Innovative Industrial Properties Is Up 20% This Month. Was Wall Street Wrong?

The once-hot cannabis stock, Innovative Industrial Properties (IIPR -0.86%) went up in flames over the last year. Its share price plummeted 56% after a pending lawsuit, default from a major tenant, and general market volatility made investors and Wall Street worried about the future of the company.

Its latest third-quarter earnings far exceed analysts' expectations and as a result, pushed share prices up over 20% over the past month. Now, investors are rightly wondering, was Wall Street wrong about the future of this company, or is trouble still ahead? Let's take a closer look to see.

Is its stellar quarter really as good as it seems?

In the third quarter of 2022, Innovative Industrial Properties grew its revenues by 32% while increasing its adjusted funds from operation (AFFO), a metric that works similarly to earnings per share, by 24% since last year. This rate of growth was slightly slower than previous quarters, but still fantastic by all means. Its AFFO and revenues beat analysts' estimates by a notable margin.

Its stellar third-quarter earnings caught many investors by surprise. In July 2022, it announced the default of Kings Garden, its fifth-largest tenant by annual base rents (ABR). Wall Street and most others expected this to negatively impact its next earnings. But the company was able to offset its losses temporarily, applying part of the tenant's security deposit. So its true impact, assuming the default continues, hasn't been realized fully.

In regards to the rest of its portfolio, the company sold one property in Pennsylvania while acquiring one new property in Massachusetts in Q3 2022. In total it's acquired 9 properties this year, with 100% of its portfolio being occupied. Outside of its King's Garden default, roughly 97% of its tenants have paid rent and/or management fees for the nine months ended 2022.

Its problems aren't over, but it's got the bandwidth to recover

After its latest earnings, it does seem Wall Street and investors' response to the King's Garden default was blown a bit out of proportion. But strong quarterly earnings don't mean the company is completely in the clear. This cannabis real estate investment trust (REIT) still has a lot of challenges to overcome in the near term.

To start, it's still battling a class action lawsuit regarding its lack of transparency about potential default risks from its tenants. This case could take years before its resolved in court and will undoubtedly cost the company a lot of money. It also has the King's Garden tenant default to deal with.

The company has received a letter of intent to occupy one of the King's Garden properties, but there are still three other properties that will need to be released. The percentage of annual base rents King's Garden accounts for has fallen notably since the last quarter. Now making up just 1.9% of its annual earnings which lowers the impact of the default on its total revenues. Plus the company has a good mix of tenants across 19 states helping support its earnings. 

There are also long-term challenges for the company to overcome. President Joe Biden recently pardoned those convicted on a federal charge of marijuana possession. Some see this pardon as a move toward Federal legalization, which many believe will hurt Innovative Industrial Properties' business model.

Short-term challenges seem far more pressing than long-term concerns, but Innovative Industrial Properties seems well suited to overcome both. The company has $76 million of cash on hand with no major debt maturities coming due until 2026. And Innovative Industrial Properties offers a service that will continue to be needed in the cannabis industry even if it's legalized on a Federal level. 

The REIT's price is extremely favorable given historical pricing, trading around 14 times its AFFO while paying a roughly 6% dividend yield. Plus investors can rest easy knowing its dividend is safe for now as its dividend payout is 84.5%. The slowing cannabis market and general challenges it's facing in the near term likely mean the company won't deliver the impressive 35% average annualized return its produced since 2016. But I believe it should continue to perform admirably in the near future, making it a worthwhile buy for income investors today.