| GLADSTONE COMMERCIAL CORP Item 1A Risk Factors We are a relatively new company with little operating history and may not be able to operate successfully |
| We were incorporated in February 2003, and, as a result, we are subject to all of the business risks and uncertainties associated with any new business enterprise |
| Our failure to operate successfully or profitably or accomplish our investment objectives could have a material adverse effect on our ability to generate cash flow to make distributions to our stockholders, and the value of an investment in our securities may decline substantially or be reduced to zero |
| We are not currently able to set a consistent distribution rate, and the distribution rate we fix in the future may have an adverse effect on the market price for our common stock |
| Because we are relatively newly organized, we currently do not have the ability to predict with any certainty the amount of our future cash flows or our distribution rate |
| For the year ended December 31, 2005, we declared monthly distributions of dlra0dtta06 per share of common stock for the three months ended March 31, 2005, dlra0dtta08 per share of common stock for both the three months ended June 30, 2005 and September 30, 2005, and dlra0dtta10 per share of common stock for the three months ended December 31, 2005, or a total of dlra0dtta96 for the entire year |
| Our future distribution rate will depend entirely on the timing and amount of rent and mortgage payments from our investments |
| Our failure to make investments at acceptable rates of return could result in our fixing a distribution rate that is not competitive with alternative investments, which could adversely affect the market price of our common stock |
| Highly leveraged tenants or borrowers may be unable to pay rent or make mortgage payments, which could adversely affect our cash available to make distributions to our stockholders |
| Some of our tenants or borrowers may have been recently restructured using leverage or been acquired in a leveraged transaction |
| Tenants or borrowers that are subject to significant debt obligations may be unable to make their rent or mortgage payments if there are adverse changes to their businesses or economic conditions |
| Tenants that have experienced leveraged restructurings or acquisitions will generally have substantially greater debt and substantially lower net worth than they had prior to the leveraged transaction |
| In addition, the payment of rent and debt service may reduce the working capital available to leveraged entities and prevent them from devoting the resources necessary to remain competitive in their industries |
| In situations where management of the tenant or borrower will change after a transaction, it may be difficult for our Adviser to determine with certainty the likelihood of the tenant’s or borrower’s business success and of its ability to pay rent or make mortgage payments throughout the lease or loan term |
| These companies generally are more vulnerable to adverse economic and business conditions, and increases in interest rates |
| Leveraged tenants and borrowers are more susceptible to bankruptcy than unleveraged tenants |
| Bankruptcy of a tenant or borrower could cause: • the loss of lease or mortgage payments to us; • an increase in the costs we incur to carry the property occupied by such tenant; • a reduction in the value of our securities; or • a decrease in distributions to our stockholders |
| Under bankruptcy law, a tenant who is the subject of bankruptcy proceedings has the option of continuing or terminating any unexpired lease |
| If a bankrupt tenant terminates a lease with us, any claim we might have for breach of the lease (excluding a claim against collateral securing the claim) will be treated as a 25 _________________________________________________________________ general unsecured claim |
| Our claim would likely be capped at the amount the tenant owed us for unpaid rent prior to the bankruptcy unrelated to the termination, plus the greater of one year’s lease payments or 15prca of the remaining lease payments payable under the lease (but no more than three years’ lease payments) |
| In addition, due to the long-term nature of our leases and terms providing for the repurchase of a property by the tenant, a bankruptcy court could re-characterize a net lease transaction as a secured lending transaction |
| If that were to occur, we would not be treated as the owner of the property, but might have additional rights as a secured creditor |
| Our real estate investments may include special use and single tenant properties that may be difficult to sell or re-lease upon tenant defaults or early lease terminations |
| We focus our investments on commercial and industrial properties, a number of which include manufacturing facilities, special use storage or warehouse facilities and special use single tenant properties |
| These types of properties are relatively illiquid compared to other types of real estate and financial assets |
| This illiquidity will limit our ability to quickly change our portfolio in response to changes in economic or other conditions |
| With these properties, if the current lease is terminated or not renewed or, in the case of a mortgage loan, if we take such property in foreclosure, we may be required to renovate the property or to make rent concessions in order to lease the property to another tenant or sell the property |
| In addition, in the event we are forced to sell the property, we may have difficulty selling it to a party other than the tenant or borrower due to the special purpose for which the property may have been designed |
| These and other limitations may affect our ability to sell or re-lease properties without adversely affecting returns to our stockholders |
| The inability of a tenant in a single tenant property to pay rent will reduce our revenues |
| Since most of our properties are occupied by a single tenant, the success of our investments will be materially dependent on the financial stability of these tenants |
| Lease payment defaults by these tenants could adversely affect our cash flows and cause us to reduce the amount of distributions to stockholders |
| In the event of a default by a tenant, we may experience delays in enforcing our rights as landlord and may incur substantial costs in protecting our investment and re-leasing our property |
| If a lease is terminated, there is no assurance that we will be able to lease the property for the rent previously received or sell the property without incurring a loss |
| Our business strategy relies heavily on external financing, which may expose us to risks associated with leverage such as restrictions on additional borrowing and payment of distributions, risks associated with balloon payments, and risk of loss of our equity upon foreclosure |
| Our current business strategy contemplates the use of leverage so that we may make more investments than would otherwise be possible in order to maximize potential returns to stockholders |
| If the income generated by our properties and other assets fails to cover our debt service, we could be forced to reduce or eliminate distributions to our stockholders and may experience losses |
| We may borrow on a secured or unsecured basis |
| Neither our articles of incorporation nor our bylaws impose any limitation on borrowing on us |
| Our board of directors has adopted a policy that our aggregate borrowing will not result in a total debt to total equity ratio greater than 2 to 1 |
| This coverage ratio means that, for each dollar of equity we have, we can incur up to two dollars of debt |
| Our board of directors may change this policy at any time, however, our existing line of credit agreement only permits aggregate borrowings that will result in a total debt to equity ratio of not greater than 1dtta5 to 1 |
| Our ability to achieve our investment objectives will be affected by our ability to borrow money in sufficient amounts and on favorable terms |
| We expect that we will borrow money that will be secured by our properties and that these financing arrangements will contain customary covenants such as those that limit our ability, without the prior consent of the lender, to further mortgage the applicable property or to discontinue insurance coverage |
| In addition, our short-term line of credit contains, and any other credit facility we might enter into is likely to contain certain customary restrictions, requirements and other 26 _________________________________________________________________ limitations on our ability to incur indebtedness, and will specify debt ratios that we will be required to maintain |
| Accordingly, we may be unable to obtain the degree of leverage we believe to be optimal, which may cause us to have less cash for distribution to stockholders than we would have with an optimal amount of leverage |
| Our use of leverage could also make us more vulnerable to a downturn in our business or the economy generally |
| There is also a risk that a significant increase in the ratio of our indebtedness to the measures of asset value used by financial analysts may have an adverse effect on the market price of our common stock |
| Some of our debt financing arrangements may require us to make lump-sum or “balloon” payments at maturity |
| Our ability to make a balloon payment at maturity is uncertain and may depend upon our ability to obtain additional financing or to sell the financed property |
| At the time the balloon payment is due, we may not be able to refinance the balloon payment on terms as favorable as the original loan or sell the property at a price sufficient to make the balloon payment, which could adversely affect the amount of distributions to our stockholders |
| We intend to acquire additional properties by using our dlra60 million short-term line of credit established in February, 2005, as amended in July of 2005 and by continuing to seek long-term financing, where we will borrow all or a portion of the purchase price of a potential acquisition and securing the loan with a mortgage on some or all of our existing real property |
| To date we have obtained approximately dlra62 million in long-term financing, which we have used to acquire additional properties |
| If we are unable to make our debt payments as required, a lender could foreclose on the property securing its loan |
| This could cause us to lose part or all of our investment in such property which in turn could cause the value of our securities or the amount of distributions to our stockholders to be reduced |
| We are subject to certain risks associated with real estate ownership and lending which could reduce the value of our investments |
| Our investments include net leased industrial and commercial property and mortgage loans secured by industrial and commercial real estate |
| Our performance, and the value of our investments, is subject to risks incident to the ownership and operation of these types of properties, including: • changes in the general economic climate; • changes in local conditions such as an oversupply of space or reduction in demand for real estate; • changes in interest rates and the availability of financing; • competition from other available space; and • changes in laws and governmental regulations, including those governing real estate usage, zoning and taxes |
| Competition for the acquisition of real estate may impede our ability to make acquisitions or increase the cost of these acquisitions, which could adversely affect our operating results and financial condition |
| We compete for the acquisition of properties with many other entities engaged in real estate investment activities, including financial institutions, institutional pension funds, other REITs, other public and private real estate companies and private real estate investors |
| These competitors may prevent us from acquiring desirable properties or may cause an increase in the price we must pay for real estate |
| Our competitors may have greater resources than we do, and may be willing to pay more for certain assets or may have a more compatible operating philosophy with our acquisition targets |
| In particular, larger REITs may enjoy significant competitive advantages that result from, among other things, a lower cost of capital and enhanced operating efficiencies |
| Our competitors may also adopt transaction structures similar to ours, which would decrease our competitive advantage in offering flexible transaction terms |
| In addition, the 27 _________________________________________________________________ number of entities and the amount of funds competing for suitable investment properties may increase, resulting in increased demand and increased prices paid for these properties |
| If we pay higher prices for properties, our profitability may decrease, and you may experience a lower return on your investment |
| Increased competition for properties may also preclude us from acquiring properties that would generate attractive returns to us |
| Most of our tenants are small and medium size businesses, which exposes us to additional risks unique to these entities |
| Leasing real property or making mortgage loans to small and medium-sized businesses exposes us to a number of unique risks related to these entities, including the following: • Small and medium-sized businesses may have limited financial resources and may not be able to make their lease or mortgage payments |
| A small or medium-sized tenant or borrower is more likely to have difficulty making its lease or mortgage payments when it experiences adverse events, such as the failure to meet its business plan, a downturn in its industry or negative economic conditions |
| • Small and medium-sized businesses typically have narrower product lines and smaller market shares than large businesses |
| Because our target tenants and borrowers are smaller businesses, they will tend to be more vulnerable to competitors’ actions and market conditions, as well as general economic downturns |
| In addition, our target tenants and borrowers may face intense competition, including competition from companies with greater financial resources, more extensive development, manufacturing, marketing and other capabilities and a larger number of qualified managerial and technical personnel |
| • There is generally little or no publicly available information about our target tenants and borrowers |
| Many of our tenants and borrowers are likely to be privately owned businesses, about which there is generally little or no publicly available operating and financial information |
| As a result, we will rely on our Adviser to perform due diligence investigations of these tenants and borrowers, their operations and their prospects |
| We may not learn all of the material information we need to know regarding these businesses through our investigations |
| • Small and medium-sized businesses generally have less predictable operating results |
| We expect that many of our tenants and borrowers may experience significant fluctuations in their operating results, may from time to time be parties to litigation, may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence, may require substantial additional capital to support their operations, to finance expansion or to maintain their competitive positions, may otherwise have a weak financial position or may be adversely affected by changes in the business cycle |
| Our tenants and borrowers may not meet net income, cash flow and other coverage tests typically imposed by their senior lenders |
| The failure of a tenant or borrower to satisfy financial or operating covenants imposed by senior lenders could lead to defaults and, potentially, foreclosure on credit facilities, which could additionally trigger cross-defaults in other agreements |
| If this were to occur, it is possible that the ability of the tenant or borrower to make required payments to us would be jeopardized |
| • Small and medium-sized businesses are more likely to be dependent on one or two persons |
| Typically, the success of a small or medium-sized business also depends on the management talents and efforts of one or two persons or a small group of persons |
| The death, disability or resignation of one or more of these persons could have a material adverse impact on our tenant or borrower and, in turn, on us |
| • Small and medium-sized businesses may have limited operating histories |
| While we intend to target as tenants and borrowers stable companies with proven track records, we may lease properties or lend money to new companies that meet our other investment criteria |
| Tenants or borrowers with limited operating histories will be exposed to all of the operating risks that new businesses face and may be particularly susceptible to, among other risks, market downturns, competitive pressures and the 28 _________________________________________________________________ departure of key executive officers |
| We may not have funding for future tenant improvements |
| When a tenant at one of our properties does not renew its lease or otherwise vacates its space in one of our buildings, it is likely that, in order to attract one or more new tenants, we will be required to expend substantial funds for tenant improvements and tenant refurbishments to the vacated space |
| We cannot assure you that we will have sufficient sources of funding available to us for such purposes in the future |
| Because we must distribute a substantial portion of our net income to qualify as a REIT, we will be largely dependent on third-party sources of capital to fund our future capital needs |
| To qualify as a REIT, we generally must distribute to our stockholders at least 90prca of our taxable income each year, excluding capital gains |
| Because of this distribution requirement, it is not likely that we will be able to fund a significant portion of our future capital needs, including property acquisitions, from retained earnings |
| Therefore, we will likely rely on public and private debt and equity capital to fund our business |
| This capital may not be available on favorable terms or at all |
| Our access to additional capital depends on a number of things, including the market’s perception of our growth potential and our current and potential future earnings |
| Moreover, additional debt financings may substantially increase our leverage |
| Our real estate portfolio is concentrated in a limited number of properties, which subjects us to an increased risk of significant loss if any property declines in value or if we are unable to lease a property |
| At February 28, 2006, we owned 33 properties and held two mortgage loans |
| To the extent we are able to leverage such investments, we will acquire additional properties with the proceeds of borrowings, subject to our debt policy |
| A consequence of a limited number of investments is that the aggregate returns we realize may be substantially adversely affected by the unfavorable performance of a small number of leases or mortgage loans or a significant decline in the value of any property |
| In addition, while we do not intend to invest 20prca or more of our total assets in a particular property at the time of investment, it is possible that, as the values of our properties change, one property may comprise in excess of 20prca of the value of our total assets |
| Lack of diversification will increase the potential that a single under-performing investment could have a material adverse effect on our cash flow and the price we could realize from the sale of our properties |
| Liability for uninsured losses could adversely affect our financial condition |
| Losses from disaster-type occurrences (such as wars or earthquakes) may be either uninsurable or not insurable on economically viable terms |
| Should an uninsured loss occur, we could lose our capital investment or anticipated profits and cash flow from one or more properties |
| Potential liability for environmental matters could adversely affect our financial condition |
| Our purchase of industrial and commercial properties subjects us to the risk of liabilities under federal, state and local environmental laws |
| Some of these laws could subject us to: • responsibility and liability for the cost of removal or remediation of hazardous substances released on our properties, generally without regard to our knowledge of or responsibility for the presence of the contaminants; • liability for the costs of removal or remediation of hazardous substances at disposal facilities for persons who arrange for the disposal or treatment of these substances; and • potential liability for common law claims by third parties for damages resulting from environmental 29 _________________________________________________________________ contaminants |
| We generally include provisions in our leases making tenants responsible for all environmental liabilities and for compliance with environmental regulations, and requiring tenants to reimburse us for damages or costs for which we have been found liable |
| However, these provisions will not eliminate our statutory liability or preclude third party claims against us |
| Even if we were to have a legal claim against a tenant to enable us to recover any amounts we are required to pay, there are no assurances that we would be able to collect any money from the tenant |
| Our costs of investigation, remediation or removal of hazardous substances may be substantial |
| In addition, the presence of hazardous substances on one of our properties, or the failure to properly remediate a contaminated property, could adversely affect our ability to sell or lease the property or to borrow using the property as collateral |
| We obtain environmental site assessments (ESAs) on all of our properties at the time of acquisition |
| The ESAs are intended to identify potential environmental contamination |
| The ESAs include a historical review of the property, a review of certain public records, a preliminary investigation of the site and surrounding properties, screening for the presence of hazardous substances and underground storage tanks, and the preparation and issuance of a written report |
| The ESAs that we have obtained have not revealed any environmental liability or compliance concerns that we believe would have a material adverse effect on our business, assets, results of operations or liquidity, nor are we aware of any such liability |
| Nevertheless, it is possible that these ESAs do not reveal all environmental liabilities or that there are material environmental liabilities or compliance concerns that we are not aware of |
| Moreover, we cannot assure you that (i) future laws, ordinances or regulations will not impose material environmental liability, or (ii) the current environmental condition of a property will not be affected by the condition of properties in the vicinity of the property (such as the presence of leaking underground storage tanks) or by third parties unrelated to us |
| Our potential participation in joint ventures creates additional risk |
| We may participate in joint ventures or purchase properties jointly with other unaffiliated entities |
| There are additional risks involved in these types of transactions |
| These risks include the potential of our joint venture partner becoming bankrupt or our economic or business interests diverging |
| These diverging interests could, among other things, expose us to liabilities of the joint venture in excess of our proportionate share of these liabilities |
| The partition rights of each owner in a jointly owned property could reduce the value of each portion of the divided property |
| Net leases may not result in fair market lease rates over time |
| We expect a large portion of our rental income to come from net leases and, net leases frequently provide the tenant greater discretion in using the leased property than ordinary property leases, such as the right to freely sublease the property, to make alterations in the leased premises and to terminate the lease prior to its expiration under specified circumstances |
| Further, net leases are typically for longer lease terms and, thus, there is an increased risk that contractual rental increases in future years will fail to result in fair market rental rates during those years |
| As a result, our income and distributions to our stockholders could be lower than it would otherwise be if we did not engage in net leases |
| Failure to hedge effectively against interest rate changes may adversely affect our results of operations |
| We may experience interest rate volatility in connection with mortgage loans on our properties or other variable-rate debt that we may obtain from time to time |
| We currently have two variable rate loans, certain of our leases contain escalations based on market interest rates, and the interest rate on our existing line of credit is variable |
| We mitigate this risk by structuring such provisions 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 30 _________________________________________________________________ holding of our cash and cash equivalents in short-term, interest-bearing investments |
| A significant change in interest rates could have an adverse impact on the results of our operations |
| We may seek to mitigate our exposure to changing interest rates by using interest rate hedging arrangements such as interest rate swaps and caps |
| These derivative instruments involve risk and may not be effective in reducing our exposure to interest rate changes |
| Risks inherent in derivative instruments include the risk that counter-parties to derivative contracts may be unable to perform their obligations, the risk that interest rates move in a direction contrary to, or move slower than the period contemplated by, the direction or time period that the derivative instrument is designed to cover, and the risk that the terms of such instrument will not be legally enforceable |
| While we intend to design our hedging strategies to protect against movements in interest rates, derivative instruments that we are likely to use may also involve immediate costs, which could reduce our cash available for distribution to our stockholders |
| Likewise, ineffective hedges, as well as the occurrence of any of the risks inherent in derivatives, could adversely affect our reported operating results or reduce your overall investment returns |
| To date we have not entered into any derivative contracts, however certain of our mortgage loans and properties have embedded derivatives in the form of interest rate floors and ceilings |
| Our Adviser and our board of directors will review each of our derivative contracts we enter into and periodically evaluate their effectiveness against their stated purposes |
| Foreign currency fluctuations may adversely affect our results of operations |
| We have purchased two properties in Canada, and the monthly rental payments on these properties are received in Canadian dollars |
| In an effort to mitigate the risk of foreign currency rate fluctuations, we have secured loans on the real estate properties in which the mortgage payments are denominated in Canadian dollars |
| While we have attempted to minimize the exchange rate risk, we are still exposed to fluctuations in the exchange rate, as we have to convert the payments into US dollars at each transaction date and value the cash, deferred rent asset, and mortgage notes related to the Canadian properties for the exchange rate at each balance sheet date |
| Our success depends on the performance of our Adviser and if our Adviser makes inadvisable investment or management decisions, our operations could be materially adversely impacted |
| Our ability to achieve our investment objectives and to pay distributions to our stockholders is dependent upon the performance of our Adviser in evaluating potential investments, selecting and negotiating property purchases and dispositions and mortgage loans, selecting tenants and borrowers, setting lease or mortgage loan terms and determining financing arrangements |
| Our stockholders have no opportunity to evaluate the terms of transactions or other economic or financial data concerning our investments and must rely entirely on the analytical and management abilities of our Adviser and the oversight of our board of directors |
| If our Adviser or our board of directors makes inadvisable investment or management decisions, our operations could be materially adversely impacted |
| We may have conflicts of interest with our Adviser and other affiliates |
| Our Adviser manages our business and locates, evaluates, recommends and negotiates the acquisition of our real estate investments |
| At the same time, our advisory agreement permits our Adviser to conduct other commercial activities and provide management and advisory services to other entities, including Gladstone Capital Corporation, Gladstone Investment Corporation, and Gladstone Land Corporation, an entity affiliated with our chairman David Gladstone |
| Moreover, all of our officers and directors are also officers and directors of Gladstone Capital Corporation and Gladstone Investment Corporation, which actively make loans to and invest in small and medium-sized companies |
| As a result, we may from time to time have conflicts of interest with our Adviser in its management of our business and with Gladstone Capital and Gladstone Investment, which may arise primarily from the involvement of our Adviser, Gladstone Capital, Gladstone Investment, Gladstone Land and their affiliates in other activities that may conflict with our business |
| Examples of these potential conflicts include: 31 _________________________________________________________________ • our Adviser may realize substantial compensation on account of its activities on our behalf; • we may experience competition with our affiliates for financing transactions; and • our Adviser may earn fee income from our borrowers or tenants; and • our Adviser and other affiliates such as Gladstone Capital, Gladstone Investment and Gladstone Land could compete for the time and services of our officers and directors |
| These and other conflicts of interest between us and our Adviser and other affiliates could have a material adverse effect on the operation of our business and the selection or management of our real estate investments |
| Our financial condition and results of operations depend on our Adviser’s ability to effectively manage our future growth |
| Our ability to achieve our investment objectives depends on our ability to sustain continued growth, which, in turn, depends on our Adviser’s ability to find, select and negotiate property purchases, net leases and mortgage loans that meet our investment criteria |
| Accomplishing this result on a cost-effective basis is largely a function of our Adviser’s marketing capabilities, management of the investment process, ability to provide competent, attentive and efficient services and our access to financing sources on acceptable terms |
| As we grow, our Adviser may be required to hire, train, supervise and manage new employees |
| Our Adviser’s failure to effectively manage our future growth could have a material adverse effect on our business, financial condition and results of operations |
| We are dependent upon our key management personnel for our future success, particularly David Gladstone, Terry Lee Brubaker and George Stelljes III We are dependent on our senior management and other key management members to carry out our business and investment strategies |
| Our future success depends to a significant extent on the continued service and coordination of our senior management team, particularly David Gladstone, our chairman and chief executive officer, Terry Lee Brubaker, our president and chief operating officer, and George Stelljes III, our executive vice president and chief investment officer, all of whom are subject to an employment agreement with our Advisor |
| The departure of any of our executive officers or key employees could have a material adverse effect on our ability to implement our business strategy and to achieve our investment objectives |
| Our rights and the rights of our stockholders to recover claims against our independent directors are limited, which could reduce our recovery and our stockholders’ recovery against them if they negligently cause us to incur losses |
| Maryland law provides that a director has no liability in that capacity if he performs his duties in good faith, in a manner he reasonably believes to be in our best interests and with the care that an ordinarily prudent person in a like position would use under similar circumstances |
| Our charter provides that no independent director shall be liable to us or our stockholders for monetary damages and that we will generally indemnify them for losses unless they are deliberately dishonest or engage in intentionally wrongful, willful or malicious acts |
| As a result, we and our stockholders may have more limited rights against our independent directors than might otherwise exist under common law, which could reduce their and our recovery from these persons if they act in a negligent manner |
| In addition, we may be obligated to fund the defense costs incurred by our independent directors (as well as by our other directors, officers, employees and agents) in some cases |
| 32 _________________________________________________________________ The limit on the number of shares of our capital stock a person may own may discourage a takeover |
| Primarily to facilitate maintenance of our qualification as a REIT, our articles of incorporation prohibit ownership of more than 9dtta8prca of the outstanding shares of our capital stock by one person |
| This restriction may discourage a change of control and may deter individuals or entities from making tender offers for our capital stock, which offers might otherwise be financially attractive to our stockholders or which might cause a change in our management |
| Certain provisions of Maryland law could restrict a change in control |
| Certain provisions of Maryland law applicable to us prohibit business combinations with: • any person who beneficially owns 10prca or more of the voting power of our common stock, referred to as an “interested stockholder;” • an affiliate of ours who, at any time within the two-year period prior to the date in question, was an interested stockholder; or • an affiliate of an interested stockholder |
| These prohibitions last for five years after the most recent date on which the interested stockholder became an interested stockholder |
| Thereafter, any business combination with the interested stockholder must be recommended by our board of directors and approved by the affirmative vote of at least 80prca of the votes entitled to be cast by holders of our outstanding shares of common stock and two-thirds of the votes entitled to be cast by holders of our common stock other than shares held by the interested stockholder |
| These requirements could have the effect of inhibiting a change in control even if a change in control were in our stockholders’ interest |
| These provisions of Maryland law do not apply, however, to business combinations that are approved or exempted by our board of directors prior to the time that someone becomes an interested stockholder |
| Our staggered director terms could deter takeover attempts and adversely impact the price of our common stock |
| Our board of directors is divided into three classes, with the term of the directors in each class expiring every third year |
| At each annual meeting of stockholders, the successors to the class of directors whose term expires at such meeting will be elected to hold office for a term expiring at the annual meeting of stockholders held in the third year following the year of their election |
| After election, a director may only be removed by our stockholders for cause |
| Election of directors for staggered terms with limited rights to remove directors makes it more difficult for a hostile bidder to acquire control of us |
| The existence of this provision may negatively impact the price of our securities and may discourage third-party bids to acquire our securities |
| This provision may reduce any premiums paid to stockholders in a change in control transaction |
| We may not qualify as a REIT for federal income tax purposes, which would subject us to federal income tax on our taxable income at regular corporate rates, thereby reducing the amount of funds available for paying distributions to our stockholders |
| We have historically operated and intend to continue to operate in a manner that will allow us to qualify as a REIT for federal income tax purposes |
| Our qualification as a REIT depends on our ability to meet various requirements set forth in the Internal Revenue Code concerning, among other things, the ownership of our outstanding common stock, the nature of our assets, the sources of our income and the amount of our distributions to our stockholders |
| The REIT qualification requirements are extremely complex, and interpretations of the federal income tax laws governing qualification as a REIT are limited |
| Accordingly, we cannot be certain that we will be successful in operating so as to qualify as a REIT At any time new 33 _________________________________________________________________ laws, interpretations or court decisions may change the federal tax laws relating to, or the federal income tax consequences of, qualification as a REIT It is also possible that future economic, market, legal, tax or other considerations may cause our board of directors to revoke our REIT election, which it may do without stockholder approval |
| If we lose or revoke our REIT status, we will face serious tax consequences that will substantially reduce the funds available for distribution to you because: • we would not be allowed a deduction for distributions to stockholders in computing our taxable income, we would be subject to federal income tax at regular corporate rates and we might need to borrow money or sell assets in order to pay any such tax; • we also could be subject to the federal alternative minimum tax and possibly increased state and local taxes; and • unless we are entitled to relief under statutory provisions, we would be disqualified from taxation as a REIT for the four taxable years following the year during which we ceased to qualify |
| In addition, if we fail to qualify as a REIT, all distributions to stockholders would be subject to tax to the extent of our current and accumulated earnings and profits, provided that the federal income tax rate on the taxable portion of such distributions is limited to 15prca through 2008 |
| If we were taxed as a regular corporation, corporate distributees might be eligible for the dividends received deduction , but we would not be required to make distributions to stockholders |
| On October 22, 2004, the President signed into law the American Jobs Creation Act, which amended certain rules relating to REITs |
| The American Jobs Creation Act revised the following REIT rules: • If we fail to satisfy the 95prca gross income test after our 2004 taxable year, as described under “Failure to make required distributions would subject us to tax,” but nonetheless continue to qualify as a REIT because we meet other requirements, we will be subject to a 100prca tax on the excess of 95prca (rather than 90prca) of our gross income over our qualifying income |
| • For purposes of the 10prca value test (ie, the requirement that we not own more than 10prca of the value of the securities of any issuer other than a Taxable REIT Subsidiary (“TRS”) or another REIT), the exception for certain “straight debt” securities includes debt subject to the following contingencies: • a contingency relating to the time of payment of interest or principal, as long as either (i) there is no change to the effective yield of the debt obligation, other than a change to the annual yield that does not exceed the greater of 0dtta25prca or 5prca of the annual yield, or (ii) neither the aggregate issue price nor the aggregate face amount of the issuer’s debt obligations held by us exceeds dlra1 million and no more than 12 months of unaccrued interest on the debt obligations can be required to be prepaid; and • a contingency relating to the time or amount of payment upon a default or prepayment of a debt obligation, as long as the contingency is consistent with customary commercial practice |
| In addition to straight debt securities, loans to individuals and estates, securities issued by REITs, and accrued obligations to pay rent will not be considered securities for purposes of the 10prca value test |
| • For purposes of the 10prca value test, holding a de minimis amount of an issuer’s securities that do not qualify for the straight debt safe harbor (either directly or through a TRS) will not prevent 34 _________________________________________________________________ straight debt of a partnership or corporation from qualifying for the safe harbor |
| Specifically, we or a controlled TRS in which we own more than 50prca of the voting power or value of the stock could hold such non-straight debt securities with a value of up to 1prca of a partnership’s or corporation’s outstanding securities |
| There is no limitation on the amount of an issuer’s securities that a non-controlled TRS can own |
| • In the event that, at the end of a calendar quarter after our 2004 taxable year, more than 5prca of our assets are represented by the securities of one issuer, or we own more than 10prca of the voting power or value of the securities of any issuer, we will not lose our REIT status if (i) the failure is de minimis (up to the lesser of 1prca of our assets or dlra10 million) and (ii) we dispose of assets or otherwise comply with the asset tests within six months after the last day of the quarter in which we identify such failure |
| • In the event of a more than de minimis failure of any of the asset tests after our 2004 taxable year, as long as the failure is due to reasonable cause and not to willful neglect, we will not lose our REIT status if we (i) dispose of assets or otherwise comply with the asset tests within six months after the last day of the quarter in which we identify such failure and (ii) pay a tax equal to the greater of dlra50cmam000 or 35prca of the net income from the nonqualifying assets during the period in which we failed to satisfy the asset tests |
| • In the event that we fail to satisfy a REIT requirement after our 2004 taxable year, other than a gross income or asset test, we will not lose our REIT status but will incur a penalty of dlra50cmam000 for each reasonable cause failure to satisfy such a requirement |
| • After our 2004 taxable year, “hedging transaction” will mean any transaction entered into in the normal course of our trade or business primarily to manage the risk of interest rate, price changes, or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, to acquire or carry real estate assets |
| We will be required to clearly identify any such hedging transaction before the close of the day on which it was acquired, originated or entered into |
| Income and gain from hedging transactions will be excluded from gross income for purposes of the 95prca gross income test (but not the 75prca gross income test) |
| Income and gain from hedging transactions will continue to be nonqualifying income for purposes of the 75prca gross income test |
| • For non-United States shareholders of our publicly traded shares, including our common shares, capital gain distributions occurring after our 2004 taxable year that are attributable to our sale of real property will be treated as ordinary dividends rather than as gain from the sale of a United States real property interest, as long as the non-United States shareholder does not own more than 5prca of that class of our shares of beneficial interest during the taxable year |
| The provisions described above relating to the expansion of the “straight debt” safe harbor, the addition of securities that would be exempt from the 10prca value test and the treatment of rent paid by a TRS apply to taxable years beginning after December 31, 2000 |
| We have not sought a ruling from the Internal Revenue Service that we qualify as a REIT, nor do we intend to do so in the future |
| An IRS determination that we do not qualify as a REIT would deprive our stockholders of the tax benefits of our REIT status only if the IRS determination is upheld in court or otherwise becomes final |
| To the extent that we challenge an IRS determination that we do not qualify as a REIT, we may incur legal expenses that would reduce our funds available for distribution to our stockholders |
| As a result of all these factors, our failure to qualify as a REIT could impair our ability to expand our business and raise capital, and would adversely affect the value of our common stock |
| 35 _________________________________________________________________ Failure to make required distributions or to satisfy certain income requirements would subject us to tax |
| In order to qualify as a REIT, each year we must distribute to our stockholders at least 90prca of our taxable income, other than any net capital gains |
| To the extent that we satisfy the distribution requirement but distribute less than 100prca of our taxable income, we will be subject to federal corporate income tax on our undistributed income |
| In addition, we will incur a 4prca nondeductible excise tax on the amount, if any, by which our distributions in any year are less than the sum of: • 85prca of our ordinary income for that year; • 95prca of our capital gain net income for that year; and • 100prca of our undistributed taxable income from prior years |
| In addition, each year at least 95prca of our gross income must be derived from passive sources in real estate and securities, and at least 75prca of our gross income must be derived from real estate sources |
| Beginning in 2005, if we fail to satisfy either of these gross income tests, but nonetheless continue to qualify as a REIT because we meet certain other requirements, we will incur a tax of up to 100prca on the greater of the excess of 95prca of our gross income over the amount of our qualifying income, or the excess of 75prca of our gross income over the amount of our qualifying income |
| We intend to pay out our income to our stockholders in a manner intended to satisfy the distribution requirement applicable to REITs and to satisfy the foregoing gross income tests and, thus, avoid corporate income taxes and the 4prca excise tax |
| Differences in timing between the recognition of income and the related cash receipts or the effect of required debt amortization payments could require us to borrow money or sell assets to pay out enough of our taxable income to satisfy the distribution requirement and to avoid corporate income tax and the 4prca excise tax in a particular year |
| In the future, we may borrow funds to pay distributions to our stockholders and the limited partners of our Operating Partnership |
| Any funds that we borrow would subject us to interest rate and other market risks |
| The IRS may treat sale-leaseback transactions as loans, which could jeopardize our REIT status |
| The IRS may take the position that specific sale-leaseback transactions we are treating as true leases are not true leases for federal income tax purposes but are, instead, financing arrangements or loans |
| If a sale-leaseback transaction were so recharacterized, we might fail to satisfy the asset or income tests required for REIT qualification and consequently lose our REIT status effective with the year of recharacterization |
| In addition, the amount of our REIT taxable income could be recalculated which could cause us to fail the distribution test for REIT qualification |
| In order to maintain our REIT status, we may be forced to forego attractive investment opportunities, thereby hindering or delaying our meeting our investment objectives and potentially lowering returns to our stockholders |
| The satisfaction of REIT qualification standards is an ongoing process and requires continuous monitoring of, among other things, the sources of our income, the nature of our assets and the amounts we distribute to our stockholders |
| We may, for example, be required to make distributions to stockholders at times when it would be more advantageous to invest in new business opportunities or when we do not have funds readily available for distribution |
| Our continuing compliance with the requirements for REIT qualification may, therefore, hinder our ability to operate solely in the interest of maximizing our profits |
| 36 _________________________________________________________________ Legislative or regulatory action could adversely affect investors |
| In recent years, numerous legislative, judicial and administrative changes have been made in the provisions of the federal income tax laws applicable to investments in REIT shares |
| Additional changes to tax laws are likely to continue to occur in the future, and we cannot assure you that any such changes will not adversely affect the taxation of our stockholders |
| Any such changes could have an adverse effect on an investment in our shares or on the market value or the resale potential of our properties |
| There are special considerations for pension or profit-sharing trusts, Keogh Plans or individual retirement accounts whose assets are being invested in our common stock |
| If you are investing the assets of a pension, profit-sharing, Section 401(k), Keogh or other retirement plan, IRA or benefit plan in us, you should consider: • whether your investment is made in accordance with the documents governing the plan or IRA, including the plan’s investment policies; • whether your investment is consistent with the applicable provisions of the Employee Retirement Income Security Act (ERISA) or the Internal Revenue Code governing standards of prudence and diversification of the plan’s or IRA’s investments; • Whether your investment will impair the liquidity of the plan or IRA; • whether your investment will produce unrelated business taxable income, referred to as UBTI, to the plan or IRA; and • your need to value the assets of the benefit plan or IRA annually |
| A failure to satisfy the fiduciary standards of conduct and other applicable requirements of ERISA and the Internal Revenue Code may result in the imposition of civil and/or criminal penalties and can also subject the plan’s or IRA’s fiduciary to certain equitable remedies |
| In addition, while we do not believe under current ERISA law and regulations that our assets would be treated as “plan assets” for purposes of ERISA, if our assets were considered to be plan assets, the management of our assets would be subject to ERISA and/or Section 4975 of the Internal Revenue Code, and some of the transactions we have entered into with our Adviser and its affiliates could be considered “prohibited transactions” which could cause a plan’s fiduciary, us, our Adviser and its affiliates to be subject to liabilities and excise taxes |
| In addition, our officers and directors, our Adviser and its affiliates could be deemed to be fiduciaries under ERISA and subject to other conditions, restrictions and prohibitions under Part 4 of Title I of ERISA Even if our assets are not considered to be plan assets, a prohibited transaction could occur if we or any of our affiliates is a fiduciary (within the meaning of ERISA) with respect to a purchase by a benefit plan and, therefore, unless an administrative or statutory exemption applies, in the event such persons are fiduciaries (within the meaning of ERISA) with respect to your benefit plan, shares should not be purchased |
| If our Operating Partnership fails to maintain its status as a partnership for federal income tax purposes, its income may be subject to taxation |
| We intend to maintain the status of our Operating Partnership as a partnership for federal income tax purposes |
| As we currently hold all of the ownership interests in our Operating Partnership, it is currently disregarded for income tax purposes |
| We intend that it will qualify as a partnership for income tax purposes upon the admission of additional partners |
| However, if the IRS were to successfully challenge the status of our Operating Partnership as a partnership, it would be taxable as a corporation |
| In such event, this would reduce the amount of distributions that our Operating Partnership could make to us |
| This could also result in our losing REIT status and becoming subject to a corporate level tax on our own income |
| This would substantially reduce our cash available to pay distributions and the return on your investment |
| In addition, if 37 _________________________________________________________________ any of the entities through which our Operating Partnership owns its properties, in whole or in part, loses its characterization as a partnership for federal income tax purposes, it would be subject to taxation as a corporation, thereby reducing distributions to our Operating Partnership |
| Such a recharacterization of an underlying property owner could also threaten our ability to maintain REIT status |
| The market price and trading volume of our securities may be volatile |
| The market price of our common and preferred stock may be highly volatile and subject to wide fluctuations and the trading volume in our common and preferred stock may fluctuate and cause significant price variations to occur |
| We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future |
| Some of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of our securities include: • price and volume fluctuations in the stock market from time to time, which are often unrelated to the operating performance of particular companies; • significant volatility in the market price and trading volume of shares of REITs, real estate companies or other companies in our sector, which is not necessarily related to the performance of those companies; • price and volume fluctuations in the stock market as a result of terrorist attacks, or speculation regarding future terrorist attacks, in the United States or abroad; • price and volume fluctuations in the stock market as a result of involvement of the United States in armed hostilities, or uncertainty regarding United States involvement in such activities; • actual or anticipated variations in our quarterly operating results or distributions; • changes in our funds from operations or earnings estimates or the publication of research reports about us or the real estate industry generally; • increases in market interest rates that lead purchasers of our shares of securities to demand a higher yield; • changes in market valuations of similar companies; • adverse market reaction to our anticipated level of debt or any increased indebtedness we incur in the future; • additions or departures of key management personnel; • actions by institutional stockholders; • speculation in the press or investment community; • changes in regulatory policies or tax guidelines, particularly with respect to REITs; • loss of REIT status for federal income tax purposes; • loss of a major funding source; and • general market and economic conditions; 38 _________________________________________________________________ Shares of common stock eligible for future sale may have adverse effects on our share price |
| We cannot predict the effect, if any, of future sales of common stock, or the availability of shares for future sales, on the market price of our common stock |
| Sales of substantial amounts of common stock (including shares of common stock issuable upon the conversion of units of our operating partnership that we may issue from time to time; the issuance of up to 930cmam000 shares reserved for issuance upon the exercise of options that have been or may be granted under our 2003 Equity Incentive Plan), or the perception that these sales could occur, may adversely affect prevailing market prices for our common stock |
| If our stockholders approve the proposed amended and restated advisory agreement with our Adviser, it is likely that a significant number of shares of stock issuable upon exercise of stock options, will be sold in the public market, which could have an adverse impact on the price of our common stock |
| If our stockholders approve the proposed amended and restated advisory agreement, we currently intend to terminate our 2003 Equity Incentive Plan |
| Additionally, we do not intend to implement the amended and restated advisory agreement until all outstanding options under the 2003 Equity Incentive Plan are terminated or exercised |
| Therefore, if our stockholders approve the amended and restated advisory agreement, we plan to seek agreement from all holders of these options to exercise or terminate their outstanding options within a limited period of time |
| In connection with seeking such agreements from our option holders, we may also accelerate the vesting of all outstanding unvested stock options |
| We also intend to file a registration statement on Form S-8 covering the issuance of shares upon exercise of these options |
| As a result of these events, if our stockholders approve the amended and restated advisory agreement, a significant number of the shares currently issuable upon exercise of outstanding options will become eligible for sale in the public market on or about the same time |
| The sale of a substantial number of such shares, or even the availability of such shares for sale, could have a material adverse effect on the price of our common stock |
| If our stockholders approve the proposed amended and restated advisory agreement with our Adviser, it could have a material adverse effect on our results of operations |
| Under our current advisory agreement with our Adviser, we are responsible for all of the expenses that our Adviser incurs for our benefit on a pass-through basis |
| Under the terms of our proposed amended and restated advisory agreement with our Adviser, we would be required to pay our Adviser an annual base management fee equal to 2prca of our stockholders’ equity (less the recorded value of preferred stock, and adjusted to exclude the effect of any unrealized gains losses or other items that do not affect realized net income) |
| The proposed agreement also provides for an incentive fee that we would be required to pay to our Adviser if our performance reaches certain benchmarks |
| Additionally, if the new advisory agreement is implemented, we will also implement an administration agreement with Gladstone Administration, LLC, which would require us to reimburse Gladstone Administration for our allocable portion of its overhead expenses, including rent, and our allocable portion of the salaries and benefits expenses of our chief financial officer, treasurer, chief compliance officer and controller and their respective staffs |
| While we expect that the base management fee and payments under the administration agreement collectively would approximate the level of payments that we have historically made to our Adviser under our existing advisory agreement, we believe that, if our performance reaches the performance benchmarks set forth in the proposed agreement, the incentive fees provided for under the proposed agreement will likely have the effect of increasing our total operating expenses |
| The incentive fee compensation to our Adviser is intended to replace our existing equity incentive plan, and we do not intend to implement the proposed agreement, even if approved by stockholders, until all outstanding options have been either exercised or terminated |
| We believe that our stockholders will experience benefits as a result of the termination of the equity incentive plan and the elimination of outstanding options, including the removal of the dilutive effects of the options and the avoidance of non-cash charges related to stock options under recently adopted accounting rules |
| Nevertheless, the benefits experienced by our stockholders as a result of the termination of our equity incentive plan may be outweighed by the additional payments that we incur 39 _________________________________________________________________ under the proposed agreement, which could have a material adverse impact on our results of operations and reduce the cash available to make distributions to our stockholders |
| An increase in market interest rates may have an adverse effect on the market price of our securities |
| One of the factors that investors may consider in deciding whether to buy or sell our common stock or preferred stock is our distribution rate as a percentage of our share price, relative to market interest rates |
| If market interest rates increase, prospective investors may desire a higher distribution yield on our securities or seek securities paying higher dividends or interest |
| The market price of our securities likely will be based primarily on the earnings that we derive from rental income with respect to our properties, interest earned on our mortgage loans and our related distributions to stockholders, and not from the underlying appraised value of the properties themselves |
| As a result, interest rate fluctuations and capital market conditions are likely to affect the market price of our securities, and such effects could be significant |
| For instance, if interest rates rise without a corresponding increase in our distribution rate, the market price of our common stock could decrease because potential investors may require a higher distribution yield on our common stock as market rates on interest-bearing securities, such as bonds, rise |
| Additionally, because our Series A Preferred Stock is entitled to receive dividends at a fixed rate, any increase in interest rates is likely to result in a decrease in the market price of our Series A Preferred Stock |
| Available Information Copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments, if any, to those reports filed pursuant to Section 13(a) or 15(d) of the Exchange Act are available free of charge through our website at www |
| GladstoneCommercial |
| com and on the SEC’s website at www |
| A request for any of these reports may also be submitted to us by writing: Corporate Secretary, Gladstone Commercial Corporation, 1521 Westbranch Drive, Suite 200, McLean, VA 22102 |