IIPR - Innovative Industrial Properties: Staying The Course

2023-11-17 11:56:57 ET

Summary

• Innovative Industrial Properties plays a unique role in a traditional investment portfolio due to its exposure to the cannabis industry.
• Although an overhang from SH Parent's uncollectibles remains, the REIT has experienced improvements in the rental collection and has a compelling weighted average lease term.
• We believe an improved debt structure could be en route, which could free up acquisition capital and drop IIPR REIT's liability base.
• Our NAVPS calculation raises concerns. However, Innovative Industrial Properties' price multiples and dividend yield are well aligned.

Innovative Industrial Properties, Inc. ( IIPR ) is today's topic of conversation. We covered the REIT just over a year ago and felt the need to revise our outlook as material events have occurred ever since.

Innovative Industrial Properties REIT plays a unique role in a traditional investment portfolio as its exposure to Cannabis provides differentiated returns. Moreover, we'd like to believe that the REIT can be treated as a growth 'stock' instead of a generic REIT income play. As such, it brings us great joy to share our latest findings on the asset.

Without further ado, let's traverse into a deeper discussion about IIPR REIT.

Operational Review

Portfolio

Let's set a foundation and remind ourselves of what Innovative Industrial Properties does for a living.

The REIT operates a net lease program wherein it also acquires from a sale-leaseback position. As illustrated in the graph below, the REIT primarily invests in Cannabis cultivators/operators. More importantly, note that approximately 90% of Innovative Industrial Properties' base rent derives from multi-state operators, consequently phasing out much of the concentration risk embedded in the Cannabis industry that relies on state laws.

Innovative Industrial Properties has experienced improvements in rental collection since our latest coverage. Long-standing failed collections from SH Parent, Inc. and Green Peak Industries have sustained their overhang on the portfolio; nevertheless, collections have improved since this time last year.

Innovative Industrial Properties' weighted average lease term of 14.9 years is compelling. However, we think concentration risk can be an issue as IIPR REIT's top ten tenants make up more than 77% of the fund's base rent. Many of its tenants are EBITDA-positive, which does phase out some of the counterparty risk; nevertheless, excess concentration risk is a worthwhile matter for investors to consider.

Recent Earnings Release

Furthermore, Innovative Industrial Properties released its third-quarter earnings at the turn of the month, revealing a revenue beat of $1.26 million . Yet, IIPR REIT's earnings beat can be rather misleading, as much of its $77.82 million of quarterly revenue was generated from tenant reimbursements like property tax and insurance (not disclosed how much).

The REIT beat its FFO target by four cents per share. Similar to IIPR's revenue, its quarterly FFO success was assisted by non-core factors, such as a more than $1 million decrease in litigation charges and lower proportionate depreciation & amortization.

Despite Innovative Industrial Properties' third-quarter results being slightly impaired by non-core matters, we hold a positive view of the REIT's prospects. We think the secular growth embedded in the Cannabis cultivator space ( 10% CAGR until 2023 ) provides a tailwind to IIPR REIT. Sure, disinflation within the U.S. might deter escalation in the real estate sector; however, we think long-term escalation potential is intact.

Lease Amendments

Additional factors to take note of are the series of rental amendments made in recent times. Innovative Industrial Properties amended its rental agreement with Goodness Growth Holdings (pertaining to one of its NYC properties) during Q3 as it escalated base rent and phased in an additional $14 million in improvement allowances to amount to $67.4 million.

The aforementioned amendment is part of a series of similar amendments IIPR REIT has agreed to with its tenants. The firm is scaling its asset base with CapEx amendments and simultaneously raising base rent as part of the agreements.

Very clever and long-term value additions are likely!

Capital Structure

Innovative Industrial Properties' capital structure consists of ordinary equity, 9% preferred shares, and short-term debt obligations via senior notes.

From an ordinary shareholder's vantage point, the preferreds don't provide much trouble as they make up for only 4.7% of Innovative Industrial Properties' capital structure. However, IIPR REIT's debt obligations require closer examination.

The REIT's debt obligations are divided into two sections: $300 million worth of senior unsecured notes at 5.5% due in 2026 and $4 million of short-term exchangeable senior notes.

Innovative Industrial Properties has a debt service coverage ratio of 16.2x and a BBB+ credit rating on its debt. Therefore, we aren't concerned about the payback of the debt. In fact, we think a likely U.S. interest rate pivot may provide IIPR REIT an opportunity to recapitalize at lower yields when it retires some of its debt in 2026.

Valuation & Dividends

Absolute Valuation

The first valuation model we utilized was a net asset value per share model that extracted its input variables straight from Innovative Industrial Properties' balance sheet. The model subtracted intangible assets from IIPR REIT's total assets and subsequently did the same with total liabilities. After dividing the result by the company's weighted average number of common shares outstanding, it was discovered that the model deems the REIT overvalued.

Side note: The model was calculated in-house. Ensure you corroborate the model's outcome before using it as part of your decision-making framework.

Despite the reliability of NAVPS in practice, our model has two shortcomings. Firstly, it did not use market values and instead used real estate values at cost, which is theoretically incorrect. Further, the NAVPS is a subjective accounting-based metric that can sometimes be unreliable.

Relative Valuation

A relative valuation paints a different picture. Seeking Alpha's data shows that IIPR REIT is undervalued relative to its peer group. In addition, we simply believe its funds and adjusted funds from operations ratios are compelling when looked at face value, especially considering the scalability of Innovative Industrial Properties' business model.

Source: Seeking Alpha

Dividends

With a forward dividend yield of 8.92% and a 5-year average dividend yield of cost of 15.11% , there is evidence that IIPR REIT provides dividend prospects. However, in our view, there are more sustainable dividend opportunities out there, as the high-risk business models of IIPR's constituents will likely lead to unexpected dividend volatility. Nevertheless, If the cannabis industry consolidates, we think significant income-based benefits are in store.

A Few Contra Points

You may have realized by now that the thesis is rather bullish about Innovative Industrial Properties' prospects. However, I wanted to outline a few risk factors to balance the argument.

Qualitative

It is known by now that the Cannabis industry still faces legal challenges. We are not legal professionals at Pearl Gray Equity and Research, nor do we have a crystal ball to work with. Therefore, I cannot comment on whether Cannabis will defeat legal opposition or not. However, I can say that Cannabis is being used as a political weapon these days, and we believe unforeseen political opposition against the industry may add to operational risk for cultivators and IIPR REIT alike.

Furthermore, the U.S. economy is in a softening period. Disinflation paired with a lower yield curve is good for the consumer in the long term. However, it can mean that a softer interim consumer environment could settle in, consequently adding pressure to IIPR's tenants.

Quantitative

I want to circle back to the NAVPS valuation model inserted earlier. Although merely an indicator, the underwhelming NAVPS is a risk factor overall, meaning many fundamentalists might refrain from investing in the REIT at its current price.

Lastly, Innovative Industrial Properties has a significant value-at-risk figure, suggesting the REIT would add tail risk to most portfolios. As such, I urge investors to consider that negative skewness is a serious risk here.

Final Word

We remain bullish on Innovative Industrial Properties. Although the REIT faces numerous systemic challenges, IIPR has established itself in a secular growth market, and its best days are likely still ahead.

Innovative Industrial Properties' rental collection has improved since our last discussion, and although non-core line items overshadowed its third-quarter revenue beat, we think its future earnings will grow at a secular trajectory.

Furthermore, a potential interest rate pivot could lead to a refinancing opportunity, which, via accessibility to acquisition capital and a reduced liability base, would add to net asset value.

We deem Innovative Industrial Properties a Strong Buy.

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