Gladstone Land -- Valuations

Terms and a Very Rough Model

Housekeeping

A reminder that next week we’ll be taking the week off for chemo. The plan is for two more episodes of Gladstone Land (another on risks and one that is designed to be a wrap-up of the process). We’ll see how that goes.

A quick update on some of the other things being written (with the recognition that I’m reading less than 1% of what’s being published), but if you don’t normally read Gurwinder, he recently made a great post on Stoicism. Essentially it focuses on distractions (I’ve found myself clicking on “news” links a lot less recently as these often turn into distractions) and separates them into desire, anger, and anxiety. It probably takes about 10-15 minutes to read (assuming you can avoid getting distracted 🤣) and is worth the time. I’m not a disciple of Stoicism, but can relate to a lot of the advice in the column.

Disclaimer — This is an informational process and is not designed to tell you whether or not you should buy Gladstone Land Corporation (LAND -0.86%↓). 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!

Key Terminology Differences

REITs are a bit strange. While we are still focusing on a discounted cash flow model, but our DCF model will be built a bit differently. Before we get to that, I want to introduce a few terms that you may or may not be familiar with.

FFO, CFFO, and AFFO — Funds From Operations

The first thing to recognize is that Net Income is not as important as it is with many firms because of the structure of the REIT. Instead, we introduce Funds From Operations, Core Funds From Operations and Adjusted Funds From Operations as alternatives (primarily due to depreciation and amortization issues). Here is Gladstone Land explaining the distinction:

Specifically, we believe that FFO is helpful to investors in better understanding our operating performance, primarily because its calculation excludes depreciation and amortization expense on real estate assets, as we believe that GAAP historical cost depreciation of real estate assets is generally not correlated with changes in the value of those assets, particularly with farmland real estate, the value of which does not diminish in a predictable manner over time, as historical cost depreciation implies. Further, we believe that CFFO and AFFO are helpful in understanding our operating performance in that it removes certain items that, by their nature, are not comparable on a period-over-period basis and therefore tend to obscure actual operating performance.

FFO starts with net income and then adjusts for amortization and depreciation. CFFO and AFFO add in a couple of additional items meant to help standardize from year to year.

FFO = Net Income + Depreciation + Amortization + Losses on Sales of Asset - Gains on Sales of Assets - Interest Income

CFFO = FFO + Acquisition- and Disposition-Related Expenses + Other Adjustments

AFFO = CFFO + Rent Adjustments + Amortization of Debt Issuance Costs + Other Adjustments

So, here you can see their FFO, CFFO, and AFFO on a total basis for the last two years.

Let’s walk through this a bit. In calculating FFO, Gladstone starts with their net income ($3,514,000). Then they reduce this by dividends paid to the Series B and Series C preferred shares (-$12,258,000) which leaves them $8,744,000 in the hole. However, since farmland actually tends to appreciate instead of depreciate, they add the value of of that back in ($27,183,000). In addition, they have losses on disposition of real estate assets ($2,537,000) and adjustments for unconsolidated entities ($36,000). Add these all together and we get $21,012,000 for the year, which is up considerably from the $14,486,000 from last year.¹

The CFFO adjusts for other one-time expenses. It adds in any acquisition and disposition related expenses of $355,000 plus other nonrecurring receipts/charges (-$12,000) to give us $21,355,000.

The AFFO makes a couple of other adjustments for net rent (-$2,371,000), amortization of debt issuance costs ($1,172,000) and other non-cash charges ($246,000) which lowers the total to $20,402,000.

You can argue which is a better measure of cash flows (you can see the specifics on the bottom of p. 51-52 on how each is calculated), but they are all pretty close to one another. I’ll leave it up to you to decide which one you feel is most appropriate, but in the case of Gladstone Land, you’re not going to see major differences between the three.

Now let’s come back to the big jump in FFO/CFFO/AFFO from 2020 to 2021. It is largely an illusion. REITs need to raise capital to expand operations. Without issuing more shares (or more debt), it is impossible for Gladstone Lands to expand. However, they did expand because they issued quite a few more shares.

Specifically, the number of shares went from 22,389,866 in 2020 to 30,523,335 in 2021. This is a 36% increase in shares outstanding, which greatly eats into the more important FFO/CFFO/AFFO on a per-share basis. Specifically, the three numbers were up by only $0.03-$0.04 per share (FFO went from $0.65 per share to $0.69 per share). These numbers are rising, but are quite a bit smaller than they appeared to be based on the overall numbers. Always remember to adjust to a per-share basis when doing calculations!

Net Asset Value

Another key difference in REITs is that instead of book value, they have a Net Asset Value measurement. The NAV is designed to capture the fair value of the firm’s assets on a per share basis less any liabilities associated with the property. Here we can see the breakdown of the calculations.

They are “showing their work”. Specifically, how did they value the properties and the assumptions that were used. Purchase price refers to firms purchased in the last year are done at purchase price. Internal valuation is done for some properties (but only 3), and Third-party appraisals are done for those that were purchased beyond the last year.²

Next we make the necessary adjustments of liabilities and preferred shares to convert to a per share Net Asset Value.

This gives us the NAV of $14.31 as of the end of the 2021 year. Note that the actual price of the stock on this day was $33.39.³ This was quite a bit higher than the NAV.

Why is the stock price so much higher than the NAV? This is a good question that I don’t have a strong answer for. One could argue that Gladstone Land is being very conservative in estimating their NAV or that farmland is expected to increase in value at a much faster rate than other real estate. While the second argument does hold some weight, you could also make a strong argument that the stock price is simply overvalued.

Blue Vault Partners recently published a table of REIT stock prices relative to Net Asset Values and concluded that the NAV for Gladstone Land is quite a bit higher than it’s price (as in 98% of the NAV as of April 29th, 2022) and is the biggest differential between the price of the stock and the NAV.

Cash Flow and Net Asset Value Thoughts

If we look at Cash Flow (FFO, CFFO, and AFFO) and Net Asset Value, it is pretty easy to come to the conclusion that Gladstone Land is either pretty overvalued OR is expected to grow significantly going forward. If I look at a Price/CF value (price based on the close of 8-15-22), I’m going to end up with $26.10/$0.70 = 37.3X to $26.10/$0.67 = 39.0 Both of these numbers are pretty high unless cash flows are expected to grow significantly going forward. If we look at Price/NAV we get $26.10/$14.31 = 82.4% premium to NAV. Again, this is a steep price that is only justified if the cash flows keep growing and NAV keeps growing at a reasonably high rate.

2nd Quarter Highlights

Fortunately, their 2nd quarter 10Q was just released this month. They added (over the first two quarters) 1 new farm (an olive farm in CA) of 1,374 acres plus a 15 acre farmroad. In other words, new acquisitions have been slower. This is not unusual as farm acquisitions can be a bit “clumpy”.⁴ Their FFO, CFFO, and AFFO are $0.33, $0.33, and $0.31 which indicates slight growth over the previous year ($0.30, $0.31, and $0.30). Their NAV has climbed to $15.60 per share. While this does reduce their premium ($26.10/$15.60 = 67.3%), it still remains relatively high.

Advisory Fees

Their adviser fees are separated into a base management fee and, each as applicable, an incentive fee, a capital gains fee, and a termination fee. There are also other fees associated with the property. Here you can see a breakdown of advisery fees for 2021 and the first 6 months of 2022.

Essentially, part of Gladstone’s revenues are channeled back into advisory fees to the tune of approximately $6M a year currently (based on the first 6 months of 2022). For the current year, their operating revenue is $40,236,000 and they are spending $2,974,000 (approximately 7.4%) in advisory fees (last year the number was higher as they earned $75,318,000 and paid $10,230,000 in fees for 13.6% rate). This is not a statement that the fees are too high or too low, merely a reflection of what they are spending. Keep in mind that the advisors are not meant to work for free and are providing a service to Gladstone Land for the work that they are doing. Instead, your decision as a potential investor is to figure out whether or not Gladstone Land is paying a fair rate, overpaying, or underpaying for these services. Given that the incentive fee gives them 100% of the return between 7% and 8.75% + 20% of the fee over 8.75%, you are losing quite a bit of your returns to incentive fees.⁵

Interest Expense

Remember that we mentioned one of the risks was related to leverage. The idea is that if Gladstone can borrow money at 3% and get a 5% return, they are finding extra money. For example, let’s say that I buy a property for $1,000,000 and negotiate a 5% lease rate. This will generate $50,000 for me (with the hope that the property will also generate a return from capital appreciation as a bonus…we’re going to ignore that for now). If I put up $700,000 to buy the land and borrow $300,000 at 3%, I’m going to still get the $50,000, but I’ll have $9000 in interest expense and get $41,000 on my $700,000 (increasing the return to 5.86%. If I put up $300,000 and borrow $700,000, I’m going to spend $21,000 in interest and get $29,000 on my $300,000 for a 9.67% return. It is easy to see how leverage can be beneficial. The downside is that spending on leverage is an expense (it NEEDS to be paid) and things could go wrong with my lease payment which creates the risk.

If we look at interest expense, it accounts for between $20,621,000 (out of $57,031,000 in revenue) in 2020 and $24,883,000 (out of $75,318,000) in 2021. This accounts for 36% of revenues in 2020 and 33% of revenues in 2021.

Preferred Dividends and Other Expenses

In addition to debt financing, they have preferred dividends (Series B and C) which get paid before common. These accounted for about 16.3% of cash flows in 2020-2021. It is reasonable to expect them to be about that much in 2022.

Other expenses (General and Administrative, Property Management, and Dividends on Preferred Series A and D, and Other) account for about 12.8% of revenues during 2020-2021. Note that this ignores Depreciation/Amortization. If we add up the expenses, we get about 35% for interest expense, 6.5% for other expenses, 13% for base expenses + incentive fees and 16.5% for dividends. This adds up to 71.0% for expenses, leaving approximately 28-30% for shareholders in terms of FFO (as it does not include the depreciation/amortization of property which is not a regular expense). If we split the difference and use 29%, we’d get an FFO of $21,842,000 which is slightly higher than the $21,012,000 for 2021. It’s not perfect, but the model projects about 28% for shareholders in 2021 instead of 29%…close enough for government work especially with the approximations that we’re using.

Valuation Summary

Valuation is hard to do and building a model for Gladstone Lands is probably not meaningful. The combination of depreciation/amortization and additional funding, makes projections pretty challenging (see above discussion). We’d need to know how much funding they are planning to use from various sources, what interest rates will be, and what they are planning to spend, what depreciation/amortization is going to look like, etc. Then, we’d need to project that out for the next 5+ years. The errors in the model are going to swamp the effort to build the model itself.

I’m also not going to tell you what I think Gladstone Land is worth. Partly that is to avoid looking like a complete idiot in the next 3-5 years, but largely it is because predicting the value of any one stock is not really possible. If you believe markets are reasonably efficient, it is probably reasonable to project a 7% return per year for the next 5 years which would put it around $33.31 (from today’s $26.10) given a 5% return + 2% dividend. If you project an 8% return, you’ll get a price of $34.93. In the last year, the price has ranged between $21.23 and $42.10, so you can see that predicting a price is pretty arbitrary.

In full disclosure, I did decide to sell 900 shares last week as I worked through the valuation analysis (I still own 1072 — purchased 1000 shares and have 72 additional shares from dividend reinvesting).

1. Not really…we’ll come back to this.

2. You can read the details on how these are calculated on p. 54 of the 10K

3. It has since dropped to $26.10.

4. It should be noted that they have acquired 5 new properties in July (a 40-acre corn farm and 4 farms totalling 1,317 acres in Oregon/Washington for wine grapes). The grape farms accounted for well over 99% of the purchase price of farms properties in July.

5. For comparison, AcreTrader takes 0.75% of the asset fees for advisory vs. 0.60% for a base management fee. However, AcreTrader does not take incentive fees. The question then becomes at what rate does that tradeoff occur? If you earn 7% per year, you save 0.15% using Gladstone. If you earn 7.15% per year, you are equal. If you earn 8.75% per year, you are paying a LOT more for Gladstone. That said, it is unlikely that you earn 7% per year in AcreTrader as many of their yields are between 2.6% - 4.0% on an annual basis before the potential big gain of a land sale is included. That is typically 10 years out and we have no idea what it will be.