The cannabis industry is expanding steadily, though stock performances of marijuana companies seem to suggest otherwise. The market has been avoiding cannabis stocks because of excess supply in the industry, and a lack of progress toward U.S. federal legalization of marijuana. Nevertheless, the industry has further room to grow. 

In the current state, investing in the cannabis industry carries risks and is not for the faint-hearted. However, if you are looking for a low-risk exposure to the industry, Innovative Industrial Properties (IIPR 0.40%) (IIP) is an excellent alternative. This real estate investment trust (REIT) has a portfolio of cannabis companies as its clients, and that allows investors to play the growing cannabis market with significantly lesser risk. Let's take a look at how this works.

Plant shaped like a green arrow pointing upward.

Image source: Getty Images.

Innovative's unique business model is the reason for its success

Innovative entered the cannabis industry with a unique business model. Because marijuana is federally illegal in the U.S., cannabis producers have struggled to establish larger production facilities. Innovative Industrial Properties stepped in by purchasing producing properties from growers and leasing those properties back to them under a sale-leaseback agreement. This creates a win-win situation for both Innovative and the producers in that cannabis growers get immediate access to liquidity and capital that would've been otherwise difficult to raise helping them expand their businesses, while Innovative receives consistent and predictable rental income from the properties it leases out.

In 2022, IIP's total revenue increased 35% year over year to $276 million, while net income increased 36% to $153 million. In addition, adjusted funds from operations (AFFO), a metric REIT investors keep a close eye and similar to cash flows, increased 34% to $234 million in the same period.

AFFO is an important metric since it determines how much cash is available for dividend payments. Innovative's dividend yield stands at a mouth-watering 9.1%, which is significantly higher than the S&P 500's average dividend yield of 1.8%. REITs pay a higher yield because they are required by law to pay out 90% of their taxable income as dividends.

When choosing a dividend stock, however, income investors look for consistency in dividend payments. Innovative's growing AFFO has enabled it to increase dividends regularly. Last September, Innovative hiked its quarterly dividend payout by 25% year over year to $1.80 per share. This marked its 14th dividend increase since its initial public offering in Dec. 2016.

Tenant default is possible, but Innovative should survive

Well-known cannabis multi-state players (MSOs) such as Trulieve Cannabis, Curaleaf Holdings, Cresco Labs, and Green Thumb Industries are among Innovative's tenants. These MSOs' expansion efforts have boosted Innovative's business. However, there is always the possibility that the REIT's tenants could default -- and a few have, in fact, defaulted recently. 

Despite these issues, Innovative's financial position remains stable. It ended the 2022 with $87 million in cash and equivalents. It has a 3.75% exchangeable senior debt note with a principal amount of $6.4 million due in 2024. Aside from that, it is debt-free. It has a manageable debt-to-asset ratio of 12%, allowing it to secure capital for future acquisitions.

Furthermore, Innovative has a long triple-net lease agreement with its tenants. Its weighted-average lease term is 15.3 years, indicating that it should continue to generate revenue for a while. With the cannabis industry expanding rapidly, Innovative should have little trouble attracting new tenants.

Fortunately, it already owns 110 properties in 19 states, all of which are fully leased. In the last five years, the company has increased its revenue and FFO significantly.

Chart showing Innovative's revenue and funds from operations rising since 2019.

IIPR Revenue (TTM) data by YCharts.

Innovative has tremendous opportunities ahead

Federal legalization of marijuana in the U.S. will probably happen over the next decade. The common assumption is that cannabis legalization will dent Innovative's business, as pot growers will have easier access to capital. However, this may not be the case. Legalization will broaden the market in the U.S. As a result, many smaller businesses may fail to meet certain financing criteria. In such cases, Innovative could help to them to grow their businesses.

At state-level, more states could legalize cannabis in the coming years. Cannabis could be fully legalized in Pennsylvania, Florida, Maryland, Ohio, and Minnesota this year, according to industry experts. That gives Innovative a lot of opportunity to grow further.

Average Wall Street estimates predict that Innovative's stock could surge as much as 75% over the next 12 months, and the stock is rated a strong buy. Innovative is an appealing pick for both growth and income investors because of its surging revenue and AFFO, consistent dividend payouts, and a strong balance sheet. So if you are looking to access an evolving industry, but while taking a far lower risk, it doesn't seem too late to buy this stock.