Is Innovative Industrial Properties a Screaming Buy After Its Big Sell-Off?

A bad year just got even worse for Innovative Industrial Properties (IIPR 2.19%) (IIP). As of the market close on Thursday, July 14, 2022, the stock had fallen 58% year to date.

On Friday, IIP revealed that one of its tenants, Kings Garden, defaulted on its rent and property management fees for July. IIP's shares closed nearly 14% lower on the news. The downward momentum continued this week, with the stock slipping around 4% on Monday. 

Some investors are undoubtedly tempted to throw in the towel. But is Innovative Industrial Properties a screaming buy after its big sell-off?

Assessing the damage

IIP stated in a filing to the U.S. Securities and Exchange Commission (SEC) that the financial impact of Kings Gardens' default totaled around $2.2 million for the month of July. Roughly $1.8 million of this amount was base rent and property management fees. Another $382,000 was for insurance premiums.

Kings Garden leases six properties from IIP. These properties made up 8% of IIP's revenue in 2021 and 7.4% of its invested capital. 

However, the big worry for investors is that there's potentially another shoe waiting to drop. In April, short-seller Blue Orca Capital highlighted concerns about Kings Garden, as well as another privately held cannabis operator, Parallel. Blue Orca's report noted that a lawsuit filed against Parallel by some investors alleged that the company is "in default on $350 million in debt, hemorrhages cash and is in essence a 'Ponzi scheme.'"

Last year, Parallel ranked as IIP's second-biggest tenant. The multi-state operator generated 9.7% of IIP's revenue and represented 9.6% of its invested capital.

IIP responded to Blue Orca's report in April, stating that it was "flawed and demonstrates a basic lack of understanding of commercial real estate generally, the regulated cannabis industry and IIP's straightforward, simple business model." With Kings Gardens now defaulting on its July rent, though, investors have a legitimate reason to be concerned that the issues identified by the short-seller present real problems for IIP.

Putting it all into context

There are several things to consider to put all of this into context. First, only Kings Gardens has defaulted on rent -- at least for now. We simply don't know if IIP could face additional problems with Parallel.

Second, IIP stated in the SEC filing that it's continuing to talk with Kings Gardens about the leases. The real estate investment trust (REIT) is also already approaching other cannabis operators about potentially leasing some of the Kings Gardens properties.

It's possible, therefore, that the negative financial impact to IIP could be limited. If so, the stock's decline over the past couple of days could prove to be overdone.

Keep in mind that IIP's share price has dropped around 18% on the Kings Gardens default. That's equal to the combined percentage of total revenue that Kings Gardens and Parallel generated for IIP last year. Since then, though, IIP has added more properties, lowering the percentage of total revenue these two tenants contribute.

A screaming buy?

My view is that the recent sell-off went too far. Every REIT, regardless of industry, does face the possibility that a tenant can default. But I don't think that IIP's broader portfolio is at risk because Kings Gardens has run into problems. A quick look at the financials for the publicly traded companies that are among IIP's tenants shows that they're in solid shape overall.

The long-term prospects for the U.S. cannabis industry remain bright. That bodes well for IIP. There could be a few bumps in the road (as we've seen with the Kings Gardens situation), but the company is still headed in a positive direction.

However, the fact that Blue Orca was right about Kings Gardens does raise serious questions about what might happen with Parallel. Kings Gardens' default has underscored the real risks that IIP faces.

The bottom line for me is that IIP stock is still a good pick for aggressive long-term investors. But I probably won't scream about the stock nearly as loudly until it's clear the Kings Gardens issue is an isolated one.