Description

IIPR: an opportunity to short both the cannabis bubble and its real estate that I believe will ultimately likely be nearly as worthless as Class B/C malls. I believe fair value is >40% below current levels

Company Overview

Innovative Industrial Properties, Inc (“IIPR” or the “Company”) is a REIT that acquires specialized industrial properties used for cannabis cultivation that are leased to state-licensed cannabis operators on a triple-net lease (“NNN”) basis. IIPR was founded in 2016 by Alan Gold, who led BioMed Realty Trust before it was acquired by Blackstone.

As of 11/6/19, IIPR owned 41 properties across 12 states (AZ, CA, CO, IL, MA, MD, MI, MN, NY, NV, OH and PA) totaling 2.8mm rentable sf. IIPR has acquired these properties for $410mm and has committed an additional $139mm (excluding $64mm of tenant option funds) for development / redevelopment of these properties. IIPR currently earns a 13.8% rental yield on its invested capital.

IIPR has been extremely acquisitive in 2019 as it has deployed / committed ~$325mm of capital thus far this year. As a result, IIPR’s stock is up 88% YTD while the HMMJ index is down (25%) over the same period. IIPR has benefited from a significant (and unsustainable in my mind) spread investing as it has been acquiring properties at low double digit cap rates, while it has been able to issue equity at mid-single digit implied cap rates. IIPR’s TEV amounts to ~93% premium to its deployed and committed capital.

Lack of Residual Value

Cannabis cultivation in the U.S. is extremely capital intensive as current law, specifically the federal prohibition on interstate commerce for Schedule 1 drugs, mandates cultivators to build cultivation facilities in each jurisdiction in which one operates. As an example, IIPR owns PharmaCann properties in NY, MA, PA, OH and IL as well as Vireo facilities in MN, NY, PA and OH. IIPR’s cost basis in its portfolio is in excess of $220 per sf. The vast majority of this cost is cultivation specific (lamps, CO2 generators, hydroponic systems, etc) to carefully control conditions in northern climates. The average facility in the IIPR portfolio averages ~90k sf at a cost of nearly $20mm.

This has resulted in a network of what I believe will become subscale, single purpose, white elephants when the barriers on interstate cannabis commerce ultimately come down. There have been recent efforts to end this prohibition.

While indoor cultivation costs upwards of $400 – 800 per pound, in more hospitable climates, such as Colombia, outdoor/greenhouse cannabis can be produced at a small fraction of that. The large Canadian operators have recognized this as an existential threat and invested in South American operations as a way to hedge their cultivation bets.

Were the Schedule 1 designation to be removed, paving the way for interstate cannabis commerce, I believe that cannabis will be produced in larger scale, warmer southern climates (even if the US ultimately shuts the door on Colombian cannabis). I believe the ultimate effect of this would be to make IIPR’s portfolio of cultivation assets obsolete and uneconomic. While I do not expect imminent changes at a federal level, especially during a Trump administration, I think there is a reasonable likelihood that there is change at a Federal level within the weighted average life of IIPR’s portfolio (~15 years)        

Tenant Credit Quality

Since IIPR’s leases come with corporate guarantees, one could argue that the lack of residual value might not matter that much if you had high quality tenants. Unfortunately that is not the case for IIPR. 

As it currently stands, US based cannabis operators are effectively shut out of traditional debt capital markets. Part of the reason for this is due to the fact that U.S. marijuana companies lack access to federal bankruptcy protection leaving creditors looking to foreclose on delinquent borrowers in ambiguous legal position.

IIPR is not immune to this since as there is no distinction between cultivators and their landlords:

With respect to landlords that lease space utilized by marijuana companies, it is unlawful to “manage or control any place, whether permanently or temporarily, either as an owner, lessee, agent, employee, occupant, or mortgagee, and knowingly and intentionally rent lease profit from, or make available for use, with or without compensation, the place for the purpose of unlawfully manufacturing, storing, distributing, or using a controlled substance”

Unlike regular reorganization, where creditors can use the debtor’s assets once they get control of them, there are significant restrictions on the transfer of state cannabis licenses. Thus, even if IIPR can get its hands on its supposed collateral through a state receivership, it is left with a cannabis cultivation facility that it must then go get a license to operate (or sell to someone who has a license, limiting the buyer pool).

This risk has come to the fore sooner than expected in the form of the DioneyMed receivership. In July, IIPR acquired DioneyMed’s LA facility for $15mm, signing a 15 year lease with DioneyMed. Less than 4 months later, IIPR finds itself without a tenant for a property that generates 2.6% of total IIPR’s rental revenue and at the mercy of the receivership.

Consequently, even though IIPR’s sale leasebacks can be viewed as relatively expensive debt for cannabis producers, it is expensive for a reason. While there have been very few examples of traditional debt financing in the sector, Green Thumb (“GTI”), which is larger and has better assets than any of IIPR’s tenants, raised 2 year senior secured financing in May ’19 at 12%. IIPR on the other hand is extending unsecured credit to less creditworthy tenants at ~11%. While PharmaCann’s financials are not public, is it doubtful that any of IIPR primary tenants produce any meaningful amount of EBITDA, much less free cash flow, making traditional REIT tenant credit quality metrics such as rent coverage inapplicable at this point. While we are here, it is worth noting that EBITDA is an extremely flawed cash flow metric for US cannabis companies due to 280E provisions that severely limit deductible expenses that will result in much higher effective tax rates than for pretty much any other type of business. As an example, Trulieve, a multi-state operator (“MSO”) with whom IIPR has recently executed sale leasebacks for its MA and FL facilities at 11% cap rates, generated ~$50mm of Adj. EBITDA for 1H ’19 but with ~$39mm of income tax expense as the Trulieve quotes its tax rate (27%) as a percentage of gross profits. Thus while, IIPR is effectively lending to Trulieve on an unsecured basis at 11%, Trulieve must borrow on a senior secured basis at 9.75% plus warrants.

Additionally, while IIPR was a first mover in the cannabis real estate space, at its core, IIPR is simply a financing provider and has no durable moat. As fast money has poured into many parts of the cannabis sector, real estate is no exception and IIPR has invited copycats that has driven down rental yields (as an example, the Company’s first deal with PharmaCann was done at an ~17.2% initial rental yield while a more recent deal with PharmaCann was consummated at a 10.6% yield). Treehouse Real Estate Investment Trust and GreenAcreage Real Estate Corp have each raised >$100mm in private placements this year to pursue the same strategy as IIPR while Inception REIT, appears to be close behind. The days of IIPR naming its price are over and it must increasingly be cheapest cost of non-equity capital for MSOs in order to continue to expand the portfolio at the expense of future credit quality.

Compared to Other NNN REITs

Despite the aforementioned challenges compared to traditional NNN REITs, IIPR trades in-line with than pretty much all other NNN REITS beyond Realty Income and National Retail Properties. 

What is IIPR Worth?

Given the aforementioned risks, I think an investor in IIPR should require a double digit dividend yield. This would equate to a cap rate >11%, which is comparable to where IIPR’s recent deals have gotten done and thus pretty close to “NAV” / invested capital. In order to get there, IIPR has 40%+ downside from current levels.   

Appendix: Capital Structure

Risks to Short

Continued ability to issue equity a significant premium to NAV

Continued Federal Prohibition / Scheduling of Cannabis

Levering up to add additional NOI (though probably positive for short in long run)

Catalyst

Poor DioneyMed receivership outcome / additional tenant credit issues

Net flows out of the cannabis space