IIPR - Innovative Industrial Properties: Avoid Share Dilution With 10% Yielding Bonds

Summary

• Innovative Industrial Properties is a complex REIT specializing in cannabis.
• The company's aggressive growth strategy has paid off with healthy profitability.
• The company's cash flow statement reveals more demands on cash than what the company has.

Innovative Industrial Properties ( IIPR ) is a specialized real estate investment trust focused on the cannabis markets. Back in November, I covered the company's high-yielding debt against an investment in common shares. Since then, both the common shares and the company's 2026 maturing debt have declined in price. Today, Innovative's 2026 bonds are yielding 10.3% and I believe they're still a wise debt instrument for income investors.

Innovative Industrial Properties' profitability in 2022 did not slow in the face of rising interest rates or a slowing economy. The company saw a growth of $70 million in revenue and only a $40 million increase in expenses, leading to a jump in operating income by almost $35 million to just under $170 million. The company's operating income continues to show its growth strategy is producing positive financial results. Additionally, properties are 100% leased with an average lease term of over 15 years, providing a stable outlook to the company's property portfolio.

Innovative Income Properties' balance sheet remained consistent with profitability in 2022. The company grew its real estate holdings at cost by nearly half a billion dollars and did so while reducing long-term debt by $25 million. Cash and investments did decline by $125 million but remained strong at $288 million. Overall, shareholder equity increased by $350 million to nearly $2 billion.

Where I become concerned for equity investors comes from the cash flow statement. The company has grown operating cash flow sequentially since 2020, but it has made significant capital expenditures to attain that growth. Between maintenance capex (which is not isolated in the company financials), tenant improvements, and real estate investments, the company has committed over $500 million in each of the last three years.

To finance the company's asset expansion and tenant improvements, Innovative Industrial Properties issued $351 million in additional common stock in 2022 alone. These issuances dilute equity investors and naturally lower share prices. The company also paid $184 million in dividends. On top of that, the company has nearly $100 million in commitment improvements to tenants that it will need to spend to fulfill its leases. Despite its growing profitability, Innovative Industrial Properties is dealing with a number of demand for its cash flow.

It's possible that Innovative Industrial Properties will continue the practice of asset growth and maintaining dividends, but to do so, investors need to recognize a few constraints. First, the company has a shelf registration that allows it to issue new common and preferred shares, both of which would be dilutive to current investors. Most recently, the company announced a $500 million at the market offering, which allows it to issue shares at any time. Investors are not going to run up the price of a stock if they suspect an issuance to be imminent.

Secondly, the company has the capacity to borrow additional funds, but it comes at a cost. While the company has an investment grade credit rating, an indenture in the 2026 notes raises the coupon by 50 to 100 basis points if the credit rating is downgraded or withdrawn. The investment grade rating is hanging by a thread, and I believe in the current environment, the credit markets are closed to debt offerings without the consequence of higher rates to existing debt. It also does not help that the company does not provide forward guidance relating to cash flow.

An additional threat to the business lies in the great unknown of the future of the cannabis market. It was pointed out in the comments section of my previous article that broad legalization would disrupt the industry. In fact, a reduction to the barriers of cannabis production would hurt Innovative Industrial Properties much like streaming has affected AMC Theatres.

While I believe this threat is real, I don't think it will transform the industry overnight. I also believe that Innovative Industrial's tenant concentration (or lack thereof) will act as a buffer of time between widespread legalization and major disruption to the business. Management also will have some time to adapt, but the 2026 notes should be paid off before these challenges metastasize.

Innovative Industrial Properties debt is immune to either the dilution of share issuance or changes to its dividend. The company has been able to generate stable profitability from its growth strategy, and it clearly has the cash flow generation and liquidity to meet the 2026 bond obligations. Investors should consider escaping the volatility of the share price and invest in the 10% yielding debt.

Please note: These bonds have limited availability on various brokerage sites, so you may need to call your brokerage to check availability.

CUSIP: 44988FAD2

Price: $87.02

Coupon: 5.50%

Date of Maturity: 5/25/2026

Yield to Maturity: 10.315%

Credit Rating: NR (The company has an investment grade rating, but it is not from S&P or Moody's)

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