Reform to federal cannabis laws continues to move in a positive direction. It’s just about impossible to miss as the data – and the subsequent opportunities – stacking up.
There are 33 U.S. states and the District of Columbia offering some level of legalization.
Agencies like the U.S. Food and Drug Administration are fast-tracking cannabis-based pharmaceutical research and testing, even approving one product (Epidiolex by GW Pharmaceuticals) that has since been rescheduled by the U.S. Drug Enforcement Administration. It’s now a Schedule 5 drug, alongside of Robitussin AC, instead of on Schedule 1, which includes heroin.
And a majority of likely Republican voters support legalization in a host of polls.
Yet, there federal illegality continues to leave a number of obstacles in place for cannabis businesses… two of the biggest being access to capital and tax relief.
Cannabis companies find it difficult or even impossible to borrow money because of federal banking regulations. What that means is that they have to build their growing operations with equity capital, which can seriously damage the company’s return on equity, a key profitability measure.
On the tax side, provision of the tax code called 280E hold back any company that produces or sells a product on Schedule I of the Controlled Substances Act…
Relief may be on the way from the U.S. Congress in time. Among the 70 active legislative proposals in the House and Senate during the current session, several would address these banking and tax codes. However, several of these efforts remain stalled and, even upon passage and a presidential signature, it will take time for the effects to make their way to companies that need it.
And there’s the beauty of an industry as creative as cannabis is: when a problem exists, someone with intelligence, an innovative spirit, and a little bravery crafts solutions to big problems.
One company does just that for the banking and tax issues. And for many reasons, it’s worth adding to any cannabis portfolio.
Innovative Industrial Properties, Inc. (NYSE: IIPR)
Innovative Industrial Properties (NYSE: IIPR) is a rarity in the cannabis business: It is profitable, pays a dividend, and has been traded on a major U.S. exchange for more than just a few months.
Innovative Industrial Properties is a real-estate investment trust (REIT) focusing on medical-cannabis growing facilities. A REIT is a special form of company which does not pay income taxes; in exchange for that privilege, it must distribute substantially all of its income as dividends.
Innovative Industrial buys growing operations from established cannabis companies and leases the spaces back to those proprietors.
These deals create a huge, and typically needed, influx of cash for the cannabis companies. They can then invest in various areas critical for growing its business – inventory, sales staff, marketing, even new facilities.
For Innovative Industrial’s part, the company gets an above-market return on real estate leasing.
Leasing a property instead of owning it also allows a cannabis company to create a string of tax-deductible payments instead of creating depreciation, which is more troublesome to deduct. It is particularly difficult for smaller companies that use cash accounting instead of Generally Accepted Accounting Principles (GAAP).
One Million Square Feet in Sight
Through fall 2018, the company owned nine properties in seven states… all leased to medical cannabis growers. Innovative Industrial had 875,000 rentable square feet.
IIPR minimizes operational risk by purchasing properties that are already in use or under construction. The company avoids building any growing operations “on spec,” which is to say they don’t build anything in hopes to lease it out later.
The company, however, has entered into deals where Innovative purchases a piece of property and custom-builds a facility to suit an intended customer. Our researchers expect this form of deal to increase for IIPR as industry growth demands larger and more complex construction projects.
The company’s properties are generating an average 15% yield. That’s more than 50% better than the average commercial real estate investment.
Currently, Innovative Industrial leases exclusively to customers in the medical cannabis industry.
However, Massachusetts recently legalized cannabis for recreational use. NICI believes that both of IIPR’s tenants there will sell to the recreational market.
Similarly, NICI expects New York to allow recreational use soon, as well… those tenants will surely seek permission to sell into the recreational market.
Finally, Innovative Industrial is currently in negotiations to acquire a property in Colorado. Colorado boats one of the most robust adult-use cannabis markets in the country. Accordingly, we expect IIPR to adjust its stated strategy of leasing only to medical cannabis growers.
That change would increase their total addressable market.
Cash is King in Cannabis and Real Estate
Following a recent equity issuance, IIPR has more than $200 million of cash and short-term investments on its balance sheet to make acquisitions. Those funds will go toward more properties with a similar return profile, more than doubling its invested capital. After that, the company’s options increase.
Innovative Industrial also carries no debt.
And because the company does not directly deal in cannabis, raising debt will be an option, going forward. Given the company’s high returns on leasing compared with the cost of debt, taking on some leverage would substantially increase the company’s return on equity.
Alternatively, the company could take a more conservative position, raising equity when the stock is high. This route would be less lucrative for new shareholders, but it would still be good for existing shareholders at the time of the capital raise. That’s because the new money would be coming in at a higher price than previous investors paid.
Because the company leases its properties on a “triple-net” basis -tenants pay for everything involved in operating the property – Innovative Industrial’s operating expenses grow slower than property rents, increasing profit margins.
The high returns and fast growth of Innovative Industrial will allow the company to increase its dividend over time. Unlike most cannabis companies, where revenue and eventually profit growth are the stories and dividends are not even issued, dividends are the main attraction of the REIT world.
So, an increasing dividend tends to indicate an increasing stock price.
As a company that will be producing profits and even dividends right from the beginning, more traditional value metrics apply to Innovative Industrial than to most cannabis businesses. And there’s good news on that front.
Despite the stock more than doubling over the past 12 months, Innovative Industrial remains an attractively priced stock compared with its growth trajectory.
Management seems well-suited to the task of growing the company. The executive chairman and much of the management team previously built a REIT dedicated to the biomedical industry, which has similar regulatory and zoning problems.
They sold that company for more than $8 billion.
An $8 billion deal is a tall order for Innovative Industrial. But the company has a highly profitable real estate niche in the cannabis industry, a huge pile of cash to put to work, a growing dividend, and a management team with proven REIT success.
All of that makes Innovative Industrial one of the lowest-risk ways to invest in the cannabis sector.
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