Innovative Industrial Properties (NYSE:IIPR) has been the best-performing cannabis stock listed on a major exchange in 2019, and for good reasons. U.S.-based marijuana producers with limited financing options have beaten a path to this real estate investment trust's (REIT) door.

At the moment, IIP is one of just a handful of cannabis-related businesses with a bottom line pointed in the right direction, and the only one committed to returning those profits to shareholders each quarter in the form of a soaring dividend. While the REIT business is famous for steady cash flows, it's important to remember no industry is immune to poor capital management decisions. 

Marijuana buds placed on a scale that's on top of a map of the continental U.S.

Image source: Getty Images.

If just a couple of tenants in IIP's property portfolio stop paying rent, the profit growth that investors are expecting would quickly disappear. In recent weeks, IIP's poured money into licensed cannabis producers that are sitting on inventory they can't sell and it's about to get worse.

A fan of the Mitten State

In June, IIP doubled down on a cultivation and processing facility run by the largest vertically integrated medical-use cannabis license holder in Michigan, Green Peak Innovations. Green Peak took on an additional $18 million raising IIP's total investment in this facility to $31 million. Just a few days later, IIP committed $10.0 million into a similar Michigan facility under development by Emerald Growth Partners. 

More recently, IIP committed another $19.8 to Ascend Wellness Holdings, which raised its investment in the licensed Michigan cultivator to $25.0 million.

At the moment, IIP owns 23 properties in 11 different states that it spent $234.5 million to acquire, plus the company's committed $72.0 million to help tenants repurpose many of these facilities to grow cannabis. In other words, roughly 22% of this REIT's investments are surrounded by the Great Lakes, which has been an extremely tough place to sell licensed cannabis and it's about to get a lot worse. 

Mason jar of cannabis and banknotes.

Image source: Getty Images.

Still 99.9% caregiver grown

The state of Michigan voted for the legalization of recreational marijuana in late 2018, but the state has operated under a caregiver system since 2008, which is still active today. In March, there were 83,693 licensed caregivers, or one for every 3.4 registered patients in the state.

Caregivers are allowed a limited number of plants per registered patient, and they're allowed to unload their excess product onto 76 licensed provisioning centers eager to buy it. Provisioning centers are allowed to sell products grown and processed in small batches by the army of caregivers that surround them. Customers simply need to sign affidavits that prove they know they're buying unlicensed cannabis.

Many of the most popular provisioning centers in Michigan don't even bother carrying licensed dry flower grown by IIP's tenants. That's why they've been lobbying state representatives, unsuccessfully, to prohibit dispensaries from carrying caregiver grown products. Green Peak even launched the MICleanCannabis campaign in April, but it failed to gain any traction. 

In May, Green Peak Innovation CEO Jeff Radway complained that he was sitting on 1,000 pounds of product in storage that he can't sell because provisioning centers prefer buying from individual caregivers he can't compete with. The company recently stepped into the retail space with Skymint Bay City, the first of 30 provisioning centers Green Peak plans to build in the state.

In a nutshell, greenhouse cannabis can't hold a candle to carefully curated products that caregivers grow with hardly any overhead expenses. This is a big reason Skymint Bay City's first day was a long way from successful from a customer satisfaction standpoint. There are plenty of top rated dispensaries competing within a few miles of Green Peak's first store. If it can't improve its Weedmaps rating significantly, it will generate nothing but losses. 

Outdoor cannabis growing.

Image source: Getty Images.

About to get worse for the big guys

In 2018, the state also elected a new Governor, Gretchen Whitmer, that entered the office on a mission to improve how the state regulates one of its fastest-growing industries. Unfortunately for IIP's Michigan-based portfolio, the improvements are not kind to mass-market cannabis producers that haven't been able to deliver the economies of scale they promised investors.

Michigan's new Marijuana Regulatory Agency (MRA) recently released emergency administrative rules that companies like Green Peak, Emerald Growth, and Ascend Wellness aren't going to be happy about. For example, the MRA has tossed out minimum capitalization requirements that used to prevent intrepid caregivers from graduating to larger operations.

In addition to caregivers, vertically integrated canna-businesses will soon need to compete with licensed event organizers and the temporary marijuana events they'll hold. Temporary marijuana events will allow on-site sales and consumption in public spaces, and designated consumption establishments will also be permitted. 

Riskier than its price suggests

Luckily for IIP, its Michigan properties are leased by multistate operators and the REIT only needs its tenants to be successful enough to pay the rent. As long as operations in other states keep earning money, they could subsidize the tumbleweed factories these tenants plan on opening in Michigan. 

Since IIP has already locked all its tenants into 15-year leases that include annual increases, there is a chance it won't have to write down investments made in Michigan but it isn't a chance worth taking. At recent prices, IIP sports a $1.3 billion market cap that could come crashing down if investors see any of its tenants going belly up. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.