On Jan. 18, Innovative Industrial Properties (IIPR 0.37%) dropped a bombshell with its operating and investment activity update for the fourth quarter and full year 2022. It had only collected 92% of its rent payments for January, indicating that three of its tenants are having trouble paying up. As a result, since the announcement, its shares are down by more than 24%.
Now, the company's difficulties are clearly much larger than in July 2022, when its tenant Kings Garden defaulted, spooking investors. That issue was eventually settled out of court, but the downturn in the cannabis industry is now an undeniable threat to shareholders, and it might be hard to deal with in the near term. So is it time for shareholders to consider cutting losses, or is this stock still ripe for buying with plans for a long-term hold? As it turns out, the answer to both those questions is yes, and here's what to do about it.
Stormy waters are here, and there's no end in sight
As a real estate investment trust (REIT), Innovative Industrial Properties makes money by doing sale-leaseback transactions in which it pays cash for cannabis cultivation real estate and then inks a lease for the space's former owner, turning it into a rent-paying tenant. Tenants are on the hook for everything from utilities to maintenance to facility improvements, so the ongoing costs for IIP to continue renting a property are practically nil, enabling it to generate trailing-12-month net income of more than $139.3 million. Then, the company distributes whatever income is left over to investors via its dividend, which presently has a forward yield above 8%.
Under ideal conditions, management uses a combination of capital raised from debt and accumulated rent payments to buy new cultivation facilities at attractive prices. It also performs due diligence to ensure that prospective tenants are likely to be able to keep paying rent for years and years. But it can't predict the future, and much of its success depends on whether the market for marijuana continues to grow, as it's much easier for its tenants to make money when demand for their products is high and rising. For a brief time, the U.S. market for regulated cannabis was booming, and many cultivators sought to expand their operations to capture the demand being let loose by waves of legalization.
Now that time is over, and the market is saturated. Average selling prices per gram of cannabis are plummeting in many states, and many cannabis operators are seeing their top lines shrink or come under pressure. Most public U.S. pure-play marijuana businesses were unprofitable before the market became saturated, making the issue of insufficient demand all the more damaging.
If this sounds bleak for IIP, it is. While its tenants are largely public, and 85% are multistate operators (MSOs) -- which are the most likely to be financially sound -- its smaller and less stable renters are likely to continue facing severe headwinds that imperil their ability to pay rent. Expect more defaults on rent and more delays in collecting payments until conditions improve. Scaling down marijuana output to fit the actual level of demand will be a painful process for all involved -- except consumers -- and investors in Innovative Industrial can expect to lose some money over at least the next year.
Plan to either buckle up or back out
The good news is that eventually, gluts of goods end when the market finds an equilibrium between supply and demand. So it will be for marijuana, too, and that means IIP and its tenants will experience stability once again. The tricky question is when that might be. Further, IIP can lean on initial deposits from its tenants to cover defaults in the short term. A relatively short downturn might leave investors who sell their shares today worse off for quitting their positions thanks to the lost dividend income, but a longer cannabis winter would reward those with the discretion to walk away. And that would be especially true if the business were forced to cut its dividend in the wake of a situation like the bottom line collapsing.
At the same time, loading up on shares of IIP right now could prove to be a genius move in five years -- or a folly. The market for cannabis is likely to continue growing in the long term, but there's no guarantee that such growth will pump up the stock's price anytime soon after a period of steady decline. Therefore, investors need to do some soul-searching and think about their risk tolerance and their goals for their investment in IIP.
If you're risk-averse and aren't interested in passive income, it's probably time to hit the road and sell. On the other hand, if you're holding Innovative Industrial's shares for the dividend, hang in there a while longer until there are clear signs of financial difficulties with making the quarterly payment, which will likely first appear in the form of a year when the dividend isn't hiked.
But if you're hungry for passive income and you're comfortable with waiting years before the company's share price recovers, it makes sense to keep buying more of IIP. Cannabis cultivators are going to need warehouse space to raise their crops for as long as the industry exists, and most businesses are able to contract quite a bit before they're unable to pay rent each month.
