Dividend stocks have prospered for years in a low-interest rate environment. When bank depositors struggled to earn even a 0.5% return on their money, the 1.7% average dividend yield for the S&P 500 looked increasingly appealing.
As the 9.1% inflation rate has driven interest rates higher, income investors seem to have rotated out of some stocks, including cannabis-focused industrial REIT Innovative Industrial Properties (IIPR +1.86%). IIP now faces additional pressure, as one of its larger clients has defaulted on rent obligations. Nonetheless, with a high-yielding dividend, a history of high payout growth, and its role in a fast-growing industry, IIP can benefit income investors with some degree of risk tolerance in today's environment.
Innovative Industrial and its newest challenge
IIP is a real estate investment trust (REIT) that leases production facilities to growers of medical cannabis. It buys and develops properties; this real estate focus means it doesn't fall under the Schedule I restrictions that limit its clients. Schedule I restrictions mean that the federal government holds that cannabis offers no medical benefits and has a high abuse risk, and thus, is highly restricted. This means that IIP and all businesses in the marijuana industry prosper due to generally more lenient regulations in individual states.
Additionally, IIP benefits from Schedule I through one of its income sources, its sale-leaseback program. Schedule I restricts the access of cannabis companies to bank loans. IIP can handle this challenge by buying the property of these companies and providing them with capital. It can then earn revenue by leasing those facilities back to the former owners.
However, this is not a foolproof strategy, and its stock dropped 14% after it announced that its client Kings Garden had defaulted on $2.2 million in rent and insurance obligations. According to filings with the Securities and Exchange Commission, Kings Garden makes up 8% of company revenue across seven of its 111 properties.
NYSE: IIPR
Key Data Points
Some investors had feared such a default. In April, short-seller Blue Orca alleged that its loan book "degraded significantly" and claimed that the company's largest tenant is in "severe financial distress." Kings Garden was the fourth-largest tenant as of the end of Q1, meaning other defaults could follow if Blue Orca's fears prove true.
The effects on investors
Nonetheless, while the default sounds devastating, Fortune Business Insights forecasts a compound annual growth rate (CAGR) of 32% for the cannabis market through 2028. This strongly indicates that if IIP evicts non-paying tenants, the REIT can find tenants to replace them, though the loan terms of a new tenant may differ from the deal signed as a sale-leaseback transaction.
Moreover, as a REIT, IIP is required by government regulations to distribute at least 90% of its taxable income as dividends, so it pays shareholders $7 per share annually. Thanks to the lower stock price, that cash return has risen to over 7% at current prices.
Additionally, IIP's board passed two payout hikes in the last 12 months, resulting in the dividend growing by 25% over that period. IIP also tripled its dividend in three years, and its $43 million in cash gives it some ability to pay the dividend amid defaults.
Still, the tenant default could stop payout growth for a time, and the payout faces some risk of a reduction if defaults become widespread.
IIP by the numbers
Even amid its struggles, IIP's financials continued to improve. In the first quarter of 2022, it reported revenue of $65 million. While that translated into 50% growth year over year, it lagged the 75% growth rate in 2021.
Still, that revenue led to $49 million in adjusted funds from operations (FFO) income, a measure of a REIT's cash flow. This rose 33% from year-ago levels amid higher interest costs, the rapid growth of expenses, and the share issuances to fund property acquisitions. This income covered $46 million in dividends payable.
Furthermore, much of the increase was property expenses, a confirmation that IIP is still investing heavily in itself. Also, if extrapolating that quarterly income to the year, that would mean IIP sells for about 13 times its FFO income. Admittedly, with the recent tenant default and the possibility of others, that lower multiple comes with added concerns. Still, given the 67% drop in the stock price, IIP seems to price in those risks.
Consider IIP for income (and growth)
Investors should consider treating the drop in IIP's stock as a buying opportunity if one has some tolerance for risk. The lower stock price increases its ability to deliver a dividend that can nearly match the current inflation rate. Indeed, the 7% cash return lags behind the current 9.1% inflation rate, but it is not clear if this inflation will persist amid the increasing interest rates.
Admittedly, investors need to watch this company carefully, as IIP could face more defaults in the near term. Still, over time, the rapid growth of the cannabis industry should make it easier for IIP to find paying tenants. Considering IIP's potential to benefit from industry growth, income investors may wish they had bought Innovative Industrial at today's prices.
