IIPR - Innovative Industrial Properties: More Headwinds From Price Compression And Tenant Defaults

2023-04-10 10:23:35 ET

Summary

• Any investment in IIPR remains highly speculative, given the prolonged cannabis legalization process, uncertain macroeconomic outlook, and reduced availability of capital funding.
• The factors above have naturally impacted its tenants' prospects, especially worsened by the intense competition from the illicit cannabis market.
• With more of its tenants defaulting on rentals by February 2023, we reckon the headwinds to IIPR's execution may persist over the next few quarters, if not through 2024.
• Income investors tempted by IIPR's expanded yields need to be careful, since the dividends may not be sufficient to cover the potential losses in its stock prices ahead.

The Cannabis Headwinds Remain

Innovative Industrial Properties Inc. ( IIPR ) continues to face execution headwinds ahead, attributed to the cash flow issues experienced by its cannabis tenants thus far.

IIPR Tenant List as of 2022

As of February 28, 2023, IIPR reported yet another troubled tenant, Parallel, which defaulted on its February rental obligations for one property in Texas. This was a big concern, in our view, since Parallel was the cannabis REIT's second-largest tenant, leasing four properties comprising $25.44M (or 10%) of the REIT's rental revenues in FY2022.

This was on top of rent defaults by Kings Garden in all of its leased properties in July 2022, Parallel in Pennsylvania in November 2022, and Green Peak in Michigan in November 2022. The cannabis REIT also had to defer rental collection for Holistic in California/ Michigan and Calyx Peak in Missouri since January 2023.

While we were not able to obtain any further information on IIPR's largest tenant, PharmaCann, its third largest tenant, Ascend Wellness Holdings ( OTCQX:AAWH ) remained GAAP unprofitable in FY2022. The same was observed with Green Thumb Industries ( OTCQX:GTBIF ), Curaleaf Holdings ( OTCPK:CURLF ), Columbia Care ( OTCQX:CCHWF ), and Trulieve Cannabis ( OTCQX:TCNNF ). The uncertain prospects of its top seven tenants naturally posed further downward pressure on the cannabis REIT's execution in the short to intermediate term.

These issues have led to IIPR's reduced rental collection of 92% as of February 28, 2023, down from 97% in FY2022. While it continued to hold on to $1.7M of security deposits from Parallel and $1M from Green Peak, it was apparent that non-collection of rent had contributed to a revenue headwind of -$8.6M in FY2022, one which might increase in FY2023, in our view.

Capital availability in the cannabis industry remained an issue as well, due to the uncertain macroeconomic outlook thus far. The total cannabis capital raised in FY2022 had declined by -62.9% YoY to $3.26B, compared to FY2021 levels of $8.81B. The cannabis REIT also highlighted that "capital availability in FY2023 remained at multi-year lows ."

IIPR reported a similar issue in the public REIT markets, with capital availability declining by -68.9% YoY to $41.5B in FY2022, compared to FY2021 levels of $133.6B, suggesting increased caution from venture capitalists thus far.

The recent banking crisis was noteworthy as well, since the rising inflationary pressure and Fed's continuous rate hikes have partly contributed to the peak recessionary fears. The reduced capital availability had then forced unprofitable start-ups to rapidly draw down their deposits with SVB Financial ( SIVBQ ) to cover their cash burn , triggering cash flow issues for the bank, and resulting in the second-largest bank failure in US history.

Given that the cannabis industry is still unable to access the much-needed liquidity from the conventional banking industry, the newfound pessimism surrounding cannabis Multi-State Operators [MSO] and cannabis REITs is not surprising indeed.

Its prospects were further impacted by the intense competition from illicit cannabis markets. New Frontier Data reported that regulated cannabis sales were at $30B (+15.3% YoY) in 2022, with the illicit market recording tremendous sales at $76B (+8.5% YoY) at the same time.

Given that up to 1.4K cannabis shops operated illegally, compared to one licensed shop in New York City by January 2023, we reckon that cannabis MSOs may continue to underperform ahead, impacting IIPR's prospects at the same time. This was worsened by the strict regulations surrounding the medical and recreational cannabis programs and high taxes ranging between 3% to 37%, further compressing the cannabis MSOs' profit margins.

So, Is IIPR Stock A Buy , Sell, or Hold?

IIPR 3Y Price/AFFO Per Share Valuations

IIPR is currently trading at a Price/AFFO Per Share Valuation of 8.99x, nearing its March 2020 lows of 8.38x. Other cannabis REITs, such as NewLake Capital Partners Inc ( OTCQX:NLCP ), and cannabis mortgage REITs, such as AFC Gamma (NASDAQ: AFCG ), similarly experienced moderations in their valuations, nearing their all-time lows.

The pessimism is naturally attributed to the prolonged cannabis legalization process, uncertain macroeconomic outlook, reduced funding availability, and impacted tenant prospects from the illicit cannabis market, as discussed above.

In addition, IIPR's bottom-line growth is expected to decelerate to a CAGR of 2.7% between FY2022 and FY2025, to AFFO per share of $9.14 in FY2025. Given the comparison to the hyper-pandemic era CAGR of 37.2% between FY2019 and FY2022, it is unsurprising to see the moderation in the cannabis REIT's valuation.

IIPR 5Y Stock Price

Furthermore, the depression in IIPR's valuations and stock prices also reflects the prolonged inflationary pressure and elevated interest rates over the next few quarters. Based on its NTM Price/AFFO Per Share of 8.99x and projected FY2025 EPS, the stock is also trading near its fair value of $82.18, suggesting a minimal upside potential of 12.9% from current levels.

We believe an upward re-rating of its valuations may only happen once the cannabis industry is able to access liquidity from conventional banks and federal legalization occurs. At that time, we think we may see the cannabis REIT's valuations return to the heights of NTM Price/AFFO Per Share of 25x, similar to the hyper-pandemic levels, implying an ambitious price target in the $200s.

However, with the upcoming elections in 2024, the likelihood of federal legalization is relatively low, in our opinion. Combined with the factors discussed above, we prefer to rate the IIPR stock as a Hold (Neutral), due to the reduced margin of safety.

On the contrary, income investors may consider adding a small speculative position here, due to the attractive forward dividend yield of 9.89%. This is based on its current stock prices and annualized dividend of $7.20 per share, against its 4Y average yield of 3.22% and sector median of 4.43%.

Naturally, due to the pessimistic sentiments and prospects, the IIPR stock is only suitable for those with a higher risk tolerance and a long-term investing trajectory, especially since the dividends may not be sufficient to cover the potential losses in its stock prices ahead. Assuming further headwinds to its rental collection, a dividend cut may be entirely possible as well. Investors beware.

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