues interest at a rate of 6.85% per year and the Company may not repay this note prior to maturity, or the Company would be subject to a substantial prepayment penalty. The note has a maturity date of October 1, 2010, with three annual extension options through October 1, 2013. The Company used the proceeds from the note to pay down the outstanding balance on the line of credit.
Scheduled principal payments of mortgage notes payable are as follows:
         
    Scheduled principal  
    payments  
Three months ending December 31, 2008
  $ 467,668  
Year ending December 31, 2009
    2,380,065  
2010
    50,539,216  
2011
    2,820,750  
2012
    3,107,172  
2013
    11,837,278  
Thereafter
    184,273,076  
 
     
 
  $ 255,425,225  
 
     

18


 

Line of Credit
On December 29, 2006, the Company entered into a $75 million senior revolving credit agreement with a syndicate of banks led by KeyBank National Association (“KeyBank”), which matures on December 29, 2009 with an option to extend for an additional year. The Company subsequently increased the availability under the line of credit to $95 million in November 2007. The interest rate charged on the advances under the facility is based on the LIBOR, the prime rate or the federal funds rate, depending on market conditions, and adjusts periodically. The unused portion of the line of credit is subject to a fee of 0.15% per year. The Company’s ability to access this funding source is subject to the Company continuing to meet customary lending requirements such as compliance with financial and operating covenants and meeting certain lending limits. One such covenant requires the Company to limit its distributions to stockholders to 95% of its FFO, beginning with the quarter ended December 31, 2007. In addition, the maximum amount the Company may draw under this agreement is based on a percentage of the value of properties pledged as collateral to the banks, which must meet agreed upon eligibility standards. As the Company arranges for long-term mortgages for these pledged properties, the banks will release the properties from the line of credit and reduce the availability under the line of credit by the advanced amount of the removed property. Conversely, as the Company purchases new properties meeting the eligibility standards, the Company may pledge these new properties to obtain additional advances under this agreement. The availability under the line of credit may also be reduced by letters of credit used in the ordinary course of business. The Company may use the advances under the line of credit for both general corporate purposes and the acquisition of new investments. As of September 30, 2008, there was approximately $10.2 million outstanding under the line of credit at an interest rate of approximately 5.7%, and approximately $5.1 million outstanding under letters of credit at a weighted average interest rate of approximately 2.0%. At September 30, 2008, the remaining borrowing capacity available under the line of credit was $79.7 million, and the Company was in compliance with all covenants under the line of credit.
Short-Term Loan
On December 21, 2007, the Company entered into a $20 million unsecured term loan with KeyBank, which matures on December 21, 2008 with an option to extend for an additional six months. The Company can exercise the option to extend the term as long as it is in compliance with all covenants under the loan at the time it exercises its option. The interest rate charged on the loan is based on the LIBOR, the prime rate or the federal funds rate, depending on market conditions, and adjusts periodically. The Company’s ability to maintain this funding source is subject to it continuing to meet customary lending requirements such as compliance with financial and operating covenants and meeting certain lending limits. One such covenant requires the Company to limit distributions to its stockholders to 95% of its FFO beginning with the quarter ended December 31, 2007. As of September 30, 2008, the interest rate on the short-term loan was approximately 5.2%, and the Company was in compliance with all covenants under the short-term loan.
8. Stockholders’ Equity
The following table summarizes the changes in stockholders’ equity for the nine months ended September 30, 2008:
                                                 
                            Notes     Distributions in        
                    Capital in     Receivable     Excess of     Total  
    Common     Preferred     Excess of     From Sale of     Accumulated     Stockholders’  
    Stock     Stock     Par Value     Common Stock     Earnings     Equity  
Balance at December 31, 2007
  $ 8,565     $ 2,150     $ 170,640,979     $ (2,769,923 )   $ (25,513,703 )   $ 142,368,068  
 
                                               
Repayment of Principal on Notes Receivable
                      140,077             140,077  
 
                                               
Distributions Declared to Common and Preferred Stockholders
                            (12,706,239 )     (12,706,239 )
 
                                               
Net income
                            3,777,707       3,777,707  
 
                                               
 
                                   
Balance at September 30, 2008
  $ 8,565     $ 2,150     $ 170,640,979     $ (2,629,846 )   $ (34,442,235 )   $ 133,579,613  
 
                                   
Dividends paid per common share for the three and nine months ended September 30, 2008 were $0.375 and $1.125 per share, respectively, and for the three and nine months ended September 30, 2007 were $0.36 and $1.08, respectively. Dividends paid per share of Series A Preferred Stock for both the three and nine months ended September 30, 2008 and 2007 were approximately $0.48 and $1.45 per share, respectively. Dividends paid per share of Series B Preferred Stock for both the three and nine months ended September 30, 2008 and 2007 were approximately $0.47 and $1.41 per share, respectively.

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The following table is a summary of all outstanding notes issued to employees of the Adviser for the exercise of stock options:
                                                 
                            Outstanding                
    Number of     Strike Price of     Amount of     Balance of                
    Options     Options     Promissory Note     Employee Loans             Interest Rate  
Date Issued   Exercised     Exercised     Issued to Employees     at 9/30/08     Term of Note     on Note  
Sep-04
    25,000     $ 15.00     $ 375,000     $ 366,348       9 years     5.00 %
Apr-06
    12,422       16.10       199,994       199,994       9 years     7.77 %
May-06
    50,000       16.85       842,500       842,500     10 years     7.87 %
May-06
    15,000       16.10       241,500       241,500     10 years     7.87 %
May-06
    2,500       16.01       40,000       38,544     10 years     7.87 %
May-06
    2,000       16.10       32,200       32,200     10 years     7.87 %
May-06
    2,000       16.10       32,200       32,200     10 years     7.87 %
May-06
    2,000       16.68       33,360       33,360     10 years     7.87 %
May-06
    2,000       15.00       30,000       30,000     10 years     7.87 %
Oct-06
    12,000       16.10       193,200       193,200       9 years     8.17 %
Nov-06
    25,000       15.00       375,000       245,000       9 years     8.15 %
Dec-06
    25,000       15.00       375,000       375,000     10 years     8.12 %
 
                                         
 
 
    174,922             $ 2,769,954     $ 2,629,846                  
 
                                         
In accordance with the note agreements with each employee, they are required to remit interest payments to the Company on their outstanding loan balance quarterly in arrears. In accordance with Emerging Issues Task Force No. 85-1, “Classifying Notes Received for Sale of Stock,” receivables from employees for the issuance of capital stock to employees prior to the receipt of cash payment should be reflected in the balance sheet as a reduction to stockholders’ equity. Therefore, these notes were recorded as loans to employees and are included in the equity section of the accompanying consolidated balance sheets.
9. Segment Information
As of September 30, 2008, the Company’s operations were derived from two operating segments. One segment purchases real estate (land, buildings and other improvements), which is simultaneously leased to existing users and the other segment extends mortgage loans and collects principal and interest payments. The following table summarizes the Company’s consolidated operating results and total assets by segment as of and for the three and nine months ended September 30, 2008 and 2007:
                                                                 
    As of and for the three months ended September 30, 2008     As of and for the nine months ended September 30, 2008  
    Real Estate     Real Estate                     Real Estate     Real Estate              
    Leasing     Lending     Other     Total     Leasing     Lending     Other     Total  
Operating revenues
  $ 10,240,697     $ 216,446     $     $ 10,457,143     $ 29,522,531     $ 673,548     $     $ 30,196,079  
Operating expenses
    (3,523,080 )           (1,594,404 )     (5,117,484 )     (10,204,526 )           (4,400,483 )     (14,605,009 )
Other expense
    (3,183,823 )           (1,012,955 )     (4,196,778 )     (9,128,081 )           (2,650,326 )     (11,778,407 )
Discontinued operations
    (1,322 )                 (1,322 )     (34,956 )                 (34,956 )
 
                                               
Net income
  $ 3,532,472     $ 216,446     $ (2,607,359 )   $ 1,141,559     $ 10,154,968     $ 673,548     $ (7,050,809 )   $ 3,777,707  
 
                                               
 
 
                                               
Total Assets
  $ 409,461,178     $ 10,070,714     $ 10,751,163     $ 430,283,055     $ 409,461,178     $ 10,070,714     $ 10,751,163     $ 430,283,055  
 
                                               
                                                                 
    As of and for the three months ended September 30, 2007     As of and for the nine months ended September 30, 2007  
    Real Estate     Real Estate                     Real Estate     Real Estate              
    Leasing     Lending     Other     Total     Leasing     Lending     Other     Total  
Operating revenues
  $ 8,104,953     $ 255,555     $     $ 8,360,508     $ 23,065,514     $ 758,333     $     $ 23,823,847  
Operating expenses
    (2,902,795 )           (1,082,174 )     (3,984,969 )     (8,406,164 )           (3,239,038 )     (11,645,202 )
Other expense
    (2,693,509 )           (131,032 )     (2,824,541 )     (7,502,386 )           (111,832 )     (7,614,218 )
Discontinued operations
    39,462                   39,462       112,688                   112,688  
 
                                               
Net income
  $ 2,548,111     $ 255,555     $ (1,213,206 )   $ 1,590,460     $ 7,269,652     $ 758,333     $ (3,350,870 )   $ 4,677,115  
 
                                               
 
 
                                               
Total Assets
  $ 343,702,960     $ 10,083,333     $ 7,559,584     $ 361,345,877     $ 343,702,960     $ 10,083,333     $ 7,559,584     $ 361,345,877  
 
                                               

20


 

The amounts included under the other column in the tables above include other income, which consists of interest income and any other miscellaneous income earned, operating expenses that were not specifically derived from either operating segment, and other expense that is not specifically related to either operating segment.
10. Pro Forma Financial Information
The Company acquired six properties during the nine months ended September 30, 2008. The following table reflects pro-forma condensed consolidated income statements as if the six properties were acquired as of the beginning of the periods presented:
                                 
    For the three months ended September 30,     For the nine months ended September 30,  
    2008     2007     2008     2007  
Operating Data:
                               
Total operating revenue
  $ 10,719,521     $ 9,730,400     $ 32,138,406     $ 27,933,522  
Total operating expenses
    (5,313,745 )     (4,720,207 )     (15,810,891 )     (13,998,829 )
Other expense
    (4,320,745 )     (3,427,951 )     (11,984,983 )     (8,217,628 )
 
                       
Income from continuing operations
    1,085,031       1,582,242       4,342,532       5,717,065  
 
                       
Dividends attributable to preferred stock
    (1,023,437 )     (1,023,438 )     (3,070,312 )     (3,070,312 )
 
                       
Net income from continuing operations available to common stockholders
  $ 61,594     $ 558,804     $ 1,272,220     $ 2,646,753  
 
                       
 
                               
Share and Per Share Data:
                               
Basic & diluted net income from continuing operations
  $ 0.01     $ 0.07     $ 0.15     $ 0.31  
Weighted average shares outstanding-basic & diluted
    8,565,264       8,565,264       8,565,264       8,565,264  
These pro-forma condensed consolidated income statements are not necessarily indicative of what actual results would have been had the Company acquired the specified properties as of the beginning of the periods presented.
11. Commitments and Contingencies
The Company is required to pay ground lease payments on its Tulsa, Oklahoma property. The lease expires in June 2021. Future operating lease payments under the non-cancelable lease, in effect at September 30, 2008 were as follows:
         
    Lease Payments
Three months ending December 31, 2008
  $ 33,600  
Year ending December 31, 2009
    134,400  
2010
    134,400  
2011
    134,400  
2012
    134,400  
2013
    134,400  
Thereafter
    1,008,000  
12. Subsequent Events
On October 7, 2008, the Company’s Board of Directors declared cash dividends of $0.125 per common share, $0.1614583 per share of the Series A Preferred Stock, and $0.15625 per share of the Series B Preferred Stock for each of the months of October, November and December 2008. Monthly dividends will be payable on October 31, 2008, November 28, 2008 and December 31, 2008, to those stockholders of record as of the close of business for the dates of October 23, 2008, November 19, 2008 and December 22, 2008, respectively.

21


 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
All statements contained herein, other than historical facts, may constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These statements may relate to, among other things, future events or our future performance or financial condition. In some cases, you can identify forward-looking statements by terminology such as “may,” “might,” “believe,” “will,” “provided,” “anticipate,” “future,” “could,” “growth,” “plan,” “intend,” “expect,” “should,” “would,” “if,” “seek,” “possible,” “potential,” “likely” or the negative of such terms or comparable terminology. These forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. We caution readers not to place undue reliance on any such forward-looking statements, which are made pursuant to the Private Securities Litigation Reform Act of 1995 and, as such, speak only as of the date made. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, after the date of this Form 10-Q.
OVERVIEW
General
We were incorporated under the General Corporation Laws of the State of Maryland on February 14, 2003, primarily for the purpose of investing in and owning net leased industrial and commercial real property and selectively making long-term industrial and commercial mortgage loans. Most of the portfolio of real estate we currently own is leased to a wide cross section of tenants ranging from small businesses to large public companies, many of which are corporations that do not have publicly rated debt. We have in the past entered into, and intend in the future to enter into, purchase agreements for real estate having triple net leases with terms of approximately 10 to 15 years and built in rental increases. Under a triple net lease, the tenant is required to pay all operating, maintenance and insurance costs and real estate taxes with respect to the leased property. We are actively communicating with buyout funds, real estate brokers and other third parties to locate properties for potential acquisition or to provide mortgage financing in an effort to build our portfolio.
Business Environment
Conditions within the U.S. credit markets in general and the U.S. real estate credit markets in particular continue to experience historical levels of dislocation and stress that began in the summer of 2007. These conditions continue to impact us in a variety of ways, including making it difficult for us to price and finance new investment opportunities on attractive terms. We do not know when market conditions will stabilize, if adverse conditions will intensify or the full extent to which the disruptions will affect us. If market instability persists or intensifies, we may experience challenges in raising additional capital. Continued weak economic conditions could adversely impact the financial condition of one or more of our tenants and therefore, could make a tenant bankruptcy and payment default on the related lease more likely. Currently, all of our properties are fully leased and all but one of our tenants and our borrower are current and paying in accordance with their leases and loan, respectively.

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At September 30, 2008, we owned 65 properties totaling approximately 6.3 million square feet, and had one mortgage loan outstanding. The total gross investment in these acquisitions, including the mortgage loan investment, was approximately $442.9 million at September 30, 2008. Prior to September 30, 2008, we reported the aggregate number of properties we own based on the appraisals obtained in connection with the acquisition of our properties, which occasionally grouped two or more buildings together. At September 30, 2008 we are reporting, and in future periods we will report, our aggregate number of properties based on the number of individual buildings. Below is a summary of the properties we owned as of the respective periods, using the new methodology:
         
As of:   Total properties owned
December 31, 2006
    42  
March 31, 2007
    46  
June 30, 2007
    47  
September 30, 2007
    51  
December 31, 2007
    59  
March 31, 2008
    62  
June 30, 2008
    63  
September 30, 2008
    65  
Recent Events
Investment Activities: During the nine months ended September 30, 2008, we acquired six properties totaling approximately 756,000 square feet for approximately $53.6 million, and made capital improvements to our properties located in Newburyport, Massachusetts and Arlington, Texas for approximately $1.8 million, resulting in a total investment of approximately $55.4 million. Of the total investment, $48.9 million was funded under our line of credit and the remaining $6.5 million was funded under a long-term note payable with GE Commercial Mortgage Financial Corporation or GE, assumed in connection with an acquisition.
Financing Activities: During the nine months ended September 30, 2008, we had net borrowings under our line of credit of approximately $5.8 million with approximately $10.2 million outstanding at September 30, 2008. The proceeds from the line of credit were used to fund the six acquisitions during the nine-month period and to fund capital improvements to our properties located in Newburyport, Massachusetts and Arlington, Texas. In September 2008, we borrowed approximately $48.0 million pursuant to a long-term note payable with GE, collateralized by security interests in 15 of our properties. The proceeds from the long-term note payable were used to pay down the line of credit.
Our Investment Adviser and Administrator
Gladstone Management Corporation, or our Adviser, is led by a management team which has extensive experience in our lines of business. Our Adviser also has a wholly-owned subsidiary, Gladstone Administration, LLC, or the Administrator, which employs our chief financial officer, chief compliance officer, controller, treasurer and their respective staffs. All of our executive officers are officers or directors, or both, of our Adviser and our Administrator.
 
Our Adviser and Administrator also provide investment advisory and administrative services to our affiliates, Gladstone Capital Corporation and Gladstone Investment Corporation, both publicly traded business development companies, as well as Gladstone Land Corporation, a private agricultural real estate company. All of our directors and executive officers serve as either directors or executive officers, or both, of Gladstone Capital Corporation and Gladstone Investment Corporation. In the future, our Adviser may provide investment advisory and administrative services to other funds, both public and private, of which it is the sponsor.
 
Our Adviser was organized as a corporation under the laws of the State of Delaware on July 2, 2002, and is a registered investment adviser under the Investment Advisers Act of 1940, as amended. Our Adviser is headquartered in McLean, Virginia, a suburb of Washington D.C., and also has offices in New York, New Jersey, Pennsylvania, Illinois, Texas, Georgia and Washington.

23


 

Investment Advisory and Administration Agreements
We have been externally managed pursuant to a contractual investment advisory arrangement with our Adviser, under which our Adviser has directly employed all of our personnel and paid its payroll, benefits, and general expenses directly. Our initial investment advisory agreement with our Adviser, which we refer to as the Initial Advisory Agreement, was in place from August 12, 2003 through December 31, 2006. On January 1, 2007, we entered into an amended and restated investment advisory agreement with our Adviser, which we refer to as the Amended Advisory Agreement, and an administration agreement, which we refer to as the Administration Agreement, with our Administrator.
Under the terms of the Initial Advisory Agreement and the Amended Advisory Agreement, we were and remain responsible for all expenses incurred for our direct benefit. Examples of these expenses include legal, accounting, interest on short-term debt and mortgages, tax preparation, directors and officers insurance, stock transfer services, stockholder related fees, consulting and related fees. During the three and nine months ended September 30, 2008, the total amount of these expenses that we incurred was approximately $4.8 million and $13.8 million, respectively. During the three and nine months ended September 30, 2007, the total amount of these expenses that we incurred was approximately $3.4 million and $9.8 million, respectively. All of these charges are incurred directly by us rather than by our Adviser for our benefit. Accordingly, we did not make any reimbursements to our Adviser for these amounts.
In addition, we are also responsible for all fees charged by third parties that are directly related to our business, which may include real estate brokerage fees, mortgage placement fees, lease-up fees and transaction structuring fees (although we may be able to pass some or all of such fees on to our tenants and borrowers). During the three and nine months ended September 30, 2008 and 2007, none of these expenses were incurred by us directly. The actual amount of such fees that we incur in the future will depend largely upon the aggregate costs of the properties we acquire, the aggregate amount of mortgage loans we make, and the extent to which we are able to shift the burden of such fees to our tenants and borrowers. Accordingly, the amount of these fees that we will pay in the future is not determinable at this time.
Management Services and Fees under the Amended Advisory Agreement
The Amended Advisory Agreement provides for an annual base management fee equal to 2.0% of our total stockholders’ equity, less the recorded value of any preferred stock, and an incentive fee based on funds from operations, or FFO. For purposes of calculating the incentive fee, FFO includes any realized capital gains and capital losses, less any dividends paid on preferred stock, but FFO does not include any unrealized capital gains or losses. The incentive fee will reward our Adviser if our quarterly FFO, before giving effect to any incentive fee (“pre-incentive fee FFO”), exceeds 1.75%, or 7% annualized, (the “hurdle rate”) of total stockholders’ equity, less the recorded value of any preferred stock. Our Adviser will receive 100% of the amount of the pre-incentive fee FFO that exceeds the hurdle rate, but is less than 2.1875% of our pre-incentive fee FFO. Our Adviser will also receive an incentive fee of 20% of the amount of our pre-incentive fee FFO that exceeds 2.1875%. The incentive fee may be reduced because of our line of credit covenant which limits distributions to our stockholders to 95% of FFO.
For the three and nine months ended September 30, 2008, the base management fee was $404,108 and $1,255,833, respectively. For the three and nine months ended September 30, 2007, the base management fee was $459,202 and $1,412,337, respectively. For the three and nine months ended September 30, 2008, we recorded an incentive fee of $793,787 and $2,300,286, respectively, offset by a credit from an unconditional and irrevocable voluntary waiver issued by the Adviser of $205,876 and $941,928, respectively, for a net incentive fee for the three and nine months ended September 30, 2008 of $587,911 and $1,358,358, respectively. For the three and nine months ended September 30, 2007, we recorded an incentive fee of $677,104 and $1,896,677, respectively, offset by a credit from an unconditional and irrevocable voluntary waiver issued by the Adviser of $526,991 and $1,746,564, respectively, for a net incentive fee for both the three and nine months ended September 30, 2007 of $150,113. Our Board of Directors accepted our Adviser’s offer to waive a portion of the incentive fee for the three and nine months ended September 30, 2008 and 2007, in order to maintain the current level of distributions to our stockholders. Our Adviser has indicated that it intends to continue to waive all or a portion of the incentive fee in order to support the current level of distributions to our stockholders, however, our Adviser is not required to issue any waiver, in whole or in part.

24


 

Administration Agreement
Under the Administration Agreement, we pay separately for our allocable portion of our Administrator’s overhead expenses in performing its obligations including, but not limited to, rent for employees of our Administrator, and our allocable portion of the salaries and benefits expenses of our chief financial officer, chief compliance officer, controller, treasurer and their respective staffs. For the three and nine months ended September 30, 2008, we incurred $238,241 and $724,978, respectively, for the administration fee. For the three and nine months ended September 30, 2007, we incurred $175,852 and $592,996, respectively, for the administration fee.
Critical Accounting Policies
The preparation of our financial statements in accordance with generally accepted accounting principles in the United States of America, or GAAP, requires management to make judgments that are subjective in nature in order to make certain estimates and assumptions. Management relies on its experience, collects historical data and current market data, and analyzes this information in order to arrive at what it believes to be reasonable estimates. Under different conditions or assumptions, materially different amounts could be reported related to the accounting policies described below. In addition, application of these accounting policies involves the exercise of judgments on 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 elsewhere in this report. Below is a summary of accounting polices involving estimates and assumptions that require complex, subjective or significant judgments in their application and that materially affect our results of operations.
Allocation of Purchase Price
When we acquire real estate, we allocate the purchase price to the acquired tangible assets and liabilities, consisting of land, building, tenant improvements, long-term debt and identified intangible assets and liabilities, consisting of the value of above-market and below-market leases, the value of in-place leases, the value of unamortized lease origination costs, the value of tenant relationships and the value of capital lease obligations, based in each case on their fair values.
Management’s estimates of value are made using methods similar to those used by independent appraisers (e.g., discounted cash flow analysis). Factors considered by management in its analysis include an estimate of carrying costs during hypothetical expected lease-up periods considering current market conditions, and costs to execute similar leases. We also consider information obtained about each property as a result of our pre-acquisition due diligence, marketing and leasing activities in estimating the fair value of the tangible and intangible assets and liabilities acquired. In estimating carrying costs, management also includes real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, which primarily range from 9 to 18 months, depending on specific local market conditions. Management also estimates costs to execute similar leases, including leasing commissions, legal and other related expenses to the extent that such costs are not already incurred in connection with a new lease origination as part of the transaction. Management also considers the nature and extent of our existing business relationships with the tenant, growth prospects for developing new business with the tenant, the tenant’s credit quality and expectations of lease renewals (including those existing under the terms of the lease agreement), among other factors. A change in any of the assumptions above, which are very subjective, could have a material impact on our results of operations.

25


 

The allocation of the purchase price directly affects the following in our consolidated financial statements:
    The amount of acquisition costs allocated to the various tangible and intangible assets on our balance sheet;
 
    The amounts allocated to the value of above-market and below-market lease values are amortized to rental income over the remaining non-cancelable terms of the respective leases. The amounts allocated to all other tangible and intangible assets are amortized to depreciation or amortization expense. Thus changes in the purchase price allocation among our assets could have a material impact on our FFO, which is used by investors of REITs to evaluate our operating performance; and
 
    The period of time that tangible and intangible assets are depreciated over varies greatly, and thus changes in the amounts allocated to these assets will have a direct impact on our results of operations. Intangible assets are generally amortized over the respective life of the leases, which normally range from 10 to 15 years, we depreciate our buildings over 39 years, and land is not depreciated. These differences in timing could have a material impact on our result of operations.
Asset Impairment Evaluation
We periodically review the carrying value of each property to determine if circumstances that indicate impairment in the carrying value of the investment exist or that depreciation periods should be modified. If circumstances support the possibility of impairment, we prepare a projection of the undiscounted future cash flows, without interest charges, of the specific property and determine if the investment in such property is recoverable. If impairment is indicated, the carrying value of the property would be written down to its estimated fair value based on our best estimate of the property’s discounted future cash flows. Any material changes to the estimates and assumptions used in this analysis could have a significant impact on our results of operations, as the changes would impact our determination if impairment is deemed to have occurred and the amount of impairment loss we would recognize.
Provision for Loan Losses
Our accounting policies require that we reflect in our financial statements an allowance for estimated credit losses with respect to mortgage loans we have made based upon our evaluation of known and inherent risks associated with our private lending assets. Management reflects provisions for loan losses based upon our assessment of general market conditions, our internal risk management policies and credit risk rating system, industry loss experience, our assessment of the likelihood of delinquencies or defaults, and the value of the collateral underlying our investments. Any material changes to the estimates and assumptions used in this analysis could have a significant impact on our results of operations.
Recently Issued Accounting Pronouncements
Refer to Note 1 in the accompanying consolidated financial statements for a summary of all recently issued accounting pronouncements.
Results of Operations
Our weighted-average yield on the portfolio as of September 30, 2008 was approximately 9.53%. Our weighted-average yields on the six properties acquired during the nine months ended September 30, 2008 were as follows:
         
Date Acquired   Property Location   Weighted-Average Yield
1/29/08   Reading, Pennsylvania   9.95%
2/26/08   Fridley, Minnesota   8.93%
3/31/08   Concord Township, Ohio   11.27%
4/30/08   Pineville, North Carolina   11.06%
8/29/08   Marietta, Ohio   11.07%
8/29/08   Chalfont, Pennsylvania   9.01%
The weighted-average yield on our portfolio is calculated by taking the annualized straight-line rent, reflected as rental income on our consolidated statements of operations, or mortgage interest payments, reflected as interest income from mortgage notes receivable on our consolidated statements of operations, of each acquisition or mortgage loan as a percentage of the acquisition or loan price, as applicable. The weighted-average yield does not take into account the interest expense incurred on the financings placed on our properties.

26


 

A comparison of our operating results for the three and nine months ended September 30, 2008 and 2007 is below:
                                                                 
    For the three months ended September 30,     For the nine months ended September 30,  
    2008     2007     $ Change     % Change     2008     2007     $ Change     % Change  
Operating revenues
                                                               
Rental income
  $ 10,157,553     $ 8,024,305     $ 2,133,248       27 %   $ 29,269,036     $ 22,834,663     $ 6,434,373       28 %
Interest income from mortgage notes receivable
    216,446       255,555       (39,109 )     -15 %     673,548       758,333       (84,785 )     -11 %
Tenant recovery revenue
    83,144       80,648       2,496       3 %     253,495       230,851       22,644       10 %
 
                                                   
Total operating revenues
    10,457,143       8,360,508       2,096,635       25 %     30,196,079       23,823,847       6,372,232       27 %
 
                                                   
 
                                                               
Operating expenses
                                                               
Depreciation and amortization
    3,262,903       2,668,383       594,520       22 %     9,435,690       7,722,349       1,713,341       22 %
Property operating expenses
    225,020       204,972       20,048       10 %     670,442       597,273       73,169       12 %
Base management fee
    404,108       459,202       (55,094 )     -12 %     1,255,833       1,412,337       (156,504 )     -11 %
Incentive fee
    793,787       677,104       116,683       17 %     2,300,286       1,896,677       403,609       21 %
Administration fee
    238,241       175,852       62,389       35 %     724,978       592,996       131,982       22 %
Professional fees
    117,857       118,371       (514 )     0 %     362,584       442,479       (79,895 )     -18 %
Insurance
    43,354       53,943       (10,589 )     -20 %     126,947       171,275       (44,328 )     -26 %
Directors fees
    54,702       66,250       (11,548 )     -17 %     161,202       174,750       (13,548 )     -8 %
Stockholder related expense
    42,232       40,991       1,241       3 %     271,430       215,969       55,461       26 %
Asset retirement obligation expense
    35,157       29,440       5,717       19 %     98,394       86,542       11,852       14 %
General and administrative
    105,999       17,452       88,547       507 %     139,151       79,119       60,032       76 %
 
                                               
Total operating expenses before credit from Adviser
    5,323,360       4,511,960       811,400       18 %     15,546,937       13,391,766       2,155,171       16 %
 
                                                   
 
                                                               
Credit to incentive fee
    (205,876 )     (526,991 )     321,115       -61 %     (941,928 )     (1,746,564 )     804,636       -46 %
 
                                               
Total operating expenses
    5,117,484       3,984,969       1,132,515       28 %     14,605,009       11,645,202       2,959,807       25 %
 
                                                   
 
                                                               
Other income (expense)
                                                               
Interest income from temporary investments
    4,559       33,105       (28,546 )     -86 %     20,796       325,390       (304,594 )     -94 %
Interest income — employee loans
    49,624       52,728       (3,104 )     -6 %     152,620       169,608       (16,988 )     -10 %
Other income
    7,500       9,896       (2,396 )     -24 %     56,493       28,127       28,366       101 %
Interest expense
    (4,258,461 )     (2,920,270 )     (1,338,191 )     46 %     (12,008,316 )     (8,137,343 )     (3,870,973 )     48 %
 
                                               
Total other expense
    (4,196,778 )     (2,824,541 )     (1,372,237 )     49 %     (11,778,407 )     (7,614,218 )     (4,164,189 )     55 %
 
                                                   
 
                                                               
Income from continuing operations
    1,142,881       1,550,998       (408,117 )     -26 %     3,812,663       4,564,427       (751,764 )     -16 %
 
                                                   
 
                                                               
Discontinued operations
                                                               
Loss from discontinued operations
    (1,322 )     5,975       (7,297 )     -122 %     (34,956 )     471       (35,427 )     -7522 %
Net realized income from foreign currency transactions
          33,487       (33,487 )     -100 %           33,550       (33,550 )     -100 %
Taxes refunded on sale of real estate
                      0 %           78,667       (78,667 )     -100 %
 
                                               
Total discontinued operations
    (1,322 )     39,462       (40,784 )     -103 %     (34,956 )     112,688       (147,644 )     -131 %
 
                                                   
 
                                                               
Net income
    1,141,559       1,590,460       (448,901 )     -28 %     3,777,707       4,677,115       (899,408 )     -19 %
 
                                                   
 
                                                               
Dividends attributable to preferred stock
    (1,023,437 )     (1,023,438 )     1       0 %     (3,070,312 )     (3,070,312 )           0 %
 
                                                   
 
                                                               
Net income available to common stockholders
  $ 118,122     $ 567,022     $ (448,900 )     -79 %   $ 707,395     $ 1,606,803     $ (899,408 )     -56 %
 
                                                   
Operating Revenues
Rental income increased for the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007, primarily as a result of the 14 properties acquired between September 30, 2007 and September 30, 2008, coupled with properties acquired during the nine months ended September 30, 2007 that were held for the full nine-month period in 2008.
Interest income from mortgage notes receivable decreased for the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007, primarily because interest income on our mortgage loan is based on the London Interbank Offered Rate, or LIBOR, which has significantly decreased over the past year.
Tenant recovery revenue remained relatively flat for the three months ended September 30, 2008 as compared to the three months ended September 30, 2007. Tenant recovery revenue increased for the nine months ended September 30, 2008, as compared to the nine months ended September 30, 2007, primarily as a result of the reimbursement of the ground lease payments on our Tulsa, Oklahoma property acquired in March 2007, which was held for the entire nine-month period in 2008.
Operating Expenses
Depreciation and amortization expenses increased during the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007, as a result of the 14 properties acquired between September 30, 2007 and September 30, 2008, and properties acquired during the nine months ended September 30, 2007 that were held for the full nine-month period in 2008.

27


 

Property operating expenses consist of franchise taxes, management fees, insurance, ground lease payments on our Tulsa, Oklahoma property acquired in March 2007 and overhead expenses paid on behalf of certain of our properties. Property operating expenses increased during the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007, primarily as a result of repairs on several of our properties. In addition, property operating expenses for the entire nine months ended September 30, 2008 included ground lease payments on our Tulsa, Oklahoma property acquired in March 2007.
The base management fee decreased for the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007, as a result of a decrease in total common stockholders’ equity, the main component of the calculation. The calculation of the base management fee is described in detail above under “Investment Advisory and Administration Agreements.”
The incentive fee increased for the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007, due to the decrease in total common stockholders’ equity, coupled with the increase in FFO. The calculation of the incentive fee is described in detail above under “Investment Advisory and Administration Agreements.”
The administration fee increased for the three and nine months ended September 30, 2008 and 2007, primarily as a result of the increased number of employees of our Administrator, coupled with an increase in overhead expenses allocated by our Administrator. The calculation of the administrative fee is described in detail above under “Investment Advisory and Administration Agreements.”
Professional fees, consisting primarily of legal and accounting fees, remained relatively flat during the three months ended September 30, 2008, as compared to the three months ended September 30, 2007. Professional fees decreased during the nine months ended September 30, 2008, as compared to the nine months ended September 30, 2007, primarily as a result of a reduction in legal fees paid during the nine months ended September 30, 2008 combined with fees incurred during the three and nine months ended September 30, 2007 for state tax research and costs related to the implementation of FIN 48, which were not incurred during the nine months ended September 30, 2008.
Insurance expense consists of the premiums paid for directors and officers insurance, which is renewed annually each September. Insurance expense decreased for the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007, because of a decrease in the premiums for the period from September 2007 through September 2008.
Directors’ fees decreased during the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007, primarily as a result of fewer meetings occurring in the three and nine months ended September 30, 2008.
Stockholder related expense increased for the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007, primarily as a result of the increase in our costs associated with printing and filing the annual report, coupled with costs associated with the solicitation of the stockholder vote for the 2008 annual meeting.
Asset retirement obligation expense increased for the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007, primarily as a result of a property acquired between September 30, 2007 and September 30, 2008, which was required to recognize an asset retirement liability, coupled with a property acquired where a liability was recorded during the nine months ended September 30, 2007 that was held for the full period in 2008.
General and administrative expenses increased for the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007, primarily as a result of capitalized fees for financings that did not materialize, and as such, were written off.

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Other Income and Expense
Interest income from temporary investments decreased during the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007. The decrease was primarily a result of the decrease in our average cash balances during the nine months ended September 30, 2008.
During the three and nine months ended September 30, 2008, interest income on employee loans decreased, as compared to the three and nine months ended September 30, 2007. This decrease was a result of employees who paid off their loans during 2008, coupled with other partial principal repayments over the periods.
Other income was relatively flat during the three months ended September 30, 2008, as compared to the three months ended September 30, 2007. Other income increased for the nine months ended September 30, 2008 as compared to the nine months ended September 30, 2007, primarily because of a real estate tax reimbursement we received from our property located in Sterling Heights, Michigan.
Interest expense increased for the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007. This was primarily a result of the long term financings we closed on 14 of our properties subsequent to September 30, 2007, coupled with an increased amount outstanding on our line of credit during the three and nine months ended September 30, 2008. In September 2008, we paid down the outstanding balance on the line of credit using proceeds from the $48.0 million long-term note payable from GE.
Discontinued Operations
The loss from discontinued operations is the expense related to our two Canadian properties, which were sold in July 2006. The expense relates to legal fees associated with the dissolution of the entities which sold the properties. The 2006 tax returns were filed in March 2007, and we were due a refund of approximately $79,000, which is reflected on the statements of operations under taxes refunded on sale of real estate for the nine months ended September 30, 2007.
Net Income Available to Common Stockholders
Net income available to common stockholders decreased for the three and nine months ended September 30, 2008, as compared to the three and nine months ended September 30, 2007. This decrease was primarily a result of increased interest expense from the increased number of properties which have long-term financing, partially offset by the increase in the size of our portfolio of investments in the past year and the corresponding increase in our revenues and the other events described above.
Liquidity and Capital Resources
Cash and Cash Equivalents
At September 30, 2008, we had approximately $3.1 million in cash and cash equivalents. We have access to our existing line of credit with an available borrowing capacity of $79.7 million, have obtained mortgages on 55 of our properties and have a $20.0 million short-term loan. We expect that the funds from our line of credit, additional mortgages and securities offerings will provide us with sufficient capital to make additional investments and to fund our continuing operations for the foreseeable future. As previously discussed in Management’s Discussion and Analysis – Business Environment, continued weak economic conditions could adversely affect our ability to obtain additional mortgages collateralized by some or all of our real property in the future, as well as our ability to borrow funds and issue additional equity securities in order to obtain additional capital in the future. We cannot determine the terms of future borrowings or equity issuances or whether we will be able to borrow funds or issue equity on terms favorable to us, or if at all.

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Operating Activities
Net cash provided by operating activities during the nine months ended September 30, 2008 was approximately $12.2 million, compared to net cash provided by operating activities of approximately $12.0 million for the nine months ended September 30, 2007. A majority of cash from operating activities is generated from the rental payments we receive from our tenants and the interest payments we receive from our borrower. We utilize this cash to fund our property-level operating expenses and use the excess cash primarily for debt and interest payments on our mortgage notes payable, interest payments on our line of credit and short-term loan, dividend payments, management fees to our Adviser, and other entity level expenses.
Investing Activities
Net cash used in investing activities during the nine months ended September 30, 2008 was approximately $50.1 million, which primarily consisted of the purchase of six properties, as described in the “Recent Events” section above, as compared to net cash used in investing activities during the nine months ended September 30, 2007 of approximately $85.7 million, which primarily consisted of the purchase of eight properties and one leasehold interest. During the nine months ended September 30, 2008, we purchased five of the six properties using borrowings under our line of credit and assumed the mortgage on the sixth property located in Chalfont, Pennsylvania. During the nine months ended September 30, 2007, we purchased all of the properties using borrowings under our line of credit.
Net real estate consisted of the following tenant industry classifications as of September 30, 2008 and December 31, 2007:
                                 
    September 30, 2008     December 31, 2007  
            Percentage of             Percentage of  
Industry Classification   Net Real Estate     Net Real Estate     Net Real Estate     Net Real Estate  
Automobile
  $ 10,906,445       3.0 %   $ 11,072,192       3.4 %
Beverage, Food & Tobacco
    18,792,486       5.1 %     10,655,401       3.3 %
Buildings and Real Estate
    20,116,878       5.5 %     20,504,268       6.3 %
Chemicals, Plastics & Rubber
    26,175,476       7.1 %     15,371,141       4.7 %
Containers, Packaging & Glass
    16,002,508       4.4 %     16,320,658       5.0 %
Diversified/Conglomerate Manufacturing
    32,437,883       8.8 %     25,328,441       7.8 %
Diversified/Conglomerate Services
    2,569,588       0.7 %     2,615,717       0.8 %
Electronics
    54,585,128       14.8 %     55,721,882       17.2 %
Healthcare, Education & Childcare
    55,307,539       15.0 %     43,322,758       13.3 %
Home & Office Furnishings
    5,180,076       1.4 %     5,276,588       1.6 %
Insurance
    5,696,887       1.5 %     5,809,099       1.8 %
Machinery
    21,686,150       5.9 %     12,682,144       3.9 %
Oil & Gas
    10,878,990       3.0 %     11,099,726       3.4 %
Personal & Non-Durable Consumer Products
    13,024,942       3.5 %     13,207,489       4.1 %
Personal, Food & Miscellaneous Services
    4,408,674       1.2 %     4,502,040       1.4 %
Printing & Publishing
    22,167,679       6.0 %     22,594,423       7.0 %
Telecommunications
    47,778,015       13.0 %     48,677,805       15.0 %
 
                       
 
  $ 367,715,344       100.0 %   $ 324,761,772       100.0 %
 
                       
Industry groupings are based on management’s knowledge of the tenant’s operations in the leased space.
Financing Activities
Net cash provided by financing activities for the nine months ended September 30, 2008 was approximately $39.6 million, which primarily consisted of the proceeds from the long-term financing of 15 of our properties and borrowings under our line of credit, partially offset by repayments on our line of credit, principal repayments on mortgage notes payable, payments for deferred financing costs, and dividend payments. Net cash provided by financing activities for the nine months ended September 30, 2007 was approximately $39.5 million, which primarily consisted of the proceeds received from the long-term financing of seven of our properties, partially offset by repayments on our line of credit, payments for deferred financing costs, principal repayments on mortgage notes payable and dividend payments.

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Future Capital Needs
As of September 30, 2008, we had investments in 65 real properties for a net value, including intangible assets, of approximately $400.2 million and one mortgage loan receivable for $10.0 million. During the remainder of 2008 and beyond, we intend to complete additional acquisitions of real estate and to originate additional mortgage notes, although there is no guarantee we will be able to do so on favorable terms, if at all. We intend to fund our contractual obligations and acquire additional properties by borrowing all or a portion of the purchase price and collateralizing the mortgages with some or all of our real property, by borrowing against our existing line of credit with an available borrowing capacity of $79.7 million, or by issuing additional equity securities under an effective registration statement on Form S-3 (File No. 333-147856) we have on file with the Securities and Exchange Commission (the “Registration Statement”). The Registration Statement permits us to issue, through one or more transactions, up to an aggregate of $300.0 million in securities consisting of common or preferred stock, of which all $300 million was available as of September 30, 2008. We may also use these funds for general corporate needs. If we are unable to make any required debt payments on any borrowings, our lenders could foreclose on the properties collateralizing their loans, which could cause us to lose part or all of our investments in such properties. In addition, we need sufficient capital to fund our dividends, and we may require credits to our management fees, issued from our Adviser, in order to meet these obligations, although our Adviser is under no obligation to provide such credits, in whole or in part.
Mortgage Notes Payable
On September 15, 2008, through wholly-owned subsidiaries, we borrowed approximately $48.0 million pursuant to a long-term note payable from GE, which is collateralized by security interests in 15 properties. The note accrues interest at a rate of 6.85% per year and we may not repay this note prior to maturity, or we would be subject to a substantial prepayment penalty. The note has a maturity date of October 1, 2010, with three annual extension options through October 1, 2013. We used the proceeds from the note to pay down the outstanding balance on the line of credit. As of September 30, 2008, we had 16 fixed-rate mortgage notes payable in the aggregate principal amount of approximately $255.4 million, collateralized by a total of 55 properties with terms ranging from 2 years to 25 years. The weighted-average interest rate on the mortgage notes payable as of September 30, 2008 was approximately 6.0%.
Line of Credit
On December 29, 2006, we entered into a $75 million senior revolving credit agreement with a syndicate of banks led by KeyBank National Association, which matures on December 29, 2009 with an option to extend for an additional year. We subsequently increased the availability under our line of credit to $95 million in November 2007. The interest rate charged on the advances under the facility is based on LIBOR, the prime rate or the federal funds rate, depending on market conditions, and adjusts periodically. The unused portion of the line of credit is subject to a fee of 0.15% per year. Our ability to access this funding source is subject to us continuing to meet customary lending requirements such as compliance with financial and operating covenants and meeting certain lending limits. One such covenant requires us to limit distributions to our stockholders to 95% of our funds from operations, or FFO, beginning with the quarter ended December 31, 2007. In addition, the maximum amount we may draw under this agreement is based on a percentage of the value of properties pledged as collateral to the banks, which must meet agreed upon eligibility standards. As we arrange for long-term mortgages for these pledged properties, the banks will release the properties from the line of credit and reduce the availability under the line of credit by the advanced amount of the removed property. Conversely, as we purchase new properties meeting the eligibility standards, we may pledge these new properties to obtain additional advances under this agreement. The availability under the line of credit will also be reduced by letters of credit used in the ordinary course of business. We may use the advances under the line of credit for both general corporate purposes and the acquisition of new investments. As of September 30, 2008, there was approximately $10.2 million outstanding under the line of credit at an interest rate of approximately 5.7%, and approximately $5.1 million outstanding under letters of credit at a weighted average interest rate of approximately 2.0%. At September 30, 2008, the remaining borrowing capacity available under the line of credit was $79.7 million, and we were in compliance with all covenants under the line of credit.

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Short-Term Loan
On December 21, 2007, we entered into a $20 million unsecured term loan with KeyBank National Association, which matures on December 21, 2008, with an option to extend for an additional nine months. We can exercise the option to extend the term as long as we are in compliance with all covenants under the loan at the time we exercise the option. The interest rate charged on the loan is based on LIBOR, the prime rate or the federal funds rate, depending on market conditions, and adjusts periodically. Our ability to maintain this funding source is subject to us continuing to meet customary lending requirements such as compliance with financial and operating covenants and meeting certain lending limits. One such covenant requires us to limit distributions to our stockholders to 95% of our FFO beginning with the quarter ended December 31, 2007. As of September 30, 2008, the interest rate on the short-term loan was approximately 5.2%, and we were in compliance with all covenants under the short-term loan.
Off-Balance Sheet Arrangements
We did not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of SEC Regulation S-K as of September 30, 2008.
Contractual Obligations
The following table reflects our significant contractual obligations as of September 30, 2008:
                                         
    Payments Due by Period  
Contractual Obligations   Total     Less than 1 Year     1-3 Years     3-5 Years     More than 5 Years  
Debt Obligations (1)
  $ 285,625,225     $ 22,257,476     $ 63,294,033     $ 6,196,582     $ 193,877,134  
Interest on Debt Obligations (2)
    96,063,397       12,242,982       30,176,906       23,017,473       30,626,036  
Capital Lease Obligations (3)
    232,301                         232,301  
Operating Lease Obligations (4)
    1,713,600       134,400       268,800       268,800       1,041,600  
 
                             
Total
  $ 383,634,523     $ 34,634,858     $ 93,739,739     $ 29,482,855     $ 225,777,071  
 
                             
 
(1)   Debt obligations represent borrowings under our line of credit, term loan and mortgage notes payable that were outstanding as of September 30, 2008. The line of credit matures in December 2009, with an option to extend for an additional year, and the term loan matures in December 2008 with an option to extend for an additional six months.
 
(2)   Interest on debt obligations does not include interest on our borrowings under our line of credit or term loan. The balance and interest rate on our line of credit and term loan are variable and, thus, the amount of interest has not been calculated for purposes of this table.
 
(3)   Capital lease obligations represent the obligation to purchase the land held under the ground lease on our property located in Fridley, Minnesota.
 
(4)   Operating lease obligations represent the ground lease payments due on our Tulsa, Oklahoma property. The lease expires in June 2021.
Funds from Operations
NAREIT developed FFO, as a relative non-GAAP supplemental measure of operating performance of an equity REIT, in order to recognize that income-producing real estate historically has not depreciated on the basis determined under GAAP. FFO, as defined by NAREIT, is net income (computed in accordance with GAAP), excluding gains or losses from sales of property, plus depreciation and amortization of real estate assets, and after adjustments for unconsolidated partnerships and joint ventures.
FFO does not represent cash flows from operating activities in accordance with GAAP, which, unlike FFO, generally reflects all cash effects of transactions and other events in the determination of net income, and should not be considered an alternative to net income as an indication of our performance or to cash flows from operations as a measure of liquidity or ability to make distributions. Comparison of FFO, using the NAREIT definition, to similarly titled measures for other REITs may not necessarily be meaningful due to possible differences in the application of the NAREIT definition used by such REITs.
FFO available to common stockholders is FFO adjusted to subtract preferred share dividends.  We believe that net income available to common stockholders is the most directly comparable GAAP measure to FFO available to common stockholders. 

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Basic funds from operations per share, or Basic FFO per share, and diluted funds from operations per share, or Diluted FFO per share, is FFO available to common stockholders divided by weighted average common shares outstanding and FFO available to common stockholders divided by weighted average common shares outstanding on a diluted basis, respectively, during a period. We believe that FFO available to common stockholders, Basic FFO per share and Diluted FFO per share are useful to investors because they provide investors with a further context for evaluating our FFO results in the same manner that investors use net income and earnings per share, or EPS, in evaluating net income available to common stockholders. In addition, since most REITs provide FFO available to common stockholders, Basic FFO and Diluted FFO per share information to the investment community, we believe these are useful supplemental measures for comparing us to other REITs. We believe that net income is the most directly comparable GAAP measure to FFO, Basic EPS is the most directly comparable GAAP measure to Basic FFO per share, and that diluted EPS is the most directly comparable GAAP measure to Diluted FFO per share.
The following table provides a reconciliation of our FFO for the three and nine months ended September 30, 2008 and 2007, to the most directly comparable GAAP measure, net income, and a computation of basic and diluted FFO per weighted average common share, basic and diluted net income per weighted average common share and the percentage of FFO paid per common share:
                                 
    For the three months ended September 30,     For the nine months ended September 30,  
    2008     2007     2008     2007  
Net income
  $ 1,141,559     $ 1,590,460     $ 3,777,707     $ 4,677,115  
Less: Dividends attributable to preferred stock
    (1,023,437 )     (1,023,438 )     (3,070,312 )     (3,070,312 )
 
                       
Net income available to common stockholders
    118,122       567,022       707,395       1,606,803  
 
                               
Add: Real estate depreciation and amortization
    3,262,903       2,668,383       9,435,690       7,722,349  
Less: Gain on sale of real estate, net of taxes paid
                      (78,667 )
 
                       
FFO available to common stockholders
  $ 3,381,025     $ 3,235,405     $ 10,143,085     $ 9,250,485  
 
                               
Weighted average shares outstanding — basic & diluted
    8,565,264       8,565,264       8,565,264       8,565,264  
 
                               
Basic & diluted net income per weighted average common share
  $ 0.01     $ 0.07     $ 0.08     $ 0.19  
 
                       
 
                               
Basic & diluted FFO per weighted average common share
  $ 0.395     $ 0.378     $ 1.184     $ 1.080  
 
                       
 
                               
Dividends declared per common share
  $ 0.375     $ 0.360     $ 1.125     $ 1.080  
 
                       
 
                               
Percentage of FFO paid per common share
    95 %     95 %     95 %     100 %
 
                       
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk includes risks that arise from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices and other market changes that affect market sensitive instruments. The primary risk that we believe we will be exposed to is interest rate risk. We currently own one variable rate loan receivable, certain of our leases contain escalations based on market interest rates, and the interest rate on our existing line of credit and short-term loan is variable. We seek to mitigate this risk by structuring such provisions of our loans and leases to contain a minimum interest rate or escalation rate, as applicable. We are also exposed to the effects of interest rate changes as a result of the holding of our cash and cash equivalents in short-term, interest-bearing investments.
To illustrate the potential impact of changes in interest rates on our net income for the three and nine month periods ended September 30, 2008 and 2007, we have performed the following analysis, which assumes that our balance sheet remains constant and no further actions beyond a minimum interest rate or escalation rate are taken to alter our existing interest rate sensitivity.
The following table summarizes the impact of a 1% increase and 1% decrease in the one month LIBOR for the three and nine month periods ended September 30, 2008 and 2007.

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    Three months ended September 30,     Nine months ended September 30,  
    2008     2007     2008     2007  
1% increase in the one month LIBOR
                               
 
                               
Change in Rental & Interest Income
  $ 27,308     $ 9,125     $ 82,106     $ 27,375  
 
                               
Change in Interest Expense
    77,178       51,111       229,856       151,667  
 
 
                       
Net decrease
  $ (49,869 )   $ (41,986 )   $ (147,750 )   $ (124,292 )
 
                       
 
                               
Net Income available to common stockholders
  $ 118,112     $ 567,022     $ 707,395     $ 1,606,803  
 
                               
Net decrease as percentage of Net Income available to common stockholders
    -42.2 %     -7.4 %     -20.9 %     -7.7 %
 
                               
1% decrease in the one month LIBOR
                               
 
                               
Change in Rental & Interest Income
  $ (24,779 )   $ (9,125 )   $ (75,939 )   $ (27,375 )
 
                               
Change in Interest Expense
  $ (77,178 )   $ (51,111 )   $ (229,856 )   $ (152,222 )
 
                               
 
                       
Net increase
  $ 52,399     $ 41,986     $ 153,916     $ 124,847  
 
                       
 
                               
Net Income available to common stockholders
  $ 118,112     $ 567,022     $ 707,395     $ 1,606,803  
 
                               
Net increase as percentage of Net Income available to common stockholders
    44.4 %     7.4 %     21.8 %     7.8 %
As of September 30, 2008, the fair value of our fixed rate debt outstanding was approximately $231.4 million. Interest rate fluctuations may affect the fair value of our fixed rate debt instruments. If interest rates on our fixed rate debt instruments, using rates at September 30, 2008, had been one percentage point higher or lower, the fair value of those debt instruments on that date would have decreased or increased by approximately $11.0 million and $11.7 million, respectively.
In the future, we may be exposed to additional effects of interest rate changes primarily as a result of our line of credit, term loan or long-term debt used to maintain liquidity and fund expansion of our real estate investment portfolio and operations. Our interest rate risk management objectives are to limit the impact of interest rate changes on earnings and cash flows and to lower overall borrowing costs. To achieve this objective, we will borrow primarily at fixed rates or variable rates with the lowest margins available and, in some cases, with the ability to convert variable rates to fixed rates. We may also enter into derivative financial instruments such as interest rate swaps and caps in order to mitigate the interest rate risk on a related financial instrument. We will not enter into derivative or interest rate transactions for speculative purposes.
In addition to changes in interest rates, the value of our real estate is subject to fluctuations based on changes in local and regional economic conditions and changes in the creditworthiness of lessees, all of which may affect our ability to refinance debt if necessary.
Item 4. Controls and Procedures
a) Evaluation of Disclosure Controls and Procedures
As of September 30, 2008, our management, including our chief executive officer and chief financial officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, management, including the chief executive officer and chief financial officer, concluded that our disclosure controls and procedures were effective as of September 30, 2008 in providing a reasonable level of assurance that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in applicable SEC rules and forms, including providing a reasonable level of assurance that information required to be disclosed by us in such reports is accumulated and communicated to our management, including our chief executive officer and our chief financial officer, as appropriate to allow timely decisions regarding required disclosure. However, in evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated can provide only reasonable assurance of necessarily achieving the desired control objectives, and management was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

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b) Changes in Internal Control over Financial Reporting
There were no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II – OTHER INFORMATION
Item 1. Legal Proceedings
Neither we nor any of our subsidiaries are currently subject to any material legal proceedings, nor, to our knowledge, is any material legal proceeding threatened against us or our subsidiaries.
Item 1A. Risk Factors
Our business is subject to certain risks and events that, if they occur, could adversely affect our financial condition and results of operations and the trading price of our common stock. For a discussion of these risks, please refer to the “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, filed by us with the Securities and Exchange Commission on February 27, 2008, and our Quarterly Report on Form 10-Q for the quarter ended June 30, 2008, filed by us with the Securities and Exchange Commission on August 5, 2008. In connection with our preparation of this quarterly report, we have reviewed and considered these risk factors and have determined that the following risk factors should be read in connection with the existing risk factors disclosed in the Form 10-K for the year ended December 31, 2007 and Form 10-Q for the quarter ended June 30, 2008.
The current state of the economy and the capital markets increases the possibility of adverse effects on our financial position and results of operations.
The United States has entered into an economic downturn. Continued weak economic conditions could adversely impact the financial condition of one or more of our tenants and, therefore, could make a tenant bankruptcy and payment default on the related lease more likely. Impaired financial positions and operating results could, in turn, harm our results of operations and affect our ability to access capital under our line of credit. The maximum amount we may draw under our line of credit is based on a percentage of the value of properties pledged as collateral to the banks, which must meet agreed upon eligibility standards. As we arrange for long-term mortgages for these pledged properties, the banks will release the properties from the line of credit and reduce the availability under the line of credit by the advanced amount of the removed property. The economic decline generally, and the disruptions in the capital markets in particular, have decreased liquidity and increased our cost of debt and equity capital which could also impact our ability to raise capital and reduce our volume of new investments. The longer these conditions persist, the greater the probability that these factors could have an adverse effect on our operations and financial results.
Our ownership of properties through ground leases exposes us to risks which are different than those resulting from our ownership of fee title to other properties.
     We have acquired an interest in certain of our properties by acquiring a leasehold interest in the land underlying the property, and we may acquire additional properties in the future that are subject to similar ground leases. In this situation, we have no economic interest in the land underlying the property and do not control this land. Because we do not control the underlying land, this type of ownership interest poses potential risks for our business because (i) if the ground lease terminates for any reason, we will lose our interest in the property, including any investment that we made in the property, (ii) if our tenant defaults under the previously existing lease, we will continue to be obligated to meet the terms and conditions of the ground lease without the annual amount of ground lease payments reimbursable to us by the tenant, and (iii) if the third party owning the land under the ground lease disrupts our use either permanently or for a significant period of time, then the value of our assets could be impaired and our results of operations could be adversely affected.

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were voted on during the three months ended September 30, 2008.
Item 5. Other Information
Not applicable.
Item 6. Exhibits
Exhibit Index
     
Exhibit   Description of Document
 
   
3.1†
  Amended and Restated Articles of Incorporation, incorporated by reference to Exhibit 3.1 to the Registration Statement on
Form S -11 (File No. 333-106024), filed September 11, 2003.
 
   
3.2†
  Bylaws, incorporated by reference to Exhibit 3.2 to the Registration Statement on Form S-11 (File No. 333-106024), filed September 11, 2003.
 
   
3.2.1†
  First Amendment to Bylaws, incorporated by reference to Exhibit 99.1 of the Current Report on Form 8-K (File No. 000-50363), filed July 10, 2007.
 
   
4.1†
  Articles Supplementary Establishing and Fixing the Rights and Preferences of the 7.75% Series A Cumulative Redeemable Preferred Stock, incorporated by reference to Exhibit 3.3 of Form 8-A (File No. 000-50363), filed January 19, 2006.
 
   
4.2†
  Articles Supplementary Establishing and Fixing the Rights and Preferences of the 7.5% Series B Cumulative Redeemable Preferred Stock, incorporated by reference to Exhibit 3.4 of Form 8-A (File No. 000-50363), filed October 19, 2006.
 
   
4.3†
  Form of Certificate for 7.75% Series A Cumulative Redeemable Preferred Stock of Gladstone Commercial Corporation, incorporated by reference to Exhibit 4.1 of Form 8-A (File No. 000-50363), filed January 19, 2006.
 
   
4.4†
  Form of Certificate for 7.5% Series B Cumulative Redeemable Preferred Stock of Gladstone Commercial Corporation, incorporated by reference to Exhibit 4.2 of Form 8-A (File No. 000-50363), filed October 19, 2006.
 
   
10.1†
  Amended and Restated Investment Advisory between the Gladstone Commercial Corporation and Gladstone Management Corporation, dated January 1, 2007, incorporated by reference to Exhibit 99.1 of the Current Report on Form 8-K (File No. 
000-50363), filed January 3, 2007 (renewed on July 9, 2008).

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Exhibit   Description of Document
10.2†
  Administration Agreement between Gladstone Commercial Corporation and Gladstone Administration, LLC, dated January 1, 2007 incorporated by reference to Exhibit 99.2 of the Current Report on Form 8-K (File No. 000-50363), filed January 3, 2007 (renewed on July 9, 2008).
 
   
11
  Computation of Per Share Earnings from Operations (included in the notes to the unaudited financial statements contained in this report).
 
   
31.1
  Certification of Chief Executive Officer pursuant to section 302 of The Sarbanes-Oxley Act of 2002.
 
   
31.2
  Certification of Chief Financial Officer pursuant to section 302 of The Sarbanes-Oxley Act of 2002.
 
   
32.1
  Certification of Chief Executive Officer pursuant to section 906 of The Sarbanes-Oxley Act of 2002.
 
   
32.2
  Certification of Chief Financial Officer pursuant to section 906 of The Sarbanes-Oxley Act of 2002.
 
  Previously filed and incorporated by reference.

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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
         
  Gladstone Commercial Corporation
 
 
Date: November 5, 2008  By:   /s/ Harry Brill    
    Harry Brill   
    Chief Financial Officer   

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