Innovative Industrial Properties' (IIPR 1.60%) stock has lost almost half of its value since hitting a 52-week high in October 2024. Wall Street is increasingly worried about the real estate investment trust's (REIT's) strategy. A large tenant default at the end of 2024 hasn't helped. Although there are reasons to be worried, the default and its quick resolution may actually highlight one of the strengths of Innovative Industrial's approach.
What does Innovative Industrial Properties do?
From a big-picture perspective, Innovative Industrial is an industrial landlord. It makes use of net leases, which require tenants to pay for most property-level operating costs and taxes. This isn't unique in the REIT sector. What is unique about Innovative Industrial is its focus on the marijuana sector.
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Because of the murky legal status of marijuana, with conflicts between state and federal regulations, many banks refuse to offer services to marijuana companies. Innovative Industrial has stepped into that void, providing financing to pot cultivators by purchasing their properties and leasing them back to the growers. The trick is that Innovative will also finance the highly specific upgrades needed to turn an industrial property into a grow house. In return, Innovative Industrial generally gets long lease terms with generous rental rates. The downside is that its tenants have hefty rent bills to cover, which isn't ideal considering how many businesses in the pot market are struggling.
What is going wrong with Innovative Industrial's business model?
Marijuana has been a growing industry for a number of years. However, it hasn't grown in the way that many of the early entrants had hoped. Competition has been fierce among the legal growers, and, at the same time, illegal marijuana sales have remained a material portion of the industry. As such, profits haven't been quite as robust as expected.
It is still early in the industry's development and growing pains are to be expected. That said, the company expects the legal U.S. cannabis market to reach $46 billion by 2028. That will make it larger than wine ($14 billion), beer ($37 billion), and spirits ($38 billion). So, there is plenty of potential for the industry as a whole. However, after an early land grab, individual players are likely to experience a shakeout. And that is what appears to be taking shape.
The latest example within Innovative Industrial's portfolio is PharmaCann, the REIT's biggest tenant. This grower occupies 11 properties and represents 17% of rent roll. This is a big hit, and investors are right to be worried. But it may not be as bad as it at first seems, a fact borne out by the fairly quick resolution of the default.
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Key Data Points
Why Innovative Industrial's situation is less bad than Wall Street thinks
The first fact to note is that a shakeout is normal for a fast-growing industry that has attracted a lot of early competitors. Innovative Industrial has long focused on having low debt, which will help it deal with the fallout from any tenant issues. To put a number on that, Innovative Industrial's debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) is roughly 1.4 times. Realty Income (O 2.95%), the largest net lease REIT, has a debt-to-EBITDA ratio of 5.7 times, and Prologis (PLD 0.43%), the largest industrial REIT, has a ratio of 4.3 times. Tenant defaults are bad, but Innovative Industrial's balance sheet likely has the depth to deal with a little adversity.
Then there's the lease model. PharmaCann defaulted on all 11 of its leases. However, it remains current on five of those leases. All 11 fell into default because Innovative Industrial included cross-default provisions in the leases. Thus, if a single lease defaults, all of the leases would be in default.
This means that PharmaCann didn't stop paying rent altogether. So, the default is bad news, but not as bad as it seems. But the really big benefit of cross-default provisions is that they give Innovative Industrial more power in the workout process. If PharmaCann wants to keep operating the five properties on which its rent is current, it needs to come to the table and cut a deal with Innovative Industrial for all of the properties. It can't simply walk away from the six on which it isn't paying. That increases the chances of a workout that is equitable, if not tilted in favor of Innovative Industrial Properties.
As it turns out, that's exactly what happened. PharmaCann is working with Innovative to sell two properties. It will continue to lease the rest with Innovative, which in turn is giving the company a slight rent reduction to help it through this period. However, along with all of this, PharmaCann has issued Innovative an interest-bearing note, which effectively helps to make up for the lost rental income. Innovative was also able to extract other concessions that should improve PharmaCann's financial position (an equity infusion by PharmaCann investors) or protect it from further troubles with this tenant (a refinancing condition related to PharmaCann's credit facility). All in, both companies had to give something up, but it looks like Innovative Industrial managed to get the better of the deal.
Innovative Industrial is not for the faint of heart
Innovative Industrial has always been an aggressive investment, given its focus on the marijuana sector. The current 10.6% dividend yield highlights the risk. However, the marijuana industry continues to expand, and Innovative Industrial is a key player in the market. For investors willing to take on risk, Innovative Industrial is probably worth a deep dive. And although recent events are worrisome, they are, perhaps, not as problematic as they at first seem.
