IIPR - Innovative Industrial: The 9% Yield Doesn't Signal A Cut

2023-09-27 15:18:12 ET

Summary

• Innovative Industrial Properties, the only US-listed cannabis REIT, comes attached to a hefty dividend yield of 9.0%.
• Despite concerns about the sustainability of its payouts, the dividend remains covered, and the company continues to grow its top line and AFFO/share.
• Overall, Innovative Industrial's strong top and bottom line growth in a tough macro environment underscores its resilient characteristics.

High dividend yields in REITs can appear compelling. However, very high yields in the sector usually signal issues. Innovative Industrial Properties ( IIPR ), the only pure U.S.-listed cannabis REIT, is currently attached to a rather significant yield of 9.0%. Given the above statement, it's natural for investors to question the durability of its underlying payouts.

I have seen these doubts evolve amongst REIT investors for a couple of years now, with uncertainty reaching a crescendo in April when IIPR's dividend yield spiked past 11%. The fact that the company skipped its customary dividend increase for the month of September could also spur worries regarding the sustainability of its underlying payouts.

Despite these concerns, I remain relatively optimistic when it comes to IIPR's dividend. It remains covered despite some tenant issues. In fact, the company continues to grow both its top line and AFFO/share in a rising rates landscape, a feat only a handful of REITs can claim in this environment.

Growth Persists, Balance Sheet Improves

Looking at IIPR's most recent results , it's exciting to find out that the company not only posted strong growth but also exhibited signs of an improving balance sheet. Again, such a combo can be found in a handful of REITs out there.

The company reported an 8% increase in revenues, which jumped to $76.5 million. More importantly, IIPR showcased its ability to boost AFFO (Adjusted Funds from Operations) per share, even in the face of rising expenses and a higher share count due to stock issuances for acquisitions. These challenges were more than offset by the revenue upswing and strategic deleveraging.

Specifically, Innovative Industrial Properties achieved a commendable 5.1% year-over-year growth rate in AFFO per share, which reached $2.26. This deserves special recognition in an economic landscape where many REITs struggle to maintain, let alone expand, profitability due to rising interest rates.

In fact, the company managed to grow, reduce debt, and improve its dividend coverage all at the same time! Just look at Wall Street's estimates, which point toward IIPR achieving an AFFO/share of about $8.18.

The street's estimate implies a year-over-year growth rate of 5.28% as well as a payout ratio of 88% based on IIPR's current annualized dividend rate of $7.20.

At first glance, this payout ratio may not appear too comforting. Indeed, it looks somewhat concerning. However, looking into IIPR's historical payout ratios, you will quickly realize that 80%+ payout ratios have been a rather common theme for the company.

I have divided the company's dividend per share by its AFFO/share for each year between 2017 and 2022. We get the following results:

Evidently, IIPR sustained its annual dividend increases in each and every one of these years despite the payout ratio often surpassing this year's estimated payout ratio of 88%. Thus, I would attribute the fact that the company skipped this September's hike to management acting prudent rather than the company lacking the affordability to raise it.

Does IIPR's Tenant Mix Jeopardize Dividends?

Looking at the positive side of things, IIPR continues its trajectory of profitable growth. However, some shareholders continue to be troubled about the risk arising from the arguably low quality of its tenant base.

Understanding IIPR's Tenant Landscape

To gain a better understanding of IIPR's tenants, it's essential to recognize the unique challenges faced by players in the cannabis industry. This field presents distinctive hurdles to profitability, as cannabis, like other agricultural products, operates as a commodity, making substantial profits a daunting task.

While some producers attempt to differentiate themselves and enhance sales through branding, premium pricing remains elusive in this fiercely competitive landscape. Additionally, legal businesses compete with illicit market players, further squeezing profit margins. Consequently, some of IIPR's tenants have historically faced difficulties being profitable and meeting their rent obligations.

Here's a brief overview of the situation:

• In Q3 2022, two tenants in financial distress failed to meet rent obligations, resulting in $5.7 million in unpaid rent , partially mitigated by withholding $2.6 million from their deposits.
• In Q4 2022, rent collection declined, with only 94% of expected rent received , primarily due to a few tenants going out of business.
• In Q1 2023 , rent collection rebounded strongly, reaching 98%, with the remaining 2% representing outstanding amounts from tenants who had defaulted in Q4 2022, specifically Parallel and Green Peak.
• In the most recent quarter, Q2 2023, some challenges in rent collection were noted, with an outstanding rent balance of approximately $2.1 million for the quarter, mainly stemming from the previous default by tenant SH Parent. Nevertheless, overall rent collection remains robust, achieving an impressive 97%.

While concerns about IIPR's tenant base are a lasting concern in the cannabis REIT sub-industry, the current situation does not appear as alarming as some might perceive. Sure, some of IIPR's tenants remain unprofitable, and some have actually struggled to pay rent. However, in general, IIPR's rent collection is frankly better than many commercial, retail, and residential REITs out there.

Based on this, I would argue that IIPR's seemingly riskier tenants don't necessarily translate to an untrustworthy dividend.

IIPR's Valuation Provides a Margin of Safety

IIPR's investment appeal is further underscored by its attractively discounted valuation, providing a reassuring prospect for potential investors. The stock, having experienced a prolonged decline from its previous highs, coupled with its improving financials, has undergone a significant valuation compression. Based on the consensus AFFO/share estimate for the current year, the stock is currently trading at a modest P/AFFO of approximately 9.7X.

Comparing IIPR's valuation to other individual REITs proves challenging due to its distinctive cannabis-oriented operations, which do not align with any other asset class, including industrial REITs. However, a comparison to the broader sector reveals that IIPR is trading at a compelling discount of around 17%.

In essence, the company's above-average yield and below-average valuation not only enhance predictability but also provide a broader margin of safety for investors. This combination reinforces the solidity of IIPR's investment case, even in the face of apparent uncertainties.

Takeaway

Overall, Innovative Industrial Properties stands at the crossroads of skepticism and promise, particularly in light of its hefty 9%-yielding dividend. The market's concern over the sustainability of such a high yield is understandable, further stressed by a momentary pause in the company's dividend increase in September.

However, a deeper look reveals a resilient financial trajectory. IIPR not only weathered challenges in its tenant landscape but demonstrated remarkable growth, reporting an 8% increase in revenues and a commendable 5.1% year-over-year growth in AFFO per share. The company's ability to navigate rising interest rates, reduce debt, and enhance dividend coverage simultaneously sets it apart in the REIT sector.

While scrutiny is likely to persist over the perceived risk in IIPR's tenant base, the numbers tell a story of resilience. Despite occasional setbacks in rent collection, IIPR collection rates arguably outperform many "quality" REITs.

Consequently, I remain cautiously optimistic about IIPR's dividend viability, taking into account its robust financial performance and strategic positioning in a challenging market.

Simultaneously, with shares trading at what appears to be a compelling valuation, I would argue that investors should not dismiss IIPR's overall investment proposition based solely on what I see as somewhat unsupported fears.

For further details see: