Wall Street loves a good story, often painting an entire industry with the same brush without looking more deeply at the individual companies. Sometimes the price moves, both higher and lower, can be dramatic. Marijuana-focused real estate investment trust (REIT) Innovative Industrial Properties (IIPR -0.17%) has experienced this on the upside and now the downside, with a roughly 70% drawdown from 2021 highs pushing the yield up to 9.7%. What's going on, and how safe is the dividend?
Real issues
The huge run-up on Innovative Industrial's price was helped along by the hype surrounding marijuana legalization. Effectively a new (or at least newly legal) industry, this REIT was one of the first companies to offer a funding alternative to the quickly expanding businesses in the space. This was accomplished via sale/leaseback transactions, which allowed marijuana growers to access cash locked up in properties so they could invest it in growth. With marijuana still illegal at the federal level, there are few banks willing to step in on the financing front.
Image source: Getty Images.
The problem is that, as is common in newly developing industries, the roster of companies competing expanded rapidly. But as the marijuana sector has matured, it has become clear that there may be too many competitors and, just as notable, illegal pot sales are still soaking up a lot of consumer demand. Investor enthusiasm has waned as even the strongest marijuana companies haven't lived up to early lofty expectations.
The problem for Innovative Industrial is that its lessees, mostly marijuana growers, are the ones facing tougher times. When that happens, and problems are large enough, tenants stop paying rent. The company has had to work with a couple of tenants in this regard, adjusting leases and selling assets.
That's clearly not good news, but it isn't actually all that uncommon for a REIT to have issues of this nature. The difference here is Innovative Industrial's laser-like focus on pot companies, which means that investors are probably right to be at least a little worried.
It's not so bad
Here's the thing -- the REIT was able to collect 98% of its rents in the first quarter. Obviously, 100% would be better, but management is clearly doing its best to ensure that it gets what is owed. And yet there are some negatives here to watch out for. For example, the company has been using security deposits to cover rent shortfalls for a number of tenants. If, perhaps when, those security deposits run out, the rental collection rate could fall some more. Still, Innovative Industrial is doing the heavy lifting to protect its top line and, so far, appears to be executing reasonably well.
A key factor in this effort is the nature of grow houses, which are fairly complex and specialized structures. They also require a lot of permitting "red tape" to build. So it isn't so easy for a marijuana company to just pack up and move to a cheaper facility. They have an incentive to try to work things out if they can.
And then there's the adjusted funds from operations (FFO) payout ratio, which stood at 80% in the first quarter. That's fairly reasonable for a REIT like Innovative Industrial and is in the middle of the board's 75% to 85% target payout range. If you use a stricter definition of FFO, the payout ratio rises to 87%. That's a bit more troubling but not so high that the REIT seems in danger of an imminent dividend cut.
Also, adjusted FFO rose 10% year over year in the quarter, so this isn't a situation where the REIT's performance is faltering. Of note, the company bought two assets in the first quarter and provided additional funding to a lessee for investment in an existing asset. Innovative Industrial, even as it is working to deal with a handful of troubled tenants (it sold four properties for which it was no longer receiving rent payments), is still finding investment opportunities.
Hard times, but not the end of times
It wouldn't be appropriate to suggest that Innovative Industrial Properties was a low-risk REIT. Its marijuana focus alone disputes that fact, but add in a small number of tenants that are having financial troubles, and you can see why Wall Street is concerned here. And still, the dividend doesn't appear to be at material risk, given the company's ongoing growth and its efforts to solve the few tenant problems it is facing. More aggressive investors shouldn't write this high-yield stock off, as it seems the dividend is still on solid ground.
