Gladstone Land -- Risks Part Two

Non-Business Risk Factors

Liberty’s Highlights

I’ve decided to give away two one-month subscriptions to Liberty Highlights. Technically, it is free, but he also offers a subscription. Same content, but he’s trying to justify the work (and trust me, it’s a lot of work) with a subscription fee. Somewhat like a “Let me tell you some stories and hopefully you find it worth a small fee, but if not enjoy the stories.” His goal is a 5% subscription rate, but lately it’s down closer to 3%. So, let’s get the word out. We’ll do one this week and one next week. If you are interested, please send me an email saying “I’m interested” or reply to this forum and I will randomly pick a winner (winner will be selected Monday morning).

Disclaimer — This is an informational process and is not designed to tell you whether or not you should buy Gladstone Land Corporation (LAND 0.46%↑). Instead, it is designed to show you how I would go about the evaluation and what questions I have. DO NOT USE THIS SERIES TO MAKE A BUY/SELL DECISION!

Note that this is a different, multiple part (maybe too much) attempt to look closely at a company. Please let me know what you think and feel free to offer suggestions for improvement.

Other Risk Factors

After a LONG post on business risks associated with Gladstone Land, I decided having back-to-back posts on other risk factors might cause a round of head injuries from readers falling asleep onto their keyboards. While risks are important and worth spending some time with, they can also be a bit monotonous and repetitive. Therefore, I switched it up and went with a valuation topic last time around.

Doing this made me a bit wary about how much Gladstone Land I held. Therefore, I did decide to liquidate a sizeable chunk (probably about 45%). I do have other access to investing in farmland (Acretrader), own other REITs (such as Iron Mountain Inc., Innovative Industrial Properties, etc.), and real estate (Fundrise and TIAA Real Estate). That said, none of those are recommendations to buy/sell positions. Please do not blindly follow me into investments as our age, income and goals are all very different.

Now, back to more risk issues.

Advisor Risk Factors

Let’s take a look at the six risks associated with having an advisory service that recommends investments. Again, this is not to say that the firm is wrong to provide payment for advisory fees as someone is doing the legwork to find farms, tenants, and bring these parties together in a way that allows Gladstone Land to be profitable. They deserve compensation for their efforts. As of now, this includes a base fee plus an incentive fee on each deal that earns over 7%.

The first risk factor is that it is a small group of people that are largely responsible for finding and negotiating opportunities for Gladstone Land. However, there is a risk of what happens if something were to cause one of the key players to retire, have a health risk, etc. Fortunately, this is no different than any other key corporation and most have plans for replacement. Probably the biggest risk here would be to CEO/President David Gladstone.

The second risk factor has to do with adviser board competence. As stockholders, you are reliant on the advisory team to be good at what they do. If not, you may see leverage ratios get misaligned (too low or too high), poor investments, contract issues, inferior tenants, etc. Fortunately, we have the ability to monitor how well Gladstone has done with this in the recent past and the verdict is positive. They have not lost money in any given year and even managed the COVID situation positively. This is not to say that they are perfect as there is only one other farming REIT to compare them to (Farmland Partners which is up about 92% over the past 5 years). Gladstone Land during that time is up about 110% over the same time frame. The S&P 500 is up 78.4% during those same 5 years. Unfortunately, we don’t really have a lot to compare returns to in order to measure how well Gladstone Land has done.

The third risk factor is essentially an agency relationship issue. An agency relationship refers to a situation where one party (the agent) hires another party (the principal) and then grants the principal decision-making authority. This works well in certain situations, when the goals of the principal and agent are aligned. It works poorly when the goals of the principal and agent are poorly aligned. Here, there is a legitimate question regarding how well the advisory committee is aligned with the shareholders as the advisory committee is employed by Gladstone.

At the same time, our Advisory Agreement permits our Adviser to conduct other commercial activities and to provide management and advisory services to other entities, including, but not limited to, Gladstone Commercial, Gladstone Capital, and Gladstone Investment, each of which is affiliated with us.

We also see this

Examples of these potential conflicts include:

• our Adviser may realize substantial compensation on account of its activities on our behalf and may be motivated to approve acquisitions solely on the basis of increasing its compensation from us;

• our agreements with our Adviser are not arm’s-length agreements, which could result in terms in those agreements that are less favorable than we could obtain from independent third parties;

• we may experience competition with our affiliates for potential financing transactions; and

• our Adviser and other affiliates, such as Gladstone Commercial, Gladstone Capital, Gladstone Investment, and Gladstone Acquisition could compete for the time and services of our officers and directors and reduce the amount of time they are able to devote to management of our business.

In other words, there is legitimate concern that the advisers could be acting in the interest of one of the other Gladstone companies (or a different company) that conflicts with shareholders of LAND. While it is wrong to assume that the advisory board is intentionally trying to cheat LAND shareholders, it is not wrong to assume that there is potential for situations where priorities are in conflict (despite the best efforts of Gladstone) and this opens up a significant agency conflict.¹

The fourth risk is more boilerplate than anything. Technically, the company could have opportunties that it bypasses because there are not enough people to do the job or are ineffective at their job. That said, this is no different than any other company.

The fifth risk is important because I don’t see the last time that the incentive fee was waived (it is possible it was done before 2020).

The Advisory Agreement contemplates a quarterly incentive fee based on our funds from operation (“FFO”). Our Adviser has the ability to issue a full or partial waiver of the incentive fee for current and future periods; however, our Adviser is not required to issue any waiver. Any waiver issued by our Adviser is an unconditional and irrevocable waiver. If our Adviser does not issue this waiver in future quarters, it could negatively impact our earnings and may compromise our ability to maintain our current level of, or increase, distributions to our stockholders.

While they may have the ability to waive the incentive fee, it does not appear to be happening currently (if I'm wrong, please let me know as I'd rather be correct than right). Which means that in 2021, the firm paid $6,329,000 in base management fees, $3,901,000 in incentive fees, $1,526,000 in administrative fees, and $4,675,000 in operating expenses. They generated $75,318,000 in rents/leases, so their total cost is 21.8% of rental fees (5.2% incentive fees). In this situation, I’m presenting numbers because it is good to understand the costs. If the firm generates a 10% return, that will fall to 9.4% from base fees and another 2% (1.75% on the difference between 7% and 8.75% + an extra 0.25% on the difference between 10% and 8.75%) to earn 7.4% total.²

The sixth risk is similar to the mutual fund rule. You can owe taxes on a mutual fund (assuming it is in a taxable account) during a period in which you lose money. The reason is the way dividend and capital gains taxes are determined. Assume you earn a 2% dividend and have $100,000 in AGI (single) so you are in the 24% income tax bracket, you’ll pay 15% in taxes. So, if you earned $2000 in dividends, you get to keep $1700 and pay $300 in taxes.³ If they distribute capital gains and do so randomly, they could report capital gains of 10% (by selling their "winners"), even if they lose money. Gladstone is warning investors that the incentive fee is based on individual properties and they could take losses overall due to other factors.

Risks With Ownership of Common Stock and Tax Status

In addition to risks associated wtih the advisory nature of Gladstone Land, there are also risks associated with the structure of their securities, both preferred and common.

The first of these risks is that effectively the company is structured to avoid acquisition. Therefore, even if an institutional investor thought that Gladstone Land was being run inefficiently, there is little that they could do to make it more efficient.

Our articles of incorporation prohibit ownership of more than 3.3% of the outstanding shares of our capital stock by one person, except for certain qualified institutional investors, which are limited to holding 9.8% of our common stock.

In other words, it would be impossible to acquire a large enough stake gain control. In addition, they have a staggered board and the only reason for removal of a board member is for cause. Finally, a discouraged stockholders would need approval by two-thirds of the other shareholders. In other words, the chances of a hostile takeover are VERY, VERY small.

The second risk merely states that, barring a nearly criminal act by directors (only a slight exaggeration), shareholders have little recourse for protection.

The third risk factor is clearly less relevant. Essentially, it states that the firm can use Operating Partnership agreements that can make it difficult to sell properties at opportune times. That said, the firm states that it does not any of these OP pieces in place.

The fourth risk is directly related. If they were to enter an OP agreement, then the other party in the OP could force the firm to buy out their shares. Again, there are currently no Operating Partnerships in agreement. Is it a real risk? Sure, it COULD be, but it is not currently an issue.

The fifth risk is that the firm has issued preferred B, preferred C, and preferred D shares. This is not uncommon among REITs as many use preferred stock as a form of financing. What is a bit uncommon is that

Under our charter, we currently have authority to issue shares of both common stock and preferred stock (inclusive of our Series B Preferred Stock, Series C Preferred Stock, and Series D Term Preferred Stock). Our Board of Directors has the authority, without a stockholders’ vote, to classify or reclassify any unissued shares of stock, including common stock, into preferred stock (or vice versa), to increase or decrease the authorized number of shares of common stock and preferred stock and to establish the preferences and rights of any preferred stock or other class or series of shares to be issued.

Essentially, this gives the Board of Directors the right to manipulate the shares of stock outstanding to control voting rights. It is doubtful that this would occur given the difficulties of an interested party taking control of the firm (see risk one of the ownership structure), but is yet another potential hurdle which illustrates that common shareholders have essentially no control (which goes back to the shareholder rights score of 9/10 (where 10 is the worst score) and Board of 10/10.

Here are the next set of risks associated with ownership of common stock and tax status.

For the first one, let’s take a second to reintroduce the three primary types of preferred stock outstanding. You can see the full documents of Gladstone Land preferred shares on this page. Essentially Series B Preferred shares were issued in May 2018 with a 6% dividend and $25 par value (for a dividend of $1.50 per year), Series C Preferred shares were issued in February 2020 with a 6% dividend and $25 par value (again $1.50 per year), and Series D Preferred shares were issued in January 2021 with a 5% dividend and $25 par value (for a $1.25 dividend). These shares trade for around $26.50 - $27.00 per share for the Series B and $24.50 - $25 per share for the Series D (Series C is not publicly traded).

As is common, preferred dividends are paid before common and could result in the firm paying more in preferred dividends than it generates in cash flows in a given period. That said, Funds From Operations (FFO) has been positive every year since 2014 and has grown from $1,160,000 to $21,010,000 during that time (along with a lot of new shares being issued). The chance that preferred dividends will eat into Gladstone Lands cash flows to the point of using all the cash flows is, once again, not a reasonable concern. Again, it is one of the things that COULD happen, but is not something that will keep me up at night worrying about happening.

The seventh risk is essentially restating the sixth. Again, not a concern I have.

The eighth through eleventh risk are all related to maintaining their status as a REIT. Essentially, this requires them to meet several requirements including distributing at least 90% of their income in the form of dividends each year and having 75% of their assets in real estate. There are also several other rules that focus on accounting issues. That said, there are lots of REITs out there and all of them have similar disclosure agreements. It is hoped that their accounting departments are well aware of the requirements and working with management to make sure that they are on the right side of the REIT structure rules. If so, then none of these issues will be a major problem. The eleventh issue is a tax code on dividends that states that dividends for REITs are taxed as ordinary dividends (not qualified) and therefore at a higher tax rate (your ordinary income tax bracket) rather than the reduced dividend tax bracket. Therefore, if you are in the higher tax bracket range, you will be paying up to 37% (assuming you are quite wealthy) instead of the max of 20% on ordinary dividends. In other words, for every $1 you receive, you would get at least $0.63 instead of $0.80 as a worst-case scenario.

Here are the last set of risks associated with ownership/tax status.

The next risk is related to a rule for REITs which states that

To maintain our qualification as a REIT, no more than 50% of the value of our outstanding stock may be owned, directly or indirectly, by five or fewer individuals during the last half of a taxable year.

Given that they have strict rules in place to prevent this from happening (David Gladstone does own 8.7% of the shares as the largest shareholder), there is no real reason to worry about this.

The following risk is just stating that they do not intend to fight a letter from the IRS about REIT status. The next states that sale-leaseback agreements may be barred from REIT consideration. If this were to occur, it would kill half of the REITs out there. Frankly, I’m not sure why they are even listed as risks.

The next risk has to do with plan structure. The part that is confusing is that the REIT is listed as inappropriate for an IRA and I own it in my IRA. I did a little digging and found this statement:

What most RIAs would advise their clients to invest in, though, are real estate stocks, real estate mutual funds, and REITs. Of the three, REITs are the most common because there is a significant advantage for real estate firms to structure themselves this way: They aren't taxed at the corporate level. Like limited liability corporations, income isn't taxed until it's paid out to shareholders.

So, again, I’m not sure what the purpose of this warning is.

Jumping to the following risk, we see concern about operating partnerships which is a common structure in REITs. Essentially, they are saying that IF the IRS were to challenge the structure it could result in problems, but the chances of it happening are not on the radar.

Gladstone uses a Taxable REIT Subsidiary (TSR) structure in their REIT. This allows them to reduce their tax burden and is limited to under 20% of REIT assets. They are in no danger of violating this agreement based on current operating conditions.

And finally, there is a risk that “legislative or regulatory income tax changes” could occur to REITs. This is true. It is also true that tax codes for any type of business could change. It does not imply that the changes are likely to occur or would be damaging. Essentially the last set of risks are throwing in the kitchen sink. They COULD happen, however are unlikely to and are likely not major problems if they do occur.

Risks Related to the Market for our Common and Preferred Stock

And, let’s take a moment to celebrate…the LAST SET OF RISKS!

Now, before getting TOO excited about this last set of risks, realize that they could have left all of them off without missing a beat other than maybe violating the secret handshake clause of a 10K (yes, I am making that up just to see if you’re still awake because I dozed off in the last set).

Yes, increasing the supply of shares can hurt the price per share assuming the market is not deep enough. An increase in interest rates can also impact the price of common (especially one that is based largely on a dividend yield). The third risk has a little validity in that if they were to issue debt, it would take precedence over the preferred shares, but that is true for any company. It feels like we’ve covered the fourth risk already…oh yes, the sixth and seventh risk of the previous section. I guess they really want you to know that not having money means you aren’t going to receive dividends even if it hasn’t happened.

The next risk is that Series C Preferred is not listed. It still can be bought/sold, but is more of a private market transaction which means you will probably take a bit of a liquidity hit. Here’s a tip…don’t buy Series C until it is listed. 🤣 You’re welcome! Oh, and the next risk is if the rest of the stocks disappear, they will be required to buy back the Series C Preferred. If this happens, accept that your investment in Gladstone Land went bust because that is about the only situation where all other stocks will no longer be traded. The last risk is somewhat relevant in that it essentially means that the Series B, C, and D Preferred are callable by the company. This would only be relevant assuming that they could refinance the preferred shares for enough of a savings to make the repurchase worthwhile. If that were to happen, you would probably see an increase in the common (which is what we’re actually covering in the first place).

Reviewing The Risks

Okay, we started with a column covering 37 different business risks. Then we did another column covering another 31 different risks related to advisery boards and common stock ownership, tax structure, etc. That is a set of 68 different risks related to this business. Does anyone know why investors don’t want to read through a 10K? It probably has to do with identifying any and all risks that management can think of (which unfortunately is still going to miss one or two important risks that no one is even considering at this point — again, go back to 2019 and what was the warning of COVID risks?) rather than covering all the risks. Primarily because no one knows all the risks.

Of the risks presented here, there are three that I think are most important.

1. The risk associated with advisers making the correct call on which farmland to purchase, at what price, and who to lease it to. These are all challenging decisions where an advisory service will have an edge. However, that edge is going to be eaten into on two fronts. First, there are more and more competitors looking for opportunities, which implies that there will be fewer lucrative to exploit. The second is the incentive fee (which can be high) and potential agency relationships across the various Gladstone companies. This additional competition and lack of arms-length processes creates concerns about the ability of the advisory board to look out for shareholder interests as their primary focus. It could be that they do so, but there are lots of temptations between their (principals) interests and shareholder interests.

2. The second major risk is that there is little motivational force provided by takeover. The structure of Gladstone Land is such that there is not much an institution could do in order to create a potential takeover threat. Gladstone Land has created a board structure that makes it difficult to push out directors or advisory members. This effectively allows Gladstone to double-down on their lack of corporate control oversight. The first and second factors are reasons why they are rated poorly in shareholder rights and board.

3. While the first two are the biggest, the third is related to their preferred/debt structure. Having 3 classes of preferred stock plus multiple loan agreements along with the ability to raise more money going forward, it is difficult to predict what will be left to common shareholders. So far, things have been successful (assuming you want exposure to farmland). However, if you look at the last two years (2020 and 2021), Funds From Operations have increased from $14,486,000 to $21,012,000 (a 45% increase) while Funds From Operations PER SHARE have increased from $0.65 to $0.69 (a 6.2% increase). The REIT is growing, but the value of the REIT per share is not growing at anywhere near the same rate.

1. A common example I gave while teaching is when I would conduct interviews with potential students considering coming to Pittsburg State. While I would try to tell them that all schools had pros and cons and that the University of Kansas, Kansas State, Emporia State, etc. may be a better choice for them, I would be lying if I said that I was a neutral observer.

2. Remember that the incentive fee is 100% of the difference between 7% and 8.75% and 20% beyond that. Therefore, a 7% return will get 6.4%. An 8.75% return will also get 6.4%. Once we get beyond 8.75% return, we get 80% of those gains (or an additional 1%).

3. Note that REIT income taxes (like Gladstone Land) are taxed as ordinary income, so you would get to keep $1520 and pay $480 in taxes.