Innovative Industrial Properties (IIP) (IIPR 0.06%) is the top cannabis real estate investment trust, using sale-leaseback deals to acquire and rent industrial properties to existing, licensed medical marijuana operators. It's been one of the top-performing REITs of the past five years.
But a recent lawsuit seeking class action status could spell big trouble for the company and its shareholders in the near future. Here's what investors need to know.
Image source: Getty Images.
What's going on?
A statement by activist investment firm Blue Orca Capital on April 14, arguing that IIP is more of a marijuana bank than a REIT, alleges the company has misrepresented values for its properties and performance by its tenants, putting shareholders at risk in the event of a default. The news crushed share prices for IIP, which have fallen 25% since the release. Today, share prices are down almost 50% year to date.
Innovative Industrial Properties promptly responded to the allegations by stating that Blue Orca Capital's claim was both false and misleading. It went on to say that the investment firm clearly lacks understanding of commercial real estate and the operation of IIP's business model as a REIT.
Nonetheless, a lawsuit has been filed by Bronstein, Gewirtz & Grossman, LLC, claiming that IIP made false and/or misleading statements and/or failed to disclose:
(1) that IIP's focus is to be a cannabis lender rather than a real estate investment trust (REIT);
(2) that the true values of IIP's properties are significantly lower than the REIT represents;
(3) its top customers are in deep financial trouble;
(4) that top customers may not be able to continue making payments and IIP would face significant problems replacing these customers; and
(5) that IIP's statements about its business, operations, and prospects, were materially false and misleading and/or lacked a reasonable basis. Once the true details about IIP's business entered the market, the lawsuit claims, investors suffered damages.
The lawsuit only applies to those who purchased shares in IIP between May 7, 2020, and April 13, 2022.
Does this spell trouble?
Lawsuits aren't good for a company. Litigation is extremely expensive; nor is it great for attracting new investors or managing investor confidence. However, there is reason to believe the lawsuit isn't as big of a deal as it may seem on the surface.
REITs, by nature, are required to earn at least 75% of their revenues from real estate or real estate-related securities. A sale-leaseback transaction with an existing marijuana operator definitely meets this qualification. Even if IIP is found to be more of a bank than a net-lease operator, its underlying assets, which generates its revenue, would still be a real property, thus maintaining its qualification as a REIT.
The sale-leaseback structure allows the existing cannabis business to gain liquidity to make improvements to the property. This isn't uncommon. Companies borrow money all the time; taking out a loan from traditional lenders like banks or private institutions, or they issue shares if they are a publicly traded company. This helps expand the business or make necessary improvements to operations.
Blue Orca Capital has claimed that IIP's second-largest tenant, Parallel, and fourth-largest tenant, King's Garden, are both in financial distress, putting IIP and its shareholders at risk in the event of default, something the firm says should have been disclosed by IIP. Blue Orca reports that both companies are either in default or at risk of default while also facing litigation claiming that the companies are a Ponzi scheme and engaged in fraud, respectively. Other IIP tenants are also in financial trouble, Blue Orca asserted. All of that could, in turn, jeopardize IIP's financial stability and revenue, the investment firm claimed.
While potentially troubling, this claim ignores the fact that a potential default by tenants is an inherent risk for all REITs. Retail REITs were battling dozens of tenants closing their stores or filing bankruptcy in the midst of the pandemic.
So what?
Personally, I think the lawsuit will be a thorn in IIP's side causing temporary challenges but doesn't pose a serious threat. I have been a longtime investor in IIP and have monitored its quarterly earnings, presentations, and management calls, all of which disclose its performance and business model clearly.
It's latest investor presentation has added some clarification on its tenants as a percentage of net operating income, which wasn't something clearly disclosed before the lawsuit. It still doesn't disclose the percentage of rents collected by tenants however; meaning investors are expected to request this information from the company directly -- something most other REITs openly disclose this each quarter.
IIP's Q1 2022 earnings were strong, with all key metrics including, revenues, net operating income, and adjusted funds from operations (AFFO) growing year-over-year, giving no reason for concern for investors. Personally, I'd still like to see further details on tenant performance regarding rents collected each quarter because this information would directly address the claims made in the lawsuit.
To me it appears this lawsuit stems from a lack of understanding of IIP's business by investors who were riding the momentum of the stock, which rose 141% from May 7, 2020, to April 13, 2022, only now to have fallen by 52% from its all-time high.
The challenges regarding this lawsuit are just getting started, so investors in IIP should be prepared to have some patience because the shares are sure to endure some serious volatility. Those who aren't invested in IIP may want to wait to see how the case plays out before investing.
