Innovative Industrial Properties (IIPR -2.99%) has a unique focus on owning marijuana grow houses. That said, the real estate investment trust (REIT) is up 60% over the past year, more than 400% over the past three years, and an incredible 1,200% over the past five years. Is it too late to jump on the marijuana bandwagon here? Perhaps not, as long as you control your expectations. Here's why.

A humble beginning

When Innovative Industrial Properties held its initial public offering (IPO) in late 2016 it didn't own a single property. All it had was an idea -- to provide capital to marijuana growers using the net lease real estate model. It was an ideal relationship in many ways, with the company quickly closing its first deal just weeks after coming public.

A marijuana leaf with a rising stock chart line superimposed over it.

Image source: Getty Images.

But it's important to understand what the REIT is really doing. Essentially, marijuana growers are cut off from many traditional financial relationships because of the hazy legality of what they produce. Yes, marijuana is increasingly legal across North America, but it still isn't universally legal and, at least in the United States, the Federal government considers the drug illegal. Lacking the ability to easily go to a bank for a loan, Innovative Industrial Properties saw an opportunity to step in. It buys a grower's industrial assets to provide it with a cash infusion that can be used to fund growth. The grower instantly rents the property back under a long-term lease and agrees to take care of most of the operating costs of the asset. 

This is what's called a net lease and it is more of a financing transaction than a pure rental relationship. As more and more marijuana growers tried to expand to lock in market share, Innovative had a ready list of customers lining up to do deals. At the end of the third quarter, it had 76 properties. That portfolio growth is what has driven the stock price higher and supported the dividend, which has increased from $0.15 per share per quarter when it first started making payments in mid-2017 to $1.50 today. Replicating that type of growth is probably not going to happen given the REIT's larger size and increasing competition, as more players try to take advantage of the same dislocation that Innovative Industrial is exploiting. 

What's the future look like?

Innovative Industrial's business model still works and will likely work for years to come, even as legal status of marijuana gets more and more clear. In fact, it has a number of important customer relationships that should help it continue to expand, as it remains an important source of capital in the pot sector. The problem is that the REIT is much larger than it was, so it takes more to move the needle than it did before. And, though still a new industry, the marijuana sector is also larger. So investors shouldn't go in thinking that the next five years will see another 1,000% price increase here.

However, the REIT expects the cannabis industry to more than double in size between 2020 and 2025, growing from roughly $20.1 billion in sales to $45.9 billion. Back of the envelope math suggests that annualized growth will be around $5 billion a year. Which isn't out of line, given that the industry's sales increased by about $7 billion between 2019 and 2020. That should be ample room to support the industry's expansion and Innovative Industrial's continued investment efforts as more states legalize marijuana.

IIPR Chart

IIPR data by YCharts

What about the dividend? Innovative's third quarter adjusted funds from operations (FFO) came in at $1.71 per share. With that $1.50 per share dividend, it has an adjusted FFO payout ratio of around 88%, which is pretty high. That hints at a slowdown in dividend growth, highlighted by the company announcing that it would only review its dividend twice a year after a string of quarterly increases. 

Essentially, Innovative Industrial is past, or at least nearing the end of, its rapid growth phase. That's not a bad thing and suggests that future performance should be slower but more steady because acquisitions won't have as big an impact on the top and bottom lines. Contractual rent increases will likely start playing a more important role in its results over time. With an average lease length of more than 16 years, however, there's plenty of room to run on that front. Investors just need to go in understanding that slower is probably going to be the norm here from now on in, even though there remains ample opportunity for longer-term growth.

Buy list or wish list?

If you have a value focus, Innovative Industrial isn't likely to be of much interest to you given that its 2.3% yield isn't particularly generous. For example, the average REIT, using Vanguard Real Estate Index ETF as a proxy, has a yield in the same area of around 2.2%. If you are looking for a rapid growth stock, as noted above, the REIT probably won't live up to your expectations, either. But, if you can handle a notch down in growth as the company and the industry it serves both mature, you might find this an interesting growth and income play. That's a balancing act to be sure, and some years might be more exciting than others. But when the S&P 500 Index offers a scant 1.3% yield, Innovative Industrial's business prospects and dividend growth potential start to sound a lot more compelling, even if they aren't what they used to be.