In our Small-Cap Spotlight Series, we highlight some undercovered small-cap companies in the real estate sector that may not get the attention - or institutional analyst coverage - that they deserve, particularly those with a unique strategy within their property sector. Our inaugural report focuses on Innovative Industrial Properties (NYSE:IIPR), a truly "high-flying" REIT focused on a unique segment of the real estate market: cannabis cultivation facilities.
Innovative Industrial Properties is a small-cap REIT focused on the acquisition, ownership, and management of specialized properties leased to medical-use cannabis facilities. Straddling the classification line between Industrial REIT and Net Lease REIT, IIPR was the first publicly traded REIT pursuing this cannabis-focused strategy. Small-cap Power REIT (PW) announced last week that it also intends to focus on CEA-related real estate for growing various crops, including cannabis. A highly speculative REIT by any measure, we discuss the firm's business strategy and the economics of cannabis-focused real estate ownership throughout this report.
The small-cap IIPR commands a relatively minimal weight in the broad-based "Core" REIT ETFs, but accounts for a larger chunk of some newer real estate ETFs that focus on industrial and net lease REITs. The NETLease Corporate Real Estate ETF (NETL) allocates a 4% weighting to IIPR, while the Pacer Benchmark Industrial Real Estate SCTR ETF (INDS) includes a 5% weight. Investors seeking exposure to the broader cannabis theme at large can also find IIPR in cannabis-focused thematic ETFs, including those offered by AdvisorShares (YOLO), Amplify Seymour (CNBS), and Cambria (TOKE).
One of the newest and fastest-growing REITs, San Diego-based IIPR was founded in 2016 with just a single property but has been on a continuous acquisition spree over the last three years, expanding its portfolio to include 49 properties spanning 14 states, all of which have legalized marijuana cultivation. 33 states have legalized medicinal use of marijuana and 11 states have legalized recreational cannabis, while all use cases remain illegal federally - an anomalous regulatory environment that has been partially responsible for the rise of these REITs, as we'll describe in more detail below.
Innovative Industrial Properties serves as a de facto lender to the cash-strapped (and generally unprofitable) medical cannabis cultivators who struggle to finance their businesses due to the intensely challenging competitive and regulatory dynamics of marijuana cultivation. As the landlord to these multistate operators (MSOs), IIPR has rapidly amassed a portfolio of properties primarily through sale-leaseback and development agreements with emerging cannabis growers, allowing these MSOs to raise capital to build facilities and fund their core business of seeding, planting, and cultivating their cannabis products.
Growing nearly as fast as its asset portfolio (and surely faster than the plants growing inside of them) has been the share price, which has more than quadrupled since the start of 2017. IIPL has taken full advantage of the speculative investor demand for cannabis stocks, tapping the equity markets for additional “growth” capital every few months through a series of secondary equity offerings, expanding its share count by 10x over that time. Trading at steep FFO per share and NAV premiums relative to the REIT sector average, IIPR has been able to acquire properties that are accretive to FFO, whereby return on invested capital exceeds its cost of capital. Illustrative of that point, FFO per share has grown roughly 15x over the past two fiscal years.
IIPR serves as an example (albeit an extreme case) of a theme that we discuss extensively: that REITs can be far more growth-oriented than many investors believe, and that elevated share price valuations can actually have positive implications for the underlying business operations, particularly in real estate property sectors that lean heavily on acquisitions as a source of growth. REITs are no longer simply "buy-and-hold" real estate holding companies but have become dynamic real estate operators, developers, and "capital recyclers" over the past two decades. In fact, REITs are fundamentally at their best when their equity valuations are slightly elevated, thus enabling these REITs to utilize the equity capital markets to fuel accretive external growth.
IIPR typically acquires properties through sale-leaseback agreements with cultivators and enters into a triple-net lease agreement with lease terms of 15-20 years, on average. "Net lease" refers to the triple-net lease structure, whereby tenants pay all expenses related to property management: property taxes, insurance, and maintenance. Like a ground lease, triple-net leases result in long-term, high-margin, relatively predictable income streams, although this assumes that the tenant pays the bills for the entire lease term. Tenant credit quality is a key factor in net lease REIT analysis, which is one area where IIPR certainly sticks out, with leases to start-up tenants that would be viewed as "extreme risk" relative to other net lease REITs. Below, we note some key features of the Net Lease REIT business model.
While "cheap" equity capital can help to fuel a virtuous cycle of further growth, IIPR takes "elevated" valuations to another level, trading at a sky-high P/FFO multiple of 38x, nearly twice the REIT sector average. It's notable, however, that IIPR has been able to pursue this aggressive acquisition strategy without taking on excessive debt levels. In fact, it commands some of the best leverage metrics across the REIT sector with a Debt/EBITDA ratio of 2.9x and Debt Ratio of 13% compared to the REIT sector average of roughly 4.6x and 30%, respectively, according to NAREIT data.
According to New Frontier Data, the medical cannabis market is expected to double in size over the next five years, from roughly $17 billion in 2020 to nearly $30 billion in 2025. Medical applications of cannabis have seen promising results. THC and CBD are two cannabinoids, or chemical compounds, that are extracted from the cannabis plant which are used in the treatment of cancer, glaucoma, HIV/AIDS, seizures, PTSD, Parkinson’s, general pain, and nausea, amongst other ailments. As of July 2019, industry lobbyist Marijuana Policy Project estimates that there are currently 3.1 million legal patients of medical cannabis, which could grow to 4.6 million under a federally legal model.
As it exists, the status of state-licensed cannabis under federal law has impeded the ability of cannabis operators to access capital from the U.S. banking system. With traditional banking off the table due to the federal regulatory environment, IIPR currently fills a clear void as a well-capitalized landlord and financier to emerging cannabis cultivators. If shareholders continue to award IIPR premium multiples, IIPR can theoretically continue to issue equity to acquire properties that are accretive to FFO whereby return on invested capital exceeds its cost of capital. Further, IIPR is led by an experienced management team of REIT industry veterans from BioMed Realty and Alexandria Real Estate with specific expertise in acquisitions and capital raising, not the prototypical "cannabis" entrepreneurs.
Make no mistake about it, IIPR is about as "speculative" as it gets in the real estate sector. Operating as de facto financiers, the credit quality of the tenant base is generally one of the most important factors when analyzing net lease REITs. IIPR’s tenants are generally unprofitable start-ups with a limited operating history, the very definition of “high-risk” tenants. While it has rapidly improved over the last two years, IIPR still derives 50% or more of NOI from its five top tenants. Further, tenants operate in the same underlying industry and are impacted by similar macroeconomic and regulatory forces.
The eroding excess return on invested capital from increased competition in the space is also a threat with federal legalization potentially looming on the horizon. Federal legislation is slowly but surely moving away from prohibition. We see early indications through the Secure and Fair Enforcement Banking Act, or "SAFE", which would grant dispensaries access to financial services. Even without legalization, IIPR's strong performance hasn't gone unnoticed, as a number of competitors, including other REITs, have entered the space over the last two years.
Further, IIPR share price has more than tripled over the last three years and is currently trading at some of the highest FFO and NAV-based valuations across the REIT space, and it is currently paying a dividend yield of just 2.86%. Expensive and low-yielding may not be the worst qualities for a REIT, however. In our recent report, "The REIT Paradox: Cheap REITs Stay Cheap", we discussed our study that showed that lower-yielding REITs in faster-growing property sectors with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding counterparts. That said, with 40x P/FFO multiples, IIPR is priced for continued perfection, and any hints of a slowdown in growth won't be unpunished.
One of the newest and fastest-growing REITs, IIPR was founded in 2016 with just a single property but has been on a continuous acquisition spree over the last four years. IIPR serves as a de facto lender to the cash-strapped (and generally unprofitable) cannabis cultivators who struggle to finance their businesses due to the intensely challenging competitive and regulatory environment. Growing nearly as fast as its asset portfolio (and surely faster than the plants growing inside of them) has been its share price, which has more than quadrupled since the start of 2017. Trading at sky-high valuations, IIPR is a highly speculative - but immensely interesting - REIT by any measure.
For investors who are seeking speculative exposure to the cannabis "theme" but are reluctant to assume the varied operational risks of direct investments in the cultivators, IIPR offers an attractive and differentiated option to play the space through real estate ownership. Even for the most risk-tolerant investors, broad diversification is absolutely critical when investing in speculative "thematic" trends like cannabis cultivation, which makes ETFs the ideal investment vehicle to own IIPR. Two real estate ETFs - NETL and INDS - allocate healthy weights to IIPR, while investors seeking more direct exposure to the cannabis theme can find IIPR in cannabis-focused thematic ETFs, including those offered by AdvisorShares (YOLO), Amplify Seymour (CNBS), and Cambria (TOKE).
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