Wall Street has a bad habit of going to extremes, and the hype surrounding marijuana is one recent example. There's a very real trend underpinning the story here, but 2019 showed that investors got overly excited -- which is why Innovative Industrial Properties' (IIPR 2.01%) stock price is down roughly 45% from its peak. Here's what's happening and why investors shouldn't get too caught up in the negative sentiment.

One word: Legalization

The story of marijuana over the past few years has been all about the increased ability of consumers to use the drug legally. That covers two broad categories: medical and recreational. The first one has largely been viewed as a stepping stone to the second.

Either way, Wall Street clearly saw a new business emerging from the shadows. Some industry watchers have suggested the industry could eventually surpass $160 billion.

A marijuana leaf on a hand

Image source: Getty Images.

That's a lot of money, so it shouldn't be too much of a stretch to think that investors became excited by the opportunity to strike it rich, which helps explain why marijuana stocks rocketed higher. At one point, grower Canopy Growth (CGC -3.12%) was up over 1,500% from its initial public offering (IPO) in 2014. Innovative, which is a real estate investment trust (REIT) that owns the industrial facilities in which medical marijuana is grown, advanced a heady 600% or so from its late 2016 IPO, at one point. 

The problem is that investors have a bad habit of extrapolating trends into the indefinite future. When things don't work out quite as positively as hoped, they drop story stocks like a rock. That's what's been happening lately with almost anything related to marijuana.

There are very real concerns. For example, Canopy Growth has had problems turning its business profitable and has been dealing with leadership and control issues (which appear to be sorted out at this point). And though marijuana legalization has increased, illicit trade of cannabis has continued. Because of these lower prices, it's been a headwind for the legal sale of the drug

In other words, the marijuana plant isn't going to grow to the sky, to paraphrase an old Wall Street saying about trees. This helps explain why Canopy Growth is now up 500% from its IPO and Innovative is up 300% or so. To put that a different way, Canopy is down around 65% from its highs, and Innovative is down around 45%. It's been a rough ride for marijuana investors of late. 

Still hitting on all cylinders

The thing is, Innovative's business model is very different from the typical marijuana grower. While Canopy has had all sorts of business issues, Innovative has continued to execute well as it expands its property portfolio. And there's no particular reason to think it won't continue to do so. 

The best example of the REIT's ongoing success can be seen in its dividend. The dividend was initiated in mid-2017 at $0.15 per share per quarter. It has been increased six times since then, and now sits at $1 per share per quarter. That's a massive increase in a very short period of time.

Notably, despite the stock's pullback in 2019, the dividend was increased each quarter of the year. Based on the dividend story here, Innovative doesn't appear to be a company struggling to get its business on track -- it looks like one that's doing quite well. 

IIPR Dividend Per Share (Quarterly) Chart

IIPR Dividend Per Share (Quarterly) data by YCharts.

A big piece of that is the REIT's approach. It buys properties, largely from medical marijuana growers, and then rents them back to the former owners under long-term leases. The lessees are generally responsible for most of the operating costs of the facilities they occupy. In the REIT space, this is known as a net lease and means that Innovative makes the difference between its cost of capital and the rents it charges. It's a pretty low-risk business model.

Because marijuana growers still don't have easy access to banks and debt markets (it isn't legal at the federal level in the United States, which complicates things), Innovative ends up being a financing vehicle. Marijuana growers looking to find cash to fund their growth (or pay down debt) sell their facilities to Innovative to free up cash that would otherwise be locked up in a building. It's a win/win, really. 

The story gets even better when you consider that Innovative's financial debt-to-equity ratio is only about 0.15 times. That's low for a REIT (or any company, actually) and shows that much of its growth to date has been funded by equity sales (many of these shares were sold at much higher levels, meaning the equity was a cheap funding source for Innovative). Put simply, Innovative is on very solid financial ground. 

IIPR Financial Debt to Equity (Quarterly) Chart

IIPR Financial Debt to Equity (Quarterly) data by YCharts.

And Innovative's rapid growth hasn't stopped. It started life as a good idea with no properties, and today, less than three years later, it owns over 45 facilities. Since announcing third-quarter 2019 earnings in early November, it has already bought another trio of grow houses. All in all, the REIT roughly tripled the size of its portfolio in 2019. Don't forget that these purchases generally include very long leases (the average remaining lease at the end of the third quarter last year was about 15 years), so its dividend looks like it will have strong support for years to come. 

Unless something changes drastically and for the negative in the marijuana space, it looks like investors are throwing the baby out with the bathwater. Innovative is still a fast-growing company with a bright and profitable future.

Taking advantage of the fallout

After such a swift rise, it's not unreasonable to see Innovative's stock selling off. To be fair, at its peak, it was pretty expensive. However, using the third-quarter 2019 adjusted funds from operations (AFFO is like earnings for an industrial company) as a run rate, the current price-to-AFFO ratio is roughly 22 times (down from around 40, using the same run rate). So it's a lot cheaper today than it was just a few months ago, but hardly cheap.

However, when you add in the swift dividend growth with a high likelihood of seeing more dividend increases in the future, the valuation starts to look a lot more reasonable. And after the sell-off, the stock now offers a sizable dividend yield of 5.4%.

Even though the stock is far from cheap, investors who can look past the headlines can see that Innovative Industrial Properties isn't your typical marijuana stock. The REIT looks like it offers a compelling mix of income and growth.