NLCP - Innovative Industrial Properties: Buy Hold Or Sell?

Summary

• Innovative Industrial Properties has crashed.
• It is now offered at a historically low valuation and high dividend yield.
• But is it a buy just yet? I share my thoughts and discuss an alternative.

From its IPO until recently, Innovative Industrial Properties ( IIPR ) had been one of the most rewarding REITs of all time. Here is how it performed relative to the Vanguard Real Estate ETF ( VNQ ) and the S&P 500 ( SPY ):

It earned such huge returns for its shareholders because:

• It was early to enter an inefficient sector that lacks competition (cannabis cultivation facilities).

• This allowed it to buy properties at exceptionally high cap rates.

• It had access to low cost capital as it traded at a large premium to its NAV.

• Each new acquisition really moved the needle because it was small in size.

• And finally, it gained the valuation of a "growth stock".

Lots of people made A LOT of money owning it.

But if you invested any time after 2021, your experience has likely been quite the opposite.

Its stock is down among the most in the entire REIT sector, dropping from nearly $300 per share to just $92 today:

And just recently, the company gave an update and the stock dropped by another 17%. In a single day!

What's going on?

Is this a historic opportunity to get on board one of the most rewarding REITs of all time at a bargain price?

Or is the hype now over and the company falling apart along with other hyped-up growth stocks?

Well, it is tough to answer because there is a strong case to be made on the bull but also on the bear side.

Let's start with the bull case:

IIPR is now priced at just around 14x FFO and it yields 6.4%, which is one of its lowest valuations ever. It has become so cheap because IIPR actually managed to grow even as its share price collapsed. The company even hiked its dividend quite significantly in 2022. Industrial REITs like Prologis ( PLD ), Terreno Realty ( TRNO ), and Rexford Industrial Realty ( REXR ) are not perfectly comparable because they are safer, but they trade at materially higher valuations, despite growing at a slower pace.

So yes, the company's growth rate is now slowing down and the cannabis sector is experiencing some difficulties, but this is nothing new, and it is already priced into the stock.

We have always known that cannabis tenants were speculative and you cannot expect to never face tenant issues when you buy cannabis facilities at 12-15% cap rates. Occasional lease defaults are inevitable and part of this business.

The rent collection rate dipped in 2022 to 97%, and it appears that it will dip even lower in 2023, but IIPR owns desirable assets and it should be able to reposition these properties and release them to other tenants if needed.

Meanwhile, it will keep growing externally since it is still able to earn positive spreads even with today's higher cost of capital, and this should compensate for its tenant's difficulties. Today, cannabis companies are in dire need of capital and they have fewer options since their equity valuations have collapsed and so many will turn to sales and leasebacks, providing a lot of potential new deals to IIPR.

IIPR also has a strong balance sheet with a low 12% LTV and no debt maturities until mid-2026. This should allow it to take on a lot more debt to finance new acquisitions at large positive spreads. In Q4 (not reported yet), the company made 9 acquisitions and executed 12 lease amendments to provide additional improvement allowances that will grow its rents.

So growth is likely to stay positive, even despite the temporary issues that the company is facing, and eventually, as the troubled properties are repositioned, the stock could recover, leading to significant upside potential. You get paid a generous 6.4% dividend yield to wait.

But now comes the bear case:

The lease defaults could become a sector-wide issue. Rent collection first dipped to 97% in 2022 and as of today, they have only collected 92% for January.

That's a big dip and it is quite worrying. It also explains why the share price dipped by 17% in a single day when the news was announced.

If that's how the market reacts to tenant issues, what if IIPR reports even more of them in the coming months and quarters? The stock could keep dipping even lower.

The bull case only holds if the lease defaults remain limited and unfortunately, right now, it is very tough to say whether or not the troubles will spread across a larger portion of its portfolio.

My fear is that IIPR grew too fast in the past years and it pushed to lower its acquisition criteria and standards of due diligence. They had a window of opportunity to load up on properties while they had access to cheap capital and they really went for it:

This growth rate simply isn't normal for a REIT. It had to buy a huge amount of assets in a short amount of time and it wouldn't be surprising to find that it may have bought a lot of troubled assets in the process.

I think that most properties that they bought are just fine, but they couldn't be as selective and so they had some bad assets in the mix. Now they are going through a consolidation phase as they need to rework the troubled assets and we could get a steady flow of bad press that will continue to hurt its market sentiment.

Its FFO multiple could very well keep on compressing because even 14x FFO is not necessarily "cheap" for a REIT with many troubled assets and lease defaults. Other net lease REITs that grow at a steady pace are typically priced at a comparable multiple. Examples include VICI Properties ( VICI ), National Retail Properties ( NNN ), and Essential Properties Realty Trust ( EPRT ).

So what's the takeaway?

The main takeaway for me is that the risk-to-reward still isn't particularly compelling because there are simply too many unknowns and yet, the company is still priced at a valuation multiple that could compress further.

But there's still an opportunity.

IIPR has dragged down with it its close peer: NewLake Capital Partners ( NLCP ):

But as we explained in a recent article, NLCP owns higher-quality properties on average as it focuses on limited license states and buys properties with higher rent coverage. Its much smaller size has allowed it to be more selective and historically, it has not had tenant issues.

Moreover, NLCP also has a stronger balance sheet with zero debt and a lot of liquidity to keep acquiring more properties.

Despite that, it is now priced at just 9x FFO, which is quite a lot cheaper than the valuation of IIPR. It is so cheap that the company just recently announced a buyback plan and the CEO made the following comment: "we can no longer ignore the compelling investment opportunity with our stock trading at such a discount."

NLCP also trades at a higher dividend yield than IIPR:

So NLCP essentially allows you to gain exposure to the same sector in which IIPR is investing, but with better properties on average, no debt, a higher yield, and a materially lower valuation. We think that it will also grow faster and the buybacks create a lot of value as well.

Therefore, our top pick in this sector is NLCP and we continue to stay away from IIPR.

For further details see: