We're generally bearish on REITs. However, we've realized that many investors are eager to invest in the domain. Therefore, we looked for an asset that could be parted from the rest of the REIT arena.
After its more than 60% year-to-date drawdown, Innovative Industrial Properties (NYSE:IIPR) is likely oversold and possesses secular growth prospects that could ignite a price rebound while providing a staggering dividend yield.
There's a lot of froth in the legal cannabis industry due to a "green gold rush" scenario, which has been exacerbated by easy access to capital via liberalized financial markets. However, we see Innovative Industrial Properties as a "best in class" cannabis play with its phenomenally constructed REIT.
If you read our article about Vanguard Real Estate ETF (NYSEARCA:VNQ), you'd know that we're generally bearish on REITs, even if their tenants operate in industries with high embedded growth. However, we see the Cannabis industry as an exception due to its early-stage nature and the high-beta asset category coefficient sell-off we saw earlier this year.
Furthermore, Cannabis properties are often prime targets for private equity firms as they're value-added projects that need to endure a rigorous licensing process to be "cultivation ready".
In our opinion, Innovative Industrial properties is a "best in class" asset. We like the company's sale-leaseback program as it allows the fund to enter at an optimal risk/reward stage. To elaborate, the company will provide financing to companies that are license ready, meaning the REIT essentially avoids early-stage sunk capital risk but instead provides expansionary capital to its tenants. As such, the REIT is able to monetize its investments promptly at sumptuous yields.
The two growth charts below illustrate Innovative Industrial Properties' recently progress. The prior forecasts a Cannabis market compound annual growth rate of 15.3% until 2030; however, Innovative Industrial Properties' 3-year realized compound annual growth rate of 1.29x trumps the underlying industry's sales growth. Therefore, it's valid to conclude that Innovative Industrial Properties is well positioned in the legal cannabis value chain by capturing growth through its vertically integrated real estate investments.
|Revenue 3y CAGR||1.29x|
|EBITDA 3Y CAGR||1.57x|
|Levered FCF 3y CAGR||1.18x|
Source: Seeking Alpha
Innovative Industrial Properties holds a strong portfolio of assets. The firm's top ten holdings form nearly 75% of its portfolio, which many would argue is overly concentrated. However, there's a lot of froth in the Cannabis market, meaning that a narrow investment portfolio might not be a bad option.
Let's review a few of its portfolio companies' annual growth rates to contextualize the value being added to their properties.
|Company||Revenue Growth||Holding Size|
|Ascend Wellness (OTCQX:AAWH)||87.60% (YoY)||9.4%|
|Columbia Care (OTCQX:CCHWF)||125.50% (3y CAGR)||7%|
|Trulieve (OTCQX:TCNNF)||100.41% (3y CAGR)||6.7%|
|Green Thumb (OTCQX:GTBIF)||127.98% (3y CAGR)||5.7%|
|Cresco Labs (OTCQX:CRLBF)||145.44% (3y CAGR)||5.7%|
|Curaleaf (OTCPK:CURLF)||130.39% (3y CAGR)||5.1%|
Source: Seeking Alpha
Although promising, the growth figures above need to be looked at in context as factors such as legislation & policy, industry saturation, and consumer strength could all play a role in determining long-term growth rates. Nonetheless, we believe the REIT's portfolio and the long-duration nature of its leases could coalesce into sustainable cash flows. The ETF generally holds its tenants to 15 to 20-year leases, and considering the vehicle owns 109 properties; its income risk remains low.
Lastly, the REIT runs on a triple net agreement, meaning that it passes costs through to its tenants. In most industries, I'd say that costs are an issue to cope with but considering the hypergrowth/embryonic stage of the cannabis industry and the high quality of Innovative Industrial Properties' tenants, I can't foresee it running into pass-through obstacles soon.
Let's start off by running through a few isolated valuation metrics.
|Price/Funds From Operations||14.03x|
|Price/Adjusted Funds From Operations||13.06x|
|Debt to Capital||15.66%|
Source: Seeking Alpha
The REIT's debt to capital-ratio shouldn't come as a surprise. Many Cannabis investors will run at lower debt ratios as there's still a reluctance from big borrowers to lend to the industry due to its legal risks and embryonic business cycle state. However, a 15.66% debt to capital isn't bad and shows that investors are reaping the benefits of enhanced equity valuation while maintaining robust rental growth.
Furthermore, the P/AFFO and P/FFO are borderline. The P/AFFO provides a better economic representation as it considers maintenance and expansionary costs. As such, I'll focus on the P/AFFO if I were you.
Innovative Industrial Properties' P/AFFO is undervalued on a normalized basis due to a price correction of more than 60% (year-to-date). In addition, rental fees have kept rising as the firm reported a 50% year-over-year revenue rise in its first quarter while only increasing its asset count by six properties.
Therefore, I'd have to say that we could witness secular growth here, in which this REIT could separate itself from the broader asset class to sustain its rental fee rise while other sectors' rental fees wane given the global economic downturn.
Innovative Industrial Properties' dividends could remain robust. The drawdown in the REITs' listed price has provided many to invest at a low price level, which equates to a higher dividend yield, given the REIT's financial performance holds strong.
The fund is required to pay 90% of its annual taxable income in dividends to shareholders, providing certainty to its shareholders that they will receive an income stream for as long as the REIT collects rental fees.
The REIT's payout ratio adjusted to funds from operations provides a more true representation of dividend distribution, and key metrics indicate its stretching distribution by 17.51%, considering its historical average. However, with rapid rental income growth, we don't see this as a long-term issue.
|Dividend Yield (FWD)||7.35%|
|AFFO Payout Ratio (FWD)||85.04%|
Source: Seeking Alpha
Although we part Innovative Industrial Properties from the rest of the REIT space, key risks regarding the broader REIT domain and their relation to Innovative Industrial Properties still need to be discussed.
There remains a strong intra-asset correlation between this REIT and Vanguard's Real Estate ETF (enlarge the diagram below), a diversified REIT ETF, which resembles the real estate sector's general performance. In our article last week, we explained why we're generally bearish on real estate.
If the correlation between the general REIT space and Innovative Industrial were to hold, we'd likely see a drawdown of this asset's market price (read last week's article to find out why).
An additional risk here is the Cannabis industry in itself. Economists don't yet know the true demand elasticity of recreational and medical cannabis. As such, it's difficult to forecast whether rental fees will continue to proliferate or drop abruptly.
Lastly, with an abundance of capital being deployed by Innovative Industrial Properties, it will likely need to issue additional shares or take up debt to finance new acquisitions, especially considering that it pays out most of its earnings in dividends. The result is a coin toss; it's debatable whether additional share issuance and acquisitions will be profitable given the prospects of slow economic growth in the coming years.
We separate Innovative Industrial Properties from the rest of the 'REIT pack'. The fund acquires properties that undergo significant value-added procedures and releases them on the market with long-duration leases. Moreover, there's a lot of froth in the legal Cannabis real estate market; however, this REIT has a highly-concentrated portfolio of prominent industry players with secular growth prospects.
Even though we believe property appraisals could stagnate, the REIT's year-to-date sell-off provides a lucrative price level and proliferates its dividend yield.
This article was written by
Quantitative Fund & Research Firm with a Qualitative Overlay.
Coverage: Global Equities, Fixed Income, ETFs, and REITs.
Methods: Factor Analysis, Fundamental, Valuation, Street Gossip, and Common Sense.
Our work on Seeking Alpha consists of independent research and not financial advice.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.