##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-Q þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTER ENDED MARCH
31, 2005
 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 COMMISSION FILE NUMBER: 0-50363 GLADSTONE COMMERCIAL CORPORATION  MARYLAND
    
    02-0681276(State or other jurisdiction of incorporation or
organization)
    
    (I.R.S. Employer Identification No.)
 1521 WESTBRANCH DRIVE, SUITE 200
MCLEAN, VIRGINIA 22102
(Address of principal executive office)(703) 287-5800
(Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports) and (2) has been
subject to such filing requirements for the past 90 days. Yes þ Noo. Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act). Yes þ Noo. The number of shares of the issuers Common Stock, $0.001 par value, outstanding as of April 29,
2005 was 7,667,000.




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GLADSTONE COMMERCIAL CORPORATION
TABLE OF CONTENTS PAGEPART I FINANCIAL INFORMATIONItem 1.
    
    Consolidated Financial Statements (Unaudited)
    
    
    3Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004Consolidated Statements of Operations for the three months ended March 31, 2005 and 2004Consolidated Statements of Cash Flows for the three months ended March 31, 2005 and 2004Notes to Financial StatementsItem 2.
    
    Managements Discussion and Analysis of Financial Condition andResults of Operations
    
    
    17Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    30Item 4.
    
    Controls and Procedures
    
    
    31PART II OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    32Item 2.
    
    Changes in Securities and Use of Proceeds
    
    
    32Item 3.
    
    Defaults Upon Senior Securities
    
    
    32Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    32Item 5.
    
    Other Information
    
    
    32Item 6.
    
    Exhibits
    
    
    32SIGNATURES
    
    
    33
 2




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GLADSTONE COMMERCIAL CORPORATION CONSOLIDATED BALANCE SHEETS March 31, 2005
    
    
    December 31, 2004(Unaudited)ASSETSReal estate, net
    
    $
    71,226,016
    
    
    $
    60,466,330Mortgage note receivable
    
    
    11,081,931
    
    
    
    11,107,717Cash and cash equivalents
    
    
    18,059,875
    
    
    
    29,153,987Funds held in escrow
    
    
    744,129
    
    
    
    1,060,977Interest receivable  mortgage note
    
    
    71,109
    
    
    
    64,795Interest receivable  employees
    
    
    4,685
    
    
    
    4,792Deferred rent receivable
    
    
    697,210
    
    
    
    210,846Deferred financing costs
    
    
    663,134
    
    
    
    Prepaid expenses
    
    
    203,026
    
    
    
    170,685Other assets
    
    
    216,649
    
    
    
    114,819Lease intangibles, net of accumulated amortization of
$308,159 and $194,047, respectively
    
    
    4,023,315
    
    
    
    3,230,146TOTAL ASSETS
    
    
    106,991,079
    
    
    
    105,585,094LIABILITIES AND STOCKHOLDERS EQUITYLIABILITIESDue to Adviser
    
    
    142,598
    
    
    
    129,231Accounts payable and accrued expenses
    
    
    417,464
    
    
    
    168,389Dividends payable
    
    
    
    
    
    
    920,040Mortgage note payable
    
    
    3,150,000
    
    
    
    Rent received in advance, security deposits and funds held in escrow
    
    
    1,432,991
    
    
    
    1,674,741Total Liabilities
    
    
    5,143,053
    
    
    
    2,892,401STOCKHOLDERS EQUITYCommon stock, $0.001 par value, 20,000,000 shares authorized and
7,667,000 shares issued and outstanding
    
    
    7,667
    
    
    
    7,667Additional paid in capital
    
    
    105,427,549
    
    
    
    105,427,549Notes
receivable - employees
    
    
    (374,792
    )
    
    
    (375,000
    )Distributions in excess of accumulated earnings
    
    
    (3,212,398
    )
    
    
    (2,367,523
    )Total Stockholders Equity
    
    
    101,848,026
    
    
    
    102,692,693TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    106,991,079
    
    
    $
    105,585,094
 The accompanying notes are an integral part of these consolidated financial statements. 3




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GLADSTONE COMMERCIAL CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) For the three
    
    
    For the threemonths ended
    
    
    months endedMarch 31, 2005
    
    
    March 31, 2004OPERATING REVENUESRental income
    
    $
    1,847,007
    
    
    $
    197,773Interest income from mortgage note receivable
    
    
    295,583
    
    
    
    133,419Tenant recovery revenue
    
    
    2,043
    
    
    
    Total operating revenues
    
    
    2,144,633
    
    
    
    331,192OPERATING EXPENSESDepreciation and amortization
    
    
    537,755
    
    
    
    79,330Management advisory fee
    
    
    471,861
    
    
    
    229,416Professional fees
    
    
    331,244
    
    
    
    208,457Taxes and licenses
    
    
    128,273
    
    
    
    10,320Insurance
    
    
    70,383
    
    
    
    64,487Interest
    
    
    36,219
    
    
    
    General and administrative
    
    
    132,828
    
    
    
    104,949Total operating expenses
    
    
    1,708,563
    
    
    
    696,959Income (loss) from operations
    
    
    436,070
    
    
    
    (365,767
    )Interest income from temporary investments
    
    
    94,521
    
    
    
    172,462Interest
income - employee loans
    
    
    4,685
    
    
    
    Loss on foreign currency translation
    
    
    (92
    )
    
    
    Other income
    
    
    99,114
    
    
    
    172,462NET INCOME (LOSS)
    
    $
    535,184
    
    
    $
    (193,305
    )Earnings (loss) per weighted average common shareBasic
    
    $
    0.07
    
    
    $
    (0.03
    )Diluted
    
    $
    0.07
    
    
    $
    (0.03
    )Weighted average shares outstandingBasic
    
    
    7,667,000
    
    
    
    7,642,000Diluted
    
    
    7,733,335
    
    
    
    7,642,000
 The accompanying notes are an integral part of these consolidated financial statements. 4




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GLADSTONE COMMERCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) For the three
    
    
    For the threemonths ended
    
    
    months endedMarch 31, 2005
    
    
    March 31, 2004Cash flows from operating activities:Net income (loss)
    
    $
    535,184
    
    
    $
    (193,305
    )Adjustments to reconcile net income (loss) to net cash
provided by operating activities:Depreciation and amortization
    
    
    537,755
    
    
    
    79,330Changes in assets and liabilities:Amortization of deferred financing costs
    
    
    16,246
    
    
    
    Amortization of deferred rent asset
    
    
    6,136
    
    
    
    Increase in mortgage interest receivable
    
    
    (6,314
    )
    
    
    (68,261
    )Decrease in employee interest receivable
    
    
    107
    
    
    
    (Increase) decrease in prepaid expenses
    
    
    (32,341
    )
    
    
    40,620Decrease (increase) in other assets
    
    
    48,170
    
    
    
    (18,266
    )Increase in deferred rent receivable
    
    
    (97,499
    )
    
    
    (13,764
    )Increase in accounts payable and accrued expenses
    
    
    249,075
    
    
    
    102,266Increase in due to Adviser
    
    
    13,367
    
    
    
    356,115Increase in rent received in advance and security deposits
    
    
    75,098
    
    
    
    210,767Net cash provided by operating activities
    
    
    1,344,984
    
    
    
    495,502Cash flows from investing activities:Acquisition of real estate
    
    
    (12,485,610
    )
    
    
    (3,650,000
    )Issuance of mortgage note receivable
    
    
    
    
    
    
    (11,170,000
    )Deposit on future acquisition
    
    
    (200,000
    )
    
    
    Principal repayments on mortgage note receivable
    
    
    25,786
    
    
    
    Net cash used in investing activities
    
    
    (12,659,824
    )
    
    
    (14,820,000
    )Cash flows from financing activities:Offering costs
    
    
    
    
    
    
    (7,730
    )Proceeds from borrowings under mortgage note payable
    
    
    3,150,000
    
    
    
    Principal repayments on employee loans
    
    
    208
    
    
    
    Payments for deferred financing costs
    
    
    (629,380
    )
    
    
    Dividends paid
    
    
    (2,300,100
    )
    
    
    (76,420
    )Net cash provided by (used in) financing activities
    
    
    220,728
    
    
    
    (84,150
    )Net decrease in cash and cash equivalents
    
    
    (11,094,112
    )
    
    
    (14,408,648
    )Cash and cash equivalents, beginning of period
    
    
    29,153,987
    
    
    
    99,075,765Cash and cash equivalents, end of period
    
    $
    18,059,875
    
    
    $
    84,667,117
 The accompanying notes are an integral part of these consolidated financial statements 5




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GLADSTONE COMMERCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Organization and Significant Accounting Policies 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). Subsidiaries 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 January 27, 2004, the Company completed the formation of a subsidiary, Gladstone Lending
LLC (Gladstone Lending). Gladstone Lending was created to conduct all operations related to real
estate mortgage loans of the Company. As the Operating Partnership currently owns all of the
general and limited partnership interests of Gladstone Lending, the financial position and results
of operations of Gladstone Lending are consolidated with those of the Operating Partnership. 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. There have been no such fees earned to date. Interim financial information Interim financial statements of the Company are prepared in accordance with accounting
principles generally accepted in the United States of America (GAAP) for interim financial
information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of
Regulation S-X. Accordingly, certain disclosures accompanying annual financial statements prepared
in accordance with GAAP are omitted. In the opinion of management, all adjustments, consisting
solely of normal recurring accruals, necessary for the fair statement of financial statements for
the interim period have been included. Investments in real estate The Company records investments in real estate at cost and capitalizes improvements and
replacements when they extend the useful life or improve the efficiency of the asset. The Company
expenses costs of repairs and maintenance as incurred. The Company computes depreciation using the
straight-line method over the estimated useful life of 39 years for buildings and improvements,
five to seven years for equipment and fixtures and the shorter of the useful life or the remaining
lease term for tenant improvements and leasehold interests. Real estate depreciation expense was
$423,643 and $65,743 for the three months ended March 31, 2005 and 2004, respectively. 6




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The Company accounts for its acquisitions of real estate in accordance with Statement of
Financial Accounting Standards (SFAS) No. 141, Business Combinations, which requires the purchase
price of real estate to be allocated to the acquired tangible assets, 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. 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. 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 have not been significant for any of the transactions that the Company has
entered into. 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 $114,113 for the three months ended March 31, 2005, and $13,587 for three months ended March
31, 2004. 7




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The following table summarizes the gross value of customer relationship intangibles: For the threemonths ended
    
    
    For the year endedMarch 31, 2005
    
    
    December 31, 2004In-place leases
    
    $
    2,390,800
    
    
    $
    1,929,800Leasing costs
    
    
    1,940,674
    
    
    
    1,494,393Accumulated amortization
    
    
    (308,159
    )
    
    
    (194,047
    )$
    4,023,315
    
    
    $
    3,230,146
 Impairment Investments in Real Estate The Company accounts for the impairment of real estate in accordance with SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets, which requires that the Company
periodically review the carrying value of each property to determine if circumstances that indicate
impairment in the carrying value of the investment exist or that depreciation periods should be
modified. If circumstances support the possibility of impairment, the Company prepares a projection
of the undiscounted future cash flows, without interest charges, of the specific property and
determines if the investment in such property is recoverable. If impairment is indicated, the
carrying value of the property 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 March 31, 2005. 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. There are no provisions for loan losses at March 31,
2005. 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
March 31, 2005 were held in the custody
of three financial institutions, and the Companys balance at times may exceed federally
insurable limits. The Company mitigates this risk by depositing funds with major financial
institutions. 8




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Deferred financing costs Deferred financing costs consist of costs incurred to obtain long-term financing. These costs
consist of legal fees, origination fees, and administrative fees incurred in association with the
long-term financing. The costs are deferred and amortized using the straight-line method, which
approximates the effective interest method, over the term of the financing secured. 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 sheets 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. No such reserves have been recorded as of March 31, 2005. 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. Stock based compensation The Company currently accounts for the issuance of stock options under its 2003 Equity
Incentive Plan (the 2003 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 FASB Interpretation No. 44
(FIN 44), Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of
APB Opinion No. 25. In December 2004, the Financial Accounting Standards Board (FASB) approved the revision of
SFAS No. 123, Accounting for Stock-Based Compensation, and
issued the revised SFAS No. 123(R),
Share-Based Payment. In April of 2005 the effective date of adoption was changed from
interim periods ending after June 15, 2005 to annual periods
beginning after June 15, 2005. SFAS No.
123(R) effectively replaces SFAS No. 123, and supersedes APB Opinion No. 25, Accounting for Stock
Issued to Employees. The new standard is effective for awards that are granted, modified, or
settled in cash for 9




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##### 



annual periods beginning
after June 15, 2005. The adoption of SFAS No. 123(R)
will require the Company to begin expensing the value of stock options granted as compensation cost
beginning in January of 2006. The impact of the adoption of this amendment to current earnings is
discussed below. The following table summarizes 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(R),
Share-Based Payment, for the three months ended March 31, 2005 and 2004: For the three
    
    
    For the threemonths ended
    
    
    months endedMarch 31, 2005
    
    
    March 31, 2004Net income (loss), as reported
    
    $
    535,184
    
    
    $
    (193,305
    )Less: Stock-based compensation expense
determined using the fair value based method
    
    
    (95,792
    )
    
    
    (65,392
    )Net income (loss), pro-forma
    
    $
    439,392
    
    
    $
    (258,697
    )Basic, as reported
    
    $
    0.07
    
    
    $
    (0.03
    )Basic, pro-forma
    
    $
    0.06
    
    
    $
    (0.03
    )Diluted, as reported
    
    $
    0.07
    
    
    $
    (0.03
    )Diluted, pro-forma
    
    $
    0.06
    
    
    $
    (0.03
    )
 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 $1.29 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 4.99%, risk-free interest rate of 2.54%, expected
volatility factor of 18.40%, and expected lives of 3 years. 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. To the extent that
the Company satisfies the distribution requirement but distributes less than 100% of its taxable
income, the Company will be subject to federal corporate income tax on its undistributed income. Gladstone Commercial Advisers is a wholly-owned taxable REIT subsidiary, (TRS), that is
subject to federal and state income taxes. The Company accounts for such income taxes in accordance
with the provisions of SFAS No. 109. Under SFAS No. 109, the Company accounts for income taxes
using the asset and liability method under which deferred tax assets and liabilities are recognized
for the future tax
consequences attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases. Segment information SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information provides
standards for public companies relating to the reporting of financial and descriptive information
about their operating segments in financial statements. Operating segments are defined as
components of an enterprise for which separate financial information is available and is evaluated
regularly by the chief operating 10




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decision maker or decision making group in determining how to allocate resources and in
assessing performance. Company management is the chief decision making group. As discussed in
Note 8, the Companys operations are derived from two operating segments. Foreign Currency Transactions The Company purchased two properties in Canada in October of 2004. Rental payments from these
properties are received in Canadian Dollars. In accordance with SFAS No. 52 Foreign Currency
Translation, the rental revenue received is recorded using the exchange rate as of the transaction
date, which is the first day of each month. Straight line rent and any deferred rent asset or
liability are also recorded using the exchange rate as of the transaction date. If the rental
payment is received on a date other than the transaction date, then a foreign currency gain or loss
would be recorded on the financial statements. All deferred rent assets are re-valued at each
balance sheet date to reflect the current exchange rate. For the quarter ended March 31, 2005, $92
was recorded as a foreign currency loss, resulting from rental payments being received on dates
other than the transaction date and the valuation of deferred rent at the end of the quarter. 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 financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those estimates. Reclassifications Certain amounts from prior years financial statements have been reclassified to conform to
the current year presentation. These reclassifications had no effect on previously reported net
income or stockholders equity. 2. Management Advisory Fee The Company has no employees, and all of the Companys operations are managed by the Companys
Adviser pursuant to an advisory agreement. Pursuant to the advisory agreement, 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 pays the Adviser a management advisory fee, which consists
of the reimbursement of certain expenses of the Adviser. The Company reimburses the Adviser for
its pro-rata share of the payroll and related benefit expenses on an 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 the Advisers employees. Under the terms of the advisory agreement, the Company will only be required to reimburse the
Adviser for its portion of the Advisers general overhead expenses if the amount of payroll and
benefits reimbursed to the Adviser is less than 2.0% of the Companys average invested assets for
the year. Additionally, the Company will only be required to reimburse the Adviser for overhead
expenses up to the point that reimbursed overhead expenses and payroll and benefits expenses, on a
combined basis, equal 2.0% of the Companys average invested assets for the year. However, to the
extent that payroll and benefits reimbursements exceed the annual management fee cap of 2.0%, these
payroll amounts will be reimbursed by the Company. The Adviser will bill the Company on a monthly
basis for these amounts. The Adviser must reimburse the Company annually for the amount by which
amounts billed to and paid by the Company exceed this 2.0% limit during a given year. To the
extent that overhead expenses payable or reimbursable by the Company exceed this limit and the
Companys independent directors determine that the excess expenses were justified based on unusual
and nonrecurring factors which they deem sufficient, 11




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the Company may reimburse the Adviser in future years for the full amount of the excess
expenses, or any portion thereof, but only to the extent that the reimbursement would not cause the
Companys overhead expense reimbursements to exceed the 2.0% limitation in any year. To date, the
advisory fee has not exceeded the annual cap. For the three months ended March 31, 2005, the Company incurred approximately $472,000 in
management advisory fees. For the three months ended March 31, 2004, the Company incurred
approximately $229,000 in management advisory fees. Approximately $143,000 and $129,000 was unpaid
at March 31, 2005 and December 31, 2004, respectively. The following table shows the breakdown of the management advisory fee for the three months
ended March 31, 2005 and 2004: For the three
    
    
    For the threemonths ended
    
    
    months endedMarch 31, 2005
    
    
    March 31, 2004Allocated payroll and benefits
    
    $
    347,314
    
    
    $
    165,839Allocated overhead expenses
    
    $
    124,547
    
    
    $
    63,577Total management advisory fee
    
    $
    471,861
    
    
    $
    229,416
 3. Stock Options At March 31, 2005, 865,000 options were outstanding with exercise prices ranging from $15 to
$16.85 with terms of ten years. In 2004, an employee of the Company exercised 25,000 options at $15.00 per share for a like
number of shares of common stock in consideration for a promissory note in the principal amount of
$375,000. This note has full recourse back to the employee, has a term of nine years and bears
interest at 5% per year. This note was recorded as a loan to employee in the equity section of the
accompanying consolidated balance sheets. No compensation expense was recorded related to this
transaction. As of March 31, 2005, approximately $375,000 of indebtedness was owed by current
employees to the Company, and no current or former directors or executive officers had any loans
outstanding. 12




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4. Earnings Per Common Share The following tables set forth the computation of basic and diluted earnings (loss) per share
for the three months ended March 31, 2005 and 2004: For the three
    
    
    For the threemonths ended
    
    
    months endedMarch 31, 2005
    
    
    March 31, 2004Net income (loss)
    
    $
    535,184
    
    
    $
    (193,305
    )Denominator for basic weighted average shares
    
    
    7,667,000
    
    
    
    7,642,000Dilutive effect of stock options (a)
    
    
    66,335
    
    
    
    Denominator for diluted weighted average shares
    
    
    7,733,335
    
    
    
    7,642,000Basic earnings (loss) per common share
    
    $
    0.07
    
    
    $
    (0.03
    )Diluted earnings (loss) per common share
    
    $
    0.07
    
    
    $
    (0.03
    )
   (a)
    
    The dilutive effect of options
outstanding as of March 31, 2004 are not included in
the calculation as they are anti-dilutive. 5. Real Estate A summary of all properties held by the Company as of March 31, 2005 is as follows: Square FootageDate Acquired
    
    Location
    
    (unaudited)
    
    Property Description
    
    Net Real EstateDec-03
    
    Raleigh, North Carolina
    
    58,926
    
    Office
    
    $
    5,176,352Jan-04
    
    Canton, Ohio
    
    54,018
    
    Office and Warehouse
    
    
    3,553,526Apr-04
    
    Akron, Ohio
    
    83,891
    
    Office and Laboratory
    
    
    8,505,450Jun-04
    
    Charlotte, North Carolina
    
    64,500
    
    Office
    
    
    9,169,689Jul-04
    
    Canton, North Carolina
    
    228,000
    
    Commercial and Manufacturing
    
    
    5,105,669Aug-04
    
    Snyder Township, Pennsylvania
    
    290,000
    
    Commercial and Warehouse
    
    
    6,556,148Aug-04
    
    Lexington, North Carolina
    
    154,000
    
    Commercial and Warehouse
    
    
    2,927,408Sep-04
    
    Austin, Texas
    
    51,993
    
    Flexible Office
    
    
    7,243,781Oct-04
    
    Norfolk, Virginia
    
    25,797
    
    Commercial and Manufacturing
    
    
    918,236Oct-04
    
    Mt. Pocono, Pennsylvania
    
    223,275
    
    Commercial and Manufacturing
    
    
    6,117,554Oct-04
    
    Granby, Quebec
    
    99,981
    
    Commercial and Manufacturing
    
    
    3,012,465Oct-04
    
    Montreal, Quebec
    
    42,490
    
    Commercial and Manufacturing
    
    
    1,840,387Feb-05
    
    San Antonio, Texas
    
    60,245
    
    Flexible Office
    
    
    8,314,494Feb-05
    
    Columbus, Ohio
    
    39,000
    
    Industrial
    
    
    2,784,857$
    71,226,016
 The following table sets forth the components of the Companys investments in real
estate: March 31, 2005
    
    

December 31, 2004Real estate:Land
    
    $
    8,922,000
    
    
    $
    7,669,000Building
    
    
    61,848,662
    
    
    
    52,641,933Tenant improvements
    
    
    1,664,122
    
    
    
    940,522Accumulated depreciation
    
    
    (1,208,768
    )
    
    
    (785,125
    )Real estate, net
    
    $
    71,226,016
    
    
    $
    60,466,330
 13




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On February 10, 2005, the Company acquired a 60,245 square foot flexible office building in
San Antonio, Texas for $9.0 million, including transaction costs, and the purchase was funded using
a portion of the net proceeds from the Companys initial public offering. Upon acquisition of the
property, the Company was assigned the previously existing triple net lease with the sole tenant,
which had a remaining term of approximately nine years at the time of assignment. The lease
provides for annual rents of approximately $753,000 through 2008, with prescribed escalations
thereafter. On February 10, 2005, the Company acquired a 39,000 square foot industrial building in
Columbus, Ohio for $3.4 million, including transaction costs, and the purchase was funded using a
portion of the net proceeds from the Companys initial public offering. Upon acquisition of the
property, the Company was assigned the previously existing triple net lease with the sole tenant,
which had a remaining term of approximately ten years at the time of assignment. The lease
provides for annual rents of approximately $318,000 through 2006, with prescribed escalations
thereafter. In accordance with SFAS No. 141, Business Combinations, the Company allocated the purchase price
of the properties acquired during the three months ended March 31, 2005 as follows: Three months ended March 31, 2005 San Antonio,Texas
    
    
    Columbus, Ohio
    
    
    TotalLand
    
    $
    843,000
    
    
    $
    410,000
    
    
    $
    1,253,000Building
    
    
    6,795,312
    
    
    
    2,379,947
    
    
    
    9,175,259Tenant Improvments
    
    
    718,439
    
    
    
    5,161
    
    
    
    723,600Lease Intangibles
    
    
    664,218
    
    
    
    638,063
    
    
    
    1,302,281Total Purchase Price
    
    $
    9,020,969
    
    
    $
    3,433,171
    
    
    $
    12,454,140
 Future operating lease payments under non-cancelable leases, excluding customer
reimbursement of expenses, in effect at March 31, 2005 are as follows: Year
    
    Rental Payments2005
    
    $
    5,659,6442006
    
    
    7,587,0112007
    
    
    7,677,8242008
    
    
    7,780,6562009
    
    
    6,730,158Thereafter
    
    
    49,384,169
 Lease payments for certain properties, where payments are denominated in Canadian
dollars, have been translated to US dollars using the exchange rate as of March 31, 2005 for the
purposes of the table above. 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, which would amount to a total of $1.1 million on an
annual basis for all properties and loans outstanding as of March 31, 2005. 14




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6. 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 11% per year or the one month LIBOR rate plus 5% per year, and is for a period of 10
years maturing on February 18, 2014. At March 31, 2005, the outstanding balance of the note was
$11,081,931. 7. Dividends Declared per Share During the three months ended March 31, 2005, the Company commenced paying a monthly dividend.
The following table summarizes the dividends paid during the three months ended March 31, 2005: Record Date
    
    Payment Date
    
    Dividend per ShareJanuary 17, 2005
    
    January 31, 2005
    
    $0.06February 14, 2005
    
    February 25, 2005
    
    $0.06March 16,
2005
    
    March 30, 2005
    
    $0.06
 8. Segment Information As of March 31, 2005, the Companys operations are derived from two operating segments. One
segment purchases real estate (land, buildings and other improvements), which is simultaneously
leased to existing users and the other segment extends mortgage loans and collects principal and
interest payments. The following table summarizes the Companys consolidated operating results and
total assets by segment as of and for the three months ended March 31, 2005 and 2004: As of and for the Three Months Ended March 31, 2005Real Estate
    
    
    Real EstateLeasing
    
    
    Lending
    
    
    Other
    
    
    TotalRevenue
    
    $
    1,849,050
    
    
    $
    295,583
    
    
    $
    
    
    
    $
    2,144,633Expenses
    
    
    666,028
    
    
    
    
    
    
    
    1,042,535
    
    
    
    1,708,563Income (loss) from operations
    
    
    1,183,022
    
    
    
    295,583
    
    
    
    (1,042,535
    )
    
    
    436,070Other income (loss)
    
    
    (92
    )
    
    
    
    
    
    
    99,206
    
    
    
    99,114Net income (loss)
    
    $
    1,182,930
    
    
    $
    295,583
    
    
    $
    (943,329
    )
    
    $
    535,184Total Assets
    
    $
    76,146,541
    
    
    $
    11,153,040
    
    
    $
    19,691,498
    
    
    $
    106,991,079
 As of and for the Three Months Ended March 31, 2004Real Estate
    
    
    Real EstateLeasing
    
    
    Lending
    
    
    Other
    
    
    TotalRevenue
    
    $
    197,773
    
    
    $
    133,419
    
    
    $
    
    
    
    $
    331,192Expenses
    
    
    79,330
    
    
    
    
    
    
    
    617,629
    
    
    
    696,959Income (loss) from operations
    
    
    118,443
    
    
    
    133,419
    
    
    
    (617,629
    )
    
    
    (365,767
    )Other income
    
    
    
    
    
    
    
    
    
    
    172,462
    
    
    
    172,462Net income (loss)
    
    $
    118,443
    
    
    $
    133,419
    
    
    $
    (445,167
    )
    
    $
    (193,305
    )Total Assets
    
    $
    9,378,607
    
    
    $
    11,443,769
    
    
    $
    84,836,195
    
    
    $
    105,658,571
 15




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9. Line of Credit On February 28, 2005 the Company entered into a line of credit agreement with a syndicate of
banks led by Branch Banking & Trust Company, which provides the Company with up to $50 million of
financing. The line of credit matures on February 28, 2008. The Company has the option of
increasing the line of credit up to an additional $25 million, for a total of $75 million, upon
agreement of the syndicate of banks. The interest rate charged on the advances under the facility
is based on LIBOR, the Prime Rate or the Federal Funds Rate, depending on market conditions, and
adjusts periodically. The unused portion of the line of credit is subject to a fee of
0.25% per year. The Companys ability to access this funding source is subject to the
Company continuing to meet customary lending requirements such as compliance with financial and
operating covenants and meeting certain lending limits. For example, as is customary with such
line of credit facilities, the maximum amount the Company may draw under this agreement is based on
the percentage of the value of its properties meeting agreed-upon eligibility standards that the
Company has pledged as collateral to the banks. As the Company arranges for long-term
mortgages for these properties, the banks will release the properties from the line of credit and
reduce the availability under the line of credit by the advanced amount of the removed property.
Conversely, as the Company purchases new properties meeting the eligibility standards, the Company
may pledge these new properties to obtain additional advances under this agreement. As of May 4,
2005, the Company may draw up to $38.2 million under this agreement. As of March 31, 2005, there
were no borrowings under the line of credit. 10. Mortgage Note Payable On March 16, 2005 the Company borrowed $3,150,000 pursuant to a long-term note payable from
Key Bank National Association, which is collateralized by a security interest in its Canton, North
Carolina property. The note accrues interest at an initial interest rate of 6.33% per year until
the anticipated repayment date of April 1, 2010. Monthly payments on the note are based upon a
twenty-five year term, with both principal and interest being paid each month. If the note is not
repaid before the anticipated repayment date, interest will accrue on the remaining outstanding
principal balance from and after the anticipated repayment date at the greater of the initial
interest rate plus 2%, or the treasury rate for the week ending prior to the anticipated repayment
date plus 2%. The Company may repay this note at any time after June 23, 2009 and not be subject to
a prepayment penalty. The note matures on April 1, 2030, however the Company expects to repay the
note in full prior to the anticipated repayment date. The Company intends to use the proceeds from
the note to acquire additional investments for its portfolio. 11. Subsequent Events On April 15, 2005, the Company acquired a 120,000 square foot industrial building in Big
Flats, New York for $7.1 million, including transaction costs, and the purchase was funded using a
portion of the net proceeds from the Companys initial public offering. Upon acquisition of the
property, the Company was assigned the previously existing triple net lease with the sole tenant,
which had a remaining term of approximately eight years at the time of assignment. The lease
provides for annual rents of approximately $616,000 through 2006, with prescribed escalations
thereafter. On April 15, 2005, the Company extended a mortgage loan in the amount of $10.0 million on an
office building in McLean, Virginia, where the Companys Adviser
is a subtenant in the building. The loan was funded using a portion of the net proceeds
from the Companys initial public offering. This 12 year mortgage loan, collateralized by the
McLean property, accrues interest at the greater of 7.5% per year or the one month LIBOR rate plus
six percent per year, with a ceiling of 10.0%. 16




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations. The following analysis of our financial condition and results of operations should be read in
conjunction with our financial statements and the notes thereto contained elsewhere in this Form
10-Q. 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 and credit facilities. 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. 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, including
the ability to maintain and borrow under our existing credit facility
and secure one or more additional long-term credit facilities;
    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. 17




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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 purchase agreements for real estate that have triple
net leases with 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 March 31, 2005, we owned fourteen
properties and had one mortgage loan. We have also acquired one property and extended one mortgage
loan subsequent to March 31, 2005. 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
monthly 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 February 10, 2005, we acquired a 60,245 square foot flexible office building in San
Antonio, Texas for $9.0 million, including transaction costs. Upon acquisition of the property, we
were assigned the previously existing triple net lease with the sole tenant, which had a remaining
term of approximately nine years at the time of assignment. The lease provides for annual rents of
approximately $753,000 through 2008, with prescribed escalations thereafter. On February 10, 2005, we acquired a 39,000 square foot industrial building in Columbus, Ohio
for $3.4 million, including transaction costs. Upon acquisition of the property, we were assigned
the previously existing triple net lease with the sole tenant, which had a remaining term of
approximately ten years at the
time of assignment. The lease provides for annual rents of approximately $318,000 through
2006, with prescribed escalations thereafter. 18




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##### 



On March 16, 2005 we borrowed $3,150,000 pursuant to a long-term note payable from Key Bank
National Association, which is collateralized by a security interest in our Canton, North Carolina
property. The note accrues interest at an initial interest rate of 6.33% per year until the
anticipated repayment date of April 1, 2010. Monthly payments on the note are based upon a
twenty-five year term, with both principal and interest being paid each month. If the note is not
repaid before the anticipated repayment date, interest will accrue on the remaining outstanding
principal balance from and after the anticipated repayment date at the greater of the initial
interest rate plus 2%, or the treasury rate for the week ending prior to the anticipated repayment
date plus 2%. We may repay this note at any time after June 23, 2009 and not be subject to a
prepayment penalty. The note matures on April 1, 2030, however we expect to repay the note in full
prior to the anticipated repayment date. We intend to use the proceeds from the note to acquire
additional investments for our portfolio. On April 15, 2005, we acquired a 120,000 square foot industrial building in Big Flats, New
York for $7.1 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 previously existing triple net lease with the sole tenant, which had a remaining term
of approximately eight years at the time of assignment. The lease provides for annual rents of
approximately $616,000 through 2006, with prescribed escalations thereafter. On April 15, 2005, we extended a mortgage loan in the amount of $10.0 million on an office
building in McLean, Virginia, where our Adviser is a subtenant in the
building.
The loan was funded using a portion of the net proceeds from our
initial public offering. This 12 year mortgage loan, collateralized by the McLean property,
accrues interest at the greater of 7.5% per year or the one month LIBOR rate plus six percent per
year, with a ceiling of 10.0%. 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. Pursuant to the terms of our advisory agreement, we continue to
be responsible for a portion of our Advisers total payroll and benefits expenses (based on the
percentage of time our Advisers employees devote to our matters on an employee-by-employee basis)
and a portion of our Advisers total overhead expense (based on the percentage of time worked by
all of our Advisers employees on our matters). 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 months ended March 31, 2005 and 2004, payroll and benefits expenses, which
are part of the management fee paid to our Adviser, were approximately $347,000 and $165,000,
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, 2005 this amount will be approximately $1,500,000. 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 than we currently project. 19




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##### 



Under the terms of our advisory agreement, we will only be required to reimburse our Adviser
for our portion of its general overhead expenses if the amount of payroll and benefits we reimburse
to our Adviser is less than 2.0% of our average invested assets for the year. Additionally, we
will only be required to reimburse our Adviser for overhead expenses up to the point that
reimbursed overhead expenses and payroll and benefits expenses, on a combined basis, equal 2.0% of
our average invested assets for the year. However, to the extent that payroll and benefits
reimbursements exceed the annual management fee cap of 2.0%, these payroll amounts will be
reimbursed by us. Our Adviser will bill us on a monthly basis for these amounts. Our Adviser must
reimburse us annually for the amount by which amounts billed to and paid by us exceed this 2.0%
limit during a given year. To the extent that overhead expenses payable or reimbursable by us
exceed this limit and our independent directors determine that the excess expenses were justified
based on unusual and nonrecurring factors which they deem sufficient, we may reimburse our Adviser
in future years for the full amount of the excess expenses, or any portion thereof, but only to the
extent that the reimbursement would not cause our overhead expense reimbursements to exceed the
2.0% limitation in any year. To date, the advisory fee has not exceeded the annual cap. During the three months ended March 31, 2005 and 2004, the amount of overhead expenses that we
reimbursed our Adviser was approximately $125,000 and $64,000, 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, 2005 this amount
will be approximately $500,000. 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,
directors and officers insurance, consulting and related fees. During the three months ended March
31, 2005 and 2004, the total amount of these expenses that we incurred was approximately $699,000
and $388,000, 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 months ended March 31, 2005 and 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, determining the risk rating of our potential
tenants, 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. Because
certain of our leases contain 20




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rental increases at specified intervals, straight-line basis accounting requires 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 sheets 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 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. 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. In accordance with Statement of Financial Accounting Standards (SFAS) No. 141 Business
Combinations, 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 21




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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. Risk Rating In evaluating each transaction that it considers for investment, our Adviser seeks to assess
the risk associated with the potential tenant or borrower. For companies that have debt that has
been rated by a national credit ratings agency, our Adviser uses the rating as determined by such
ratings agency. For companies that do not have publicly rated debt, our Adviser calculates and
assigns to our borrowers and tenants a risk rating under our ten-point risk rating scale. Our risk
rating system is designed to assess qualitative and quantitative risks associated with our
prospective tenants and borrowers. We have developed our risk rating system to approximate the risk
rating systems of major credit ratings agencies. While we seek to mirror the systems of these
credit ratings agencies, we cannot assure you that our risk rating system provides the same risk
rating for a particular tenant or borrower as a credit ratings agency would. The following chart is
an estimate of the relationship of our risk rating system to the designations used by two credit
ratings agencies to rate the risk of public debt securities of major companies. Because we have
established our system to rate the risk associated with mortgage loans and real estate leases to
private companies that are unrated by any credit ratings agency, we cannot assure you that the
correlation between our system and the credit ratings set out below is accurate. First
    
    SecondOur
    
    Ratings
    
    RatingsSystem
    
    Agency
    
    Agency
    
    Description (a)>10
    
    Baa2
    
    BBB
    
    Probability of default during the
next ten years is 4% and the
expected loss is 1% or less10
    
    Baa3
    
    BBB-
    
    Probability of default during the
next ten years is 5% and the
expected loss is 1% to 2%9
    
    Ba1
    
    BB+
    
    Probability of default during the
next ten years is 10% and the
expected loss is 2% to 3%8
    
    Ba2
    
    BB
    
    Probability of default during the
next ten years is 16% and the
expected loss is 3% to 4%7
    
    Ba3
    
    BB-
    
    Probability of default during the
next ten years is 17.8% and the
expected loss is 4% to 5%6
    
    B1
    
    B+
    
    Probability of default during the
next ten years is 22% and the
expected loss is 5% to 6.5%5
    
    B2
    
    B
    
    Probability of default during the
next ten years is 25% and the
expected loss is 6.5% to 8%
 22




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First
    
    SecondOur
    
    Ratings
    
    RatingsSystem
    
    Agency
    
    Agency
    
    Description (a)4
    
    B3
    
    B-
    
    Probability of default during the
next ten years is 27% and the
expected loss is 8% to 10%3
    
    Caa1
    
    CCC+
    
    Probability of default during the
next ten years is 30% and the
expected loss is 10% to 13.3%2
    
    Caa2
    
    CCC
    
    Probability of default during the
next ten years is 35% and the
expected loss is 13.3% to 16.7%1
    
    Caa3
    
    CC
    
    Probability of default during the
next ten years is 65% and the
expected loss is 16.7% to 20%0
    
    N/a
    
    D
    
    Probability of default during the
next ten years is 85%, or there is a
payment default, and the expected
loss is greater than 20%
   (a)  the default rates set forth above assume a ten year lease or mortgage loan. If the particular
investment has a term other than ten years, the probability of default is adjusted to reflect the
reduced risk associated with a shorter term or the increased risk associated with a longer term. As stated above, we generally anticipate entering into transactions with tenants or borrowers that
have a risk rating of at least 4 based on the above scale or, for tenants or borrowers whose debt
rating is at least B3 or B-. Once we have entered into a transaction, we periodically re-evaluate
the risk rating, or debt rating as applicable, of the investment for purposes of determining
whether we should increase our reserves for loan losses or allowance for uncollectible rent. To
date there have been no allowances for uncollectible rent or reserves for loan losses. Our board of
directors may alter our risk rating system from time to time. The following table reflects the average risk rating of our tenants and borrowers:  Rating
    
    3/31/2005

    
    12/31/2004Average
    
    
    8.1
    
    
    
    7.8Weighted Average
    
    
    8.0
    
    
    
    7.6Highest
    
    
    10.0
    
    
    
    10.0Lowest
    
    
    6.0
    
    
    
    6.0
 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 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 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 No. 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. 23




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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 No. 133,
Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 137,
Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of
FASB Statement No. 133, an amendment of FASB Statement No. 133 and SFAS No. 149 Amendment of
Statement 133 on Derivative Instruments and Hedging Activities, 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 No. 133. As of March 31, 2005, we were not a party to any separate
derivatives contract. Certain of our leases and loans contain embedded derivatives, principally
LIBOR floors, which do not require separate accounting. 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. 24




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Stock Based Compensation We currently 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 FASB
Interpretation No. 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. We will adopt SFAS No. 123(R),
Share-Based Payment effective January 1, 2006, which will require us to begin expensing stock
options as compensation cost. Dependent upon the method chosen by our management for
implementation of SFAS No. 123(R), prior periods may need to be adjusted. Results of Operations Comparison of the three months ended March 31, 2005 to the three months ended March 31, 2004 Revenues For the three months ended March 31, 2005, we earned $1,847,007 of rental revenue as compared
to $197,773 for the three months ended March 31, 2004. The increase of $1,649,234, or 834%, in
rental revenue is primarily a result of the acquisition of twelve properties subsequent to March
31, 2004. Interest income from the mortgage loan increased to $295,583 for the three months ended March
31, 2005 as compared to $133,149 for the three months ended March 31, 2004. The increase of
$162,434, or 122%, is due to the fact that the mortgage loan was originated during the first
quarter of 2004, and interest was only earned for a portion of the first quarter of 2004. For the three months ended March 31, 2005, we earned $2,043 of tenant recovery revenue.
Tenant recovery revenue results from franchise taxes we paid that will be recovered for the 2005
tax year from the tenant of our Canton, North Carolina property. Expenses The management advisory fee for the three months ended March 31, 2005 increased to $471,861,
as compared to $229,416 for the three months ended March 31, 2004. The increase of $242,445, or
106%, is primarily a result of the increased time that our Advisers employees spent on our company
matters. 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. Depreciation and amortization expenses of $537,755 were recorded for the three months ended
March 31, 2005, as compared to $79,330 for the three months ended March 31, 2004. The increase of
$458,425, or 578%, is primarily a result of the increased number of acquisitions since March 31,
2004. Professional fees, consisting primarily of legal and accounting fees, were $331,244 for the
three months ended March 31, 2005, as compared to $208,457 for the three months ended March 31,
2004. The increase of $122,787, or 59%, was primarily a result of the increased accounting fees
related to the audit of our internal controls performed in order to comply with the The Sarbanes
Oxley Act of 2002. Taxes and licenses for the three months ended March 31, 2005 were $128,273, an increase of
$117,953, or 1143%, from $10,320 for the three months ended March 31, 2004. This increase is
primarily attributable to the payment of $119,853 of franchise taxes paid for doing business in
certain states. Approximately $100,000 of these franchise taxes
relate to taxes incurred in 2004, however management has determined
that these expenses were immaterial to the 2004 earnings, and were
expensed in the quarter ending March 31, 2005. We expect to
reduce future incurrance of these types of taxes next year by restructuring our entities in these specific states, however
we can not assure that this restructuring will reduce the taxes in all states. 25




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Insurance expense increased to $70,383 for the three months ended March 31, 2005, as compared
to $64,487 for the three months March 31, 2004. The increase of $5,896, or 9%, is a result of an
increase in insurance premiums year over year. Interest expense was $36,219 for the three months ended March 31, 2005. This amount consisted
of $11,111 in unused line of credit fees accrued on the line of credit obtained in February of
2005, $8,862 of interest expense on the mortgage note payable issued in March of 2005, and $16,246
of deferred financing fees from the line of credit. There was no interest expense incurred for the
three months ended March 31, 2004. General and administrative expenses were $132,828 for the three months ended March 31, 2005,
as compared to $104,949 and consisted mainly of directors fees and stockholder-related expenses.
The increase of $27,879, or 27%, was primarily a result of an increase in stockholder-related
expenses, and other general expenses that have increased as the number of properties has increased
year over year. 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 continue 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. Interest Income Interest income on cash and cash equivalents decreased during the three months ended March 31,
2005 to $94,521, as compared to $172,462 for the three months ended March 31, 2004. The decrease of
$77,491, or 45%, is primarily a result of the increase in our portfolio of investments in real
estate and mortgage loans, resulting in lower average cash balances invested. 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. During the three months ended March 31, 2005, we earned interest income on employee loans of
$4,685. This interest represents the interest earned on a loan extended to an employee in
September of 2004 in connection with the exercise of stock options. Net Income For the three months ended March 31, 2005, we recorded net income of $535,184, as compared to
a net loss of $193,305 for the three months ended March 31, 2004. This increase of $728,489, or
377%, is primarily a result in the increase in our portfolio of investments in the past year and
the other events described above. Based on the basic and diluted weighted average common shares
outstanding of 7,667,000 and 7,733,335, respectively, for the three months ended March 31, 2005,
the basic and diluted earnings per weighted average common share were both $0.07. Based on the
basic and diluted weighted average common shares outstanding of 7,642,000, for the three months
ended March 31, 2004, the basic and diluted loss per weighted average common share were both $0.03. Liquidity and Capital Resources Cash and Cash Equivalents At March 31, 2005, we had approximately $18.1 million in cash and cash equivalents available
to make investments and fund our continuing operations, a decrease of $11.1 million from $29.2
million at December 31, 2004. The funds on hand were predominantly raised though our initial
public offering in 2003. 26




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Operating Activities Net cash provided by operating activities during the three months ended March 31, 2005 was
approximately $1.3 million, consisting primarily of net income, decreases in other assets,
increases in rent received in advance and security deposits, increases in amounts due our Adviser
and an increase in accrued expenses and accounts payable, partially offset by increases in mortgage
interest receivable, increases in deferred rent receivable and prepaid expenses. Net cash provided by operating activities during three months ended March 31, 2004 was
$495,502, consisting primarily of an increase in the amount due to Adviser, increases in rent
received in advance and security deposits and an increase in accrued expenses and other
liabilities. Investing Activities Net cash used in investing activities during the three months ended March 31, 2005 was $12.7
million, which consisted of our purchases of the San Antonio, Texas flexible office property, and
the Columbus, Ohio industrial building, both purchased in February of 2005, and deposits placed on
future acquisitions, partially offset by principal repayments from our mortgage note receivable. Net cash used in investing activities during the three months ended March 31, 2004 was $14.8
million, and consisted of our purchase of the Canton, Ohio commercial office and warehouse property
in January 2004 and our extension of a mortgage loan of approximately $11.2 million in February
2004. Financing Activities Net cash provided by financing activities for the three months ended March 31, 2005 was
approximately $220,000. This amount consisted of the proceeds received from the long-term financing
of our Canton, North Carolina property of $3.1 million, partially offset by the dividend payments
to our stockholders of $2.3 million and approximately $630,000 of financing costs paid in
connection with our line of credit and mortgage note payable. Net cash used in financing activities was $84,150 for the three months ended March 31, 2004.
These amounts consisted of the dividend payments to our stockholders of $76,420 and of $7,730 in
costs associated with our initial public offering. Future Capital Needs We had a purchase commitment for one property at March 31, 2005 in the aggregate amount of
$13.4 million, where a deposit had been placed on the real estate as of March 31, 2005. Subsequent
to March 31, 2005, we made two investments in the aggregate amount of $17.1 million. As of
May 4, 2005, we have invested approximately $105.4 million, or
substantially all of the
net proceeds from our initial public offering in real properties and mortgage loans. Investments
in fifteen real properties account for approximately $84.2 million of the currently invested net
proceeds, and investments in two mortgage loans account for approximately $21.2 million of the
currently invested net proceeds. During the remainder of 2005 and beyond, we expect to complete
additional acquisitions of real estate and to extend additional mortgage notes. The net proceeds
of our initial public offering have been fully invested, and we intend to acquire additional
properties by borrowing all or a portion of the purchase price and collateralizing the loan with
mortgages secured by some or all of our real property, or by borrowing against our existing line of
credit. If we are 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. 27




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Line of Credit On February 28, 2005 we entered into a line of credit agreement with a syndicate of banks led
by Branch Banking & Trust Company, which provides us with up to $50 million of financing. The line
of credit matures on February 28, 2008. We have the option of increasing the line of credit up to
an additional $25 million, for a total of $75 million, upon agreement of the syndicate of banks.
The interest rate charged on the advances under the facility is based on LIBOR, the prime rate or
the federal funds rate, depending on market conditions, and adjusts periodically. The unused
portion of the line of credit is subject to a fee of 0.25% per year. Our ability to access this
funding source is subject to our continuing to meet customary lending requirements such as
compliance with financial and operating covenants and meeting certain lending limits. For example,
as is customary with such line of credit facilities, the maximum amount we may draw under this
agreement is based on the percentage of the value of our properties meeting agreed-upon eligibility
standards that we have pledged as collateral to the banks. As we arrange for long-term mortgages
for these properties, the banks will release the properties from the line of credit and reduce the
availability under the line of credit by the advanced amount of the removed property. Conversely,
as we purchase new properties meeting the eligibility standards, we may pledge these new properties
to obtain additional advances under this agreement . As of May 4, 2005, we may draw up to
$38.2 million under this agreement. As of May 4, 2005 we had no borrowings outstanding under the
line of credit. Mortgage Note Payable On March 16, 2005 we borrowed $3,150,000 pursuant to a long-term note payable from Key Bank
National Association, which is collateralized by a security interest in our Canton, North Carolina
property. The note accrues interest at an initial interest rate of 6.33% per year until the
anticipated repayment date of April 1, 2010. Monthly payments on the note are based upon a
twenty-five year term, with both principal and interest being paid each month. If the note is not
repaid before the anticipated repayment date, interest will accrue on the remaining outstanding
principal balance from and after the anticipated repayment date at the greater of the initial
interest rate plus 2%, or the treasury rate for the week ending prior to the anticipated repayment
date plus 2%. We may repay this note at any time after June 23, 2009 and not be subject to a
prepayment penalty. The note matures on April 1, 2030, however we expect to repay the note in full
prior to the anticipated repayment date. We intend to use the proceeds from the note to acquire
additional investments for our portfolio. Contractual Obligations The following table reflects our significant contractual obligations as of March 31, 2005: Payments Due by PeriodMore than 5Contractual Obligations
    
    Total
    
    
    Less than 1 Year
    
    
    1-3 Years
    
    
    3-5 Years
    
    
    YearsLong-Term Debt Obligations
    
    
    3,150,000
    
    
    
    47,000
    
    
    
    110,000
    
    
    
    126,000
    
    
    
    2,867,000Capital Lease Obligations
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Operating Lease Obligations (1)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Purchase Obligations (2)
    
    
    13,400,000
    
    
    
    13,400,000
    
    
    
    
    
    
    
    
    
    
    
    Other Long-Term Liabilities Reflected on
the Registrants Balance Sheet under GAAP
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    16,550,000
    
    
    $
    13,447,000
    
    
    $
    110,000
    
    
    $
    126,000
    
    
    $
    2,867,000
   (1)
    
    This does not include the portion of the operating lease on office space
that is allocated to us by our adviser
in connection with our advisory agreement.(2)
    
    The purchase obligations reflected in the above table represents committiments outstanding at
March 31, 2005 to purchase
real estate. 28




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##### 



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) supplemental measure of operating performance of an equity REIT in order to recognize that
income-producing real estate historically has not depreciated on the basis determined under GAAP.
FFO, as defined by NAREIT, is net income (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. 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 FFO and
Diluted FFO per share are useful to investors because they provide investors with a further context
for evaluating our FFO results in the same manner that investors use net income and earnings per
share (EPS) in evaluating net income available to common shareholders. In addition, since most
REITs provide FFO and Diluted FFO per share information to the investment community, we believe FFO
and Diluted FFO per share are useful supplemental measures for comparing us to other REITs. We
believe that net income is the most directly comparable GAAP measure to FFO and that diluted EPS is
the most directly comparable GAAP measure to Diluted FFO per share. The following table provides a reconciliation of our FFO for the three months ended March 31,
2005 and 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: For the three
    
    
    For the threemonths ended
    
    
    months endedMarch 31, 2005
    
    
    March 31, 2004Net income (loss)
    
    $
    535,184
    
    
    $
    (193,305
    )Real estate depreciation and amortization
    
    
    537,755
    
    
    
    79,330Funds from operations
    
    
    1,072,939
    
    
    
    (113,975
    )Weighted
average shares outstanding - diluted
    
    
    7,733,335
    
    
    
    7,642,000Diluted net income (loss) per weighted average
common share
    
    $
    0.07
    
    
    $
    (0.03
    )Diluted funds from operations per weighted average
common share
    
    $
    0.14
    
    
    $
    (0.01
    )
 29




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##### 



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. We currently have one variable rate loan and certain of our leases contain escalations based
on market interest rates. We seek to 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 holding of our cash and cash equivalents in short-term,
interest-bearing investments. To illustrate the potential impact of changes in interest rates on our net income, we have
performed the following analysis, which assumes that our balance sheet remains constant and no
further actions beyond a minimum interest rate or escalation rate are taken to alter our existing
interest rate sensitivity. Under this analysis, a hypothetical increase in the one month LIBOR rate by 1% would increase
our net income by approximately $22,630 or 1.0% over the next twelve months, compared to net income
for the latest twelve months ended March 31, 2005. A hypothetical decrease in the one month LIBOR
by 1% would have no impact on our net income over the next twelve months, due to the existing
minimum interest rates in place on the loans and in our leases. Although management believes that
this analysis is indicative of our existing interest rate sensitivity, it does not adjust for
potential changes in credit quality, size and composition of our loan and lease portfolio on the
balance sheet and other business developments that could affect net income. Accordingly, no
assurances can be given that actual results would not differ materially from the results under this
hypothetical analysis. In the future, we may be exposed to additional effects of interest rate changes primarily as a
result of our line of credit or long-term debt used to maintain liquidity and fund expansion of our
real estate investment portfolio and operations. Our interest rate risk management objectives are
to limit the impact of interest rate changes on earnings and cash flows and to lower overall
borrowing costs. To achieve this objective, we will borrow primarily at fixed rates or variable
rates with the lowest margins available and, in some cases, with the ability to convert variable
rates to fixed rates. We may also enter into derivative financial instruments such as interest
rate swaps and caps in order to mitigate the interest rate risk on a related financial instrument.
We will not enter into derivative or interest rate transactions for speculative purposes. We have purchased two properties in Canada, and the monthly rental payments on these
properties are received in Canadian dollars. In order to mitigate the risk of foreign currency
rate fluctuations, we are currently exploring the possibility of securing one or more loans on the
real estate properties in which the mortgage payments would be denominated in Canadian dollars.
Until one or more loans has been secured on the properties, we are exposed to foreign currency
risk. However, exchange rate movements to date have not had a significant effect on our financial
position or results of operations. For the three months ended March 31, 2005, we had a $92 foreign
currency transaction loss in connection with the translation of monthly rental payments denominated
in a foreign currency. To illustrate the potential impact of changes in exchange rates on our net income, we have
performed the following analysis, which assumes that our balance sheet remains constant and no
further actions beyond a minimum exchange rate fluctuation are taken to alter our existing foreign
currency sensitivity. Under this analysis, a hypothetical increase or decrease in the Canadian exchange rate by 10%
would increase or decrease our net income by approximately $60,453 or 2.6% over the next twelve
months, compared to net income for the latest twelve months ended March 31, 2005. Although
management
believes that this analysis is indicative of our existing exchange rate sensitivity, no
assurances can be given that actual results would not differ materially from the results under this
hypothetical analysis. 30




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##### 



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 March 31, 2005, 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) Changes in Internal Control over Financial Reporting There were no changes in internal controls for the period ended March 31, 2005 that have
materially affected, or are reasonably likely to materially affect, our internal control over
financial reporting. 31




---



##### 



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 As of March 31, 2005, we had invested approximately $88.3 million of the net proceeds from our
initial public offering in fourteen real properties and one mortgage loan. As of March 31, 2005,
we had used approximately $4.0 million in our operating activities, of which approximately $2.0
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 March 31, 2005, 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 Not applicable. Item 5. Other Information Not applicable. Item 6. Exhibits Exhibit Index Exhibit
    
    Description of Document3.1
    
    Amended and Restated Articles of
Incorporation, incorporated by reference
to Exhibit 3.1 to the Registration
Statement on Form S-11 (File No.
333-106024), filed June 11, 2003.3.2
    
    Bylaws, incorporated by reference to
Exhibit 3.2 to the Registration Statement
on Form S-11 (File No. 333-106024), filed
June 11, 2003.10.1
    
    Promissory Note between Key Bank National
Association and CMI04 Canton NC LLC,
dated March 14, 2005.10.2
    
    First Amendment to Credit Agreement
and Waiver by and among Gladstone Commercial Corporation, Gladstone
Commercial Limited Partnership, Branch Banking and Trust Company and
certain other parties, dated as of April 21, 2005.11
    
    Computation of Per Share Increase in
Stockholders Equity from Operations
(included in the notes to the unaudited
financial statements contained in this
report).31.1
    
    Certification of Chief Executive Officer
pursuant to Section 302 of The
Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer
pursuant to Section 302 of The
Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer
pursuant to Section 906 of The
Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer
pursuant to Section 906 of The
Sarbanes-Oxley Act of 2002.
   
    
    Previously filed and incorporated by reference. 32




---



##### 



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized. Gladstone Commercial CorporationDate: May 4, 2005
    
    By:
    
    /s/ Harry BrillHarry BrillChief Financial Officer and Treasurer
 33




---



##### 



Exhibit Index Exhibit
    
    Description of Document3.1
    
    Amended and Restated Articles of
Incorporation, incorporated by reference
to Exhibit 3.1 to the Registration
Statement on Form S-11 (File No.
333-106024), filed June 11, 2003.3.2
    
    Bylaws, incorporated by reference to
Exhibit 3.2 to the Registration Statement
on Form S-11 (File No. 333-106024), filed
June 11, 2003.10.1
    
    Promissory Note between Key Bank National
Association and CMI04 Canton NC LLC,
dated March 14, 2005.10.2
    
    First Amendment to Credit Agreement
and Waiver by and among Gladstone Commercial Corporation, Gladstone
Commercial Limited Partnership, Branch Banking and Trust Company and
certain other parties, dated as of April 21, 2005.11
    
    Computation of Per Share Increase in
Stockholders Equity from Operations
(included in the notes to the unaudited
financial statements contained in this
report).31.1
    
    Certification of Chief Executive Officer
pursuant to Section 302 of The
Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer
pursuant to Section 302 of The
Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer
pursuant to Section 906 of The
Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer
pursuant to Section 906 of The
Sarbanes-Oxley Act of 2002.
   
    
    Previously filed and incorporated by reference. 34