##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q  x
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTER ENDED SEPTEMBER 30, 2004  o
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER: 0-50363 GLADSTONE COMMERCIAL CORPORATION  MARYLAND
    
    02-0681276(State or other jurisdiction of incorporation or
    
    (I.R.S. Employer Identification No.)organization)
 1616 ANDERSON ROAD, SUITE 208
MCLEAN, VIRGINIA 22102
(Address of principal executive office) (703) 286-7000
(Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days.
Yes x  No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).

Yes o  No x. Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practicable date. The number of shares of the
issuers Common Stock, $0.001 par value, outstanding as of October 29, 2004 was
7,667,000.    1




---



##### 



GLADSTONE COMMERCIAL CORPORATION
TABLE OF CONTENTS PART I
    
    FINANCIAL INFORMATIONItem 1
    
    Consolidated Financial Statements (Unaudited)Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003Consolidated Statement of Operations for the three months ended September 30, 2004
and September 30, 2003 and for the nine months ended September 30, 2004 and for the
period February 14, 2003 (inception) through September 30, 2003Consolidated Statements of Cash Flows for the nine months ended September 30, 2004
and for the period February 14, 2003 (inception) through September 30, 2003Notes to Financial StatementsItem 2
    
    Managements Discussion and Analysis of Financial Condition and Results of OperationsOverviewResults of OperationsLiquidity and Capital ResourcesItem 3
    
    Quantitative and Qualitative Disclosure About Market RiskItem 4
    
    Controls and ProceduresPART II
    
    OTHER INFORMATIONItem 1
    
    Legal ProceedingsItem 2
    
    Changes in Securities and Use of ProceedsItem 3
    
    Defaults Upon Senior SecuritiesItem 4
    
    Submission of Matters to a Vote of Security HoldersItem 5
    
    Other InformationItem 6
    
    ExhibitsSignatures
 2




---



##### 



GLADSTONE COMMERCIAL CORPORATION CONSOLIDATED BALANCE SHEETS (Unaudited) September 30,
    
    December 31,2004
    
    2003ASSETSReal estate, net
    
    $
    48,784,959
    
    
    $
    5,436,153Mortgage note receivable
    
    
    11,131,050
    
    
    
    Cash and cash equivalents
    
    
    41,349,714
    
    
    
    99,075,765Funds held in escrow
    
    
    983,501
    
    
    
    Interest receivable  mortgage note
    
    
    61,840
    
    
    
    Interest receivable  officers
    
    
    1,250
    
    
    
    Deferred rent receivable
    
    
    100,110
    
    
    
    Prepaid expenses
    
    
    228,725
    
    
    
    191,432Other assets
    
    
    225,319
    
    
    
    Lease intangibles, net of accumulated amortization of
$98,755 and $1,208, respectively
    
    
    2,246,939
    
    
    
    358,020TOTAL ASSETS
    
    $
    105,113,407
    
    
    $
    105,061,370LIABILITIES AND STOCKHOLDERS EQUITYLIABILITIESDue to Adviser
    
    $
    109,639
    
    
    $
    234,295Accounts payable and accrued expenses
    
    
    11,898
    
    
    
    Dividends payable
    
    
    920,040
    
    
    
    76,420Rent received in advance, security deposits and funds held in escrow
    
    
    1,459,016
    
    
    
    Total Liabilities
    
    $
    2,500,593
    
    
    $
    310,715STOCKHOLDERS EQUITYCommon stock, $0.001 par value, 20,000,000 shares authorized and
7,667,000 and 7,642,000 shares issued and outstanding, respectively
    
    $
    7,667
    
    
    $
    7,642Additional paid in capital
    
    
    105,427,549
    
    
    
    105,060,304Notes receivable - employees
    
    
    (375,000
    )
    
    
    Distributions in excess of accumulated earnings
    
    
    (2,447,402
    )
    
    
    (317,291
    )Total Stockholders Equity
    
    $
    102,612,814
    
    
    $
    104,750,655TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    105,113,407
    
    
    $
    105,061,370
 The accompanying notes are an integral part of these consolidated financial statements. 3




---



##### 



GLADSTONE COMMERCIAL CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) For the periodFor the three
    
    For the three
    
    For the nine
    
    February 14, 2003months ended
    
    months ended
    
    months ended
    
    (inception)September 30,
    
    September 30,
    
    September 30,
    
    through2004
    
    2003
    
    2004
    
    September 30, 2003OPERATING REVENUESRental income
    
    $
    1,066,076
    
    
    $
    
    
    
    $
    1,667,538
    
    
    $
    Interest income from mortgage note receivable
    
    
    284,659
    
    
    
    
    
    
    
    697,059
    
    
    
    Total operating revenues
    
    
    1,350,735
    
    
    
    
    
    
    
    2,364,597
    
    
    
    OPERATING EXPENSESManagement advisory fee
    
    
    333,825
    
    
    
    124,096
    
    
    
    843,360
    
    
    
    124,096Depreciation and amortization
    
    
    313,032
    
    
    
    
    
    
    
    519,133
    
    
    
    General and administrative
    
    
    173,806
    
    
    
    71,644
    
    
    
    868,046
    
    
    
    82,298Total operating expenses
    
    
    820,663
    
    
    
    195,740
    
    
    
    2,230,539
    
    
    
    206,394Net income (loss) from operations
    
    
    530,072
    
    
    
    (195,740
    )
    
    
    134,058
    
    
    
    (206,394
    )Interest income from temporary investments
    
    
    153,716
    
    
    
    91,532
    
    
    
    488,701
    
    
    
    91,532Interest income - employee loans
    
    
    1,250
    
    
    
    
    
    
    
    1,250
    
    
    
    NET INCOME (LOSS)
    
    $
    685,038
    
    
    $
    (104,208
    )
    
    $
    624,009
    
    
    $
    (114,862
    )Earnings (loss) per weighted average common shareBasic
    
    $
    0.09
    
    
    $
    (0.03
    )
    
    $
    0.08
    
    
    $
    (0.08
    )Diluted
    
    $
    0.09
    
    
    $
    (0.03
    )
    
    $
    0.08
    
    
    $
    (0.08
    )Weighted average shares outstandingBasic
    
    
    7,648,250
    
    
    
    3,547,297
    
    
    
    7,644,099
    
    
    
    1,448,482Diluted
    
    
    7,697,079
    
    
    
    3,547,297
    
    
    
    7,703,504
    
    
    
    1,448,482
 The accompanying notes are an integral part of these consolidated financial statements. 4




---



##### 



GLADSTONE COMMERCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) For the periodFor the nine
    
    February 14, 2003months ended
    
    (inception)September 30,
    
    through2004
    
    September 30, 2003Cash flows from operating activities:Net income (loss)
    
    $
    624,009
    
    
    $
    (114,862
    )Adjustments to reconcile net income (loss) to net cash provided
by (used in) operating activities:Depreciation and amortization
    
    
    519,133
    
    
    
    Changes in assets and liabilities:Increase in mortgage interest receivable
    
    
    (61,840
    )
    
    
    Increase in employee interest receivable
    
    
    (1,250
    )
    
    
    Increase in prepaid expenses
    
    
    (37,293
    )
    
    
    (267,058
    )Increase in other assets
    
    
    (25,319
    )
    
    
    Increase in deferred rent receivable
    
    
    (100,110
    )
    
    
    Increase in accounts payable and accrued expenses
    
    
    11,898
    
    
    
    (Decrease) increase in due to Adviser
    
    
    (124,656
    )
    
    
    41,203Increase in rent received in advance and security deposits
    
    
    475,515
    
    
    
    Net cash provided by (used in) operating activities
    
    
    1,280,087
    
    
    
    (340,717
    )Cash flows from investing activities:Acquisition of real estate
    
    
    (45,756,858
    )
    
    
    Mortgage note receivable
    
    
    (11,170,000
    )
    
    
    Deposit on future acquisition
    
    
    (200,000
    )
    
    
    Principal repayments on mortgage note receivable
    
    
    38,950
    
    
    
    Net cash used in investing activities
    
    
    (57,087,908
    )
    
    
    Cash flows from financing activities:Proceeds from share issuance
    
    
    
    
    
    
    105,233,148Offering costs
    
    
    (7,730
    )
    
    
    Dividends paid
    
    
    (1,910,500
    )
    
    
    Net cash (used in) provided by financing activities
    
    
    (1,918,230
    )
    
    
    105,233,148Net (decrease) increase in cash and cash equivalents
    
    
    (57,726,051
    )
    
    
    104,892,431Cash and cash equivalents, beginning of period
    
    
    99,075,765
    
    
    
    Cash and cash equivalents, end of period
    
    $
    41,349,714
    
    
    $
    104,892,431Non-cash financing activities:Notes receivable issued in exchange for common stock associated
with the exercise of employee stock options
    
    $
    375,000
    
    
    $
    
 The accompanying notes are an integral part of these consolidated financial statements 5




---



##### 



GLADSTONE COMMERCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization Gladstone Commercial Corporation, a Maryland corporation, (the Company)
was incorporated on February 14, 2003 under the General Corporation Law of
Maryland for the purpose of engaging in the business of investing in property
net leased to creditworthy entities and making mortgage loans to creditworthy
entities. Subject to certain restrictions and limitations, the business of the
Company is managed by Gladstone Management Corporation (the Adviser). On February 15, 2003, the Companys initial stockholder purchased 52,000
shares of common stock (the Shares) for $52,000 and was admitted as the
initial stockholder of the Company. On August 18, 2003, the Company closed its initial public offering (the
Offering) and sold 6,600,000 shares of its common stock and on September 17,
2003, the underwriters purchased an additional 990,000 shares of common stock,
both sales at $15.00 per share less an underwriting discount of $1.05 per
share, offering costs were $699,352 for total net proceeds to the Company of
$105,015,946. 2. Summary of Significant Accounting Policies On May 28, 2003, the Company completed the formation of a subsidiary,
Gladstone Commercial Limited Partnership (the Operating Partnership). The
Company conducts substantially all of its operations through the Operating
Partnership. As the Company currently owns all of the general and limited
partnership interests of the Operating Partnership, the financial position and
results of operations of the Operating Partnership are consolidated with those
of the Company. On August 23, 2004, the Company completed the formation of a subsidiary,
Gladstone Commercial Advisers, Inc. (Commercial Advisers). Commercial
Advisers is a taxable REIT subsidiary, which was created to collect all
non-qualifying income related to the Companys real estate portfolio. This
income will predominately consist of fees received by the Company related to
the leasing of real estate. Since the Company owns 100% of the voting
securities of Commercial Advisers, the financial position and results of
operations of Commercial Advisers are consolidated with those of the Company. Interim financial information Interim financial statements of the Company are prepared in accordance
with generally accepted accounting principles (GAAP) for interim financial
information and pursuant to the requirements for reporting on Form 10-Q and
Article 10 of Regulation S-X. Accordingly, certain disclosures accompanying
annual financial statements prepared in accordance with GAAP are omitted. All
adjustments, consisting solely of normal recurring accruals, necessary for the
fair statement of financial statements for the interim period have been
included. Investments in real estate The Company records investments in real estate at cost and capitalizes
improvements and replacements when they extend the useful life or improve the
efficiency of the asset. The Company expenses costs of repairs and maintenance
as incurred. The Company computes depreciation using the straight-line method
over the estimated useful life of 39 years for buildings and improvements, five
to seven years for equipment and fixtures and the shorter of the useful life or
the remaining lease term for tenant improvements and leasehold interests. Real
estate depreciation expense was $253,256 and $421,586 for the three and nine
months ended September 30, 2004, respectively. The Company accounts for its acquisitions of real estate in accordance
with Statement of Financial Accounting Standards No. 141, Business
Combinations, which requires the purchase price of real estate to 6




---



##### 



be allocated to the acquired tangible assets, consisting of land, building
and tenant improvements, and identified intangible assets and liabilities,
consisting of the value of above-market and below-market leases, other value of
in-place leases and value of tenant relationships, based in each case on their
fair values. The Company allocates purchase price to the fair value of the tangible
assets of an acquired property (which includes the land, building, and tenant
improvements) to be determined by valuing the property as if it were vacant.
The as-if-vacant value is allocated to land, building, and tenant
improvements based on managements determination of the relative fair values of
these assets. Above-market and below-market in-place lease values for owned properties
are recorded based on the present value (using an interest rate which reflects
the risks associated with the leases acquired) of the difference between (i)
the contractual amounts to be paid pursuant to the in-place leases and (ii)
managements estimate of fair market lease rates for the corresponding in-place
leases, measured over a period equal to the remaining non-cancelable term of
the lease. The capitalized above-market lease values will be amortized as a
reduction of rental income over the remaining non-cancelable terms of the
respective leases. The capitalized below-market lease values (presented in the
accompanying balance sheet as value of assumed lease obligations) are amortized
as an increase to rental income over the initial term and any fixed-rate
renewal periods in the respective leases. Since the Companys strategy to a
large degree involves sale-leaseback transactions with newly originated leases
at market rates, the above-market and below-market in-place lease values are
not significant for many of the transactions that the Company enters into. The aggregate value of other intangible assets acquired are measured based
on the difference between (i) the property valued with existing in-place leases
adjusted to market rental rates and (ii) the property valued as if vacant.
Managements estimates of value are made using methods similar to those used by
independent appraisers (e.g., discounted cash flow analysis). Factors
considered by management in its analysis include an estimate of carrying costs
during hypothetical expected lease-up periods considering current market
conditions, and costs to execute similar leases. The Company also considers
information obtained about each property as a result of its pre-acquisition due
diligence, marketing and leasing activities in estimating the fair value of the
tangible and intangible assets acquired. In estimating carrying costs,
management also includes real estate taxes, insurance and other operating
expenses and estimates of lost rentals at market rates during the expected
lease-up periods, which primarily range from six to 18 months, depending on
specific local market conditions. Management also estimates costs to execute
similar leases including leasing commissions, legal and other related expenses
to the extent that such costs are not already incurred in connection with a new
lease origination as part of the transaction. The total amount of other intangible assets acquired is further allocated
to in-place lease values and customer relationship intangible values based on
managements evaluation of the specific characteristics of each tenants lease
and the Companys overall relationship with that respective tenant.
Characteristics considered by management in allocating these values include the
nature and extent of the Companys existing business relationships with the
tenant, growth prospects for developing new business with the tenant, the
tenants credit quality and expectations of lease renewals (including those
existing under the terms of the lease agreement), among other factors. The value of in-place leases is amortized to expense over the initial term
of the respective leases, which range from five to twenty years. The value of
customer relationship intangibles are amortized to expense over the initial
term and any renewal periods in the respective leases, but in no event does the
amortization period for intangible assets exceed the remaining depreciable life
of the building. Should a tenant terminate its lease, the unamortized portion
of the in-place lease value and customer relationship intangibles will be
charged to expense. Total amortization expense was $59,776 and $97,547 for the
three and nine months ended September 30, 2004, respectively. 7




---



##### 



Impairment Investments in Real Estate The Company accounts for the impairment of real estate in accordance with
Statement of Financial Accounting Standards No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, which requires that the Company
periodically review the carrying value of each property to determine if
circumstances that indicate impairment in the carrying value of the investment
exist or that depreciation periods should be modified. If circumstances support
the possibility of impairment, the Company prepares a projection of the
undiscounted future cash flows, without interest charges, of the specific
property and determines if the investment in such property is recoverable. If
impairment is indicated, the carrying value of the property is written down to
its estimated fair value based on the Companys best estimate of the propertys
discounted future cash flows. There have been no impairments recognized on the
Companys real estate assets at September 30, 2004. Provision for Loan Losses The Companys accounting policies require that it reflect in its financial
statements an allowance for estimated credit losses with respect to mortgage
loans it has made based upon its evaluation of known and inherent risks
associated with its private lending assets. The Company has extended one
mortgage loan and has not experienced any actual losses in connection with its
lending investments. Management reflects provisions for loan losses on a
portfolio basis based upon its assessment of general market conditions, its
internal risk management policies and credit risk rating system, industry loss
experience, its assessment of the likelihood of delinquencies or defaults, and
the value of the collateral underlying its investments. Actual losses, if
any, could ultimately differ from these estimates. Cash and cash equivalents The Company considers all short-term, highly liquid investments that are
both readily convertible to cash and have a maturity of generally three months
or less at the time of purchase to be cash equivalents; except that any such
investments purchased with funds on deposit in escrow or similar accounts are
classified as restricted deposits. Items classified as cash equivalents include
commercial paper and money-market funds. All of the Companys cash and cash
equivalents at September 30, 2004 were held in the custody of one financial
institution, and the Companys balance at times may exceed federally insurable
limits. The Company mitigates this risk by depositing funds with major
financial institutions. Organizational costs The Company expenses organizational costs (primarily filing fees and legal
expenses) as incurred. Stock based compensation In December 2002, the Financial Accounting Standards Board (FASB)
approved the issuance of Statement of Financial Accounting Standards (SFAS)
No. 148 Accounting for Stock-Based Compensation  Transition and Disclosure.
The statement amended SFAS No. 123 Accounting for Stock-Based Compensation to
provide alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock based employee compensation.
Furthermore, SFAS No. 148 amended the disclosure requirements of SFAS No. 123
to require more prominent disclosures in both annual and interim financial
statements about the method and related effect on results of accounting for
stock-based employee compensation, effective for fiscal years and interim
periods beginning after December 15, 2002. In October 2004, the FASB postponed the effective date of the proposed
statement which would amend FASB Statement No. 123, Accounting for Stock-Based
Compensation, and will likely be known as FASB Statement No. 123R, Share-Based
Payment. The new standard would be effective for awards that are 8




---



##### 



granted, modified, or settled in cash for interim or annual periods beginning
after June 15, 2005. The adoption of SFAS 123R will require the Company to
begin expensing stock options as compensation cost, and prior periods may need
to be restated. The impact of the adoption of this amendment to current
earnings can be seen in Note 4 to the Financial Statements, Stock Options. The Company accounts for the issuance of stock options under its 2003
Equity Incentive plan in accordance with APB Opinion No. 25, Accounting for
Stock Issued to Employees. In this regard, these options have been granted to
individuals who are the Companys officers, and who would qualify as leased
employees under FIN 44, Accounting for Certain Transactions Involving Stock
Compensation, an Interpretation of APB Opinion No. 25. Income taxes The Company has operated and intends to continue to operate in a manner
that will allow it to qualify as a real estate investment trust under the
Internal Revenue Code of 1986, and accordingly will not be subject to Federal
income taxes on amounts distributed to stockholders (except income from
foreclosure property), provided it distributes at least 90% of its real estate
investment trust taxable income to its stockholders and meets certain other
conditions. Revenue recognition Rental revenues include rents that each tenant pays in accordance with the
terms of its respective lease reported on a straight-line basis over the
non-cancelable term of the lease. Certain of the Companys leases currently
contain rental increases at specified intervals, and straight-line basis
accounting requires the Company to record an asset, and include in revenues,
deferred rent receivable that will be received if the tenant makes all rent
payments required through the expiration of the initial term of the lease.
Deferred rent receivable in the accompanying balance sheet represents the
cumulative difference between rental revenue as recorded on a straight line
basis and rents received from the tenants in accordance with the lease terms.
Accordingly, the Company determines, in its judgment, to what extent the
deferred rent receivable applicable to each specific tenant is collectible. The
Company reviews deferred rent receivable on a quarterly basis and takes into
consideration the tenants payment history, the financial condition of the
tenant, business conditions in the industry in which the tenant operates and
economic conditions in the area in which the property is located. In the event
that the collectability of deferred rent with respect to any given tenant is in
doubt, the Company records an increase in the allowance for uncollectible
accounts or records a direct write-off of the specific rent receivable, which
would have an adverse effect on the net income for the year in which the
reserve is increased or the direct write-off is recorded and would decrease
total assets and stockholders equity. Management considers its loans and other lending investments to be
held-for-investment. The Company reflects held-for-investment investments at
amortized cost less allowance for loan losses, acquisition premiums or
discounts, deferred loan fees and undisbursed loan funds. On occasion, the
Company may acquire loans at small premiums or discounts based on the credit
characteristics of such loans. These premiums or discounts are recognized as
yield adjustments over the lives of the related loans. Loan origination or
exit fees, as well as direct loan origination costs, are also deferred and
recognized over the lives of the related loans as yield adjustments. If loans
with premiums, discounts, loan origination or exit fees are prepaid, the
Company immediately recognizes the unamortized portion as a decrease or
increase in the prepayment gain or loss. Interest income is recognized using
the effective interest method applied on a loan-by-loan basis. Prepayment
penalties or yield maintenance payments from borrowers are recognized as
additional income when received. Use of estimates The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts
of assets and liabilities and disclosure of contingent assets and liabilities
at the date of the 9




---



##### 



financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates. Segment information SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information provides standards for public companies relating to the reporting
of financial and descriptive information about their operating segments in
financial statements. Operating segments are defined as components of an
enterprise for which separate financial information is available and is
evaluated regularly by the chief operating decision maker or decision making
group in determining how to allocate resources and in assessing performance.
Company management is the chief decision making group. As of September 30, 2004, the Companys operations are derived from two
operating segments. One segment purchases real estate (land, buildings and
other improvements), which are simultaneously leased to existing users and the
other segment extends mortgage loans and collects principal and interest
payments. For the three months ended September 30, 2003 and the period
February 14, 2003 (inception) through September 30, 2003, there was no activity
relating to segments because the Company had only recently begun operations.
The following tables summarize the Companys operating results by segment for
the three and nine months ended September 30, 2004: Three Months Ended September 30, 2004Real Estate
    
    Real EstateLeasing
    
    Lending
    
    Other
    
    TotalRevenue
    
    $
    1,066,076
    
    
    $
    284,659
    
    
    $
    
    
    
    $
    1,350,735Expenses
    
    
    313,032
    
    
    
    
    
    
    
    507,631
    
    
    
    820,663Income (loss) from operations
    
    
    753,044
    
    
    
    284,659
    
    
    
    (507,631
    )
    
    
    530,072Other income
    
    
    
    
    
    
    
    
    
    
    154,966
    
    
    
    154,966Net income (loss)
    
    $
    753,044
    
    
    $
    284,659
    
    
    $
    (352,665
    )
    
    $
    685,038Total Assets
    
    $
    52,021,413
    
    
    $
    11,286,986
    
    
    $
    41,805,008
    
    
    $
    105,113,407
 Nine Months Ended September 30, 2004Real Estate
    
    Real EstateLeasing
    
    Lending
    
    Other
    
    TotalRevenue
    
    $
    1,667,538
    
    
    $
    697,059
    
    
    $
    
    
    
    $
    2,364,597Expenses
    
    
    519,133
    
    
    
    
    
    
    
    1,711,406
    
    
    
    2,230,539Income (loss) from operations
    
    
    1,148,405
    
    
    
    697,059
    
    
    
    (1,711,406
    )
    
    
    134,058Other income
    
    
    
    
    
    
    
    
    
    
    489,951
    
    
    
    489,951Net income (loss)
    
    $
    1,148,405
    
    
    $
    697,059
    
    
    $
    (1,221,455
    )
    
    $
    624,009Total Assets
    
    $
    52,021,413
    
    
    $
    11,286,986
    
    
    $
    41,805,008
    
    
    $
    105,113,407
 3. Management Advisory Fee The Company has entered into an agreement with the Companys Adviser
pursuant to which the Adviser is responsible for managing the Company on a
day-to-day basis and for identifying, evaluating, negotiating and consummating
investment transactions consistent with the Companys criteria. In exchange
for such services, the Company reimburses the Adviser for certain expenses.
The Company has no employees and all operations are managed by the Companys
Adviser subject to a management advisory agreement. The Company reimburses the
Adviser for its pro-rata share of the payroll and related benefit expenses on
an 10




---



##### 



employee-by-employee basis, based on the percentage of each employees time
devoted to Company matters. The Company also reimburses the Adviser for
general overhead expenses multiplied by the ratio of hours worked by Adviser
employees on Company matters to the total hours worked by Adviser employees.
For the three and nine months ended September 30, 2004, the Company incurred
approximately $334,000 and $843,000, respectively, in management advisory fees.
For the three months ended September 30, 2003 and the period February 14, 2003
(inception) through September 30, 2003, the Company incurred approximately
$124,000 in management advisory fees. Approximately $110,000 and $41,000 was
unpaid at September 30, 2004 and September 30, 2003, respectively. 4. Stock Options The following tables summarize the Companys operating results as if the
Company elected to account for its stock-based compensation under the fair
value provisions of SFAS No. 123, Accounting for Stock-Based Compensation,
for the three and nine months ended September 30, 2004 and the three months
ended September 30, 2003 and the period February 14, 2003 (inception) through
September 30, 2003: For the periodThree months
    
    Nine months
    
    Three months
    
    February 14, 2003ended
    
    ended
    
    ended
    
    (inception)September 30,
    
    September 30,
    
    September 30,
    
    through2004
    
    2004
    
    2003
    
    September 30, 2003Net income (loss), as reported
    
    $
    685,038
    
    
    $
    624,009
    
    
    $
    (104,208
    )
    
    $
    (114,862
    )Less: Stock-based compensation expense
determined using the fair value based method
    
    
    (142,298
    )
    
    
    (377,842
    )
    
    
    (53,819
    )
    
    
    (53,819
    )Net income (loss), pro-forma
    
    $
    542,740
    
    
    $
    246,167
    
    
    $
    (158,027
    )
    
    $
    (168,681
    )Basic, as reported
    
    $
    0.09
    
    
    $
    0.08
    
    
    $
    (0.03
    )
    
    $
    (0.08
    )Basic, pro-forma
    
    $
    0.07
    
    
    $
    0.03
    
    
    $
    (0.04
    )
    
    $
    (0.12
    )Diluted, as reported
    
    $
    0.09
    
    
    $
    0.08
    
    
    $
    (0.03
    )
    
    $
    (0.08
    )Diluted, pro-forma
    
    $
    0.07
    
    
    $
    0.03
    
    
    $
    (0.04
    )
    
    $
    (0.12
    )
 The stock-based compensation expense under the fair value method, as reported
in the above table, was computed using an estimated weighted average fair value
of $1.89 using the Black-Scholes option-pricing model, based on options issued
from date of inception forward, and the following weighted-average assumptions:
dividend yield of 5.0% percent, risk-free interest rate of 2.54%, expected
volatility factor of
18.40%, and expected lives of 3 years. At September 30, 2004, 880,500 options were outstanding with exercise prices
ranging from $15 to $16.85 with terms of ten years. 5. Earnings Per Common Share The following tables set forth the computation of basic and diluted
earnings (loss) per share for the three and nine months ended September 30,
2004 and for the three months ended September 30, 2003 and for the period
February 14, 2003 (inception) through September 30, 2003: 11




---



##### 



Three months ended
    
    Three months endedSeptember 30, 2004
    
    September 30, 2003Net income (loss)
    
    $
    685,038
    
    
    $
    (104,208
    )Denominator for basic weighted average shares
    
    
    7,648,250
    
    
    
    3,547,297Dilutive effect of stock options (a)
    
    
    48,829
    
    
    
    Denominator for diluted weighted average shares
    
    
    7,697,079
    
    
    
    3,547,297Basic earnings (loss) per common share
    
    $
    0.09
    
    
    $
    (0.03
    )Diluted earnings (loss) per common share
    
    $
    0.09
    
    
    $
    (0.03
    )
 Nine months
    
    For the periodended
    
    February 14, 2003September 30,
    
    (inception) through2004
    
    September 30, 2003Net income (loss)
    
    $
    624,009
    
    
    $
    (114,862
    )Denominator for basic weighted average shares
    
    
    7,644,099
    
    
    
    1,448,482Dilutive effect of stock options (a)
    
    
    59,405
    
    
    
    Denominator for diluted weighted average shares
    
    
    7,703,504
    
    
    
    1,448,482Basic loss per common share
    
    $
    0.08
    
    
    $
    (0.08
    )Diluted loss per common share
    
    $
    0.08
    
    
    $
    (0.08
    )
  (a)
    
    The dilutive effect of options outstanding as of September 30, 2003 are not included
in the calculation as they are anti-dilutive. 6. Real Estate A summary of all properties held by the Company as of September 30, 2004
is as follows: Date Acquired
    
    Location
    
    Square Footage
    
    Property Description
    
    Net Real EstateDec-03
    
    Raleigh, North Carolina
    
    
    58,926
    
    
    Office
    
    $
    5,280,272Jan-04
    
    Canton, Ohio
    
    
    54,018
    
    
    Office and Warehouse
    
    
    3,594,872Apr-04
    
    Akron, Ohio
    
    
    83,891
    
    
    Office and Laboratory
    
    
    8,595,313Jun-04
    
    Charlotte, North Carolina
    
    
    64,500
    
    
    Office
    
    
    9,279,621Jul-04
    
    Canton, North Carolina
    
    
    228,000
    
    
    Commercial and Manufacturing
    
    
    5,170,413Aug-04
    
    Snyder Township, Pennsylvania
    
    
    290,000
    
    
    Commercial and Warehouse
    
    
    6,634,412Aug-04
    
    Lexington, North Carolina
    
    
    154,000
    
    
    Commercial and Warehouse
    
    
    2,948,224Sep-04
    
    Austin, Texas
    
    
    51,993
    
    
    Flexible Office
    
    
    7,281,832$
    48,784,959
 12




---



##### 



The following table sets forth the components of the Companys investments
in real estate: September 30, 2004
    
    December 31, 2003Real estate:Land
    
    $
    6,219,000
    
    
    $
    960,000Building
    
    
    42,117,224
    
    
    
    3,740,996Tenant improvements
    
    
    874,940
    
    
    
    739,776Accumulated depreciation
    
    
    (426,205
    )
    
    
    (4,619
    )Real estate, net
    
    $
    48,784,959
    
    
    $
    5,436,153
 On July 6, 2004, the Company acquired a 228,000 square foot commercial
warehouse and manufacturing building in Canton, North Carolina for $5.2
million, including transaction costs, and the purchase was funded using a
portion of the net proceeds from the Companys initial public offering. The
Company, upon acquisition of the property, extended a twenty year triple net
lease with the sole tenant, with a provision whereby the tenant may purchase
the property from the Company on or around the fifth anniversary of the
purchase date for $5.6 million. The lease provides for annual rent of
$494,000, with approximately $124,000 of base rents due during the remaining
months of 2004 with prescribed escalations thereafter. On August 5, 2004, the Company acquired two separate properties from a
single seller: a 290,000 square foot commercial warehouse building in Snyder
Township, Pennsylvania; and a 154,000 square foot commercial warehouse building
located in Lexington, North Carolina. These two properties were acquired for
an aggregate cost to the Company of $10.2 million in cash, including
transaction costs, and the purchase was funded using a portion of the net
proceeds from the Companys initial public offering. Each building is a single
tenant facility and each was fully occupied at the time of purchase under
previously existing leases with remaining terms of approximately five years,
which were assigned to the Company at the time of purchase. Both leases
contain an option to renew for an additional five years. The leases provide
for an aggregate annual rent of $1,268,000, with approximately $317,000 of base
rents due during the remaining months of 2004. On September 16, 2004, the Company acquired a 51,993 square foot flexible
office building in Austin, Texas for $7.9 million, including transaction costs,
and the purchase was funded using a portion of the net proceeds from the
Companys initial public offering. The Company, upon acquisition of the
property, was assigned the remainder of an eleven year triple net lease with
the sole tenant. The lease provides for annual rent of $688,000, with
approximately $153,000 of base rents due during the remaining months of 2004
with prescribed escalations thereafter. 13




---



##### 



In accordance with Statement of Financial Accounting Standards No. 141,
Business Combinations, the Company allocated the purchase price of the
properties acquired for the three months ended September 30, 2004 as follows: Three months ended September 30, 2004Canton,
    
    Snyder Township,
    
    Lexington,North Carolina
    
    Pennsylvania
    
    North Carolina
    
    Austin, TexasLand
    
    $
    150,000
    
    
    $
    100,000
    
    
    $
    850,000
    
    
    $
    1,000,000Building
    
    
    5,050,000
    
    
    
    6,558,627
    
    
    
    2,107,229
    
    
    
    6,204,786Tenant improvements
    
    
    
    
    
    
    3,958
    
    
    
    
    
    
    
    91,007Lease intangibles
    
    
    
    
    
    
    440,494
    
    
    
    259,482
    
    
    
    616,907Total Purchase Price
    
    $
    5,200,000
    
    
    $
    7,103,079
    
    
    $
    3,216,711
    
    
    $
    7,912,700
 Future operating lease payments under non-cancelable leases, excluding
customer reimbursement of expenses, in effect at September 30, 2004 are as
follows: Year
    
    Rental Payments2004
    
    
    1,278,8212005
    
    
    5,249,3572006
    
    
    5,302,7642007
    
    
    5,362,8782008
    
    
    5,424,010Thereafter
    
    
    32,886,421
 In accordance with the lease terms, substantially all tenant expenses are
required to be paid by the tenant, however the Company would be required to pay
property taxes on the respective property in the event the tenant fails to pay
them. 7. Mortgage Note Receivable On February 18, 2004, the Company extended a promissory mortgage note in
the amount of $11,170,000 collateralized by property in Sterling Heights,
Michigan. The note was issued from a portion of the net proceeds of the
Companys initial public offering. The note accrues interest at the greater of
10% per annum or the one month LIBOR rate plus 4% per annum, and is for a
period of 10 years maturing on February 18, 2014. At September 30, 2004, the
outstanding balance of the note was $11,131,050. 8. Dividends Declared per Share During the nine months ended September 30, 2004, the Company declared
three quarterly dividends: a $0.12 per common share dividend to stockholders of
record on March 31, 2004, which was paid on April 15, 2004; a $0.12 per common
share dividend to stockholders of record on June 30, 2004, which was paid on
July 15, 2004; and a $0.12 per common share dividend to stockholders of record
on September 24, 2004, which was paid on October 8, 2004. 14




---



##### 



9. Subsequent Event On October 15, 2004, the Company acquired four separate properties from a
single seller: a 233,275 square foot commercial manufacturing building in Mt.
Pocono, Pennsylvania; a 25,797 square foot commercial manufacturing building
located in Norfolk, Virginia; a 42,490 square foot commercial manufacturing
building located in Montreal, Quebec; and a 99,981 square foot commercial
manufacturing building located in Granby, Quebec. These four properties were
acquired for an aggregate cost to the Company of $12.8 million, including
transaction costs, and the purchase was funded using a portion of the net
proceeds from the Companys initial public offering. Each building is a single
tenant facility and each was fully occupied at the time of purchase under
previously existing leases with remaining terms of approximately 17 years,
which were assigned to the Company at the time of purchase. The leases provide
for an aggregate annual rent of $1,206,000, with approximately $258,000 of base rents due during the remaining
months of 2004 with prescribed escalations thereafter. 15




---



##### 



Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations. Forward-Looking Statements Some of the statements in this Quarterly Report onForm 10-Qconstitute
forward-looking statements under Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended,
including statements made with respect to possible or assumed future results of
our business, financial condition, liquidity, results of operations, plans and
objectives. When we use the words believe, expect, anticipate, estimate
or similar expressions, we intend to identify forward-looking statements. You
should not place undue reliance on these forward-looking statements. Statements
regarding the following subjects are forward-looking by their nature:  
    
    our business strategy;  
    
    pending transactions;  
    
    our projected operating results;  
    
    our ability to obtain future financing arrangements;  
    
    estimates relating to our future distributions;  
    
    our understanding of our competition;  
    
    market trends;  
    
    projected capital expenditures; and  
    
    use of the proceeds of our initial public offering. These statements involve known and unknown risks, uncertainties and other
factors that may cause results, levels of activity, growth, performance, tax
consequences or achievements to be materially different from any future
results, levels of activity, growth, performance, tax consequences or
achievements expressed or implied by such forward-looking statements. Such
factors include, among other things, those listed below, as well as those
further set forth under the heading Risk Factors included in our Annual
Report onForm 10-Kfor the year ended December 31, 2003 filed with the SEC on
March 11, 2004. The forward-looking statements are based on our beliefs, assumptions and
expectations of our future performance, taking into account all information
currently available to us. Although we believe that these beliefs, assumptions
and expectations are reasonable, we cannot guarantee future results, levels of
activity, performance, growth or achievements. These beliefs, assumptions and
expectations can change as a result of many possible events or factors, not all
of which are known to us. If a change occurs, our business, financial
condition, liquidity and results of operations may vary materially from those
expressed in or implied by our forward-looking statements. You should carefully
consider these risks before you make an investment decision with respect to our
common stock, along with the following factors that could cause actual results
to vary from our forward-looking statements:  
    
    the loss of any of our key employees, such as Mr. David Gladstone, our
chairman and chief executive officer, Mr. Terry Lee Brubaker, our
president and chief operating officer, or Mr. George Stelljes III, our
executive vice president and chief investment officer;  
    
    general volatility of the capital markets and the market price of our
common stock;  
    
    risks associated with negotiation and consummation of pending and future
transactions;  
    
    changes in our business strategy;  
    
    availability, terms and deployment of capital;  
    
    availability of qualified personnel;  
    
    changes in our industry, interest rates or the general economy; and  
    
    the degree and nature of our competition. We are under no duty to update any of the forward-looking statements after
the date of this report to conform such statements to actual results. 16




---



##### 



Overview We were incorporated under the General Corporation Law of the State of
Maryland on February 14, 2003 primarily for the purpose of investing in and
owning net leased industrial and commercial rental property and selectively
making long-term mortgage loans collateralized by industrial and commercial
property. We expect that a large portion of our tenants and borrowers will be
small and medium-sized businesses that have significant buyout fund ownership
and will be well capitalized, with equity constituting between 20% and 40% of
their permanent capital. We expect that other tenants and borrowers will be
family-owned businesses that have built significant equity from paying down the
mortgage loans securing their real estate or through the appreciation in the
value of their real estate. We seek to enter into triple net leases having
terms of approximately 15 years, with rent increases built into the leases.
Under a triple net lease, the tenant is required to pay all operating,
maintenance and insurance costs and real estate taxes with respect to the
leased property. At September 30, 2004, we owned eight properties and had one
mortgage loan. We have also acquired four properties, from a single seller,
subsequent to September 30, 2004. We are actively communicating with buyout
funds, real estate brokers and other third parties to locate properties for
potential acquisition or mortgage financing in an effort to build our
portfolio. We conduct substantially all of our activities through, and all of our
properties are held directly or indirectly by, Gladstone Commercial Limited
Partnership, a Delaware limited partnership formed on May 28, 2003, which we
refer to as our Operating Partnership. We control our Operating Partnership
through our wholly owned subsidiary Gladstone Commercial Partners, LLC, which
serves as the Operating Partnerships sole general partner, and we also own all
limited partnership units of our Operating Partnership. We expect our Operating
Partnership to issue limited partnership units from time to time in exchange
for industrial and commercial real property. By structuring our acquisitions in
this manner, the sellers of the real estate will generally be able to defer the
realization of gains until they redeem the limited partnership units. Limited
partners who hold limited partnership units in our Operating Partnership will
be entitled to redeem these units for cash or, at our election, shares of our
common stock on a one-for-one basis at any time. Whenever we issue common
stock for cash, we will be obligated to contribute any net proceeds we receive
from the sale of the stock to our Operating Partnership and our Operating
Partnership will, in turn, be obligated to issue an equivalent number of
limited partnership units to us. Our Operating Partnership will distribute the
income it generates from its operations to Gladstone Commercial Partners, LLC
and its limited partners, including us, on a pro rata basis. We will, in turn,
distribute the amounts we receive from our Operating Partnership to our
stockholders in the form of quarterly cash distributions. We have historically
operated, and intend to continue to operate, so as to qualify as a REIT for
federal tax purposes, thereby generally avoiding federal and state income taxes
on the distributions we make to our stockholders. Gladstone Management Corporation, a registered investment adviser and an
affiliate of ours, serves as our external adviser (our Adviser). Our Adviser
is responsible for managing our business on a day-to-day basis and for
identifying and making acquisitions and dispositions that it believes meet our
investment criteria. Recent Events On July 6, 2004, we acquired a 228,000 square foot commercial warehouse
and manufacturing building in Canton, North Carolina for $5.2 million including
transaction costs and the purchase was funded using a portion of the net
proceeds of our initial public offering. Upon acquisition of the property, we
extended a twenty year triple net lease with the sole tenant, with a provision
whereby the tenant may purchase the property from us on or around the fifth
anniversary of the purchase date for $5.6 million. The lease provides for
annual rent of $494,000, with approximately $124,000 of base rents due during
the remaining months of 2004 with prescribed escalations thereafter.. On August 5, 2004, we acquired two separate properties from a single
seller: a 290,000 square foot commercial warehouse building in Snyder Township,
Pennsylvania; and a 154,000 square foot commercial warehouse building located
in Lexington, North Carolina. These two properties were acquired for an 17




---



##### 



aggregate cost to us of $10.2 million in cash, including transaction costs, and
the purchase was funded using a portion of the net proceeds from our initial
public offering. Each building is a single tenant facility and each was fully
occupied at the time of purchase under previously existing leases with
remaining terms of approximately five years, which were assigned to us at the
time of purchase. Both leases contain an option to renew for an additional
five years. The leases provide for an aggregate annual rent of $1,268,000,
with approximately $317,000 of base rents due during the remaining months of
2004. On September 16, 2004, we acquired a 51,993 square foot flexible office
building in Austin, Texas for $7.9 million, including transaction costs, and
the purchase was funded using a portion of the net proceeds from our initial
public offering. Upon acquisition of the property, we were assigned the
remainder of an eleven year triple net lease with the sole tenant. The lease
provides for annual rent of $688,000, with approximately $153,000 of base rents
due during the remaining months of 2004 with prescribed escalations thereafter. On October 15, 2004, we acquired four separate properties from a single
seller: a 233,275 square foot commercial manufacturing building in Mt. Pocono,
Pennsylvania; a 25,797 square foot commercial manufacturing building located in
Norfolk, Virginia; a 42,490 square foot commercial manufacturing building
located in Montreal, Quebec; and a 99,981 square foot commercial manufacturing
building located in Granby, Quebec. These four properties were acquired for an
aggregate cost to us of $12.8 million, including transaction costs, and the
purchase was funded using a portion of the net proceeds from our initial public
offering. Each building is a single tenant facility and each was fully
occupied at the time of purchase under previously existing leases with
remaining terms of approximately 17 years, which were assigned to us at the
time of purchase. The leases provide for an aggregate annual rent of $1,206,000, with approximately
$258,000 of base rents due during the remaining months of 2004 with prescribed
escalations thereafter. Expenses Prior to October 1, 2004, our Adviser had an expense sharing arrangement
with Gladstone Capital Advisers, a wholly-owned subsidiary of our affiliate,
Gladstone Capital Corporation, through which our entire workforce was employed.
Under that relationship, our Adviser reimbursed Gladstone Capital Advisers for
a portion of Gladstone Capital Advisers total payroll and benefits expenses
(based on the percentage of total hours worked by Gladstone Capital Advisers
employees on our matters on an employee-by-employee basis) and a portion of
Gladstone Capital Advisers total overhead expense (based on the percentage of
total hours worked by all Gladstone Capital Advisers employees on our
matters). In turn, subject to the terms and conditions of our advisory
agreement, our Adviser passed these charges on to us. Effective October 1,
2004, the expense sharing arrangement with Gladstone Capital Advisers was
terminated, and all of our personnel are now directly employed by our Adviser.
The termination of the arrangement between our Adviser and Gladstone Capital
Advisers is not expected to materially change the level of our expenses. During the three and nine months ended September 30, 2004, payroll and
benefits expenses, which are part of the management fee paid to our adviser,
were approximately $247,000 and $628,000, respectively. The actual amount of
payroll and benefits expenses which we will be required to reimburse our
Adviser in the future is not determinable, but we currently estimate that
during the year ending December 31, 2004 this amount will be approximately
$875,000. This estimate is based on our current expectations regarding our
Advisers payroll and benefits expenses and the proportion of our Advisers
time we believe will be spent on matters relating to our business. To the
extent that our Advisers payroll and benefits expenses are greater than we
expect or our Adviser allocates a greater percentage of its time to our
business, our actual reimbursement of our Adviser for our share of its payroll
and benefits expenses could be materially greater that we currently project. During the three and nine months ended September 30, 2004, the amount of
overhead expenses that we reimbursed our Adviser was approximately $68,000 and
$196,000, respectively. The actual amount of overhead expenses for which we
will be required to reimburse our Adviser in the future is not
determinable, but we currently estimate that during the year ending December
31, 2004 this amount will be approximately $275,000. 18




---



##### 



Under the terms of the advisory agreement, we are responsible for all
expenses incurred for our direct benefit. Examples of these expenses include,
legal, accounting, tax preparation, consulting and related fees. During the
three and nine months ended September 30, 2004, the total amount of these
expenses that we incurred was approximately $174,000 and $868,000,
respectively. In addition, we are also responsible for all fees charged by third parties
that are directly related to our business, which may include real estate
brokerage fees, mortgage placement fees, lease-up fees and transaction
structuring fees (although we may be able to pass some or all of such fees on
to our tenants and borrowers). During the three and nine months ended
September 30, 2004, we passed all such fees along to our tenants, and
accordingly we did not incur any such fees during this time. The actual amount
of such fees that we incur in the future will depend largely upon the aggregate
costs of the properties we acquire, the aggregate amount of mortgage loans we
make, and the extent to which we are able to shift the burden of such fees to
our tenants and borrowers. Accordingly, the amount of these fees that we will
pay in the future is not determinable at this time. Critical Accounting Policies Management believes our most critical accounting policies are revenue
recognition (including straight-line rent), purchase price allocation,
accounting for our investments in real estate, provision for loans losses, the
accounting for our derivative and hedging activities, if any, income taxes and
stock based compensation. Each of these items involves estimates that require
management to make judgments that are subjective in nature. Management relies
on its experience, collects historical data and current market data, and
analyzes these assumptions in order to arrive at what it believes to be
reasonable estimates. Under different conditions or assumptions, materially
different amounts could be reported related to the accounting policies
described below. In addition, application of these accounting policies involves
the exercise of judgments on the use of assumptions as to future uncertainties
and, as a result, actual results could materially differ from these estimates. Revenue Recognition Rental revenues include rents that each tenant pays in accordance with the
terms of its respective lease reported on a straight-line basis over the
initial term of the lease. Certain of the Companys leases currently contain
rental increases at specified intervals, straight-line basis accounting will
require us to record as an asset, and include in revenues, deferred rent
receivable that we will only receive if the tenant makes all rent payments
required through the expiration of the initial term of the lease. Deferred rent
receivable in the accompanying balance sheet represents the cumulative
difference between rental revenue as recorded on a straight-line basis and
rents received from the tenants in accordance with the lease terms.
Accordingly, our management must determine, in its judgment, to what extent the
deferred rent receivable applicable to each specific tenant is collectible. We
review deferred rent receivable on a quarterly basis and take into
consideration the tenants payment history, the financial condition of the
tenant, business conditions in the industry in which the tenant operates and
economic conditions in the area in which the property is located. In the event
that the collectability of deferred rent with respect to any given tenant is in
doubt, we would be required to record an increase in our allowance for
uncollectible accounts or record a direct write-off of the specific rent
receivable, which would have an adverse effect on our net income for the year
in which the reserve is increased or the direct write-off is recorded and would
decrease our total assets and stockholders equity. Management considers its loans and other lending investments to be
held-for-investment. We reflect held-for-investment investments at amortized
cost less allowance for loan losses, acquisition premiums or discounts,
deferred loan fees and undisbursed loan funds. On occasion, we may acquire
loans at small premiums or discounts based on the credit characteristics of
such loans. These premiums or discounts are recognized as yield adjustments
over the lives of the related loans. Loan origination or exit fees, as well as
direct loan origination costs, are also deferred and recognized over the lives
of the related
loans as yield adjustments. If loans with premiums, discounts, loan
origination or exit fees are prepaid, we immediately recognize the unamortized
portion as a decrease or increase in the prepayment gain or loss. 19




---



##### 



Interest
income is recognized using the effective interest method applied on a
loan-by-loan basis. Prepayment penalties or yield maintenance payments from
borrowers are recognized as additional income when received. Purchase Price Allocation We record above-market and below-market in-place lease values for owned
properties based on the present value (using an interest rate which reflects
the risks associated with the leases acquired) of the difference between (i)
the contractual amounts to be paid pursuant to the in-place leases and (ii)
managements estimate of fair market lease rates for the corresponding in-place
leases, measured over a period equal to the remaining non-cancelable term of
the lease. We amortize the capitalized above-market lease values as a reduction
of rental income over the remaining non-cancelable terms of the respective
leases. We amortize the capitalized below-market lease values (presented in the
accompanying balance sheet as value of assumed lease obligations) as an
increase to rental income over the initial term and any fixed-rate renewal
periods in the respective leases. Since our strategy to a large degree involves
sale-leaseback transactions with newly originated leases at market rates, the
above-market and below-market in-place lease values are generally not
significant. The total amount of other intangible assets acquired are further allocated
to in-place lease values and customer relationship intangible values based on
managements evaluation of the specific characteristics of each tenants lease
and our overall relationship with that respective tenant. Characteristics to be
considered by management in allocating these values include the nature and
extent of our existing business relationships with the tenant, growth prospects
for developing new business with the tenant, the tenants credit quality and
expectations of lease renewals (including those existing under the terms of the
lease agreement), among other factors. Managements estimates of value are made using methods similar to those
used by independent appraisers (e.g., discounted cash flow analysis). Factors
considered by management in its analysis include an estimate of carrying costs
during hypothetical expected lease-up periods considering current market
conditions, and costs to execute similar leases. We also consider information
obtained about each property as a result of our pre-acquisition due diligence,
marketing and leasing activities in estimating the fair value of the tangible
and intangible assets acquired. In estimating carrying costs, management also
includes real estate taxes, insurance and other operating expenses and
estimates of lost rentals at market rates during the expected lease-up periods,
which primarily range from six to eighteen months, depending on specific local
market conditions. Management also estimates costs to execute similar leases
including leasing commissions, legal and other related expenses to the extent
that such costs are not already incurred in connection with a new lease
origination as part of the transaction. We amortize the value of in-place leases to expense over the initial term
of the respective leases, which generally range from five to twenty years. The
value of customer relationship intangibles are amortized to expense over the
initial term and any renewal periods in the respective leases, but in no event
will the amortization period for intangible assets exceed the remaining
depreciable life of the building. Should a tenant terminate its lease, the
unamortized portion of the in-place lease value and customer relationship
intangibles would be charged to expense. Investments in Real Estate We record investments in real estate at cost and we capitalize
improvements and replacements when they extend the useful life or improve the
efficiency of the asset. We expense costs of repairs and maintenance as
incurred. We compute depreciation using the straight-line method over the
estimated useful life of 39 years for buildings and improvements, five to seven
years for equipment and fixtures and the shorter of the useful life or the
remaining lease term for tenant improvements and leasehold interests. We are required to make subjective assessments as to the useful lives of
our properties for purposes of determining the amount of depreciation to record
on an annual basis with respect to our investments in real estate. These
assessments have a direct impact on our net income because, if we were 20




---



##### 



to
shorten the expected useful lives of our investments in real estate, we would
depreciate these investments over fewer years, resulting in more depreciation
expense and lower net income on an annual basis. We have adopted Statement of Financial Accounting Standards (SFAS) No.
144, Accounting for the Impairment or Disposal of Long-Lived Assets, which
establishes a single accounting model for the impairment or disposal of
long-lived assets including discontinued operations. SFAS 144 requires that
the operations related to properties that have been sold or that we intend to
sell be presented as discontinued operations in the statement of operations for
all periods presented, and properties we intend to sell be designated as held
for sale on our balance sheet. When circumstances such as adverse market conditions indicate a possible
impairment of the value of a property, we review the recoverability of the
propertys carrying value. The review of recoverability is based on our
estimate of the future undiscounted cash flows, excluding interest charges,
expected to result from the propertys use and eventual disposition. Our
forecast of these cash flows considers factors such as expected future
operating income, market and other applicable trends and residual value, as
well as the effects of leasing demand, competition and other factors. If
impairment exists due to the inability to recover the carrying value of a
property, an impairment loss is recorded to the extent that the carrying value
exceeds the estimated fair value of the property. We are required to make
subjective assessments as to whether there are impairments in the values of our
investments in real estate. Provision for Loan Losses Our accounting policies require that we reflect in our financial
statements an allowance for estimated credit losses with respect to mortgage
loans we have made based upon our evaluation of known and inherent risks
associated with our private lending assets. We have extended one mortgage loan
and have not experienced any actual losses in connection with our lending
investments. Management reflects provisions for loan losses on a portfolio
basis based upon our assessment of general market conditions, our internal risk
management policies and credit risk rating system, industry loss experience,
our assessment of the likelihood of delinquencies or defaults, and the value of
the collateral underlying our investments. Actual losses, if any, could
ultimately differ from these estimates. Accounting for Derivative Financial Investments and Hedging Activities We will account for our derivative and hedging activities, if any, using
SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as
amended by SFAS 137 and SFAS 149, which requires all derivative instruments to
be carried at fair value on the balance sheet. Derivative instruments designated in a hedge relationship to mitigate
exposure to variability in expected future cash flows, or other types of
forecasted transactions, will be considered cash flow hedges. We will formally
document all relationships between hedging instruments and hedged items, as
well as our risk-management objective and strategy for undertaking each hedge
transaction. We will periodically review the effectiveness of each hedging
transaction, which involves estimating future cash flows. Cash flow hedges
will be accounted for by recording the fair value of the derivative instrument
on the balance sheet as either an asset or liability, with a corresponding
amount recorded in other comprehensive income within stockholders equity.
Amounts will be reclassified from other comprehensive income to the income
statement in the period or periods the hedged forecasted transaction affects
earnings. Derivative instruments designated in a hedge relationship to
mitigate exposure to changes in the fair value of an asset, liability, or firm
commitment attributable to a particular risk, such as interest rate risk, will
be considered fair value hedges under SFAS 133. As of September 30, 2004, we
were not a party to any separate derivatives contract. Certain of our leases
and loans contain embedded derivatives which do not require separate
accounting. 21




---



##### 



Income Taxes Our financial results generally do not reflect provisions for current or
deferred income taxes. Management believes that we have operated and will
operate in a manner that will allow us to qualify as a REIT and, as a result,
we do not expect to pay substantial corporate-level income taxes. Many of the
requirements for REIT qualification, however, are highly technical and complex.
If we were to fail to meet these requirements, we would be subject to federal
income tax which could have a material adverse impact on our results of
operations and amounts available for distributions to our stockholders. Stock Based Compensation We apply the intrinsic value method to account for the issuance of stock
options under our 2003 Equity Incentive Plan in accordance with APB Opinion No.
25, Accounting for Stock Issued to Employees, where appropriate. In this
regard, the substantial portion of these options were granted to individuals
who are our officers and who qualify as leased employees under FIN 44,
Accounting for Certain Transactions involving Stock Compensation, an
interpretation of APB Opinion No. 25. Accordingly, because the grants were at
exercise prices equal to the fair value of the stock at date of grant, we did
not record any expense related to the issuance of these options under the
intrinsic value method. Results of Operations For the three months ended September 30, 2003 Results of operations for the three months ended September 30, 2003 are
not comparative because operations had only recently begun and there was
minimal activity during this period. For the three months ended September 30, 2004 Revenues For the three months ended September 30, 2004, we earned $1,066,076 of
rental revenue, representing: three months of rent from our Raleigh, North
Carolina property, Canton, Ohio property, Akron, Ohio property, and Charlotte,
North Carolina property; approximately three months of rent from our Canton,
North Carolina property acquired on July 6, 2004; approximately two months of
rent from our Lexington, North Carolina and Snyder Township, Pennsylvania
properties acquired on August 5, 2004; and approximately two weeks of rent from
our Austin, Texas property acquired on September 16, 2004. We recorded interest income of $284,659 for the three months ended
September 30, 2004, which represents interest income on the mortgage loan that
we extended for the purchase of a Sterling Heights, Michigan commercial
property. Expenses Operating expenses for the three months ended September 30, 2004 were
$820,663. Operating expenses mainly consist of the management advisory fee,
depreciation and amortization, and general and administrative expenses. The
management advisory fee consists of the reimbursement of expenses, including
direct allocation of employee salaries and benefits, as well as general
overhead expense, to our Adviser in accordance with the terms of the advisory
agreement. For the three months ended September 30, 2004, the management
advisory fee was $333,825. Because we have only recently begun our operations, we do not believe that
our current level of operating expenses relative to revenues is indicative of
our operating expenses in the future. As we begin to expand our real estate
investments, we expect our revenues and operating expenses to increase and that
ultimately our annual management advisory fee will be approximately 2% of our
invested assets. 22




---



##### 



Depreciation and amortization expenses of $313,032 were recorded for the
three months ended September 30, 2004. General and administrative expenses were
$173,806 for the three months ended September 30, 2004 and consisted mainly of
incurred insurance expense for directors and officers insurance, as well as
general insurance, directors fees, professional fees (consisting of legal and
accounting fees), and also stockholder-related expenses. Interest Income During the three months ended September 30, 2004, we earned interest
income on cash and cash equivalents of $153,716. This interest represents the
interest earned on the investment of the net proceeds from our initial public
offering in short-term investment grade securities, primarily U.S. Treasury
Bills. As we increase our portfolio of investments in real estate and mortgage
loans with cash on hand, we anticipate that the interest earned on cash and
cash equivalents will decrease. During the three months ended September 30, 2004, we earned interest
income on employee loans of $1,250. This interest represents the interest
earned on loans extended to employees in connection with the exercise of
employee stock options. These loans are granted at a fair market interest rate
of 5.0%, which is approved by our Board of Directors. Net Income For the three months ended September 30, 2004, we recorded net income of
$685,038. Based on the basic and diluted weighted average common shares
outstanding of 7,648,250 and 7,697,079, respectively, for the three months
ended September 30, 2004, the basic and diluted earnings per weighted average
common share was $0.09. For the period from February 14, 2003 (inception) to September 30, 2003 Results of operations for the period from February 14, 2003 (inception) to
September 30, 2003 are not comparative because operations had only recently
begun and there was minimal activity during this period. For the nine months ended September 30, 2004 Revenues For the nine months ended September 30, 2004, we earned $1,667,538 of
rental revenue, representing: nine months of rent from our Raleigh, North
Carolina property; approximately eight months of rent from our Canton, Ohio
property acquired in January 2004; approximately five months of rent from our
Akron, Ohio property acquired in April 2004; three months of rent from our
Charlotte, North Carolina property acquired in June 2004; approximately three
months of rent from our Canton, North Carolina property acquired on July 6,
2004; approximately two months of rent from our properties purchased in
Lexington, North Carolina and Snyder Township, Pennsylvania on August 5, 2004;
and approximately two weeks of rent from our Austin, Texas property acquired on
September 16, 2004. We recorded interest income of $697,059 for the nine months ended
September 30, 2004, which represents approximately eight months of interest
income on the mortgage loan that we extended in February 2004 for the purchase
of a Sterling Heights, Michigan commercial property. Expenses Operating expenses for the nine months ended September 30, 2004 were
$2,230,539. Operating expenses mainly consist of the management advisory fee,
depreciation and amortization, and general and administrative expenses. The
management advisory fee consists of the reimbursement of expenses, including
direct allocation of employee salaries and benefits as well as general overhead
cost to our Adviser in accordance with the terms of the advisory agreement.
For the nine months ended September 30, 2004, the management advisory fee was
$843,360. 23




---



##### 



Because we have only recently begun our operations, we do not believe that
our current level of operating expenses relative to revenues is indicative of
our operating expenses in the future. As we begin to expand our real estate
investments, we expect our revenues and operating expenses to increase and that
ultimately our annual management advisory fee will be approximately 2% of our
invested assets. Depreciation and amortization expenses of $519,133 were recorded for the
nine months ended September 30, 2004. General and administrative expenses were
$868,046 for the nine months ended September 30, 2004 and consisted mainly of
incurred insurance expense for directors and officers insurance, as well as
general insurance, directors fees, professional fees (consisting of legal and
accounting fees), and also stockholder-related expenses such as the printing of
our 2003 annual report. Interest Income During the nine months ended September 30, 2004, we earned interest income
on cash and cash equivalents of $488,701. This interest represents the
interest earned on the investment of the net proceeds from our initial public
offering in short-term investment grade securities, primarily U.S. Treasury
Bills. As we increase our portfolio of investments in real estate and mortgage
loans with cash on hand, we anticipate that the interest earned on cash and
cash equivalents will decrease. During the nine months ended September 30, 2004, we earned interest income
on employee loans of $1,250. This interest represents the interest earned on
loans extended to employees in connection with the exercise of employee stock
options. These loans are granted at a fair market interest rate of 5.0%, which
is approved by our Board of Directors. Net Income For the nine months ended September 30, 2004, we recorded net income of
$624,009. Based on the basic and diluted weighted average common shares
outstanding of 7,644,099 and 7,703,504, respectively, for the nine months ended
September 30, 2004, the basic and diluted earnings per weighted average common
share was $0.08. Liquidity and Capital Resources Cash and Cash Equivalents At September 30, 2004, we had approximately $41.3 million in cash and cash
equivalents available to make investments and fund our continuing operations, a
decrease of $57.7 million from $99.0 million at December 31, 2003. The funds
on hand were predominantly raised though our initial public offering in 2003. Operating Activities Net cash provided by operating activities during the nine months ended
September 30, 2004 was approximately $1.1 million, consisting primarily of net
income, increases in rent received in advance and security deposits and an
increase in accrued expenses and accounts payable, partially offset by a
decrease in amounts due our Adviser, increases in mortgage interest receivable,
increases in deferred rent receivable and an increase in other assets. Net
cash used in operating activities during the period February 14, 2003
(inception) through September 30, 2003 was $340,717, consisting primarily of an
increase in prepaid expenses. Investing Activities Net cash used in investing activities during the nine months ended
September 30, 2004 was $56.9 million, which consisted of our purchase of the
Canton, Ohio commercial office and warehouse property in January 2004, the
Akron, Ohio commercial office and laboratory space in April 2004, the
Charlotte, North 24




---



##### 



Carolina commercial office space in June 2004, the Canton, North Carolina
commercial warehouse and manufacturing property in July 2004, the Lexington,
North Carolina and Snyder Township, Pennsylvania properties purchased in August
of 2004, the Austin, Texas flexible office space in September 2004, and our
extension of a mortgage loan of approximately $11.2 million on the Sterling
Heights, Michigan commercial property in February 2004. On October 15, 2004, we purchased four separate properties, from a single
seller, for a total purchase price of $12.8 million, utilizing available cash
on hand. Financing Activities Net cash used in financing activities for the nine months ended September
30, 2004 was approximately $1.9 million. These amounts consisted primarily of
the dividend payments to our stockholders of $1.9 million. Net cash provided
by financing activities was approximately $105 million for the period from
inception through September 30, 2003 and consisted of the net proceeds from the
initial public offering and the initial issuance of common stock from our
founder in connection with our formation. Future Capital Needs We had a purchase commitment for four separate properties owned by a
single seller at September 30, 2004 in the aggregate amount of $12.8 million,
the purchase of which closed on October 15, 2004. The purchase commitments
included properties where a deposit had been placed on the respective real
estate as of September 30, 2004. As of November 4, 2004, we have invested approximately $75.4 million, or
71.8%, of the net proceeds from our initial public offering in real properties
and mortgage loans. Investments in twelve real properties account for
approximately $64.2 million of the currently invested net proceeds, and an
investment in one mortgage loan accounts for approximately $11.2 million of the
currently invested net proceeds. During the remainder of 2004 and beyond, we
expect to complete additional acquisitions of real estate and to extend
additional mortgage notes. We expect to finance these activities as we have in
the past, using the funds on hand predominately raised through our initial
public offering in 2003. We anticipate that the remaining net proceeds will be
sufficient to fund our real estate investments for the foreseeable future.
However, once the net proceeds of our initial public offering have been
substantially fully invested, we intend to acquire additional properties by
borrowing all or a portion of the purchase price and collateralizing the loan
with a mortgage on some or all of our real property. If we were unable to make
any required debt payments on any borrowings we make in the future, our lenders
could foreclose on the properties collateralizing their loans, which could
cause us to lose part or all of our investments in such properties. We also
may issue additional equity securities in the future to finance future
investment although there can be no assurance that we would be able to do so on
favorable terms if at all. Funds from Operations The National Association of Real Estate Investment Trusts (NAREIT)
developed Funds from Operations (FFO), as a relative non-GAAP (Generally
Accepted Accounting Principles in the United States) financial measure of
performance and liquidity of an equity REIT in order to recognize that
income-producing real estate historically has not depreciated on the basis
determined under GAAP. FFO, as defined by NAREIT, is net income (loss)
(computed in accordance with GAAP), excluding gains (or losses) from sales of
property, plus depreciation and amortization of real estate assets, and after
adjustments for unconsolidated partnerships and joint ventures. FFO does not represent cash flows from operating activities in accordance
with GAAP (which, unlike FFO, generally reflects all cash effects of
transactions and other events in the determination of net income (loss)) and
should not be considered an alternative to net income (loss) as an indication
of our performance or to cash flow from operations as a measure of liquidity or
ability to make distributions. Comparison of FFO, using the NAREIT definition,
to similarly titled measures for other REITs may not necessarily be meaningful
due to possible differences in the application of the NAREIT definition used by
such REITs. 25




---



##### 



Diluted funds from operations per share (Diluted FFO per share) is FFO
divided by weighted average common shares outstanding on a diluted basis during
a period. We believe that Diluted FFO per share is useful to investors
because it provides investors with a further context for evaluating our FFO
results in the same manner that investors use earnings per share (EPS) in
evaluating net income available to common shareholders. In addition, since
most REITs provide Diluted FFO per share information to the investment
community, we believe Diluted FFO per share is a useful supplemental measure
for comparing us to other REITs. We believe that diluted EPS is the most
directly comparable GAAP measure to Diluted FFO per share. The following table provides a reconciliation of our FFO for the three and
nine months ended September 30, 2004 to the most directly comparable GAAP
measure, net income, and a computation of diluted FFO per weighed average
common share and diluted net income per weighted average common share. Three months
    
    Nine monthsended
    
    endedSeptember 30,
    
    September 30,2004
    
    2004Net income
    
    $
    685,038
    
    
    $
    624,009Real estate depreciation and amortization
    
    
    313,032
    
    
    
    519,133Funds from operations
    
    
    998,070
    
    
    
    1,143,142Weighted average shares outstanding  diluted
    
    
    7,697,079
    
    
    
    7,703,504Diluted net income per weighted average
common share
    
    $
    0.09
    
    
    $
    0.08Diluted funds from operations per weighted
average common share
    
    $
    0.13
    
    
    $
    0.15
 26




---



##### 



Item 3. Quantitative and Qualitative Disclosure About Market Risk Market risk includes risks that arise from changes in interest rates,
foreign currency exchange rates, commodity prices, equity prices and other
market changes that affect market sensitive instruments. The primary risk that
we believe we will be exposed to is interest rate risk. In the future, we may be exposed to the effects of interest rate changes
primarily as a result of long-term debt used to maintain liquidity and fund
expansion of our real estate investment portfolio and operations. Our interest
rate risk management objectives are to limit the impact of interest rate
changes on earnings and cash flows and to lower overall borrowing costs. To
achieve this objective, we will borrow primarily at fixed rates or variable
rates with the lowest margins available and, in some cases, with the ability to
convert variable rates to fixed rates. We may also enter into derivative
financial instruments such as interest rate swaps and caps in order to mitigate
the interest rate risk on a related financial instrument. We will not enter
into derivative or interest rate transactions for speculative purposes. In addition to changes in interest rates, the value of our real estate is
subject to fluctuations based on changes in local and regional economic
conditions and changes in the creditworthiness of lessees, all of which may
affect our ability to refinance debt if necessary. Item 4. Controls and Procedures a) Evaluation of Disclosure Controls and Procedures As of September 30, 2004, our management, including the chief executive
officer and chief financial officer, evaluated the effectiveness of the design
and operation of our disclosure controls and procedures. Based on that
evaluation, management, including the chief executive officer and chief
financial officer, concluded that the disclosure controls and procedures were
effective in timely alerting management of material information about the
company required to be included in our periodic Securities and Exchange
Commission filings. However, while evaluating the disclosure controls and
procedures, management recognized that any controls and procedures, no matter
how well designed and operated can provide only reasonable assurance of
achieving the desired control objectives, and management necessarily was
required to apply judgment in evaluating the cost-benefit relationship of
possible controls and procedures. b) Change in Internal Control over Financial Reporting There were no changes in internal controls for the period ended September
30, 2004 that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting. 27




---



##### 



PART II  OTHER INFORMATION Item 1. Legal Proceedings Neither we nor any of our subsidiaries are currently subject to any material
legal proceedings nor, to our knowledge, is any material legal proceeding
threatened against us or our subsidiaries. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds On September 7, 2004, we issued and sold 25,000 shares of common stock to an
employee upon exercise of an option granted under our 2003 Equity Incentive
Plan. The employee exercised his option by delivering a promissory note for
the full purchase price. The principal amount of the promissory note was
$375,000. We issued these shares in reliance upon the exemption from
registration provided by Section 4(2) under the Securities Act and Rule 506
promulgated therunder. As of September 30, 2004, we had invested approximately $62.5 million of the
net proceeds from our initial public offering in eight real properties and one
mortgage loan. As of September 30, 2004, we had used approximately $2.3
million in our operating activities, of which approximately $1.2 million has
been paid to our Adviser (which is an affiliate of ours) in partial payment of
amounts owed under our advisory agreement. As of September 30, 2004,
substantially all of the remaining net proceeds from our initial public
offering were invested in short-term, investment grade, interest-bearing
instruments. Item 3. Defaults Upon Senior Securities Not applicable. Item 4. Submission of Matters to a Vote of Security Holders No matters were voted on during the three months ended September 30, 2004. Item 5. Other Information. Not applicable. Item 6. Exhibits See Exhibit Index. 28




---



##### 



SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. GLADSTONE COMMERCIAL CORPORATIONBy:
    
    /s/ Harry BrillHarry BrillChief Financial OfficerDate:
    
    November 3, 2004
 29




---



##### 



Exhibit Index Exhibit
    
    Description of Document3.1
    
    Amended and Restated Articles of Incorporation of the
Registrant, incorporated by reference to the Registration Statement
on Form S-11 (File No. 333-106024), filed September 11, 2003.3.2
    
    Bylaws of the Registrant, incorporated by reference to the
Registrant, incorporated by reference to the registration Statement
on Form S-11 (File No. 333-106024), filed September 11, 2003.11
    
    Computation of earnings (loss) per common share (included in the notes
to the unaudited financial statements contained in this report.)31.1
    
    Certification of Chief Executive Officer pursuant to Section 302
of The Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer pursuant to Section 302
of The Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer pursuant to Section 906
of The Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer pursuant to Section 906
of The Sarbanes-Oxley Act of 2002.
    
    Previously filed.
 30