Last week, Innovative Industrial Properties (IIPR 0.40%), a real estate investment trust (REIT) focused on the U.S. cannabis sector, reported solid third-quarter results

Revenue jumped 32% year over year to $70.9 million, driven primarily by the acquisition and leasing of new properties, along with contractual rental increases at certain properties. Earnings per share increased 10% to $1.32, and adjusted funds from operations (FFO) -- a key profitability metric for REITs -- grew 25% to $1.71 per share.  

As of Nov. 3, IIP (as the company is often called) owned 111 properties (109 operating and two under construction) across 19 states where marijuana for medical use is legal.  

Earnings releases tell only part of the story. Here are two key things you should know from Innovative Industrial Properties' Q3 earnings call.

A strong balance sheet

Interest rates are sharply rising and there is widespread concern about a possible recession. In this environment, the health of a company's balance sheet is especially important. This is particularly true for companies that operate in highly interest rate-sensitive industries, such as real estate. 

Many REIT investors count on dividends for current income. So, a REIT's balance sheet strength is crucial for this group of investors. IIP's stock is currently yielding about 6.4%. 

From CFO Catherine Hastings' remarks:

[W]e continue to maintain one of the most conservative balance sheets in the commercial real estate industry with 12% debt to total assets, no material maturities until 2026 and a debt service coverage ratio in excess of 15 times.

The debt-to-asset ratio (sometimes called the debt ratio) shows the percentage of a company's assets that are financed with debt. This metric can be expressed as a ratio (0.12) or as a percentage (12%). This metric is low for IIP because the company has primarily been raising capital by issuing stock. 

As points of comparison, the two largest industrial REITs by market cap, Prologis and Public Storage, had debt-to-asset ratios of 30% and 42%, respectively, in the third quarter.  Public Storage's relatively high debt leverage increases the stock's risk level in the current rising-interest rate environment.

The debt service ratio measures a company's ability to pay its debt obligations from its operating cash flow.

2. Tenant rent collection 

From Executive Chairman Alan Gold's remarks:

Rent collection for IIP's operating portfolio was 97% for the nine months ended September 30, 2022, with only tenants Kings Garden and Vertical not paying their full contractual rent. As we noted in our [Securities and Exchange Commission (SEC) Form] 8-K filed in September, we entered into a confidential conditional settlement agreement with Kings Garden. We are limited at this juncture as to what we can discuss. 

For now, Kings Garden continues to occupy four of the properties under that agreement, while relinquishing two of the properties (both in California) that are under development back to us. 

Kings Garden was IIP's fifth largest tenant (by total investments, including committed investments) as of the end of last year, so it's inability to fully pay its rent presents more concern than when a smaller tenant (such as Vertical) is struggling financially. Kings Garden defaulted on rents in July. 

That said, IIP is relatively diversified by tenant and geography, which helps control the magnitude of the negative impact from such a situation. At the end of last year, no single tenant represented more than 15% of the company's total committed investments.

It's good news for investors that IIP has a letter of intent (LOI) for a long-term lease at one of the former Kings Garden properties that's under development. A LOI isn't a lease, however, so it's not yet a done deal. It's also a positive that it took just over a month of marketing this property to obtain a LOI. 

As to the other former Kings Garden property under development, which is in San Bernardino, Gold said that with the current challenging legal cannabis market in California, the company is "evaluating all possible uses for that property, including non-cannabis uses."

Ben Regan, VP of Investments, added that "Vertical, a tenant of ours in Southern California that represents less than 1% of the company's total invested capital and contractual rents, has been making partial payments over time."

While these defaults are unfortunate, the company's rent collection rate of 97% for its operating portfolio over nine months is still solid. These situations are bound to occur every now and then with even the best managed property portfolios.