The net lease business model used by Innovative Industrial Properties(NYSE: IIPR) is hardly unique. What sets it apart from other net lease real estate investment trusts (REITs) is its focus on the marijuana industry. That was a selling point for the stock at one point, but it is now a reason for investors to be worried. But how worried is the real question.
Same model, different industry
There are a lot of net lease REITs out there, and they all use the same basic approach. A company with a property sells it to a REIT and then instantly leases it back. The lease includes the requirement that the tenant pay for most property-level expenses. Why would a company do this?
It costs a lot of money to buy a property, which ends up tying up cash that could be used for other purposes. That might include investing in growth initiatives or simply fortifying the balance sheet. Selling the property and then leasing it back frees up that cash while still ensuring that the company has access to the asset. Agreeing to pay for most property-level expenses, meanwhile, ensures that the property is maintained to the tenant's required standards.
The REIT benefits from expanding its portfolio. Net leases are also generally fairly long term in nature, so it also locks in what is expected to be a reliable tenant. It's pretty close to a win/win, with investors benefiting from the opportunity to own a reliable dividend-paying stock and, hopefully, dividend growth over time driven by regular rent increases. Innovative Industrial's marijuana grow house focus, however, adds an important wrinkle.
Marijuana was hot, and now it is not
While legal in many states, marijuana remains illegal at the federal level. So many banks are reluctant to work with pot companies, limiting their access to capital. Innovative Industrial has happily stepped into that void, with little competition allowing it to charge sizable rents in its lease agreements. The REIT's tenants have used the cash to push the accelerator on growth in what is a relatively new industry.
The story was very good for a while, with investors bidding up the prices of marijuana-related stocks. But as is common in new industries, there were too many companies rushing in. And now there's a shakeout, with companies struggling to live up to the upside expectations investors once held. Stocks throughout the sector have cratered, including shares of Innovative Industrial. The fear was that its tenants would struggle and not be able to pay their rent.
That has, in fact, been one of the outcomes. In the second quarter of 2023, the REIT's rental collection rate was 98%. That's up one percentage point from the low point of 97% in the first quarter. That doesn't seem so bad, but it hints at the problems facing the industry and the REIT. So far, it has mostly been smaller operators that have been struggling. And right now Innovative has been able to use deposits to offset rental shortfalls. That can only go on for so long. Rental collection rates may dip further from here, but, still, most tenants continue to pay the REIT in a timely fashion.
That said, management isn't sitting by and doing nothing. The portfolio contained 110 properties at the end of 2022, and by mid-2023 was down to 108. It has been selling assets that either have tenants to which it wants to reduce exposure or that have been outright vacated by the tenant. It was also able to release a development property to a new tenant in the second quarter. These are the right moves, which all other REITs make, and there are likely to be more such actions in the future as management works to deal with the relatively small number of tenants it has that are still struggling to pay their rental obligations.
This is not the end of the world
What's interesting here is that, despite the headwinds from troubled tenants, Innovative Industrial Properties was able to grow adjusted funds from operations (FFO) by 5% year over year in the second quarter of 2023. That's a slowdown from previous growth rates, but it suggests that the marijuana industry pullback isn't impacting this REIT as badly as investors might be fearing, given its ultra-high 9.4% dividend yield. It seems to be handling the industry's shift fairly well so far.
There are clearly reasons to be worried here. Since this is the first true test of the REIT's business model, there's no history to go on. But for more aggressive investors, the company's ability to handle the headwinds in relative stride might be a sign that this high-yield REIT is worth the risk.
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