Innovative Industrial Properties (IIPR 1.86%) is my favorite cannabis stock because of its highly stable yet profitable business model. By buying indoor cultivation space from marijuana companies that need cash and then leasing the properties back to the sellers immediately, Innovative Industrial Properties is constantly building a larger and larger hoard of commercial rental income.
IIP's market cap is nearly $6 billion today. I'm of the opinion that it will have no trouble reaching at least $12 billion in value before 2030. Let's walk through its business model and then do a few quick calculations to see why I'm so confident in this stock.
Solid business models make for predictable profits
IIP is a real estate investment trust, which means that it makes money by controlling properties that yield income, which is then largely passed on to shareholders in the form of dividends.
With more than $1.7 billion of capital committed to real estate investments, the REIT expects to make $195.5 million in annual rental revenue in 2021, a significant increase from 2020's $116.9 million. To keep growing that rental revenue, the business will need to do more sale-leaseback transactions to accrue more real estate from its customers in the medicinal cannabis industry.
Once IIP owns a new facility, it pockets the rental income permanently, or at least until the lease expires or the tenant defaults. The weighted average lease length for its tenants is 16.7 years, so turnover shouldn't be a major concern between now and 2030. Therefore, when we calculate the company's future market cap in a few moments, we'll assume that its existing rental revenue will continue unperturbed from quarter to quarter for the next eight years.
But I'd be remiss if I didn't mention the potential of marijuana legalization between now and 2030. This would present a risk for IIP, as if cannabis companies can get access to the traditional sources of financing that legalization would allow, they might not need to sell their cultivation space to IIP to raise cash.
Assuming the status quo holds, earnings are likely to plod onward without disruption. In 2020, the company had normalized earnings before interest, taxes, depreciation, and amortization of $100.23 million. Over the past three years, its quarterly EBITDA has risen by more than 1,590%. Plus, earnings are rising extremely smoothly from quarter to quarter because its total operating costs remain static and low as a percent of quarterly revenue.
Doubling will be a walk in the park
Now that we've established that both revenue and earnings are both secure and steadily growing over time, we can sketch out the rate at which the REIT needs to keep expanding on a yearly basis to double in value.
If we divide IIP's expected $195.5 million in annual revenue for 2021 by its $1.7 billion in invested capital, we can find that its capital is deployed today at about an 11.5% gross annual return. Of course, the actual rate of return available for reinvestment into new properties will be a bit less, as some of the income will be used for keeping the lights on, paying staff, and paying off debt.
So, if we look at the company's free cash flow from the second quarter of this year and divide it by the total revenue in the quarter, we can calculate that its free cash flow margin is 95.7%. That means the predicted 2021 rental income should yield about $187.1 million in free cash flow, which in turn lets us estimate that IIP will have an annual FCF yield on its investments of approximately 11%.
Assuming that the company can keep reinvesting its annual free cash flow from rentals to get that same rate of return, doubling in value over the next eight years will be trivially easy. Provided that the market's appraisal of its valuation remains roughly the same, that is.
Right now, the stock's trailing ratio of price to FCF is 31.5.
Therefore, if Innovative Industrial Properties' FCF grows at an annual rate of 11% and the entire sum is reinvested each year at the same rate, in eight years it'll be making about $431.1 million in annual FCF. At its current price-to-FCF ratio, that means its market cap will be about $13.6 billion in late 2029. That estimate leaves a margin of safety in case its return on investment slightly drops or its costs rise.
Either way, Innovative Industrial Properties looks like it's set to double in value before the close of the decade. And to shareholders like me, that's exciting.