Cannabis real estate investment trust (REIT) Innovative Industrial Properties (IIPR 2.21%) has had a wild year. Like most other stocks in today's bear market, pessimism surrounding the economy and the likelihood of a recession have pushed shares down notably.

Things only got worse for the company when a class action lawsuit was filed against Innovative Industrial Properties in April. Shortly after, it announced the default of one of its major tenants, Kings Garden, which resulted in a massive sell-off.

The REIT was rebounding nicely at the end of 2022, but a recent update on its operating, capital markets, and investment activity revealed several new tenant defaults. In turn, the stock started sinking again.

Does its latest round of tenant defaults spell trouble for the company or can Innovative Industrial Properties overcome these challenges quickly? Let's take a look.

What's going on

Innovative Industrial Properties (IIP for short) released an operating, investment, and capital markets activity update for the fourth-quarter and full-year 2022 on Jan. 18, 2023. The report announced the default of three tenants: Parallel, Skymint, and Vertical. The companies have defaulted on one or more properties leased in Pennsylvania, California, and Michigan. But as of now, they are paying for the remaining properties leased from IIP.

The REIT also executed lease amendments to defer or avoid defaults for two additional tenants in California and Michigan leased to Holistic and for a property in Missouri leased to Calyx Peak. Holistic is receiving the application of its security deposit for the first nine months of 2023 while Calyx is receiving a deferment of its base rent with a pro-rata payback starting in April 2023.

The announcement also provided an update on the Kings Garden default. IIP has applied a portion of the tenant's security deposit to meet its contractual rent obligations through the third quarter of 2022. Kings Garden is paying rent on the four properties it's occupying in California and exploring merger options to help meet its current lease obligations.

In total, these six tenants account for around 11% of Innovative Industrial Properties' invested capital.

Many investors see the increase in defaults as a sign of the challenges and the weakening foundation of cannabis operators in today's economy. Complex legal structures that vary from state to state make it increasingly difficult for operators to turn a profit. Add in high inflation, which has increased costs for many producers, and it's easy to see why defaults could be increasing.

So what?

How this will affect the company's balance sheet isn't fully known yet as its update did not give guidance on the default's impact on key metrics of profitability like funds from operations (FFO) or net income. It did share that 100% of its properties are occupied and 92% of its rents were collected through January 2023.

Its upcoming full-year and fourth-quarter 2022 earnings report will provide more insight into how severe these impacts are for the company. For now, investors can only speculate on how damaging this can be.

As of the third quarter, when only one tenant had defaulted, its net income and FFO were down quarter over quarter but still up year over year. Defaults making up roughly 11% of its invested capital aren't insignificant, but it's also not enough to sink the company.

Innovative Industrial Properties doesn't have any major debt maturities due until 2026. That means it has significant time to get its affairs in order by releasing properties to new (paying) tenants or restructuring agreements to get existing tenants paying again. It also has $76 million of cash and cash equivalents on hand and low debt ratios. Meaning it's got the money to cover its dividend payouts for the foreseeable future.

I also don't see the need for IIP's services drying up anytime soon. Legislation on financial cannabis reform and legalization of marijuana on the federal level are in the works, but still a very long way from becoming law. Until then, cannabis operators that need liquidity will continue to rely on private financing or companies like Innovative Industrial Properties.

I've been an advocate of IIP for years now and plan to hold my shares in the company for the long haul. I definitely would love to see fewer defaults by its tenants, but I believe the REIT can withstand the current challenges and come out as a stronger company years from now.

If you have a high tolerance for risk and are looking for a high-paying dividend stock, IIP can be a worthwhile investment with its 8.1% yield. If you're looking for a slightly safer bet considering the challenging environment for this operator right now, it might be worthwhile to wait before investing.