Sometimes, the market goes a little bit overboard when a piece of bad news breaks, creating an opportunity to profit for investors who see past the noise. On that note, shares of the cannabis cultivation real estate investment trust (REIT) Innovative Industrial Properties (IIPR 0.05%) collapsed by more than 14.1% on Friday as of 2:24 p.m. ET after it filed a document with the Securities and Exchange Commission (SEC) late on July 13 describing the default of one of its tenants, Kings Garden.
The company probably won't get much in the way of compensation for its delinquent tenant, but the news is hardly a death knell for IIP. Let's look a bit more closely at what happened and put it into context so that you can decide whether to take advantage of the freshly discounted stock price.
The default won't change much of anything
Kings Garden leases cultivation space from IIP across six different locations, and per the SEC filing, for the month of July it defaulted on $2.2 million in rent and property management fees. If we assume that the tenant is on the hook for that $2.2 million every month, it works out to be an annual sum of $26.4 million.
But IIP's trailing-12-month revenue is more than $226.1 million. That means the tenant was worth just over 11.6% of the REIT's revenue. Pointing to a few accounting adjustments for the expiration of rent payment phase-ins, management contends that it was worth an even smaller share, at 8% of the company's stabilized revenue. So it's true that the default will lead to tangible harm to the top line for a while, but it's not as bad as it might seem at first.
And it's also true that there's nothing stopping the company from finding another tenant and renting the space out to it, which it may already be in the process of doing. The only questions are whether it'll be able to find another tenant that's willing to pay exactly as much as Kings Garden was, and how long it'll take to do so. Either way, IIP still retains full control of the space, and with the anticipated expansion of the cannabis industry over time, its facilities won't stay unoccupied forever.
Furthermore, IIP's quarterly revenue grew by 50.4% year over year as of its latest earnings report, so the company is growing rapidly. It's also strongly profitable, and its trailing-12-month funds from operations (FFO) have burgeoned by 665.2% over the last three years. A tenant in default is a bump in the road that's fully expected over a long enough timeframe, not an existential crisis. It probably won't even put much of a dent in the business's top line after a couple of quarters pass.
What's coming up next?
Regardless of the situation with Kings Garden, Innovative Industrial is continuing to expand its roster of renters and making improvements to its holdings so that they'll command higher rental prices in the future beyond the yearly rent increases that it cooks into its leases. IIP will report its earnings sometime during the week of Aug. 2, and investors should expect to hear a bit more about how management is handling the default of Kings Garden. In particular, be on the lookout for any planned revisions to its underwriting and monitoring guidelines, which determine the terms that it offers to its sale-leaseback targets and therefore its future tenants.
Finally, don't be too surprised if management opts to tone down its expectation of bringing in $258 million in revenue in the 2022 fiscal year. As such, there's likely a bit more chop on the way for shareholders as the market digests the news of the default. But the company's long-term prospects are as strong as ever, so it probably isn't a good idea to sell your shares. In fact, right now might be an attractive time to grab a few more.