Right now, marijuana is a highly politicized industry, one heavily regulated by many governments, including the federal government of the United States. Over the next decade this will dramatically change. We're seeing a tidal shift in marijuana regulations at the state level. States are decriminalizing marijuana, legalizing "medical marijuana," and in some cases are legalizing recreational marijuana.   

This shift in criminal law at the state level is causing a disconnect between federal law and state law. Ultimately, the federal government will have to shift its laws to match criminal laws in the states. Meanwhile, however, federal regulations are causing bottlenecks in the marijuana industry. For instance, banks are not allowed to loan marijuana companies money under federal law. Many of these pot start-ups are starved for cash. 

Innovative Industrial Properties (NYSE:IIPR) is addressing this pain point by is financing much of the marijuana industry in the United States. And by doing so, the company has now become the largest owner of marijuana acreage in the U.S. This dynamic will make IIP the strongest pot stock over the next 10 years. 

medical marijuana prescription bottles

Image source: Getty Images.

What causes the demand for marijuana? 

To understand where the cannabis market is headed and why, you need to first understand what's in the plant itself. Cannabis contains over 500 distinct chemical compounds. The two best-known ones are delta-9-tetrahydrocannabinol (THC), the compound that makes you high, and cannabidiol (CBD), which might have medically useful properties (and does not make you high). To be blunt (sorry for the pun), THC is why marijuana was a crime for so long, and THC is why there is such high demand for marijuana.

What about CBD? Brightfield Group, a market research company, predicts that the CBD market will double every year and hit $23.7 billion in four years. This bullishness is based on the fact that the federal government has recently legalized hemp (from which CBD can be derived). But it doesn't follow from this that there will be sky-high demand for hemp products or CBD.   

While the Food and Drug Administration has approved one CBD drug -- Epidiolex from GW Pharmaceuticals (NASDAQ:GWPH) -- there is also evidence that CBD causes liver damage. The FDA can and will crack down on any claims that CBD improves your health. Efficacy has to be proven, as does the chemical's safety profile. 

Investors should probably focus on marijuana stocks and not get sidetracked into hemp stocks. The demand for marijuana is obvious -- people like the high they get from THC. It's analogous to the buzz people get from alcohol or tobacco. In 2019, the market for alcohol in the United States was $250 billion. Tobacco is about a $115 billion market.  Those two sin stocks are a good proxy for how large a market cannabis could become. 

Sin is a big business

The upside for marijuana is huge. Right now marijuana is a far smaller market than alcohol or tobacco, because marijuana is a controlled substance -- it's illegal under federal law. However, at the state level (where most criminal laws are made), the rules about marijuana are in serious flux. And it's very clear that the overall trend is toward full legalization. 

Here is a pretty good map (updated monthly) about the status of marijuana laws in all 50 states. So far, 11 states have legalized recreational marijuana. And 31 additional states have either decriminalized marijuana, or now allow for medical marijuana, or both. Only eight states, and the federal government, have refused to budge.

Because marijuana remains illegal under federal law, right now banks cannot provide financing to marijuana companies. Many marijuana companies that are publicly traded raise funds through secondary offerings, diluting shareholders and sending the stocks down. There is no question that federal rules are stifling the cannabis industry. However, Innovative Industrial Properties is taking advantage of these regulations -- and profiting from them.

Which marijuana stock will win?

IIP's business model is simple: The company purchases the marijuana farm (sending cash to the start-up), and then it rents the property back to the seller. IIP now owns 3.1 million square feet of marijuana property in the United States. Owning massive amounts of marijuana acreage is a smart way to play the marijuana boom.

In addition, IIP has fantastic financials: 194% revenue growth and 51% profit margins. Plus the company pays a dividend of 5%. The stock is heavily shorted, which translates into future buyers. 

An investment in IIP is simultaneously an investment in the illegality of marijuana at the federal level and a long-term bet that marijuana will eventually be legalized. The inability of banks to profit from marijuana is a huge short-term boon for IIP. The company is rapidly acquiring marijuana farms across the United States because of federal regulations that keep the banks from loaning money to marijuana companies.

This makes IIP the safest (and strongest) play in the marijuana sector. Right now it's profiting from marijuana regulation. And in the future, if and when pot is legalized? The largest owner of cannabis farms in the country will benefit the most. 

Innovative Industrial Properties is a volatile stock, currently down 30% from 52-week high last July. It's a battleground stock with a high short interest (42% of its float is sold short). This makes the stock comparatively cheap right now with a forward P/E of 20, down sharply from the multiples in the 40x-50x range it posted last year. If you're bullish on the future of marijuana, but aren't sure where to invest, consider starting right here.

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.