The past year has been a horrific one for every single publicly traded stock that produces and distributes cannabis. The frenzy of the 2017/2018 rally has been utterly killed, as the major cannabis players are currently trading below, or at around the same levels as their IPO prices. The hype quickly faded away, as their valuations at the time could never reflect any degree of such potential underlying profitability. The once multiples of 300X P/S were simply out of this world and could never justify their, admittedly, hyper-growth. Adding concerns over cannabis oversupply, as well as competing with what could be a more efficient black market, has led to the current long-term sell-off. During the last twelve months alone, investors of the cannabis majors have seen their stocks fall anywhere from 60% to 90%, allowing for little excitement and optimism for the future.
However, the cannabis industry itself is far from not exciting. The legal marijuana market is expected to be worth $73.6B in 2027, with a CAGR of 18.1%. Now, instead of searching and gambling towards finding the dominant producers over the next decade, investors can profit the smarter way, by allocating capital towards what every single one of those players needs: land and real estate. Despite its major industry-attached risks, Innovative Industrial Properties (IIPR), being the only publicly traded REIT in the industry is, in my view, the smartest way to play the cannabis sector.
This article aims to cover:
- The bullish case
- The growth and income prospects
- The future of the industry
- The moat and management
- The bearish case
- Potential tenant weaknesses
- Market and Credit risks
- Conclusion on why IIPR is a decent bet
The Bullish Case
Growth and Income
As I mentioned, cannabis-producing stocks had a terrible year. However, this has not been the case for IIPR. The company is growing at an explosive rate. In fact, IIPR is currently the fastest-growing REIT in the world. Revenues increased by 270% YoY in its latest earnings report. For comparison, the next fastest-growing industrial REIT over the same period in terms of rental growth is the Plymouth Industrial REIT (PLYM), at "only" 65.4% YoY.
During 2019, the company acquired 35 properties, comprising approximately 1.9 million additional rentable square feet. At the end of FY2019, it owned 46 properties that were 100% leased to state-licensed medical-use cannabis operators. Being a REIT, IIPR is obligated to distribute the majority of its FFO back to shareholders in the form of dividends. Since its rental income has been growing at such a rapid pace, FFOs and, in turn, dividends have also followed suit.
Management has been raising the dividend at least once every two quarters. In FY2019, the dividend grew by an astonishing 135.8%. While it seems that the company is over-distributing on a quarterly basis, FFO/share is growing so rapidly, that on an annual perspective, the dividend is well-covered. Dividend growth has been reasonable, and the payout ratio has been maintained below 90% over the past four years.
Considering such a growth in its distributions, one would imagine that IIPR is a low-yielding REIT, trading at a premium valuation to reflect its future growth, but that's not the case. The stock is trading at a forward P/AFFO of 14.7, and as a result, its current dividend yield is 5.78%, and that is assuming management doesn't increase the next dividend, as it usually does.
Buying the fastest-growing REIT in the world while getting such a rich dividend, however, would be simply too good to be true. The reality is that the market is pricing-in the numerous risks that come with IIPR, but I will touch on that later on.
The Future of the Industry
Many of the risks that I will mention later are attached to the future of the cannabis industry. However, there are many aspects of it to be excited about and bullish on as well. IIPR relies on acquiring properties that it can lease to the fast-growing marijuana operators. Properties are 100% leased on long-term, triple-net leasing arrangements with licensed medical-use cannabis operators, and which are subject to contractual rental rate increases. The boom in the number of these operators has been phenomenal over the past few years, as reflected in rental growth. However, for the growth to continue, several catalysts need to be considered in regard to the future of the industry.
- The SAFE Banking Act
The bill will protect financial institutions working with state-approved cannabis companies. Raising money in the cannabis industry had been a headache for a long time, as laws would not make it easy for credit unions and community banks to provide checking and deposit services to the sector. This is a massive step for the industry, especially in the merchant/vendor level, which will hopefully push sales on the consumer level even faster should the bill be passed as intended.
- The STATES Act
This one aims to harmonize federal and state cannabis laws by turning to the state's decisions on cannabis policy. The bill is expected to be discussed during the year and would be a game-changer for the industry, should it pass.
- The MORE Act
This one would be the most significant catalyst and a massive milestone for the cannabis industry in general. In my view, this bill is the "end-game" for the sector and the ultimate goal any operator could hope for. The bill would make marijuana federally legal across all states and remove the plant's categorization as a schedule-1 drug. Moreover, it would tax cannabis products at 5 percent and allow establishing trust funds for various purposes. The act would also authorize a Cannabis Justice Office within the Department of Justice Office of Justice Programs, responsible for administering the grants. Needless to say that the boost such a bill would provide to the industry would be immeasurable, should it pass. Not only on a cultural level, but what we, of course, as investors care about. That is the compatibility of cannabis operators with the overall market, both in terms of capital access and terminating discrimination.
These three are currently the hottest catalysts for the industry on a legislation level. Considering the continuous legalization of cannabis, and the overall trend towards the marijuana industry moving forward at a rapid pace, I believe that in that regard, the future of the sector is one to be excited about.
Moat and Management
Being the only public REIT focused on cannabis-related properties has allowed the company to build a great moat. The most essential one is the company's access to capital and financing (risks on that mentioned later). As you may know, REITs base almost all of their future projects' financing either through debt or equity and not from retained earnings since most earnings are being distributed.
Being publicly traded, IIPR can easily issue new shares and acquire further properties easily. The few private cannabis REITs have to rely on private placements. Not only is it harder for them to attract new investors (compared to public markets), but do so at a higher cost as well. For example, private REIT Treehouse signed for a planned debt facility which expects to carry a 6.1% interest rate over a five-year term.
In February 2019, IIPR issued $143.75 million aggregate principal amount of Exchangeable Senior Notes, which bears interest at a fixed rate of 3.75%/annum until maturity. Being publicly traded and, therefore, more transparent, IIPR can borrow at a much cheaper rate.
As for management, fellow author The Dividend Sensei did a great job summarizing the excellent traits of the team that runs IIPR. I urge you to read his full report in detail here. Long story short, IIPR investors are in safe hands. Executives have decades of experience in the real estate sector. Moreover, many have previously worked together in BioMed, which should allow for excellent communication and swift execution.
Closing the Bullish case for IIPR, the future is definitely promising and could yield massive returns. The company is growing at a stunning rate, and the industry is moving forward on the legislation and cultural level. The stock is the only public REIT in the sector, run by an experienced management team. Moreover, investors are getting paid a very rich dividend yield.
The Bearish Case
While there are lots to be excited and potentially be rewarded about, investors must also pay attention and acknowledge the underlying risks that could lead to a bearish case.
Tenant Weaknesses
I can's skip but urge you to read the latest IIPR article by Se Levanta Investments, in which the author highlights the potential tenant weaknesses in great detail.
As the company highlights in its latest 10-K, tenant risks are not to be taken lightly. Many of their existing tenants are, and they expect that many of their future tenants will be, start-up firms that may be unable to pay rent with FFOs or at all. This type of scenario could negatively affect IIPR's cash available to make distributions to stockholders or otherwise impair the value of the common stock.
Rental income, and as a result the distributions, are 100% correlated with the financial stability of IIPR's tenants. The company does have a due diligence team that aims to research the most out of said tenants, however, since there is generally little or no publicly available operating and financial information on them, that process may not be of the highest standards and/or accuracy.
Profitability is a major issue, as well. The big players, which can achieve economies of scale, struggle to report positive cash flow, regardless of that being because of costs or reinvestment. The case for the smaller operators, to which IIPR rents its properties should be even more critical, as their profitability prospects are questionable. Sure, as I mentioned earlier, IIPR signs triple-net-leases for long-term periods, but a potential bankruptcy from operators would make such agreements worthless.
Four of their tenants, PharmaCann (5 properties), Ascend Wellness Holdings, LLC (2 properties), Vireo Health, Inc. (4 properties) and Green Peak Industries, LLC (7 properties), represented approximately 26%, 12%, 9%, and 7%, respectively, of IIPR's rental revenues for the year ended December 31, 2019. Lease payment defaults by any of these four tenants would notably negatively affect the company's cash flow and financial position.
Market and Credit Risks
IIPR is pretty much the only game in town at the moment. However, this may not be the case in the future. Competition may eventually arrive, and additional companies file for a public listing in the future.
Competition for the acquisition of properties suitable for the cultivation and production of cannabis may deter IIPR from having its current negotiating leverage. In the best-case scenario, it would increase acquisition costs and spoil the company's currently magnificent FFO/Total rental revenue ratio, which hovers between 60% and 70%.
Moreover, what gives IIPR the advantage of operating at such a niche market with great leverage and negotiating power, may turn out to be a drawback. Since the company is focused on acquiring a very specific type of properties that accommodate the needs of operators, it may not be easy for management to find similar assets in the future, as the market matures and market share is being captured either by competitors or even the company itself.
Additionally, all of IIPR's properties are expected to continue to be geographically weighed in states that permit medical use cannabis cultivation, and as a result will be subject to social, political, and economic risks of doing business in these states. On top of that, because the properties are not located anywhere near commercial areas, they have no other use, should the company want to sell them to other parties. Unlike a building near a town center, these properties are greenhouse-focused and have minimal to no secondary market liquidity.
Finally, I want to focus on the company's ability to raise capital. While advances through a possible signing of the SAFE Act should overall make it easier for the industry to raise cash, the risks remain. Not all banks may want to have a relationship with cannabis producers or they may demand a much higher interest rate for that reason. Higher interest rates may also be demanded as a result of the numerous risks mentioned above. If the company then deters from raising money through debt, because of the higher rates, it will turn to equity. But remember that the market is also pricing the stock at a lower multiple than the overall market, for those exact reasons, as well. That would cause the cost of equity to be materially higher, as IIPR needs to pay its already juicy dividend on those additional shares.
Closing the Bearish case, my concern is that should a domino effect of tenants defaulting, that would plunge the stock, that would, in turn, make it exceptionally hard to raise capital, and could essentially kill the stock. It may sound like too much of a dire scenario; however, investors must not ignore such risks. In my view, the market is pricing the stock very attractively considering the growth/income reward aspect because of such a potential scenario; however, (un)likely.
Conclusion
IIPR is a unique case. The cannabis market, while growing, is very volatile, and while advancing in many aspects, it remains unpredictable. Considering all factors, my stance on the stock is bullish. The reason is simple. While I acknowledge and take into account all of the risks, and even their potential to drive the stock worthless, the reward is simply too exciting. Should investors be willing to hold the stock with no expectations in mind, it could turn out to be an amazing long-term winner.
Being the only publicly traded REIT, as well as the fastest-growing one in the world, the long-term potential of a successful cannabis industry towards maturity is just too good. Moreover, the market pricing the stock at a discount for the risks mentioned, allows current investors to take advantage of a juicy 5.78% dividend yield. This is a unique high risk-high reward case that I urge investors to think carefully before allocating their capital on.
