Real estate investment trust (REIT) Innovative Industrial Properties (IIPR -0.17%), which offers a huge 9.8% dividend yield, has a fairly simple business model. But the company depends heavily on the success of one industry, marijuana. For many years that was a net benefit, as the industry's success fueled the REIT's growth. The big end goal for the marijuana industry, however, could be a big problem for Innovative Industrial.
Huge growth
When Innovative Industrial held its initial public offering (IPO) in late 2016, it basically owned no properties. It used the cash from the stock sale to buy its first asset a couple days after the IPO. In other words, this wasn't a business that existed in any material form before it sold shares to the public. The IPO was based on the idea for a business model.
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Essentially, Innovative Industrial would buy properties from marijuana growers in sale/leaseback transactions. This would allow the grower to retain access to the property while providing the REIT with a new asset. Importantly, the tenant would be able to use the cash from the sale to invest in its business. The linchpin here was that the marijuana industry was still in its early days, so companies were investing heavily in growth.
Marijuana itself is hardly new. But the legal use of marijuana is. As more states legalized the drug, the growth opportunity increased. Innovative ended 2016 with one property, and at the end of the first quarter of 2023 it owned 108. The number of tenants in its portfolio rose from 1 to 29. And the number of states in which it owns property increased from 1 to 19. There's just one wrinkle here on the legalization front. While states have been moving toward legalization, marijuana is still illegal at the federal level.
This is big
Because of the complicated legal landscape, marijuana companies can have a difficult time accessing growth capital. Selling stock has been possible, but getting bank loans is a bit more problematic. Banks are largely worried about running afoul of federal rules, so they tend to avoid marijuana companies. Banks are a key source of capital for companies, particularly when it comes to things like construction loans and mortgages.
Innovative Industrial is basically filling the financing void left by banks. In fact, the sale and leasebacks it does often include capital that is meant for property improvements specific to the use of the property as a marijuana facility. That may not sound like a big deal, but marijuana growing is a complex task that requires expensive equipment and working through often difficult permitting processes and regulation.
Because of the limited options for capital, Innovative Industrial is able to demand fairly high lease rates. As more companies move into the space of providing capital to marijuana companies, lease rates will likely move lower. It's a basic supply-and-demand issue. So far the competition has been limited, with just a few other REITs providing similar access to capital.
But federal legalization could materially change the playing field, opening the marijuana sector up to hundreds if not thousands of new competitors. It would likely transition from a niche investment opportunity to a mainstream investment opportunity, with lease rates potentially plunging as it does. With no need to pay a premium for access to capital, few marijuana companies are going to do it anymore. There's no question that federal legalization of marijuana would be good for the marijuana industry, but it would likely put material stress on Innovative Industrial's business model.
Careful what you wish for
Innovative Industrial is already facing some headwinds as the marijuana industry faces growing pains, pushing some small tenants to stop paying rent. That's not shocking for an up-and-coming industry, and so far the REIT appears to be handling the headwinds relatively well. However, the end goal of federal legalization could turn out to be a bad thing for Innovative Industrial's current advantaged business model. The best outcome, in fact, would likely be continued legalization at the state level without legalization at the federal level.
