(Hoya Capital Real Estate, Co-Produced with Colorado Wealth Management)
High Flyers: Cannabis REITs have been far-and-away the best-performing property sector for the second year in a row in 2020, soaring more than 150% despite the ongoing pandemic. Within the Hoya Capital Cannabis Index, we track the two cannabis REITs, which account for roughly $4 billion in market value: Innovative Industrial Properties (NYSE:IIPR) and Power REIT (NYSE:PW). Not included in the index are a half-dozen non-exchange-traded REITs including Treehouse REIT, Advanced Flower Capital, and Inception REIT.
Cannabis is a group of flowing plant species with psychoactive properties that have been consumed via smoking, vaporizing, within food products, or via extract for medical or recreational purposes since at least 2500 BC. The psychoactive components in cannabis - primarily THC - can produce a mild sense of euphoria, while other cannabinoids in the plant such as CBD have been shown in studies to be effective in medical use for treatments of cancer, AIDS, and other illnesses. Cannabis has been federally restricted since the 1930s but has continued along a path towards increased legalization over the past several decades. After the 2020 election, medical usage is now legal in 35 states while recreational usage is legal in 15 states.
The ongoing federal prohibition - and the resulting limit on access to traditional banking - has forced cultivators and retailers to turn to alternative sources for capital, including cannabis REITs. These REITs serve as a de facto lender to the cash-strapped cannabis cultivators who often struggle to finance their businesses due to the intensely challenging competitive and regulatory dynamics of marijuana cultivation. These REITs typically acquire properties through sale-leaseback agreements with cultivators - often after the REIT provides funding to construct the facility - and enters into a triple-net lease agreement with lease terms of 15-20 years, on average.
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 currently 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.
While still an unproven business model with an unclear future if federal legalization proceeds as expected, cannabis REITs have been the single-best performing property sector in each of the past two years, led by industry leader Innovative Industrial Properties. While the pandemic has slammed other REIT sectors, cannabis REITs have surged by more than 160% this year as measure by the Hoya Capital Cannabis Index and are one of just eight property sectors in positive territory for the year compared to the 14.1% decline on the broad-based Vanguard REIT ETF (VNQ).
San Diego-based Innovative Industrial Properties was founded in 2016 with just a single property but has been on a continuous acquisition spree over the last four years, expanding its portfolio to include 63 properties spanning 14 states, all of which have legalized marijuana cultivation. Straddling the classification line between Industrial REIT and Net Lease REIT, IIPR was the first publicly-traded REIT pursuing this cannabis-focused strategy. IIPR is now included in the S&P Small-Cap 600 Index and has a listed Preferred (IIPR.PA).
IIPR focuses exclusively on the acquisition, ownership, and management of specialized properties leased to medical-use cannabis facilities. IIPR owns a national portfolio of over 5,000,000 square feet comprised of specialized industrial and greenhouse buildings, 100% leased to state-licensed medical-use cannabis growers. IIPR's tenant roster includes 22 cultivators, some of which are essentially "start-ups" with a limited operating history. IIPR derives 50% of Net Operating Income ("NOI") from its five top tenants.
New York-based Power REIT has a more complex operating history, emerging in its current form in 2011 as the successor company to Pittsburgh & West Virginia Railroad. Until it began a strategy shift last year towards a focus on cannabis real estate, the firm was focused on the ownership, development, and management of transportation and energy infrastructure related real-estate. PW is a micro-cap REIT but does also has a listed Preferred (PW.PA).
Power REIT is currently diversified into 3 industries: Controlled Environment Agriculture (greenhouses), Solar Farm Land, and Transportation. Power REIT announced last year that it intends to focus primarily on expanding its real estate portfolio of Controlled Environment Agriculture greenhouse. Power REIT owns six CEA properties in Colorado and Maine comprised of 131,000 square feet of greenhouse and processing space. The properties are leased to tenants that are licensed for the production of medical cannabis at the facilities.
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). The largest ETF by AUM advised by ETFMG (MJ) does not include either of the cannabis REITs. YOLO also includes exposure to six tenants of IIPR: Curaleaf Holdings (OTCPK:CURLF), Green Thumb Industries (OTCQX:GTBIF), Cresco Labs (OTCQX:CRLBF), Trulieve Cannabis (OTCQX:TCNNF), Columbia Care (OTCQX:CCHWF), and Jushi Holdings (OTCQX:JUSHF).
Other common top-holdings among these cannabis ETFs include Canada-based Aphria Inc. (APHA), Canopy Growth (CGC), Tilray, Inc. (TLRY), and Cronos Group (CRON), as well as U.K.-based GW Pharmaceuticals (GWPH), U.S.-based Scotts Miracle-Gro (SMG) and Charlotte's Web Holdings (OTCQX:CWBHF).
For growth-oriented investors seeking exposure to cannabis, cannabis REITs offer an attractive and differentiated option to play the space through real estate ownership. With traditional banking off the table due to the federal regulatory environment, cannabis REITs currently fill a clear void as a well-capitalized landlord and financier to emerging cannabis cultivators. If shareholders continue to award these REITs premium multiples, they can theoretically continue to issue equity to acquire properties that are accretive to FFO whereby return on invested capital exceeds its cost of capital.
While less "risky" than alternatives, REITs in any unproven property sector are inherently speculative. 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, and cannabis REIT's tenants generally are far from "creditworthy." Federal legalization appears likely at some point during the Biden Administration and it's unclear whether the positive demand-effects of legalization will outweigh the negative supply-effects for cannabis REITs. Even without legalization, these REITs' strong performance hasn't gone unnoticed, as a number of competitors have entered the space over the last two years.
Despite the incredible share price performance of these REITs over the past two years, cannabis REIT valuations are not entirely unreasonable. Cannabis REITs currently trade with a roughly 30x multiple based on current-year FFO ("Funds from Operations") but trade at a more reasonable 22x multiple based on 2021 consensus FFO. We should note, however, that forward FFO estimates for both IIPR and PW are limited and have a wide range and also assume a continuation of each firms' aggressive acquisition strategy.
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. IIPR 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 20x over that time. We estimate that these REITs trade at a 10-20% premium to their private-market-implied Net Asset Value ("NAV") and maintaining this NAV premium is critical for their external growth strategy. Because of this valuation premium, IIPR has been able to acquire properties that are accretive to FFO.
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.
While much of the REIT sector was slashing dividends this year, Innovative Industrial is one of 48 equity REITs that has raised its dividend this year, and one of just five REITs that has raised its dividend twice this year. After the raise, Innovative Industrial, currently, has a dividend yield of 2.9%. Power REIT, however, has not paid a dividend since 2013.
As noted above, both REITs offer preferred securities. IIPR.PA is a standard cumulative redeemable preferred stock with an initial call date in October 2022. IIPR.PA currently yields roughly 7.3% and has gained 4.2% this year, which is roughly 120% below the performance of its common stock. PW.PA is also a standard cumulative redeemable preferred stock with an initial call date in February 2019. PW.PA currently yields 7.22% and has declined 1.5% this year despite the 235% gains from its respective common stock.
Cannabis REITs have been far-and-away the best-performing property sector for the second year in a row in 2020, soaring more than 150% despite the ongoing pandemic. The ongoing federal prohibition - and the resulting limit on access to traditional banking - has forced cultivators and retailers to turn to alternative sources for capital, including cannabis REITs, which have delivered eye-popping shareholder returns over the last several years.
Federal legalization appears increasingly likely in the near future, and it's unclear whether the positive demand-effects of legalization will outweigh the negative supply-effects for cannabis REITs. For growth-oriented investors seeking exposure to cannabis, cannabis REITs offer an attractive and differentiated option to play the space through real estate ownership.
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