NLCP - Innovative Industrial Properties: High-Growth Cannabis REIT With 7.6% Yield

Summary

• Innovative Industrial Properties is a cannabis REIT with a stock trading at a 7.6% yield.
• Its leases carry built-in 2% to 3% annual lease escalators, and the company acquires properties at high cap rates in excess of 12%.
• The stock has crashed on fears regarding some of its largest tenants.
• The stock is very buyable here, though I continue to prefer its smaller peer.

Innovative Industrial Properties, Inc. ( IIPR ) dropped after reporting second quarter earnings. The actual results were quite strong, but investors have focused on the fate of tenant King's Garden and the implications for the rest of the portfolio. I continue to have the view that the stock is too cheap here, as the strong growth profile should more than compensate for tenant weakness. While its smaller peer is considerably cheaper, IIPR remains very attractive at a 7.6% yield.

IIPR Stock Price

After peaking around $288 per share, IIPR is now trading close to $92 per share.

The vicious stock price action is due to concerns with regards to the sustainability of its dividend and business model. I expect the stock to rally considerably once it moves beyond these near-term headwinds.

IIPR Stock Key Metrics

We can see IIPR's top 15 tenant list below - the company primarily owns cultivation facilities which it leases to cannabis operators. Many of its tenants are well-known multi-state operators ('MSOs') like Curaleaf ( CURLF ) and Green Thumb Industries ( GTBIF ).

The quarter saw IIPR grow its bottom line by 30.4%, an astounding rate for a real estate investment trust ("REIT").

Recall that IIPR primarily grows through two avenues: first, its leases have annual lease escalators in excess of 2%. Second and more significantly, IIPR can acquire properties at high 12% to 15% cap rates due to cannabis operators having restricted access to the capital markets. The growth comes from being able to raise capital at rates far lower than the 12% to 15% cap rate on acquisitions. In the quarter, IIPR made 4 acquisitions across Maryland, Arizona, Massachusetts, and Texas for $92.2 million.

In conjunction with 5 lease amendments for tenant improvements, IIPR acquired $239.4 million in the quarter.

Year to date, IIPR has already acquired around $349 million of properties.

That investment pace is extraordinary considering that the company had just raised $330.9 million in early April. Regarding that capital raise, IIPR had issued 1.8 million shares at around $183 per share. Given where the stock is trading now, that is astounding timing - I mention this not to necessarily give the company credit for it but merely due to the interesting nature of it.

Regarding its pace of investments, management stated the following on the conference call (emphasis added):

And because of that strategic decision, we are -- while we had indicated in the past that we would be doing between $125 million to $150 million of transactions a quarter or between $500 million and $600 million annually, we think we're going to be probably for this year closer to the $400 million and maybe if things evolve a little bit differently, maybe $500 million. And if you think about where we are already, we've already closed on $350 million, which is just a -- it's above that hundred $50 million per quarter pace. And if we were to go to another $50 million to get us to the $400 million range, well, we certainly have that capacity. And as we've described, we have assets under PSA already. And we have the capital to easily -- between our uncommitted capital and our free cash flow, we have the capital to achieve at the very minimum. Now the question then becomes how do we go beyond the $400 million, and that would require us to raise equity, raise debt, come up with new capital. And we think we could do that with variety of debt structures, including convertible debt and straight debt and other unique opportunities which we're exploring.

While some tech companies need to innovate to drive growth, IIPR merely needs to underwrite investments and fund them. The company continues to execute strongly on both fronts.

With the stock trading at distressed valuations, the company will find it difficult to raise capital through issuing equity. I do not foresee this being an issue because the company maintains a conservative balance sheet with only $306.5 of debt.

That represents a debt to EBITDA ratio just over 1x - far too conservative considering that traditional net lease REITs often have debt to EBITDA in the 5x to 6x range.

Is IIPR Stock A Buy, Sell, Or Hold?

IIPR is yielding around 7.6% as of recent prices. That kind of yield screams danger - and indeed, IIPR has noted that California tenant King's Garden has defaulted on lease payments. In total, King's Garden makes up around 8% of total rental revenues. On the conference call, management emphasized that not all California operators are struggling, with the implication that there should be interest in finding a new tenant. I expect any re-tenanting to come with a significant reduction in lease payments.

It is not ideal that IIPR had invested so heavily in the unlimited state of California, but I differ from the market in how I view the implications for the rest of the portfolio. Wall Street seems concerned that the rest of the portfolio will face similar struggles. In reality, most of IIPR's portfolio is focused on tenants in limited license states, where unit economics are more attractive. Growth rates should invariably slow down due to the low equity valuations, but that is typical with the investment of any NNN REIT. Unlike "normal" NNN REITs which typically have 0.5% to 1% annual lease escalators, IIPR's annual lease escalators stand at around 2% to 3%. This means that even before accounting for external acquisition potential, IIPR could deliver double-digit returns through its dividend yield and annual lease escalators. IIPR's AFFO payout ratio stands at 82%, suggesting that even if 8% of revenues literally disappear, then IIPR would still be able to nearly cover the $7.00 per share annualized dividend (I estimate that in the worst-case, quarterly AFFO might stand at $1.95 per share).

In the meantime, I expect IIPR to continue to grow its cash flow base through the annual lease escalators and external acquisitions. I note that due to IIPR being a net lease REIT, maintenance expenditures are very low - the company should not have to retain cash flows for maintenance costs.

There has been some chatter regarding the prospects for the passage of SAFE banking. I continue to be of the view that prospects for cannabis regulatory reform are not so optimistic - this is just my opinion based on what I have heard from our Senators. That said, some investors may view SAFE to be highly bearish for IIPR. That is not totally true. Sure, SAFE banking may decrease the cost of capital for cannabis operators, making it difficult for IIPR to keep acquiring properties at 12+% cap rates with 2+% annual lease escalators. But one should also take into account that NNN REITs like STORE Capital ( STOR ) are still underwriting at around a 7.8% cap rate - it stands within reason to expect cannabis real estate to demand a greater risk premium to the average net lease property. Perhaps cap rates compress to the 9% to 10% range - that would be a sizable fall from where they are now, but IIPR would still be able to generate attractive returns on investment activity.

More importantly, in such a scenario IIPR's tenants would see an immediate boost to their credit quality (due to their sudden access to the capital markets), which again makes me wonder why IIPR's dividend yield stands in excess of 7%. SAFE banking may also make it easier for IIPR to raise debt capital - I estimate that the company could increase cash flows by at least 25% if it levered its balance sheet to just 5x debt to EBITDA. These all suggest that SAFE banking would be a bullish event for IIPR - in spite of popular sentiment - and may lead to an immediate rally as the overhang is removed.

The key risk here is continued tenant stress. IIPR has indicated that multi-state operator ("MSO") tenant Parallel has been in restructuring negotiations. It is possible that Parallel also goes the way of King's Garden and eventually stops fulfilling its lease obligations, but Parallel's assets should be easier to re-tenant given the great limited license exposure. Parallel made up 10% of rental revenue as of the latest quarter. In the worst case scenario, IIPR loses 18% of total rental revenue with no recovery. That might place quarterly AFFO at $1.69 per share. As of recent prices, IIPR is trading at 14x that number annualized. That is an incredibly low multiple considering the high annual lease escalators and high cap rates on acquisition - I could see the stock trading back to 20x to 25x AFFO - not to mention that IIPR is likely to get at least something in recovery.

The stock is cheap even in the worst-case scenarios, but I continue to prefer NewLake Capital ( NLCP ) - NLCP is smaller and does not trade on the major exchanges like IIPR, but it has an increased focus on limited license states and trades cheaper at an 8.4% yield.

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