Innovative Industrial Properties, Inc.

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 3/5

Innovative Industrial Properties, Inc. is a real estate investment trust (REIT) focused on acquiring and managing properties leased to state-licensed cannabis operators for their cultivation and processing activities.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

IIPR’s business model centers around the regulated cannabis industry, where the federal illegality of cannabis creates unique operational challenges and barriers to entry for tenants, and it aims to capitalize on these factors by acquiring, owning, and leasing properties to state-licensed operators.

Business Overview

Innovative Industrial Properties (IIPR) operates as a real estate investment trust (REIT) focused on the regulated cannabis industry. Instead of directly engaging in the cannabis business, IIPR focuses on acquiring properties and leasing them to state-licensed cannabis operators for their cultivation and processing needs. Here’s a breakdown:

  • Revenue Model: IIPR generates revenue primarily through rental income from leases with cannabis operators, which are generally structured on a triple-net basis, meaning the tenants pay for property taxes, insurance, and maintenance in addition to rent.
  • Industry Trends: The regulated cannabis industry is marked by rapid growth and increasing legalization at the state level, yet federal illegality creates obstacles. This disparity introduces risks, such as limited access to capital and financial services for operators, but also opportunities for specialized investors like IIPR.
  • Margins: Given their triple net leases, the operating margins are highly dependent on the rental revenues. The company has a fairly consistent operating margin which is very close to the adjusted EBITDA margin. But due to their heavy growth through acquisitions, the profitability is highly correlated with their investment in property. In this case, for example, even though revenues were up from $156 million to $187 million the operating profit decreased from $106 million to $85 million. This is due to the fact the company had to write down losses because of one of its tenant’s bankruptcies.
  • Competitive Landscape: The REIT landscape in cannabis is characterized by few major participants such as Innovative Industrial Properties, NewLake Capital Partners, and others who try to take an advantage from the difficult and unusual market that the cannabis market present. Also, there may be new entrants into this field over time.
  • What Makes IIPR Different? IIPR’s approach differs from many real estate and traditional REIT companies, it is heavily specialized in the cannabis industry, and as the industry is still relatively new, this is a risk but also a reward.
  • Other Relevant Details: The company emphasizes long-term leases, with weighted average lease terms of around 15.5 years, providing consistent and predictable cash flows. It also typically finances new investments by issuing equity and debt, which is reflected by the balance sheet.

Moat Analysis: 2/5

IIPR is operating in the specialized market for the real estate needed by the cannabis industry, and this is creating some form of moat but it is not strong enough and has problems. * Network Effects: No. The network effect does not apply to their business model, other operators do not become more valuable by the addition of a new tenant. * Switching Costs: Moderate. It’s difficult for tenants to relocate because they need to get a specific license for each address. However, there are other REITs available in the industry, meaning that the cost of switching it is not too high. In other words, customers might be likely to switch to a competitor if the costs are low enough. * Intangible Assets: No. IIPR does not have a proprietary formula, brand or patents that makes it different from others. * Cost Advantages: No. The cost of their debt and equity financing is quite similar to others in the industry. * Size Advantage: Moderate. IIPR is one of the most dominant players in this sector. This gives them a scale that is hard to replicate by competitors and enables them to have better relationships with sellers and with tenants.

Risks to the Moat and Business Resilience

Several risks can impact IIPR’s moat and business resilience:

  • Regulatory Risk: Changes in federal or state cannabis laws can significantly affect IIPR’s tenants. For example, if federal prohibition ends, more operators may be able to get access to capital, and the competitive landscape may change significantly.
  • Tenant Credit Risk: Although IIPR does their due diligence when taking on new customers and tenants, the companies that are doing business in this sector are relatively small and young, with the average business being younger than 10 years old and most of the time unproven with long-term profitability. Financial distress or bankruptcy of tenants can lead to vacancy and rental losses. There’s been already losses because some tenants defaulted.
  • Concentration Risk: IIRP’s high concentration in cannabis real estate and its dependency on a single sector creates high concentration. A down turn in the legal cannabis industry could seriously hurt IIPR’s revenues and value.
  • Competition: The REIT landscape is constantly changing with new entrants coming in. This leads to tighter competition and better offers.

Financials Analysis

Here’s an in-depth look into IIPR’s financials, referencing the latest reports:

  • Revenue Growth: IIPR has consistently increased revenues but has recently shown a slow down in revenue growth. From 2019 to 2021 they had an annual growth of more than 50% but the last year shows an increase of only 35% showing a slowdown in growth. Furthermore, they need to take higher losses into account, thus leading to reduced margins. The recent growth is mainly based on the acquisition of new properties.
  • Profitability: While gross profit margins are high, the net profits are highly unstable and are heavily influenced by the impairment of their investments. The company needs to maintain revenue growth, operating efficiency, and low-cost financing to maintain high profitability.
  • Cash Flow: IIPR has traditionally had a strong cash flow but this has been negatively impacted by the defaults of some of their tenants.
    • Liquidity: Cash is 349 million.
    • Operating cash flow: 155 Million, a drastic drop from the previous quarter.
    • Debt: Total debt is $1,494 million, almost 50% of the total capital used by the company. The leverage is considerable.
  • Capital Structure: The capital structure of IIPR is heavily reliant on debt financing, which could increase the risks of interest rate hikes and other risks. Equity dilution is needed when the company issues stock in order to make new acquisitions. This increases the shares outstanding and reduces the per share value of their stock. In other words, if they cannot find deals that can raise the revenue, they are losing the money of their shareholders. The weighted cost of capital for Home Depot is calculated as the total interest rate and cost of equity with the appropriate weighing in the company’s balance sheet. This might be difficult for a retail company like Home Depot, but more or less standard for an REIT such as IIPR.
  • Other pertinent financial metrics:
    • EBITDA: $133 million
    • Operating Profit: $85 million
    • Net Income: $26 million
    • Book Value: $8.62 billion
    • Diluted EPS: 0.99
    • Revenues: $187.5 million
    • Debt to equity: 1.36

Understandability: 2/5

While the concept of leasing properties to cannabis operators is easy to grasp, a full comprehension of IIPR’s business model is complicated because of the nature of the cannabis industry, the intricacies of their leases, and the heavy reliance on various financial instruments.

Balance Sheet Health: 3/5

IIPR’s balance sheet shows a mix of strengths and weaknesses. While they hold a substantial number of assets (almost 3 Billion), a growing debt burden, high dependency on debt financing, and the need for high growth and high acquisition rates, make the balance sheet volatile and prone to risks.

Additional Notes:

  • Recent Earnings Calls: Management has acknowledged the high sensitivity in the market to bad news and has said that they will start communicating more about their underlying values. They also mentioned that they will continue to diversify their customer bases and their properties and said that the recent market instability does not reflect their intrinsic value. Furthermore, there was a lot of questions from analysts during the earnings call, in regards to a decrease in revenues, and increase in risks, and lower earnings per share, due to the fact, some tenants defaulted.
  • Recent controversies: During the last few quarters, a couple of the tenants of IIPR went bankrupt. This is a problem for the company as it loses the rental income and will probably be required to make some adjustments to their properties before leasing it to a new customer.