Over the past 22 years, we've witnessed a near-180 in North America when it comes to cannabis. Mexico, which had long held a negative view of marijuana, legalized medical weed in June 2017. To our north, Canada OK'd the use of medicinal marijuana in 2001, and it now stands on the verge of becoming the first developed country in the world to legalize adult-use cannabis. And within the U.S., we've gone from zero states having legalized marijuana in any capacity in 1995 to 29 as of today, including nine where recreational weed is legal.
This change in perception is especially remarkable in the United States, where marijuana remains wholly illegal at the federal level, as evidenced by its Schedule I classification by the U.S. Drug Enforcement Agency. Since 1995, favorability toward the idea of legalizing pot in Gallup's survey has jumped from 25% to an all-time high of 64% as of October 2017.
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Given this steady shift in perception toward pot, as well as rapidly rising sales in North America -- legal sales rose by 33%, to $9.7 billon, in North America in 2017 -- investors have been looking for ways to profit from this trend. The most logical means of doing so has been purchasing stock in cannabis growers. Any company that has its hands directly on the plant is bound to have a high correlation with how well or poorly the cannabis market is performing.
But growers aren't the only means by which investors can take part in the marijuana industry. There's a budding industry of ancillary companies that'll never touch the cannabis plant, which nonetheless play a vital role in the well-being of the industry. This ancillary market may be home to some hidden gems.
This "innovative" marijuana stock just delivered stellar quarterly results
Two weeks ago, one of these under-the-radar ancillary pot stocks reported its first-quarter results -- and despite having been public for just five quarters, it managed to turn a reasonably strong per-share profit and declared a dividend. Ladies and gentlemen, say hello to Innovative Industrial Properties (IIPR -0.82%).
What makes Innovative Industrial Properties so "innovative" is its business model. This is the first publicly traded marijuana real-estate investment trust (REIT). As with other REIT-modeled companies, the idea is simple: purchase land, buildings, or real-estate assets that can then be leased out for long periods of time, and/or sold for a healthy profit in the future.
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In Innovative Industrial Properties' case, it owns a half-dozen cannabis grow farms spanning five U.S. states, which are then leased out in 15-year agreements, with options for up to two five-year extensions. If the U.S. cannabis industry continues to thrive, growers will need a place to plant their product, and Innovative Industrial Properties is looking to corner that niche. As of its most recently completed quarter, all six of its properties were leased out for an average remaining term of 14.4 years, and the company notes that it's reviewing up to $100 million worth of additional properties for purchase and eventual lease.
According to the company's press release, it generated $2.68 million in revenue in the first quarter, leading to $607,000 in net income, or $0.09 on a diluted basis. It's worth pointing out that it doesn't take a lot of revenue to turn a healthy profit for a REIT since expenses tend to be more or less range-bound from one quarter to the next. Property expenses, depreciation, and general and administrative expenses are all relatively predictable depending on the size of the REIT and whether any new acquisitions have been made.
In terms of adjusted funds from operations, the company produced $0.23 per diluted share, which is what allowed it to declare a robust $0.25 per-share quarterly dividend. At a payout of $1 per share per year, Innovative Industrial Properties is yielding just a hair over 3%, which is notably higher than the average yield of the S&P 500.
Even ancillary weed stocks come with risks
In many ways, Innovative Industrial Properties is breaking the mold of what an ancillary pot stock should look like. But, as is the case with any publicly traded company involved in the marijuana industry in some capacity, it's not without risks.
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One of the more front-and-center risks of operating any marijuana-based business in the U.S. is the fact that it operates in opposition to federal law. Even though President Trump recently backed the idea of states' rights, he's changed his mind on cannabis before. Likewise, even though riders in federal spending bills have protected the medical marijuana industry from federal prosecution, ardent opponents like Jeff Sessions, the head of the U.S. Department of Justice, stand at the ready to prosecute cannabis businesses at a moment's notice.
Another concern is that with Innovative Industrial Properties being such a new REIT, it essentially has no choice but to raise capital. What little it's earning is being disbursed to shareholders in the form of a dividend, as is required by its REIT structure. This means the tens of millions of dollars it's spending on acquiring new properties that it can lease are being financed through common stock offerings. While it's not uncommon for REITs to sell stock in order to raise capital, investors should understand that this effect is dilutive to existing shareholders. Additional capital raises seem likely, which could pressure shares of this ancillary pot stock.
Make no mistake, the business model is incredibly intriguing, and the cash flow should be very predictable given the long-term nature of these leases. However, with more properties to be purchase, and with more common stock offerings likely to follow, the safest place might be on the sidelines until this REIT matures a bit.
