Innovative Industrial: The 10% Yield Gives Plenty Of Comfort (NYSE:IIPR)

Being patient and waiting for the dust to settle is one of the most useful things a value investor can do, especially when it comes to higher risk sectors that garner attention-grabbing headlines.

Such I find the case to be with cannabis REITs, with plenty of uncertainty over the past 12+ months as it relates to growing pains within the industry. This brings me to Innovative Industrial Properties (NYSE:IIPR), whose share price has more than halved since the start of 2022.

I’ve sat on the sidelines on this stock since inception, but believe that now is a good time to look at it for its high yield, margin of safety, and potentially strong returns for risk tolerant investors, so let’s get started.

Why IIPR?

Innovative Industrial is by far the largest player in the cannabis REIT space. It’s Executive Chairman and co-founder is real estate veteran Alan Gold, who co-founded the well-respected life sciences REIT, Alexandria Real Estate Equities (ARE) and BioMed Realty Trust, which was sold to private equity in 2016.

100% of IIPR’s leases are triple-net, which means that the tenant is responsible for paying property maintenance, tax, and insurance costs, thereby resulting in higher margins and simplicity for IIPR. IIPR also has one of the longest weighted average lease durations compared to other net lease REITs, at 15 years.

Most of IIPR’s properties (91%) are industrial properties that are specialized to meet the needs of cannabis producers, with the remaining 3% dedicated to retail and 6% related to a combination of industrial/retail. Plus, the majority of IIPR’s tenants (89%) are multi-state operators, which carry advantages of scale and are less susceptible to changes in legislation in any one state compared to single-state operators.

IIPR is well-diversified by state, with presence across nearly every state where cannabis is legalized, including Pennsylvania, Massachusetts, Illinois, Michigan, and California, in which IIPR has the highest exposure. As shown below, these 5 states represent 40% of IIPR’s property investments.

One of the key advantages of IIPR compared to smaller REITs like NewLake Capital Partners (OTCQX:NLCP) is its scale. This enables it to spread fixed corporate overhead over a wider asset base, thereby resulting in higher margins. IIPR was able to achieve this scale due to its share price being priced for growth in recent years before the downturn, enabling management to issue new shares at accretive valuations. As shown below, this resulted in a 111% CAGR in NOI and a material reduction in G&A costs as a percentage of NOI since 2017.

Risks to IIPR include the fact that cannabis sales remain illegal at the federal level and states could again criminalize sales in the future. However, IIPR’s industrial properties are not like hospitals in the sense that they could be repurposed for other uses.

Also, the market has had plenty of time to digest tenant defaults, which arose last year. This includes properties that were leased to Parallel and Green Peak, which ceased to pay rent, and which management is pursuing action against in court. As IIPR works through these issues, it appears that the remaining overhangs are manageable. This is reflected by the 98% rent collection that IIPR saw in the last reported quarter, with $4.2 million (of the total $76 million total revenue) being drawn against security deposits from other tenants currently experiencing issues.

Moreover, IIPR saw 18% YoY revenue growth to $76 million during the first quarter. This was driven in part by acquisitions in Ohio, leased to Battle Green, and Pennsylvania, leased to TILT Holdings. IIPR also introduced cross-default provisions across its portfolio of properties leased to PharmaCann and Goodness Growth in New Jersey and New York.

This limits the potential for tenants with multiple properties under lease to simply walk away from any single property, lest they default on all properties, as what IIPR saw with Battle Green. I would expect for more cross-default provisions to come into play as leases come up for renewal.

Looking ahead, legal cannabis remains an attractive space to be in, despite the near-term “growing” pains. As with any new industry, the current “green rush” has created a good number of new players, which drive down margins for existing players. This is the same dynamic that played out in the oil industry a century ago before the industry grew wiser and consolidated.

This same could potentially play out in the legal cannabis industry. For example, management noted during the last conference call that the tenant Kings Garden was exploring a merger transaction. As shown below, annual legal cannabis sales are projected to nearly double to $58 billion by 2030, based on the more conservative forecast of no further states legalizing cannabis.

Importantly, IIPR has the balance sheet capacity to deal with tenant uncertainty, as it carries one of the lowest leverage in the REIT industry. This includes a very low debt to gross assets ratio of 12% and high debt service coverage ratio of 16.2x. IIPR also carries zero secured debt, and has no debt maturities until May 2026.

IIPR currently yields a very high 9.9% and the dividend is covered by an 80% AFFO payout ratio, sitting lower than IIPR’s historical norm of a ~90% payout ratio since inception. While I wouldn’t expect for IIPR’s dividend to grow at the double-digit rates of years past, the current high yield more than compensates for the lack of growth.

Lastly, IIPR currently trades at an appealing $72.66 with a blended P/FFO of just 9.3. It appears that the market has already baked in plenty of risks to the stock while ignoring the potential upside and strong balance sheet. Even with a low bar expectation of long-term FFO/share growth in the mid-single digit (analysts expect 4% FFO/share growth this year), IIPR should reasonably trade at a P/FFO in the 11-13x range, representing potentially strong double-digit returns based on price appreciation alone.

Investor Takeaway

In conclusion, IIPR is well-positioned to capitalize on the long-term growth of the legal cannabis sector due to its specialized properties and presence across nearly every state where cannabis is legalized. It has great scale advantages over smaller REITs, allowing it to spread fixed overhead costs over a wider asset base for higher margins.

Plus, IIPR carries very low leverage relative to the REIT sector. While IIPR does have headwinds to work through, I see it as a natural cost of doing business in this growing industry, which could become more sturdy should large players consolidate. Considering all the above, risk tolerant investors may want to consider this stock for its covered 10% yield and potential capital appreciation.