Innovative Industrial Properties (IIPR +5.47%) is unique among industrial real estate investment trusts (REITs) because it focuses on marijuana-related assets. There are a lot of differences when you compare it to a more traditional industrial REIT like Prologis (PLD 0.17%).
One key metric that is radically different is the average remaining lease term. Here's how different it is, and why it matters.
These deals provide companies with a source of cash
The warehouses Prologis owns and leases out are vital infrastructures that companies need to facilitate their business. While those same facts are true of the marijuana grow houses that Innovative Industrial owns and leases out, the sale/leaseback deals it inks are really about providing capital to companies that have limited access to it. That's largely because banks, fearful of the fact that marijuana is illegal at the federal level, aren't eager to provide cash to pot companies. This materially changes the dynamic when it comes to leases.
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The key number here is that Prologis' average remaining lease term is around four years. That's not atypical for an industrial REIT. In fact, it is probably a benefit today, because Prologis has been able to dramatically jack up rents on expiring leases. The company estimates that its rental revenue would be 68% higher if it marked all of its leases to market today.
Innovative Industrial's average lease length is roughly 15 years. That's a very long time compared to normal industrial leases, and even when compared to the leases of net-lease REITs, where the average lease term is often around 10 years or so. (Innovative Industrial uses the net-lease approach, which requires tenants to pay for most property-level expenses.) There are positives and negatives here.
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What does it mean?
Because Innovative Industrial is more like a financial partner than a service provider, it makes sense that the leases would be long-term in nature. Moreover, it is much more difficult and expensive to build a marijuana grow house than it is to build a typical warehouse. So marijuana companies want to be, and frankly need to be, in these assets for a long time. The risk here, however, is that Innovative Industrial is partnering with a company for an extended period, and that could open it up to more risk if the marijuana company falters.
That's a problem right now, with Innovative Industrial dealing with some tenants that have been having problems paying their rent. It appears to be handling the issue well, having collected 98% of the rent it was owed in the first quarter. But with the marijuana industry currently going through a shake out, there is the risk that it could have other, more important tenants that hit the skids too. With so much of its future performance dependent on those long leases performing as expected, the importance of each of its 29 tenants is much higher.
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On the other side of the spectrum, meanwhile, if the leases are getting paid, the company has a clear line of sight into the future. Add in regular rent escalations, and slow and steady growth could easily become the norm as the marijuana sector matures. Assuming Innovative Industrial navigates the industry shakeout well, the huge 9.7% dividend yield on offer today wouldn't look so risky under that scenario.
Then there's the issue of lease rollovers. That's a net benefit for Prologis today, because rent rates have risen and demand for warehouse space is fairly robust. But it also means that the giant industrial REIT needs to find new tenants when a lessee decides to vacate a property, which could be a problem if warehouse demand weakens. With longer lease terms, Innovative Industrial doesn't have the same opportunity to jack up rates to market rents (which probably wouldn't be a net benefit today anyway given the marijuana industry shake out), but it also doesn't have to find new tenants as frequently. Given the relatively modest size of the pot sector, that's probably a net win.
Different, not better
When you add it all up, Innovative Industrial's long lease terms are an important factor for investors to consider. It is a unique aspect of the industrial REIT relative to similar REITs in both the industrial and net-lease spaces. But it isn't all good or all bad -- the issue is more nuanced than that in a still-maturing property niche. For now, the benefits probably outweigh the negatives, but investors should keep the lease term issue in the back of their minds as they assess Innovative Industrial's results during the marijuana industry's shakeout.
