Cannabis REITs: When They Go Low, We Get High

Summary

• High on Growth: Cannabis REITs are far-and-away the best-performing REIT sector of the past half-decade as the budding industry thrives in the murky and often contradictory regulatory framework of legalized marijuana.
• Joining Innovative Industrial, Power REIT, and AFC Gamma, a pair of newcomers will soon enter the pot party - Chicago Atlantic Real Estate Finance and Freehold Properties - both operating as mortgage REITs.
• The ongoing federal prohibition - and the resulting limit on access to traditional banking - has forced cultivators and distributors to turn to alternative sources for capital, particularly cannabis REITs.
• Critically, states have adopted tax and regulatory frameworks in which marijuana cultivation licenses are "attached" to the real estate asset - and limited in quantity - an ideal structure for these REITs.
• Legalized marijuana production is set to grow 25% annually this decade. Risks are plentiful and valuations are persistently sky-high, but these REITs have established a genuine competitive moat and a track record that can't be ignored, and we see opportunity in the recent pullback.
• This idea was discussed in more depth with members of my private investing community, Hoya Capital Income Builder. Learn More »

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REIT Rankings: Cannabis

High on Growth: Riding a seemingly never-ending 'high' since emerging onto the scene in the mid-2010s, Cannabis REITs are far-and-away the best-performing REIT sector of the past half-decade as the budding industry thrives in the murky and often contradictory regulatory framework of legalized marijuana. Within the Hoya Capital Cannabis REIT Index, we track the three cannabis REITs, which account for roughly $6.5 billion in market value: Innovative Industrial Properties (IIPR), Power REIT (PW), and newly-listed AFC Gamma (AFCG), which went public in March.

Joining these three established REITs, a pair of newcomers will soon enter the pot party - Chicago Atlantic Real Estate Finance (REFI) and Freehold Properties (FHP) - both operating as commercial mortgage REITs - similar to AFCG which went public in early 2021. Chicago Atlantic announced plans this week to raise about $106M and will list on NASDAQ under the symbol "REFI." According to its registration statement, REFI booked $5 million in revenue for the 12 months ended September 30, 2021. Elsewhere, Freehold Properties - based in Tennessee - booked $4 million in revenue over the past year and plans to raise up to $115 million and will list on Nasdaq under the symbol "FHP."

Existing in a legal "grey area" in which federal, state, and local laws often contradict, cannabis has been federally restricted since the 1930s, but medical usage is now legal in 37 states while recreational usage is legal in 18 states following a burst of activity this year which has seen five additional states legalize weed: New Jersey, New York, Virginia, New Mexico, and Connecticut. Just three U.S. states currently maintain a full prohibition of any cannabis-based product. Roughly two-thirds of the U.S. population now support marijuana legalization, up from roughly 15% in the 1970s and 35% in the early 2000s while roughly 1-in-8 Americans consume cannabis regularly.

Cannabis is a genus of flowing plants - one species of which is marijuana - which has 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 marijuana - 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. The legal cannabis market is expected to more than double in size over the next five years, from roughly $16 billion in 2020 to nearly $41 billion in 2025, representing a compound annual growth rate of 21%.

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. These REITs effectively serve as "non-bank" lenders to state-licensed cannabis cultivators who often are shut out from access to traditional lending from federally-regulated banks. Despite the Democrat sweep of the 2020 Elections and campaign promises made by President Biden, the outlook for full Federal legalization remains murky. Other potential federal reform measures include the SAFE Banking Act, which would lift restrictions on federally-regulated banks to lend to state-licensed cannabis businesses.

While still early in the evolution of the industry, we see emerging parallels with the casino industry where REITs have carved out a profitable and attractive niche with a sustainable competitive advantage as the most efficient source of capital despite their tenants' legal access to traditional sources of capital. Critically, as additional states adopt tax and regulatory frameworks, marijuana cultivation licenses are increasingly "attached" to the real estate asset - and limited in quantity - an ideal structure for these REITs and structurally similar to casino gaming licenses which stay with the property in the event of default.

In a report on the linkage of cannabis businesses with an underlying real estate asset within state legal frameworks, Hoban Law Group notes, "In many cases, state marijuana statutes and regulations are closely tied to real estate laws." In Colorado, for example, the marijuana license is attached to the physical premises and stays with the property in the event of default.

This ideal legal framework - which effectively puts the real estate asset at the center of the business - suggests that REITs would continue to be a primary capital provider even in the event of full federal legalization. While capitalization rates and investment yields would compress over time with more plentiful access to traditional sources of capital, we see similar long-term competitive advantages and operating efficiencies as the casino REIT industry if states do indeed adopt a similar regulatory framework.

Reflecting the effects of this legal framework - along with the lack of available capital sources - demand for suitable cannabis real estate properties far outstrips the supply, particularly for large cultivation facilities that are housed in industrial facilities, a property sector that is as short on supply as any. Riding this supply/demand imbalance, cannabis REITs were the single-best performing property sector in each of the past two years with a real shot to make it three-straight in 2021. Cannabis REITs are higher by an average of 68.2% this year, outpacing the 23.6% gain on the Vanguard Real Estate ETF (VNQ) and the 16.0% gain on the S&P 500 ETF (SPY).

To truly capture the incredible performance of cannabis REITs, we chart the performance relative to the Vanguard Real Estate ETF below beginning in 2018. IIPR and PW have produced almost identical returns during this time - both of which were more than seven times higher than the broad-based index. PW has led the charge this year with returns of 99.8% while IIPR has gained 36.7%. Despite a pull-back amid the recent volatility, AFCG is roughly 11% above its IPO price since listing earlier this year in March.

Deeper Dive: Innovative Industrial

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 five years, expanding its portfolio to include 76 properties spanning 19 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 is the single-best performing REIT since the start of 2017 and focuses on the acquisition, ownership, and management of specialized properties leased to medical-use cannabis facilities. IIPR owns a national portfolio of over 7.5M square feet comprised of specialized industrial and greenhouse buildings and retail distribution facilities, 100% leased to state-licensed medical-use cannabis businesses. IIPR's tenant roster includes state-licensed cultivators comprised of a diverse mix of established players and unproven "start-ups."

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. Because of this valuation premium, IIPR has been able to acquire properties that are accretive to FFO. We see substantial potential for FFO growth simply by evolving its equity-heavy capital stack to be more akin to a typical REIT by tapping the long-term debt markets and redeeming its high-cost preferreds.

Deeper Dive: Power REIT

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 in 2018 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 small-cap REIT and also has a listed Preferred (PW.PA).

Power REIT - which is one of the best-performing REITs this year with gains of nearly 100% - is currently diversified into 3 industries: Controlled Environment Agriculture (greenhouses), Solar Farm Land, and Transportation. Power REIT announced in 2019 that it intends to focus primarily on expanding its real estate portfolio of Controlled Environment Agriculture greenhouse. Power REIT owns 21 CEA properties in Colorado, Maine, and Oklahoma, comprised of 1,100,000 square feet of greenhouse and processing space.

Deeper Dive: AFC Gamma

Florida-based AFC Gamma is the newest publicly-listed cannabis REIT following its $115m IPO in March. Prior to its public listing on the Nasdaq, AFC Gamma operated as a non-traded REIT under the name Advanced Flower Capital and is led by Leonard Tannenbaum, who previously founded the asset management firm Fifth Street Finance. Unlike IIPR and PW which are both equity REITs, AFCG operates as an externally-managed mortgage REIT, originating and managing real estate-backed loans for cannabis companies.

AFCG's portfolio is comprised of loans to eleven different borrowers across 49 individual properties, totaling approximately $297 million in total principal amount. Its loan portfolio has an average cash interest rate of 12.9% and its loans typically have up to a five-year maturity, secured by a lien on the real estate. AFC noted in its IPO filing that "due to the capital-constrained cannabis market which does not typically have access to traditional bank financing, we believe we are well-positioned to become a prudent financing source to established cannabis industry operators."

Cannabis ETFs & Cannabis Public Players

While we'd prefer to own the real estate owners than the producers in this sector, investors seeking more diversified exposure across the cannabis "theme" can find these REITs in several cannabis-focused thematic ETFs, including those offered by AdvisorShares (MSOS) and (YOLO), by Amplify Seymour (CNBS), Global X (POTX) and by Cambria (TOKE). The largest ETF by AUM advised by ETFMG (MJ) does not include any of the cannabis REITs.

Common top-holdings among these ETFs include Canada-based Canopy Growth (CGC), Aurora Cannabis (ACB), Tilray, Inc. (TLRY), Village Farms (VFF) and Cronos Group (CRON), U.K.-based GW Pharmaceuticals (OTCPK:GWPRF), and U.S.-based GrowGeneration (GRWG), Hydrofarm (HYFM), Scotts Miracle-Gro (SMG), and Charlotte's Web (OTCQX:CWBHF).

Interestingly, both cannabis REITs have delivered significant outperformance compared with these ETFs over most recent and long-term measurement periods, a trend that we expect to continue if state regulatory frameworks continue to evolve in the "landlord-friendly" structure discussed previously. Underscoring the underperformance of many of these cannabis ETFs, since its launch in late 2015, the ETFMG Alternative Harvest ETF (MJ) - the oldest and largest cannabis ETF - has produced meager average annual total returns of less than 1%, woefully underperforming the S&P 500's 16% annual returns during this time, and being "left in the dust" by the two cannabis REITs.

Data by YCharts

Cannabis REIT Dividend Yield & Preferreds

Together, cannabis REITs pay an average dividend of 2.7%, which is slightly below the REIT market-cap-weighted average of 2.8%. Cannabis REITs have delivered the strongest dividend growth over the past five years, led by IIPR which has delivered incredible 104% average annualized growth since the start of 2017, more than doubling its dividend every year during this time.

While much of the REIT sector was slashing dividends last year, Innovative Industrial was one of 52 equity REITs that has raised its dividend last year. IIPR and AFCG are two of 121 REITs to have raised its dividend thus far in 2021. After the raise, Innovative Industrial currently pays a forward indicated dividend yield of 2.40%. Recent entrant AFC Gamma pays a forward indicated dividend yield of 8.15%. Power REIT has not paid a dividend since 2013.

As noted above, IIPR and PW REITs offer preferred securities. The Innovative Industrial 9.00% Series A Preferred (IIPR.PA) is a standard cumulative redeemable preferred stock with an initial call date in October 2022. IIPR.PA currently yields 7.03% and trades at a steep 28% premium to par value. The Power REIT 7.75% Series A Preferred (PW.PA) is also a standard cumulative redeemable preferred stock with an initial call date in February 2019. PW.PA currently yields 7.07% and trades at a 10% premium to par.

Takeaways: When They Go Low, We Get High

Cannabis REITs are far-and-away the best-performing REIT sector of the past half-decade as the budding industry thrives in the murky and often contradictory regulatory framework of legalized marijuana. The ongoing federal prohibition - and the resulting limit on access to traditional banking - has forced cultivators and distributors to turn to alternative sources for capital, particularly cannabis REITs. Critically, states have adopted tax and regulatory frameworks in which marijuana cultivation licenses are "attached" to the real estate asset - and limited in quantity - an ideal structure for these REITs.

For an in-depth analysis of all real estate sectors, be sure to check out all of our quarterly reports Apartments, Homebuilders, Manufactured Housing, Student Housing, Single-Family Rentals, Cell Towers, Casinos, Industrial, Data Center, Malls, Healthcare, Net Lease, Shopping Centers, Hotels, Billboards, Office, Storage, Timber, Prisons, and Cannabis.

Disclosure: Hoya Capital Real Estate advises two Exchange-Traded Funds listed on the NYSE. In addition to any long positions listed below, Hoya Capital is long all components in the Hoya Capital Housing 100 Index and in the Hoya Capital High Dividend Yield Index. Index definitions and a complete list of holdings are available on our website.

Disclosure: I/we have a beneficial long position in the shares of RIET, HOMZ, IIPR, AFCG either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.