Innovative Industrial Properties: Cannabis Is Sinking, 10% Yield, Hold (IIPR)

Is Innovative Industrial Properties (NYSE:IIPR) a sell on the back of what’s been a marked decline in the equity values of listed US multi-state operators? The situation is truly dire with a wholesale lack of liquidity, entrenched unprofitability, and a risk-off macro backdrop driving MSOs to new lows. At stake here is the US cannabis dream and a sector that was brought out of the dark by a wave of statewide legalizations. A once-promising market is now imploding and is currently amidst a dearth of liquidity that runs the risk of deteriorating into a full-blown crisis. AdvisorShares Pure US Cannabis ETF (MSOS), the largest cannabis ETF, is down 27% year-to-date with Innovative Industrial down 21% over the same time frame to build on a selloff that started last year. The preferred shares (NYSE:IIPR.PA) have also been trending down.

Innovative Industrial’s largest tenants are all at risk. PharmaCann, its largest tenant with 11 leases which form 15% of rental revenue as of the end of its fiscal 2023 first quarter, is private so has been spared from the public chaos. But Ascend Wellness (OTCQX:AAWH), Green Thumb Industries (OTCQX:GTBIF), and Curaleaf (OTCPK:CURLF) have all faced pressure on the back of flagging stock prices reducing the opportunities to tap their shares for liquidity. To be clear here, the bearish argument is that with pandemic-era retail-driven cannabis euphoria now fully swapped for fear and a pertinent risk-off environment, Innovative Industrial’s largest tenants could eventually struggle to pay rent.

Innovative Industrial Reports Strong First Quarter Earnings As Tenants Face Headwinds

Ascend has 4 leases with Innovative Industrial that form 10% of rental revenue. The New York-based MSO is down 73% over the last year and last reported a fiscal 2023 first-quarter cash and equivalents position of $76.5 million against trailing 12-month negative free cash flow of $93.7 million. Bulls would be right to flag that Ascend reported positive operating cash flows of $5.8 million during its first quarter but the now penny stock held total debt of $569.8 million as of the end of its first quarter. To highlight how critical the situation is, Ascend’s quarterly interest expense is running at around $8.85 million per quarter, around 7.6% of its $116 million market cap with the company also owing $44 million in federal taxes.

Innovative Industrial’s fiscal 2023 first-quarter earnings were strong, defying broader industry headwinds. Revenue came in at $76.1 million, a growth of 18% over the year-ago comp and a beat by $5.45 million on consensus estimates. Net income attributable to common stockholders was $40.8 million, around $1.43 per diluted share, and up around $0.11 from the year-ago comp. Weighted average shares outstanding increased by 1.88 million. The REIT last declared a quarterly cash dividend of $1.80 per share, in line with its prior payout and a 10.2% annualized forward yield.

Property expenses did jump 183% year-over-year due to how the equity REIT bills its tenants for insurance and taxes. Innovative Industrial also benefited from a jump in interest income to $2.23 million during the quarter on the back of a cash and investments balance that was $201.7 million as of the end of the first quarter. Crucially, rent collection from the operating portfolio was 98% for the quarter with adjusted FFO per share of $2.25 more than enough to cover the quarterly dividend and growing by $0.21 from $2.04 in the year-ago quarter. It also handily beat consensus estimates for FFO to come in at $1.91 per share.

The End Of The Dividend Growth Golden Age

Innovative Industrial’s FFO payout ratio currently stands at 80%, a level that does not pose a risk to the current payout but does not provide a large enough space for a near-term blockbuster raise especially against $4.2 million of rent, around 5.5% of the rental revenue, being from security deposits. Bulls would highlight the REIT has a low debt-to-total gross assets ratio of just 12% and that it faces no large debt maturities until May 2026.

Longer-term the US cannabis market is forecasted to grow to reach $71 billion in sales by 2030. This has raised the prospect of an industry starved of liquidity and at risk in the near term but with a healthier long-term macro profile. Critically, the prospect of widescale tenant chapter 11s on the back of a prolonged dearth of liquidity poses a real risk to Innovative Industrial. However, with MSO licenses extremely valuable any ramp in bankruptcies would be matched with intense consolidation that would see the consolidated entity take over any leases with the REIT.

I’ve switched from bullish to neutral because of the stress some of Innovative Industrial’s tenants are currently under. This will continue to weigh down on sentiment towards Innovative Industrial and could possibly disrupt its FFO. For now, the era of marked dividend growth is over as the REIT moves to a more uncertain period.