Is Innovative Industrial Properties a Buy?

The notoriously struggling marijuana industry doesn’t provide much fertile ground for growth. Despite this, weed real estate investment trust (REIT) Innovative Industrial Properties (IIPR 0.44%) has been rather successful as a landlord to pot growers, processors, and retailers.

Note the past tense — has been. Earlier this year, Innovative was hit with its first-ever tenant default, and given the privations of the weed business, this likely won’t be its last. Until now, the REIT had been one of the very few compelling marijuana-sector buys for many investors and analysts. Let’s look at the current state of the company to see whether that still holds true.

Rent collection downer

Innovative announced the default, specifically by a tenant called Kings Garden that leases six of its California properties, in mid-July. Understandably, that rattled investors, and the company’s stock price has yet to fully recover from the blow.  

Compared to more traditional REITs, Innovative isn’t very large. Compare its operations with that of, say, monster retail REIT Realty Income (O -0.11%). In 2021, Innovative took in just over $409 million in revenue on an asset base of nearly $2.1 billion. Those numbers for Realty Income are, respectively, slightly under $2.1 billion and $43 billion and change.

A default from a six-property tenant would barely cause a ripple at Realty Income. For Innovative, it’s a bigger headache. When added up, the base rent plus the other operating expenses and fees Kings Garden is obligated to pay amounted to roughly $2.2 million for July alone. All told, the half-dozen properties comprised 8% of the REIT’s rental revenue for its second quarter.

According to Innovative’s latest utterance on the situation (within the 10Q regulatory filing for said quarter), it has brought a lawsuit against Kings Garden, claiming breach of contract and seeking financial relief. So the resolution of the matter might take some time, cost the REIT quite a bit of money, and is not guaranteed to have a satisfactory ending.

It might also not be an isolated incident. This past April, a short-seller called Blue Orca Capital disclosed a short position in Innovative, describing the company as “a marijuana bank masquerading as a REIT” due largely to its habit of entering sale-leaseback deals with cash-strapped weed businesses. One of these is a tenant called Parallel, which Blue Orca claims was sued by a group of its investors earlier this year for securities fraud and has defaulted on $350 million worth of its debt.

As per that 10Q, Parallel held four leases comprising around 10% of Innovative’s total rental revenue.

Still growing like a weed

We should bear in mind, though, that defaults are part of life in the real estate world and, by extension, for REITs. They usually aren’t business killers for operators of any scale. Yes, Innovative is small compared to the Realty Incomes of this world, but it’s still large enough to support a 110-property portfolio that helps bring in revenue steadily marching toward the $500 million-per-year mark.

Also, while the marijuana industry is facing many challenges, there’s no shortage of weed companies in the U.S. Those companies need suitable properties to grow and process their product, and cannabis-specialized facilities aren’t commonplace. And, because of widespread public support, time will tell if weed is decriminalized at the federal level once the national politics evolve sufficiently.

All this is to say that if worse comes to worst and a tenant drops off the portfolio list, it’s easy to imagine that another pot company will be happy to move into one or more of its properties.

So far, Innovative is a big question mark regarding its handling of tenant defaults; the impact on its fundamentals is similarly uncertain. We’ll get a sharper picture of this as the Kings Garden situation develops. While it does, though, we’d do well to remember that the company is still on a growth path.

All told, Innovative’s second-quarter revenue improved by a robust 44% year over year to more than $70.5 million. Adjusted funds from operations (AFFO), the key profitability metric for REITs, saw a nearly 40% rise to just over $60 million, or $2.14 per share. That’s more than enough to cover the company’s latest quarterly dividend of $1.75 per share, which, by the way, yields nearly 7% these days.

A sub-7% figure qualifies as a high-yield dividend, and this, of course, implies some risk. Investors remain spooked about the Kings Garden default, and they’re right to be. However, I think what Innovative offers is compelling enough to win replacement tenants without too much pain (assuming no agreements/settlements are reached with defaulters). I’d feel safe investing in the company’s stock during this bearish period of uncertainty.