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 SEPTEMBER 30, 2005

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

GLADSTONE COMMERCIAL CORPORATION

(Exact name of registrant as specified in its charter)

MARYLAND		02-0681276
(State or other jurisdiction of incorporation or		(I.R.S. Employer Identification No.)
organization)

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.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ .

The number of shares of the issuer’s Common Stock, $0.001 par value, outstanding as of October 28, 2005 was 7,672,000.

 

 

GLADSTONE COMMERCIAL CORPORATION

TABLE OF CONTENTS

				PAGE
		PART I FINANCIAL INFORMATION
Item 1.		Consolidated Financial Statements (Unaudited)			3
		Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004
		Consolidated Statements of Operations for the three and nine months ended September 30, 2005 and 2004
		Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004
		Notes to Financial Statements
Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			21
Item 3.		Quantitative and Qualitative Disclosures About Market Risk			41
Item 4.		Controls and Procedures			42
		PART II OTHER INFORMATION
Item 1.		Legal Proceedings			43
Item 2.		Changes in Securities and Use of Proceeds			43
Item 3.		Defaults Upon Senior Securities			43
Item 4.		Submission of Matters to a Vote of Security Holders			43
Item 5.		Other Information			43
Item 6.		Exhibits			43
SIGNATURES					45

GLADSTONE COMMERCIAL CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

		September 30, 2005				December 31, 2004
ASSETS
Real estate, net		$	129,028,346			$	60,466,330
Lease intangibles, net of accumulated amortization of $826,865 and $194,047, respectively			11,062,110				3,230,146
Mortgage notes receivable			21,047,274				11,107,717
Cash and cash equivalents			364,282				29,153,987
Funds held in escrow			1,723,782				1,060,977
Replacement reserve			1,088,242				—
Interest receivable — mortgage note			67,511				64,795
Interest receivable — employees			4,681				4,792
Deferred rent receivable			2,460,616				210,846
Deferred financing costs			1,486,841				—
Prepaid expenses			234,108				170,685
Deposits on real estate			200,000				50,000
Other assets			78,338				64,819
TOTAL ASSETS		$	168,846,131			$	105,585,094
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
Due to Adviser		$	164,189			$	129,231
Accounts payable and accrued expenses			435,962				168,389
Dividends payable			—				920,040
Mortgage notes payable			42,158,247				—
Borrowings under line of credit			23,810,000				—
Rent received in advance, security deposits and funds held in escrow			2,078,037				1,674,741
Total Liabilities			68,646,435				2,892,401
STOCKHOLDERS’ EQUITY
Common stock, $0.001 par value, 20,000,000 shares authorized and 7,672,000 and 7,667,000 shares issued and outstanding, respectively			7,672				7,667
Additional paid in capital			105,502,544				105,427,549
Notes receivable — employees			(432,906	)			(375,000	)
Distributions in excess of accumulated earnings			(4,877,614	)			(2,367,523	)
Total Stockholders’ Equity			100,199,696				102,692,693
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	168,846,131			$	105,585,094

The accompanying notes are an integral part of these consolidated financial statements.

GLADSTONE COMMERCIAL CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

		For the three				For the three				For the nine				For the nine
		months ended				months ended				months ended				months ended
		September 30, 2005				September 30, 2004				September 30, 2005				September 30, 2004
OPERATING REVENUES
Rental income		$	3,453,777			$	1,066,076			$	7,536,025			$	1,667,538
Interest income from mortgage notes receivable			553,968				284,659				1,351,197				697,059
Tenant recovery revenue			28,208				—				69,808				—
Total operating revenues			4,035,953				1,350,735				8,957,030				2,364,597
OPERATING EXPENSES
Depreciation and amortization			1,140,181				313,032				2,374,912				519,133
Management advisory fee			609,171				333,825				1,564,826				843,360
Professional fees			99,799				38,373				447,802				313,804
Taxes and licenses			37,399				973				191,112				13,543
Insurance			70,244				59,579				207,648				188,554
Interest			895,775				—				1,186,798				—
General and administrative			107,059				74,881				337,722				352,145
Total operating expenses			2,959,628				820,663				6,310,820				2,230,539
Income from operations			1,076,325				530,072				2,646,210				134,058
Interest income
Interest income from temporary investments			10,093				153,716				117,806				488,701
Interest income — employee loans			5,562				1,250				15,483				1,250
Total interest income			15,655				154,966				133,289				489,951
Realized and unrealized loss from foreign currency
Net realized loss from foreign currency transactions			(3,007	)			—				(5,943	)			—
Net unrealized appreciation (depreciation) on translation of assets and liabilities in a foreign currency			(221,562	)			—				(221,428	)			—
Total net realized and unrealized loss from foreign currency			(224,569	)			—				(227,371	)			—
NET INCOME		$	867,411			$	685,038			$	2,552,128			$	624,009
Earnings per weighted average common share
Basic		$	0.11			$	0.09			$	0.33			$	0.08
Diluted		$	0.11			$	0.09			$	0.33			$	0.08
Weighted average shares outstanding
Basic			7,672,000				7,648,250				7,669,619				7,644,099
Diluted			7,725,667				7,697,079				7,718,441				7,703,504

The accompanying notes are an integral part of these consolidated financial statements.

GLADSTONE COMMERCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

		For the nine				For the nine
		months ended				months ended
		September 30, 2005				September 30, 2004
Cash flows from operating activities:
Net income		$	2,552,128			$	624,009
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			2,374,912				519,133
Changes in assets and liabilities:
Amortization of deferred financing costs			158,457				—
Amortization of deferred rent asset			114,700				—
Increase in mortgage interest receivable			(2,716	)			(61,840	)
Decrease (increase) in employee interest receivable			111				(1,250	)
Increase in prepaid expenses			(63,423	)			(37,293	)
Increase in other assets			(13,520	)			(25,319	)
Increase in deferred rent receivable			(369,624	)			(100,110	)
Increase in replacement reserve			(1,088,242	)			—
Increase in accounts payable and accrued expenses			267,574				11,898
Increase (decrease) in due to Adviser			34,958				(124,656	)
(Decrease) increase in rent received in advance and security deposits			(259,509	)			475,515
Net cash provided by operating activities			3,705,806				1,280,087
Cash flows from investing activities:
Acquisition of real estate			(80,763,736	)			(45,756,858	)
Issuance of mortgage note receivable			(10,000,000	)			(11,170,000	)
Deposit on future acquisition			(200,000	)			(200,000	)
Principal repayments on mortgage note receivable			60,443				38,950
Net cash used in investing activities			(90,903,293	)			(57,087,908	)
Cash flows from financing activities:
Offering costs			—				(7,730	)
Proceeds from borrowings under mortgage note payable			42,190,283				—
Principal repayments on mortgage note payable			(32,036	)			—
Borrowings from line of credit			69,410,000				—
Repayments on the line of credit			(45,600,000	)			—
Principal repayments on employee loans			17,094				—
Payments for deferred financing costs			(1,595,299	)			—
Dividends paid			(5,982,260	)			(1,910,500	)
Net cash provided by (used in) financing activities			58,407,782				(1,918,230	)
Net decrease in cash and cash equivalents			(28,789,705	)			(57,726,051	)
Cash and cash equivalents, beginning of period			29,153,987				99,075,765
Cash and cash equivalents, end of period		$	364,282			$	41,349,714
Cash paid during period for interest		$	1,028,341			$	—
NON-CASH FINANCING ACTIVITIES
Notes receivable issued in exchange for common stock associated with the exercise of employee stock options		$	75,000			$	375,000

The accompanying notes are an integral part of these consolidated financial statements

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 July 17, 2003, the Company completed the formation of a subsidiary, Gladstone Commercial Partners, LLC (“Commercial Partners”). Commercial Partners was organized to engage in any lawful act or activity for which a limited liability company may be organized in Delaware. Commercial Partners has the power to make and perform all contracts and to engage in all activities to carry out the purposes of the Company, and all other powers available to it as a limited liability company. As the Company currently owns all of the membership interests of Commercial Partners, the financial position and results of operations of Commercial Partners 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 membership 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 real estate investment trust (“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 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, the value of in-place leases, the value of unamortized lease origination costs and the value of tenant relationships, based in each case on their fair values.

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.

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 nine 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 Company allocates purchase price to the fair value of the tangible assets of an acquired property 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. Real estate depreciation expense on these tangible assets was $770,467 and $ 1,742,094 for the three and nine months ended September 30, 2005, respectively, and $253,256 and $421,586 for the three and nine months ended September 30, 2004, respectively.

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, included in the accompanying balance sheet as part of deferred rent receivable, are amortized as a reduction of rental income over the remaining non-cancelable terms of the respective leases. The value of these above-market leave values as of September 30, 2005 was $1,880,146. The capitalized below-market lease values will be amortized as an increase to rental income over the initial term and any fixed-rate renewal periods in the respective leases. Total amortization related to above-market lease values was $21,315 and $114,700 for the three and nine months ended September 30, 2005, respectively. There was no amortization related to above-market lease values in 2004.

The total amount of the remaining intangible assets acquired, which consist of in-place lease values, unamortized lease origination costs, and customer relationship intangible values, are allocated 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 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.

The value of in-place leases and unamortized lease origination costs are 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 related to these intangible assets was $369,714 and $632,818 for the three and nine months ended September 30, 2005, respectively, and $59,776 and $97,547 for three and nine months ended September 30, 2004, respectively.

The following table summarizes the gross value of other intangible assets:

		September 30, 2005				December 31, 2004
In-place leases		$	4,228,962			$	1,929,800
Leasing costs			4,843,746				1,494,393
Customer relationships			2,816,267				—
Accumulated amortization			(826,865	)			(194,047	)
		$	11,062,110			$	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 September 30, 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 two mortgage loans and has not experienced any actual losses in connection with its lending investments. Management reflects provisions for loan losses 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 have been no provisions for loan losses at September 30, 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 held in escrow or similar accounts are classified as restricted deposits. Items classified as cash equivalents include commercial paper and money-market funds. All of the Company’s cash and cash equivalents at September 30, 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.

Replacement reserve

The replacement reserve consists of funds held by certain of the Company’s lenders for properties held as collateral by these lenders. These funds will be released to the Company upon completion of agreed upon tasks as specified in the mortgage agreements, mainly consisting of maintenance and repairs on the buildings.

Deferred financing costs

Deferred financing costs consist of costs incurred to obtain long-term financing, including, legal fees, origination fees, and administrative fees. 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 sheet includes 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, along with the capitalized above-market lease values of certain acquired properties. 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, as is it relates to straight line rents, 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 collectibility 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 September 30, 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 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 and nine months ended September 30, 2005 and 2004:

		For the three				For the three				For the nine				For the nine
		months ended				months ended				months ended				months ended
		September 30, 2005				September 30, 2004				September 30, 2005				September 30, 2004
Net income, as reported		$	867,411			$	685,038			$	2,552,128			$	624,009
Less: Stock-based compensation expense determined using the fair value based method			(43,588	)			(159,343	)			(140,219	)			(530,399	)
Net income, pro-forma		$	823,823			$	525,695			$	2,411,909			$	93,610
Basic, as reported		$	0.11			$	0.09			$	0.33			$	0.08
Basic, pro-forma		$	0.11			$	0.07			$	0.31			$	0.01
Diluted, as reported		$	0.11			$	0.09			$	0.33			$	0.08
Diluted, pro-forma		$	0.11			$	0.07			$	0.31			$	0.01

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 $1.26 using the Black-Scholes option-pricing model, based on options issued from date of inception forward, and the following weighted-average assumptions: dividend yield of 5.06%, risk-free interest rate of 2.60%, expected volatility factor of 18.11%, 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 REIT under the Internal Revenue Code of 1986, as amended, 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. Because the Company is not able to deduct any of its unrealized depreciation on the translation of assets and liabilities in a foreign currency for tax purposes, the Company must distribute these amounts to its stockholders or the Company would be subject to federal and state corporate income tax on the amounts of these losses.

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, “Accounting for Income Taxes.” 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 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, 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.

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. If the rental payment is received on a date other than the transaction date, then a realized foreign currency gain or loss would be recorded on the financial statements. Straight line rent and any deferred rent asset or liability recorded in connection with monthly rental payments are also recorded using the exchange rate as of the transaction date. The Company also remits quarterly tax payments to Canada from amounts withheld from the tenants in the Canadian properties. Since these payments are received from the tenants on dates different then the remittance date to Canada, the tax payments also result in realized foreign currency gains and losses on the income statement. In addition to rental payments that are denominated in Canadian dollars, the Company also has a bank account in Canada and the long-term financings on the two Canadian properties were issued in Canadian dollars. All cash, deferred rent assets and mortgage notes payable related to the Canadian properties are re-valued at each balance sheet date to reflect the current exchange rate, and the gains and losses from the valuation is recorded on the income statement as unrealized appreciation or depreciation on translation of assets and liabilities. For the three and nine months ended September 30, 2005, $3,007 and $5,943, respectively, was recorded as a realized foreign currency loss and, $221,562 and $221,428, respectively, was recorded as unrealized depreciation on translation of assets and liabilities.. The unrealized depreciation was primarily a result of the valuation of the mortgage notes payable due to a decrease in the value of the US dollar relative to the Canadian dollar by approximately 5% between the date the notes were issued, July 19, 2005, and September 30, 2005. There was no foreign currency loss during the three or nine months ended September 30, 2004.

Use of estimates

The preparation of financial statements in conformity with GAAP 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 the Adviser’s employees on Company matters to the total hours worked by the Adviser’s employees.

The Company compensates its Adviser through reimbursement of its portion of the Adviser’s payroll, benefits and general overhead expenses. This reimbursement is generally subject to a combined annual management fee limitation of 2.0% of the Company’s average invested assets for the year, with certain exceptions. Reimbursement for overhead expenses is only required 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, and general overhead expenses are required to be reimbursed only if the amount of payroll and benefits reimbursed to the Adviser is less than 2.0% of its average invested assets for the year. However, payroll and benefits expenses are required to be reimbursed by the Company to the extent that they exceed the overall 2.0% annual management fee limitation. 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, 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 and nine months ended September 30, 2005, the Company incurred approximately $609,000 and $1,565,000, respectively, in management advisory fees. For the three and nine months ended September 30, 2004, the Company incurred approximately $334,000 and $843,000, respectively, in management advisory fees. Approximately $164,000 and $129,000 was unpaid at September 30, 2005 and December 31, 2004, respectively.

The following table shows the breakdown of the management advisory fee for the three and nine months ended September 30, 2005 and 2004:

		For the three				For the three				For the nine				For the nine
		months ended				months ended				months ended				months ended
		September 30, 2005				September 30, 2004				September 30, 2005				September 30, 2004
Allocated payroll and benefits		$	446,625			$	265,888			$	1,128,502			$	647,139
Allocated overhead expenses		$	162,546			$	67,937			$	436,324			$	196,221
Total management advisory fee		$	609,171			$	333,825			$	1,564,826			$	843,360

3. Stock Options

At September 30, 2005, 916,000 options were outstanding with exercise prices ranging from $15 to $16.85 with terms of ten years.

The following table is a summary of all notes issued to employees for the exercise of stock options:

		Number of				Strike Price of				Amount of
		Options				Options				Promissory								Interest Rate
Date Issued		Exercised				Exercised				Note				Term of Note				on Note
Sep-04			25,000			$	15.00			$	375,000			9 years					5.0	%
May-05			5,000			$	15.00			$	75,000			9 years					6.0	%

These notes were recorded as loans to employees in the equity section of the accompanying consolidated balance sheets. No compensation expense was recorded related to these transactions. As of September 30, 2005, approximately $433,000 of indebtedness was owed by current employees to the Company, and no current or former directors or executive officers had any loans outstanding.

4. Earnings Per Common Share

The following tables set forth the computation of basic and diluted earnings per share for the three and nine months ended September 30, 2005 and 2004:

		For the three				For the three				For the nine				For the nine
		months ended				months ended				months ended				months ended
		September 30, 2005				September 30, 2004				September 30, 2005				September 30, 2004
Net income		$	867,411			$	685,038			$	2,552,128			$	624,009
Denominator for basic weighted average shares			7,672,000				7,648,250				7,669,619				7,644,099
Dilutive effect of stock options			53,667				48,829				48,822				59,405
Denominator for diluted weighted average shares			7,725,667				7,697,079				7,718,441				7,703,504
Basic earnings per common share		$	0.11			$	0.09			$	0.33			$	0.08
Diluted earnings per common share		$	0.11			$	0.09			$	0.33			$	0.08

5. Real Estate

A summary of all properties held by the Company as of September 30, 2005 is as follows:

Square Footage

Date Acquired

Location

(unaudited)

Property Description

Net Real Estate

Dec-03

Raleigh, North Carolina

58,926

Office

$

5,072,431

Jan-04

Canton, Ohio

54,018

Office and Warehouse

3,512,179

Apr-04

Akron, Ohio

83,891

Office and Laboratory

8,415,585

Jun-04

Charlotte, North Carolina

64,500

Office

9,059,759

Jul-04

Canton, North Carolina

228,000

Commercial and Manufacturing

5,040,926

Aug-04

Snyder Township, Pennsylvania

290,000

Commercial and Warehouse

6,471,549

Aug-04

Lexington, North Carolina

154,000

Commercial and Warehouse

2,900,312

Sep-04

Austin, Texas

51,993

Flexible Office

7,159,424

Oct-04

Norfolk, Virginia

25,797

Commercial and Manufacturing

908,789

Oct-04

Mt. Pocono, Pennsylvania

223,275

Commercial and Manufacturing

6,041,608

Oct-04

Granby, Quebec

99,981

Commercial and Manufacturing

2,976,064

Oct-04

Montreal, Quebec

42,490

Commercial and Manufacturing

1,825,646

Feb-05

San Antonio, Texas

60,245

Flexible Office

8,210,205

Feb-05

Columbus, Ohio

39,000

Industrial

2,754,104

Apr-05

Big Flats, New York

120,000

Industrial

6,684,741

May-05

Wichita, Kansas

69,287

Office

11,168,009

May-05

Arlington, Texas

64,000

Warehouse and Bakery

4,023,257

Jun-05

Dayton, Ohio

59,894

Office

2,368,006

Jul-05

Eatontown, New Jersey

30,268

Office

4,843,652

Jul-05

Franklin Township, New Jersey

183,000

Office and Warehouse

8,169,812

Jul-05

Duncan, South Carolina

278,020

Office and Manufacturing

15,211,744

Aug-05

Hazelwood, Missouri

51,155

Office and Warehouse

3,031,623

Sep-05

Angola, Indiana

52,080

Industrial

1,019,116

Sep-05

Angola, Indiana

50,000

Industrial

1,140,689

Sep-05

Rock Falls, Illinois

52,000

Industrial

1,019,116

$

129,028,346

The following table sets forth the components of the Company’s investments in real estate:

		September 30, 2005				December 31, 2004
Real estate:
Land		$	17,032,402			$	7,669,000
Building			112,074,922				52,641,933
Tenant improvements			2,448,241				940,522
Accumulated depreciation			(2,527,219	)			(785,125	)
Real estate, net		$	129,028,346			$	60,466,330

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 in 2006, 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 in 2006, with prescribed escalations thereafter.

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 in 2006, with prescribed escalations thereafter.

On May 18, 2005, the Company acquired the leasehold interest in a 69,287 square foot office building in Wichita, Kansas for $13.4 million, including transaction costs, and the purchase was funded using borrowings from the Company’s line of credit and proceeds the Company received from the long-term mortgage on the Canton, North Carolina property. Under the terms of the leasehold interest, the Company has a capital lease with the City of Wichita because of a bargain purchase option contained within the lease that gives the Company the right to purchase the land and building for $1,000. Upon acquisition of the leasehold interest in the building, the Company was assigned the previously existing triple net lease with the sole tenant, which had a remaining term of approximately seven years at the time of assignment. The tenant also has two options to extend the lease for additional periods of five years each. The lease provides for annual rents of approximately $1.3 million in 2006, with prescribed escalations thereafter.

On May 26, 2005, the Company acquired a 64,000 square foot warehouse and bakery in Arlington, Texas for $5.3 million, including transaction costs, and the purchase was funded using borrowings from the Company’s line of credit. 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, and the tenant has two options to extend the lease for additional periods of five years each. The lease provides for annual rents of approximately $521,000 in 2006, with prescribed escalations thereafter.

On June 30, 2005, the Company acquired a 59,894 square foot office building in Dayton, Ohio for $2.7 million, including transaction costs, and the purchase was funded using borrowings from the Company’s line of credit. 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 thirteen years at the time of assignment. The tenant also has the ability to terminate the lease in eight years with nine months notice to the Company prior to the effective date of termination. The tenant also has two options to extend for additional periods of five years each. The lease provides for annual rents of approximately $240,000 in 2006, with prescribed escalations thereafter.

On July 7, 2005, the Company acquired a 30,268 square foot office building in Eatontown, New Jersey for $5.6 million, including transaction costs, and the purchase was funded using borrowings from the Company’s line of credit. 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 tenant also has two options to extend the lease for additional periods of five years each. The lease provides for annual rents of approximately $507,000 in 2006, with prescribed escalations thereafter.

On July 11, 2005, the Company acquired a 183,000 square foot office and warehouse building in Franklin Township, New Jersey for $8.2 million, including transaction costs, and the purchase was funded using borrowings from the Company’s line of credit. The Company, upon acquisition of the property, extended a fifteen year triple net lease with the sole tenant, and the tenant has three options to extend the lease for additional periods of five years each. The lease also has a provision whereby the tenant may purchase the property from the Company on or around the eleventh anniversary of the purchase date for $9.1 million. The lease provides for annual rents of approximately $809,000 in 2006, with prescribed escalations thereafter.

On July 14, 2005, the Company acquired a 278,020 square foot office and manufacturing building in Duncan, South Carolina for $19.2 million, including transaction costs, and the purchase was funded using borrowings from the Company’s line of credit. 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 tenant also has two options to extend the lease for

additional periods of five years each. The lease provides for annual rents of approximately $1.9 million in 2006, with prescribed escalations thereafter.

On August 5, 2005, the Company acquired a 51,155 square foot office and warehouse building in Hazelwood, Missouri for $3.2 million, including transaction costs, and the purchase was funded using borrowings from the Company’s line of credit. 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 seven years at the time of assignment. The lease provides for annual rents of approximately $277,000 in 2006, with prescribed escalations thereafter.

On September 2, 2005, the Company acquired three separate properties from a single seller: a 52,080 square foot industrial building in Angola, Indiana; a 50,000 square foot industrial building located in Angola, Indiana; and a 52,000 square foot industrial building located in Rock Falls, Illinois. These three properties were acquired for an aggregate cost to the Company of $3.2 million, including transaction costs, and the purchase was funded using borrowings from the Company’s line of credit. Upon acquisition of the properties, the Company extended a fifteen year triple net lease with the tenant of each building. The lease provides for annual rents of approximately $281,000 in 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 nine months ended September 30, 2005 as follows:

						Nine months ended September 30, 2005
										Tenant				Lease				Deferred				Total Purchase
		Land				Building				Improvements				Intangibles				Rent Asset				Price
San Antonio, Texas		$	843,000			$	6,817,984			$	718,439			$	664,218				—			$	9,043,641
Columbus, Ohio			410,000				2,379,947				5,161				243,063				395,000				3,433,171
Big Flats, New York			275,000				6,492,984				—				337,589				—				7,105,573
Wichita Kansas			1,525,000				9,633,478				119,182				606,701				1,587,822				13,472,183
Arlington, Texas			635,964				3,350,586				68,246				1,300,087				12,024				5,366,907	(1)
Dayton, Ohio			525,000				1,416,431				444,137				392,741				—				2,778,309
Eatontown, New Jersey			1,350,630				3,388,970				131,091				774,996								5,645,687
Franklin Township, New Jersey			1,800,000				6,410,908				—				—				—				8,210,908
Duncan, South Carolina			977,898				14,325,669				—				3,980,102				—				19,283,669
Hazelwood, Missouri			763,178				2,257,115				21,463				165,285				—				3,207,041
Angola, Indiana & Rock Falls, Illinois			257,732				2,927,444				—				—				—				3,185,176
		$	9,363,402			$	59,401,516			$	1,507,719			$	8,464,782			$	1,994,846			$	80,732,265

Future operating lease payments under non-cancelable leases, excluding customer reimbursement of expenses, in effect at September 30, 2005 are as follows:

Year		Rental Payments
2005		$	3,509,119
2006			14,118,165
2007			14,355,646
2008			14,651,591
2009			13,752,844
Thereafter			80,049,268

Lease payments for certain properties, where payments are denominated in Canadian dollars, have been translated to US dollars using the exchange rate as of September 30, 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. The total property taxes, on an annual basis, for all properties outstanding as of September 30, 2005 is summarized in the table below:

Location		Real Estate Taxes
Raleigh, North Carolina		$	45,743
Canton, Ohio			6,374
Akron, Ohio			81,933
Charlotte, North Carolina			56,438
Canton, North Carolina			47,877
Snyder Township, Pennsylvania			99,222
Lexington, North Carolina			21,102
Austin, Texas			167,499
Norfolk, Virginia			11,411
Mt. Pocono, Pennsylvania			115,232
Granby, Quebec			38,201
Montreal, Quebec			81,944
San Antonio, Texas			159,551
Columbus, Ohio			37,610
Big Flats, New York			24,594
Wichita, Kansas			5,222
Arlington, Texas			63,520
Dayton, Ohio			49,156
Eatontown, New Jersey			53,440
Franklin Township, New Jersey			140,280
Duncan, South Carolina			351,257
Hazelwood, Missouri			67,961
Angola, Indiana & Rock Falls, Illinois			43,591
		$	1,769,158

6. Mortgage Notes 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 September 30, 2005, the outstanding balance of the note was $11,047,274.

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 6.0% per year, with a ceiling of 10.0%. The mortgage loan is interest only for the first nine years of the term, with payments of principal commencing after the initial period. The balance of the principal and all interest remaining is due at the end of the 12 year term.

7. Dividends Declared per Share

The Company commenced paying a monthly dividend in 2005. The following table summarizes the dividends paid during the nine months ended September 30, 2005, and those dividends declared subsequent to the quarter end for October, November and December of 2005:

Record Date		Payment Date		Dividend per Share
January 17, 2005		January 31, 2005		$	0.06
February 14, 2005		February 25, 2005		$	0.06
March 16, 2005		March 30, 2005		$	0.06
April 15, 2005		April 29, 2005		$	0.08
May 13, 2005		May 27, 2005		$	0.08
June 16, 2005		June 30, 2005		$	0.08
July 21, 2005		July 29, 2005		$	0.08
August 23, 2005		August 31, 2005		$	0.08
September 22, 2005		September 30, 2005		$	0.08
October 21, 2005		October 31, 2005		$	0.10
November 21, 2005		November 30, 2005		$	0.10
December 21, 2005		December 30, 2005		$	0.10

8. Segment Information

As of September 30, 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 and nine months ended September 30, 2005 and 2004:

		As of and for the Three Months Ended September 30, 2005																As of and for the Nine Months Ended September 30, 2005
		Real Estate				Real Estate												Real Estate				Real Estate
		Leasing				Lending				Other				Total				Leasing				Lending				Other				Total
Revenue		$	3,481,985			$	553,968			$	—			$	4,035,953			$	7,605,833			$	1,351,197			$	—			$	8,957,030
Expenses			1,410,209				—				1,549,419				2,959,628				2,857,852				—				3,452,968				6,310,820
Income (loss) from operations			2,071,776				553,968				(1,549,419	)			1,076,325				4,747,981				1,351,197				(3,452,968	)			2,646,210
Other income (loss)			(224,569	)			—				15,655				(208,914	)			(227,371	)			—				133,289				(94,082	)
Net income (loss)		$	1,847,207			$	553,968			$	(1,533,764	)		$	867,411			$	4,520,610			$	1,351,197			$	(3,319,679	)		$	2,552,128
Total Assets		$	143,839,316			$	21,114,785			$	3,892,030			$	168,846,131			$	143,839,316			$	21,114,785			$	3,892,030			$	168,846,131

		As of and for the Three Months Ended September 30, 2004																As of and for the Nine Months Ended September 30, 2004
		Real Estate				Real Estate												Real Estate				Real Estate
		Leasing				Lending				Other				Total				Leasing				Lending				Other				Total
Revenue		$	1,066,076			$	284,659			$	—			$	1,350,735			$	1,667,538			$	697,059			$	—			$	2,364,597
Expenses			313,032				—				507,631				820,663				519,133				—				1,711,406				2,230,539
Income (loss) from operations			753,044				284,659				(507,631	)			530,072				1,148,405				697,059				(1,711,406	)			134,058
Other income			—				—				154,966				154,966				—				—				489,951				489,951
Net income (loss)		$	753,044			$	284,659			$	(352,665	)		$	685,038			$	1,148,405			$	697,059			$	(1,221,455	)		$	624,009
Total Assets		$	52,021,413			$	11,286,986			$	41,805,008			$	105,113,407			$	52,021,413			$	11,286,986			$	41,805,008			$	105,113,407

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. This line of credit initially provided the Company with up to $50 million of financing, with an option to increase the line of credit up to a maximum of $75 million upon agreement of the syndicate of banks. On July 6, 2005, the Company amended the line of credit to increase the maximum availability under the line from $50 million to $60 million. The line of credit matures on February 28, 2008. 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 and, as of September 30, 2005, the Company is in compliance with all financial and operating covenants. 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. The Company may use the advances under the line of credit for both general corporate purposes and the acquisition of new investments. As of September 30, 2005, there was $23.8 million outstanding under the line of credit at an interest rate of 5.97%.

10. Mortgage Notes 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 used the proceeds from the note to acquire additional investments for its portfolio.

On July 19, 2005, the Company, through wholly-owned subsidiaries, entered into two separate long-term notes payable with the RBC Life Insurance Company, which are collateralized by its Canadian Properties. The Company borrowed $2.1 million in Canadian dollars, which translated to $1.7 million in US dollars as of July 19, 2005, and the loan is collateralized by a security interest in its Montreal, Quebec property. The Company borrowed an additional $3.4 million in Canadian dollars, which translated to $2.8 million in US dollars as of July 19, 2005, and the loan is collateralized by a security interest in its Granby, Quebec property. These notes both accrue interest at an interest rate of 5.22% per year. Monthly payments on the notes are based upon a twenty-five year term, with both principal and interest being paid each month. The notes mature on August 1, 2015, and the Company does not have the right to prepay the principal amount prior to the maturity date on either note. The Company used the proceeds from the notes to pay down the Company’s line of credit.

On August 25, 2005, the Company, through wholly-owned subsidiaries, borrowed $21,757,000 pursuant to a long-term note payable from Bank of America, N.A., which is collateralized by a security interest in its Charlotte, North Carolina property for $7,125,000 and its Duncan, South Carolina property for $14,632,000. The note accrues interest at a rate of 5.331% per year. The Company may repay this note at any time after June 1, 2015 and not be subject to a prepayment penalty. The note matures on September 1, 2015. The Company used the proceeds from the note to pay down the Company’s line of credit.

On September 12, 2005, the Company, through a wholly-owned subsidiary, borrowed $12,588,000 pursuant to a long-term note payable from JP Morgan Chase Bank, N.A., which is collateralized by a security interest in its Akron, Ohio property for $7,560,000, its Canton, Ohio property for $2,950,000, and its Dayton, Ohio property for $2,078,000. The note accrues interest at a rate of 5.21% per year. The note matures on September 1, 2015, and the Company may not repay this note at any time before maturity. The Company used the proceeds from the note to pay down the Company’s line of credit.

11. Subsequent Events

On October 3, 2005, the Company filed a shelf registration statement with the Securities and Exchange Commission (“SEC”) that will allow the Company to issue additional equity securities in one or more offerings up to an aggregate dollar amount of $75 million. The registration statement was declared effective by the SEC on October 24, 2005. The registration statement provides for the issuance of both common stock and preferred stock, the terms of which would be determined in the future by the Company’s board of

directors. The Company has no current plans to conduct an offering under the registration statement. The Company expects to use the net proceeds from any offerings pursuant to the shelf registration statement to make additional investments and fund its continuing operations.

On October 11, 2005, the Board of Directors of the Company considered the possibility of entering into a new advisory agreement with the Adviser, which would provide for a performance-based incentive structure, rather than the structure under the current advisory agreement which provides for a pass through of costs incurred by the Adviser in connection with the management of the Company’s operations. The Board of Directors agreed to explore this possibility further and agreed that any proposed advisory agreement would be submitted to stockholders for approval before being implemented. The Company has not yet determined the terms that would be contained in the proposed advisory agreement or when, if ever, such an agreement will be presented to stockholders for approval.

On October 17, 2005, the Company acquired a 70,598 square foot industrial building in Newburyport, Massachusetts for $7.8 million, including transaction costs, and the purchase was funded using borrowings from the Company’s line of credit. 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 seven years at the time of assignment. The tenant also has one option to extend the lease for an additional period of five years. The lease provides for annual rents of approximately $669,000 in 2006, with prescribed escalations thereafter.

On October 31, 2005, the Company acquired a 291,142 square foot industrial manufacturing facility in Clintonville, Wisconsin for $5.2 million, including transaction costs, and the purchase was funded using borrowings from the Company’s line of credit. The Company, upon acquisition of the property, extended a fifteen year triple net lease with the sole tenant, and the tenant has three options to extend the lease for additional periods of five years each. The lease provides for annual rents of approximately $499,000 in 2006, with prescribed escalations thereafter.

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 on Form 10-Q constitute 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;
	•		estimates of our future operating expenses, including payments to our Adviser under the terms of our advisory agreement;
	•		projected capital expenditures; and
	•		use of the proceeds of our credit facilities, mortgage notes payable, offerings of equity securities and other future capital resources, if any.

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, arrange for long-term mortgages on our properties; secure one or more additional long-term credit facilities, and to raise equity capital;
	•		availability of qualified personnel;
	•		changes in our industry, interest rates, exchange 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.

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 September 30, 2005, we owned twenty-five properties and had two mortgage loans. We have also acquired two properties subsequent to September 30, 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 meets our investment criteria.

Recent Events

Investments

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, 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 nine years at the time of assignment. The lease provides for annual rents of approximately $753,000 in 2006, 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, 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 ten years at the time of assignment. The lease provides for annual rents of approximately $318,000 in 2006, with prescribed escalations thereafter.

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 in 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 6.0% per year, with a ceiling of 10.0%. The mortgage loan is interest only for the first nine years of the term, with payments of principal commencing after the initial period. The balance of the principal and all interest remaining is due at the end of the 12 year term.

On May 18, 2005, we acquired the leasehold interest in a 69,287 square foot office building in Wichita, Kansas for $13.4 million, including transaction costs, and the purchase was funded using borrowings from our line of credit and proceeds we received from the long-term mortgage on the Canton, North Carolina property. Under the terms of the leasehold interest, we have a capital lease with the City of Wichita because of a bargain purchase option contained within the lease that gives us the right to purchase the land and building for $1,000. Upon acquisition of the leasehold interest in the building, we were assigned the previously existing triple net lease with the sole tenant, which had a remaining term of approximately seven years at the time of assignment. The tenant also has two options to extend the lease for additional periods of five years each. The lease provides for annual rents of approximately $1.3 million in 2006, with prescribed escalations thereafter.

On May 26, 2005, we acquired a 64,000 square foot warehouse and bakery in Arlington, Texas for $5.3 million, including transaction costs, and the purchase was funded using borrowings from our line of credit. 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, and the tenant has two options to extend the lease for additional periods of five years each. The lease provides for annual rents of approximately $521,000 in 2006, with prescribed escalations thereafter.

On June 30, 2005, we acquired a 59,894 square foot office building in Dayton, Ohio for $2.7 million, including transaction costs, and the purchase was funded using borrowings from our line of credit. 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 thirteen years at the time of assignment. The tenant also has the ability to terminate the lease in eight years with nine months notice to us prior to the effective date of termination. The tenant also has two options to extend the lease for additional periods of five years each. The lease provides for annual rents of approximately $240,000 in 2006, with prescribed escalations thereafter.

On July 7, 2005, we acquired a 30,268 square foot office building in Eatontown, New Jersey for $5.6 million, including transaction costs, and the purchase was funded using borrowings from our line of credit. 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, and the tenant has two options to extend the lease for additional periods of five years each. The lease provides for annual rents of approximately $507,000 in 2006, with prescribed escalations thereafter.

On July 11, 2005, we acquired a 183,000 square foot office and warehouse building in Franklin Township, New Jersey for $8.2 million, including transaction costs, and the purchase was funded using borrowings from our line of credit. Upon acquisition of the property, we extended a fifteen year triple net lease with the sole tenant, and the tenant has three options to extend the lease for additional periods of five years each. The lease also has a provision whereby the tenant may purchase the property from us on or around the eleventh anniversary of the purchase date for $9.1 million. The lease provides for annual rents of approximately $809,000 in 2006, with prescribed escalations thereafter.

On July 14, 2005, we acquired a 278,020 square foot office and manufacturing building in Duncan, South Carolina for $19.2 million, including transaction costs, and the purchase was funded using borrowings from our line of credit. 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 tenant also has two options to extend the lease for additional periods of five years each. The lease provides for annual rents of approximately $1.9 million in 2006, with prescribed escalations thereafter.

On August 5, 2005, we acquired a 51,155 square foot office and warehouse building in Hazelwood, Missouri for $3.2 million, including transaction costs, and the purchase was funded using borrowings from our line of credit. 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 seven years at the time of assignment. The lease provides for annual rents of approximately $277,000 in 2006, with prescribed escalations thereafter.

On September 2, 2005, we acquired three separate properties from a single seller: a 52,080 square foot industrial building in Angola, Indiana; a 50,000 square foot industrial building located in Angola, Indiana; and a 52,000 square foot industrial building located in Rock Falls, Illinois. These three properties were acquired for an aggregate cost to us of $3.2 million, including transaction costs, and the purchase was funded using borrowings from our line of credit. Upon acquisition of the properties, we extended a fifteen year triple net lease with the tenant of each building. The lease provides for annual rents of approximately $281,000 in 2006, with prescribed escalations thereafter.

On October 17, 2005, we acquired a 70,598 square foot industrial building in Newburyport, Massachusetts for $7.8 million, including transaction costs, and the purchase was funded using borrowings from our line of credit. 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 seven years at the time of assignment. The tenant also has one option to extend the lease for an additional period of five years. The lease provides for annual rents of approximately $669,000 in 2006, with prescribed escalations thereafter.

On October 31, 2005, we acquired a 291,142 square foot industrial manufacturing facility in Clintonville, Wisconsin for $5.2 million, including transaction costs, and the purchase was funded using borrowings from our line of credit. Upon acquisition of the property, we extended a fifteen year triple net lease with the sole tenant, and the tenant has three options to extend the lease for additional periods of five years each. The lease provides for annual rents of approximately $499,000 in 2006, with prescribed escalations thereafter.

Mortgage Loans

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 September 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 used the proceeds from the note to acquire additional investments for our portfolio.

On July 19, 2005 we, through wholly-owned subsidiaries, entered into two separate long-term notes payable with the RBC Life Insurance Company, which are collateralized by our Canadian Properties. We borrowed $2.1 million in Canadian dollars, which translated to $1.7 million in US dollars as of July 19, 2005, and the loan is collateralized by a security interest in our Montreal, Quebec property. We borrowed an additional $3.4 million in Canadian dollars, which translated to $2.8 million in US dollars as of July 19, 2005, and the loan is collateralized by a security interest in our Granby, Quebec property. These notes both accrue interest at an interest rate of 5.22% per year. Monthly payments on the notes are based upon a twenty-five year term, with both principal and interest being paid each month. The notes mature on August 1, 2015, and we do not have the right to prepay the principal amount prior to the maturity date on either note. We used the proceeds from the notes to pay down our line of credit.

On August 25, 2005 we, through wholly-owned subsidiaries, borrowed $21,757,000 pursuant to a long-term note payable from Bank of America, N.A., which is collateralized by a security interest in our Charlotte, North Carolina property for $7,125,000 and our Duncan, South Carolina property for $14,632,000. The note accrues interest at a rate of 5.331% per year. We may repay this note at any time after June 1, 2015 and not be subject to a prepayment penalty. The note matures on September 1, 2015. We used the proceeds from the note to pay down our line of credit.

On September 12, 2005 we, through a wholly-owned subsidiary, borrowed $12,588,000 pursuant to a long-term note payable from JP Morgan Chase Bank, N.A., which is collateralized by a security interest in our Akron, Ohio property for $7,560,000, our Canton, Ohio property for $2,950,000, and our Dayton, Ohio property for $2,078,000. The note accrues interest at a rate of 5.21% per year. We used the proceeds from the note to pay down our line of credit.

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 has not materially changed the level of our expenses.

During the three and nine months ended September 30, 2005, payroll and benefits expenses, which are part of the management fee paid to our Adviser, were approximately $445,000 and $1,129,000, respectively, and during the three and nine months ended September 30, 2004, payroll and benefits expenses were approximately $266,000 and $647,000, 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 $1.5 million. 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.

We compensate our Adviser through reimbursement of our portion of our Adviser’s payroll, benefits and general overhead expenses. This reimbursement is generally subject to a combined annual management fee limitation of 2.0% of our average invested assets for the year, with certain exceptions. Reimbursement for overhead expenses is only required 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, and general overhead expenses are required to be reimbursed only if the amount of payroll and benefits reimbursed to our Adviser is less than 2.0% of our average invested assets for the year. However, payroll and benefits expenses are required to be reimbursed by us to the extent that they exceed the overall 2.0% annual management fee limitation. 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 and nine months ended September 30, 2005, the amount of overhead expenses that we reimbursed our Adviser was approximately $163,000 and $436,000, respectively, and during the three and nine months ended September 30, 2004, the amount of overhead expenses that we reimbursed our Adviser was approximately $68,000 and $196,000, respectively. The actual amount of overhead expenses for which we will be required to reimburse our Adviser in the future is not determinable, but we currently estimate that during the year ending December 31, 2005 this amount will be approximately $600,000.

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 and nine months ended September 30, 2005, the total amount of these expenses that we incurred was approximately $1,210,000 and $2,371,000, respectively. During the three and nine months ended September 30, 2004, the total amount of these expenses was $174,000 and $868,000, respectively.

In addition, we are also responsible for all fees charged by third parties that are directly related to our business, which may include real estate brokerage fees, mortgage placement fees, lease-up fees and transaction structuring fees (although we may be able to pass some or all of such fees on to our tenants and borrowers). During the three and nine months ended September 30, 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.

On October 11, 2005, our board of directors considered the possibility of entering into a new advisory agreement with our Adviser, which would provide for a performance-based incentive structure, rather than the structure under the current advisory agreement which provides for a pass through of costs incurred by our Adviser in connection with the management of our operations. Our board of directors agreed to explore this possibility further and agreed that any proposed advisory agreement would be submitted to stockholders for approval before being implemented. We have not yet determined the terms that would be contained in the proposed advisory agreement or when, if ever, such an agreement will be presented to stockholders for approval.

Critical Accounting Policies

Management believes our most critical accounting policies are revenue recognition (including straight-line rent), investment accounting, 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 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 includes 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, along with the capitalized above-market lease values of certain acquired properties. 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, as is it relates to straight line rents, 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 collectibility 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.

Investment Accounting

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 account for 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, the value of in-place leases, the value of unamortized lease origination costs and the value of tenant relationships, based in each case on their fair values.

Management’s estimates of value are made using methods similar to those used by independent appraisers (e.g., discounted cash flow analysis). Factors considered by management in its analysis include an estimate of carrying costs during hypothetical expected lease-up periods considering current market conditions, and costs to execute similar leases. We also consider information obtained about each property as a result of our pre-acquisition due diligence, marketing and leasing activities in estimating the fair value of the tangible and intangible assets acquired. In estimating carrying costs, management also includes real estate taxes, insurance and other operating expenses and estimates of lost rentals at market rates during the expected lease-up periods, which primarily range from nine 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.

The total amount of other intangible assets acquired are 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.

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.

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, included in the accompanying balance sheet as part of deferred rent receivable, as a reduction of rental income over the remaining non-cancelable terms of the respective leases. We will amortize any capitalized below-market lease values as an increase to rental income over the initial term and any fixed-rate renewal periods in the respective leases.

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		Second
Our		Ratings		Ratings
System		Agency		Agency		Description (a)
>10		Baa2		BBB		Probability of default during the next ten years is 4% and the expected loss is 1% or less
10		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%
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%

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		9/30/2005				12/31/2004
Average			8.4				7.8
Weighted Average			8.5				7.6
Highest			10.0				10.0
Lowest			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.

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 two mortgage loans 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 materially 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 September 30, 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.

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 any unvested and future stock options as compensation cost.

Results of Operations

A comparison of our operating results for the three and nine months ended September 30, 2005 and 2004 is below:

		For the three months ended																For the nine months ended
		September 30,				September 30,												September 30,				September 30,
		2005				2004				$ Change				% Change				2005				2004				$ Change				% Change
OPERATING REVENUES
Rental income		$	3,453,777			$	1,066,076			$	2,387,701				224	%		$	7,536,025			$	1,667,538			$	5,868,487				352	%
Interest income from mortgage note receivable			553,968				284,659				269,309				95	%			1,351,197				697,059				654,138				94	%
Tenant recovery revenue			28,208				—				28,208				100	%			69,808				—				69,808				100	%
Total operating revenues			4,035,953				1,350,735				2,685,218				199	%			8,957,030				2,364,597				6,592,433				279	%
OPERATING EXPENSES
Depreciation and amortization			1,140,181				313,032				827,149				264	%			2,374,912				519,133				1,855,779				357	%
Management advisory fee			609,171				333,825				275,346				82	%			1,564,826				843,360				721,466				86	%
Professional fees			99,799				38,373				61,426				160	%			447,802				313,804				133,998				43	%
Taxes and licenses			37,399				973				36,426				3744	%			191,112				13,543				177,569				1311	%
Insurance			70,244				59,579				10,665				18	%			207,648				188,554				19,094				10	%
Interest			895,775				—				895,775				100	%			1,186,798				—				1,186,798				100	%
General and administrative			107,059				74,881				32,178				43	%			337,722				352,145				(14,423	)			-4	%
Total operating expenses			2,959,628				820,663				2,138,965				261	%			6,310,820				2,230,539				4,080,281				183	%
Income from operations			1,076,325				530,072				546,253				103	%			2,646,210				134,058				2,512,152				1874	%
Interest income from temporary investments			10,093				153,716				(143,623	)			-93	%			117,806				488,701				(370,895	)			-76	%
Interest income — employee loans			5,562				1,250				4,312				345	%			15,483				1,250				14,233				1139	%
Loss on foreign currency translation			(224,569	)			—				(224,569	)			100	%			(227,371	)			—				(227,371	)			100	%
Other (loss) income			(208,914	)			154,966				(363,880	)			-235	%			(94,082	)			489,951				(584,033	)			-119	%
NET INCOME		$	867,411			$	685,038			$	182,373				27	%		$	2,552,128			$	624,009			$	1,928,119				309	%