When you're a shareholder of a profitable, growing business like Innovative Industrial Properties (IIPR 1.02%), it's easy to get complacent. After all, over the last three years, the company's shares have returned 146.2%, smashing the overall market's returns of around 63.4%.
Still, IIP isn't invincible, and there's one development in the cannabis industry that seems like it could spell trouble. In short, there's an early sign that marijuana companies don't need its services as much as they might have in the past. Let's investigate this in more detail to see if it's actually as bad as it sounds.
Image source: Getty Images.
What might be concerning
Innovative Industrial leases units from its portfolio of 105 cannabis cultivation facilities to marijuana companies that need somewhere to grow their greens. Its tenants provide a steady stream of income in the form of rent, and investors get their cut of the pie in the form of a dividend, which currently has a forward yield of around 3.6%.
But if the pool of potential tenants in the cannabis industry is not interested in scaling up their businesses by renting new cultivation facilities, investors might have a big problem.
Image source: Statista.
Based on the chart above, cannabis growers scaled up their cultivation areas from 2016 through 2020, after which there was a slight pullback. Generally speaking, it's advantageous for IIP when cultivators need more floor space, as the higher demand means that it could in theory charge higher rents for its facilities.
So, it seems to make sense why a drop in the average amount of cultivation space might appear to be a threat. After all, lower demand for floor space implies tenants are less willing to pay higher prices to secure a place to call their own. But this entire line of thinking has a fundamental misunderstanding about the company's business model.
Innovative Industrial may be a real estate investment trust (REIT), but it isn't a traditional landlord. Rather than owning properties and then renting them out to whichever tenants come calling, the business uses its cash to buy the rights to cultivation facilities in active use. Then, as part of the same sale-leaseback transaction, it leases the facility back to the prior owner, which becomes a long-term tenant; IIP's weighted average lease length is 16.6 years.
Notably, Innovative Industrial doesn't need to court new tenants for its existing space by expanding its holdings with sale-leasebacks, so there isn't any downward pressure on rents that could be exerted by a dip in the average cultivation space. Also, existing tenants aren't about to get a break on their monthly rate. And that means there isn't much reason to be concerned about the pullback in cultivation floor space last year.
One big tailwind should give investors hope
There's a second big reason why the dip in average cultivation space doesn't threaten IIP: The dip is almost certainly temporary . Demand for cannabis is surging in the U.S., and growers will eventually need to beef up their facilities.
People in 2025 are expected to be consuming more than three times as much marijuana as they did in 2020. Producers scrambling to meet the demand will need both a place to grow cannabis and cash to finance the purchase of productive capital like extraction equipment. IIP will be there to help them close the loop.
It's also worth remembering that this company flourished in the cannabis industry's recent run-up. Over the last three years, its trailing 12-month revenue grew by 747%, reaching $204.5 million, and its trailing 12-month cash from operations (CFO) rose by more than 609%.
Therefore, shareholders don't need to be too concerned about IIP's health or its prospects of continuing to deliver solid returns due to the contraction in average growing space last year.
