With the recent IPO of Innovative Industrial Property REIT (NYSE:IIPR) there has been increased analysis of the cannabis real estate space. The general label or perception of the product is that it is "risky" or "uncertain" compared to traditional real estate investment opportunities. This is partially true, but in my opinion has not been quantified or adequately vetted which creates a huge opportunity.
The first question is what specifically is the risk related to cannabis real estate investing compared to a traditional industrial investment. The primary risk that is unique to this investment type is regulatory risk which in of itself has two questions that should be addressed:
1) What is the new administration going to do with cannabis legislation?
2) What happens if the new administration decides to begin to aggressively enforce the Controlled Substances Act of 1970?
Let's start with question one. Unfortunately, there is no clear answer on how the Trump Administration is going to handle the current differences between the CSA and state laws. Under the Obama administration there were a series of memos from the Department of Justice collectively referred to as the Cole Memo(s). In essence the Cole provided guidance to federal and local law enforcement not to investigate and prosecute cannabis businesses who are operating in legal state jurisdictions, unless they were doing one of the eight forbidden activities. The eight items are as follows:
· Selling to minors
· Diverting revenue to criminal enterprises
· Diversion of product from a legal state to an illegal state
· Using business as a cover for other illegal activities
· Engaging in violent activities and the use of firearms
· Involvement in drugged driving (Need to proactively take steps to prevent)
· Growing cannabis on public lands
· Possession and use on federal property
Additionally, Congress passed the Hinchey-Rohrbacher Rider in December 2014. This received almost no news coverage, but is the single most important piece of legislation passed at the federal level. It effectively defunds the Drug Enforcement Agency (NYSE:DEA) and DOJ from investigating and prosecuting legal cannabis businesses who are in compliance in the Cole Memo. This rider has had bipartisan support and has been renewed each year and does not expire until April 2017. So where does that leave us now? Unfortunately, I do not have the perfect answer. What I can do is share the data I have along with some of my opinions and perspective.
In my opinion, Donald Trump will rule his administration with an iron fist and no policy will be set without his approval. To date, Donald Trump has not presented a plan for cannabis legalization and it does not appear to be a core issue for him or the Republican Party. Trump made statements in the 1990's about the necessity for some form of drug legalization and made similar statements more recently. In October 2015, he told the Washington Post, "In terms of marijuana and legalization, I think it should be a state issue, state-by-state." He continued with, "Marijuana is such a big thing. I think medical should happen - right? I really believe we should leave it up to the states." He also claimed to know people who have benefited from using medical marijuana during an interview with Fox News in February, 2016. I also believe that Trump's primary focus is keeping as many jobs and economics in the United States, and shutting down cannabis will immediately send $6 Billion in revenue (2016 Legal cannabis sales) to Mexico. It would also kill all of the cannabis jobs created, and greatly reduce the demand for periphery services (Legal, accounting, architectural, engineering, all building trades, equipment and material suppliers etc.).
Additionally, I believe Donald Trump and the Congress are watching public opinion polling data which is compelling. In the most recent Quinnipiac Poll regarding Marijuana legalization, 54% of Americans favor adult use or recreational legalization. More telling is that 89% of Americans support legalization for medical use with all demographics and parties polling at 81% or higher. While the polling data does not guarantee that actual policy will reflect the will of the people, it does make it less likely that legislators will be motivated to aggressively challenge policy that currently allows for states to choose.
With that said, I would never advocate for an investment thesis that solely relies on the action of the Trump Administration which leads into my second question. What happens to real estate owners who are leasing to cannabis tenants. Unfortunately, the answer is it depends. In the case of IIPR, I think they would be sunk. Their initial acquisition which accounts for almost half of their IPO is a $250/SF warehouse in a tertiary market which would have limited demand for traditional industrial use which would result in much lower rental rates and valuation. The returns on this investment are nice (~18% unlevered) but are 100% dependent on the legislative environment and the strength of the tenant.
There are other models of cannabis real estate investing in the market place similar to the one I employ (www.greenspacere.com) which do not have the same scale as IIPR, but in my opinion have superior downside protection. We acquire industrial buildings at traditional real estate basis (~$90/SF) and require the tenant to invest the capital to improve the property which forces them to have skin in the game and keeps our $/SF at a defensible value. In the event that there is legislative change, the upside would be lost, but initial investment capital would be preserved. The unlevered yield would drop from a 16%-18% cap (Cannabis rates) to a 6%-7% cap rate which with no leverage would not stress the asset and would allow for an orderly exit from the portfolio.
A second risk that is commonly referred to is tenant risk. I do believe this point is valid, but I do not think it is unique to cannabis industrial. What I look at is what can you do with the property if the tenant fails? Are you at a basis where you can rent to a traditional tenant and not lose money? Are there other cannabis tenants in the market to backfill? I currently focus on the Oregon markets for this exact reason.
The final question is about how do you price the risk. Given the perception of risk in the market place, the current pricing is in the 16-18% unlevered range which is appropriate for situations where the basis is above replacement cost. However, I do think it provides an asymmetric risk/reward opportunity when the owner is in at a standard industrial basis. For simple math, if a building was acquired for $90/SF and received a cannabis rate of $14.40/SF for one year and legislation changed or the tenant failed, you would have a basis of $75.60/SF ($90.00-$75.60). At that basis one could lease to a traditional tenant for $5.40/SF (6%of $90) and be at a stabilized unlevered 7.1% yield on outstanding equity ($5.40 / $75.60/SF). A 7.1% unlevered yield is far from mind blowing, but it would not result in a loss of principal in either downside scenario.
In conclusion, I think IIPR has a talented management team who will be able to build a core asset cannabis REIT vehicle over time. The next 12-24 months will be critical to their success as that should shake out the regulatory environment and determine whether their tenant can support the $5 MM annual rent. I have 100% conviction that they will be able to continue to find interesting deal flow and believe that even if 10 more REITS come into the space to compete that the market will be grossly under-supplied. I will discuss the supply / demand and the supporting data around cannabis real estate in my next post.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.