When it comes to investing in the cannabis space, there are a few directions investors can go. For those who are interested in the companies growing and selling cannabis, there are plenty of options, and much of the buzz is around those names.
However, another way to get exposure to the space is to invest in the businesses that support the cannabis space. This is where Innovative Industrial Properties (IIPR -0.36%) comes into play. By buying land that it leases to cannabis operators, IIP offers a unique opportunity for investors who are smart enough to know these three things.
1. IIP is a REIT
REIT stands for real estate investment trust, and it is a type of investment that has some advantages for investors. REITs are required to pay at least 90% of their taxable income to shareholders. As a result, it's typical for REITs to have above-average dividend yields, and IIP is no exception. As of this writing, IIP's dividend yield is 7.3%, crushing the S&P 500's yield of 1.8%.
IIP also enters into triple-net leases with the cannabis companies, meaning all costs related to maintaining the property are the responsibility of the tenants. This type of lease agreement shifts much of the risk to the cannabis companies and away from IIP.
2. Tenant default risk is real
In general, IIP's lease agreements are long-term, often 15 to 20 years in length. This provides clear cash flow predictability for the business. IIP also boasts very high rent collection rates. Over the past five years, rent collection has never been lower than 99%. However, the cannabis space is risky due to the fact that cannabis is still federally illegal. Unfortunately for IIP, it has some customer concentration risk that could spell trouble if one or more of its tenants falls on tough times.
Currently, three companies make up approximately 30% of IIP's rent portfolio. Should any one of these default on their rent, that would spell big trouble for the company. While this may be unlikely to happen, the recent default of private cannabis company Kings Garden was a blow to the company's reputation with investors and serves as a reminder of the risks in the cannabis space.
If Kings Garden is a unique situation, IIP should be fine. But if this default ends up being the proverbial canary in the coal mine, it would be a big red flag for the business.
3. IIP helps its tenants with financing
As mentioned, despite more and more states making cannabis legal, it remains illegal federally. One of the most important negative consequences of this is how it affects cannabis companies' ability to secure financing. Historically, cannabis companies have funded their growth through highly dilutive forms of capital, impacting business results.
To address this challenge, IIP provides capital to its tenants to help them expand their operations and enhance their productivity. This is a win-win situation as it gives the cannabis companies much-needed capital at more advantageous rates while serving as an additional revenue stream for IIP.
So should smart investors buy IIP?
Like much of the stock market, IIP is down 67% from its 2021 high. However, over the course of its life as a publicly traded company, IIP has been a market-beating investment, outpacing the S&P 500 475% to 81%.
As of this writing, IIP trades for a price-to-sales (P/S) multiple of 10.1, not far above its all-time low of 9.5 and well below its average of 24.5. It trades more cheaply today than it did at its IPO. However, over that same period of time, it has grown its funds from operations by almost 22,000%.
An investment in IIP is not without its risk, but with shares this cheap and a dividend yield above 7%, the potential upside may outweigh the potential downside.