Innovative Industrial Properties: A Speculative Buy

Thesis

Innovative Industrial Properties (NYSE:IIPR) operates in a sector where many of their tenants face uncertain futures. The legal status of cannabis hangs in limbo and as a result the companies face onerous tax burdens and difficulty raising capital. Despite the financial woes of their tenants, Innovative Industrial Properties maintains a rock solid balance sheet with little debt. The company should be able to weather an economic downturn or a period of time where they face difficulty collecting all of the rent owed to them. Innovative Industrial Properties has a lot of pessimism priced into the shares and appears to be attractively valued relative to their financial prospects.

This article will refer to the company as "IIPR" instead of Innovative Industrial Properties for brevity's sake.

The Discount Factor

IIPR services companies that operate within the cannabis sector. This has resulted in a tenant base that faces an uncertain financial future. Many of their tenants are currently unprofitable, and this has caused investors to doubt the stability of their cash flows. Businesses in the sector also face intense competition from the black market. As such, the stock is well off its all-time high and trades at a discounted valuation relative to both their historical valuation and the valuation of other industrial REITs. The market has priced the risks into the stock and will likely continue to do so until the company proves they can maintain their FFO and keep tenant default rates low.

The negative investor sentiment surrounding the stock and the sector has merit, but where there are discounts, there can be opportunity. For risk-tolerant investors, IIPR represents a speculative buy.

The Opportunity

Innovative Industrial Properties is a company that is in a financially healthy position and has multiple catalysts that could improve the fundamental picture and send shares higher. This combination results in a stock that has an asymmetric risk/reward to the upside with a decent margin of safety.

IIPR has a low amount of net debt relative to FFO and relative to their book value. This means that the company is in a reasonable financial position to weather a temporary loss in rental income.

IIPR's low debt load is the result of the company taking advantage of raising equity to fund their expansion, rather than taking on debt. While those who participated in past equity raises may be regretting their decision, those buying shares now can benefit from a financially strong balance sheet.

There are a few potential upside catalysts for shares. The first is a possible rescheduling of cannabis on the federal level. This would open the door for businesses in the sector to operate much like other businesses elsewhere in the economy, and remove the inconsistent treatment of the drug on the federal and state levels.

Additionally, there could be progress on the SAFE Banking Act which would allow cannabis businesses to work with banks and card networks, as well as reducing the tax burden placed on them by section 280e. This could also allow the companies to up-list onto US stock exchanges instead of being forced to trade over the counter.

Both of these catalysts would improve the financial health of IIPR's tenants and de-risk the fundamental thesis. This would likely propel shares of IIPR higher and cause them to trade more in line with other industrial REITs.

Valuation

IIPR is trading at an attractive valuation relative to their financials. The company is trading at a price to FFO per share of 10.12. This is despite their continuous FFO growth. The company has been executing well, but factors outside of their control may lead to a deterioration of the business.

IIPR is trading close to its book value, which is uncommon for a REIT. The market is likely skeptical of the accuracy of this book value and believes that there may be some impairments on the horizon. If IIPR's tenants defaulted and the company was unable to get new tenants for that space, they may need to convert it for a different use case. This would validate the market's skepticism surrounding book value. We believe the low price to book ultimately means there is a reasonable margin of safety in the stock.

IIPR currently has a dividend yield of nearly 10%. This would make it a great choice for income investors, if there wasn't so much uncertainty surrounding the business. For this reason, we believe that risk-averse income investors should stay away from this stock, but investors who are tolerant of risk can take a position here and enjoy a nice yield while they wait for a catalyst event to take place.

Price Action

IIPR was having a rough year but has since recovered modestly. The stock is still trading far below their 2021 highs, but that valuation was achieved during a period of speculation and isn't likely to return anytime soon. Bullish investors can use the current discount to accumulate shares, but should be aware that the stock can be highly volatile and is unlikely to see meaningful and sustained price appreciation until some of the risks come off the table.

Risks

The biggest risk surrounding IIPR is their reliance on tenants who have an uncertain financial future. Many of these companies are unprofitable and could be forced to close their doors. This would lead to a decline in rental income for IIPR and investors would likely sell the stock in droves.

Another risk is the potential for larger REITs to move into the sector which would push down rental rates. While this is always a possibility, the space is highly specialized and IIPR has the first mover advantage. In the event that this risk factor materializes, it is likely that some other catalyst has taken place to make other REITs comfortable with investing into serving the sector, meaning that investors would likely have a gain in IIPR and be fine with cashing out.

We view the overall risk/reward as being acceptable for investors who are risk tolerant and see upside for the cannabis sector. Risk-averse income focused investors should probably stay away and avoid being lured into a risky stock by the high yield.

Key Takeaway

Innovative Industrial Properties is a polarizing stock. On one hand, the company has tenants who could face significant financial hardships and be unable to pay rent in the future. On the other hand, the company has little debt on their balance sheet and is trading at a low valuation with a high dividend yield. Investors who want to take a position here should acknowledge that the stock will be highly volatile and is unlikely to see sustained upward momentum until either some of the risks dissipate or the market enters a period of risk-on mentality.