January 6, 2021
Picks & Shovels Play in the Cannabis Sector

In my previous post I explained how I believe we can derisk our exposure to fast growing areas of the market by investing in the ‘picks and shovels’ providers to the trend. Today I would like to tell you about one example of a US listed stock - Innovative Industrial Properties - which provides a safer picks and shovels’ way to benefit from the growth and deregulations of the cannabis sector.

Cannabis Industry Growth Statistics

The Cannabis Sector is one of the themes that we in the Pynk Investment Committee feel has attractive growth prospects. Since its deregulation, the marijuana industry has been on the rise both for recreational and medical purposes. It has an above-average growth rate compared to other industries as more states and countries approve the product both for medicinal and recreational uses. According to Arcview Market Research , over the next 7 years, the legal cannabis industry will continue to deregulate and grow around the globe to hit $57 billion by 2027. The adult-use (recreational) market will cover 67% of the spending; medical marijuana will take up the remaining 33%.The largest group of cannabis buyers will be in North America, going from $9.2 billion in 2017 to $47.3 billion a decade later The largest growth spread, however, is predicted within the rest-of-world markets, from $52 million spent in 2017 to a projected $2.5 billion in 2027.

IIPR research cannabis sector investing blog Pynk community

Innovative Industrial Properties

IIPR offers a robust picks and shovels business model benefitting from the long term growth of the Cannabis sector but also offering recurring income as well as property and yield value support

IIPR stats cannabis sector investing blog Pynk community
Source: Company’s result presentation

Innovative Industrial Properties (“IIPR”) is a large cap ($3bln, share price $154) real estate investment trust (REIT) focused on the acquisition, ownership and management of specialized industrial properties leased to state-licensed operators for their regulated state-licensed cannabis facilities. It acquires properties through sale leaseback transactions and third-party purchases. The Company partners with medical-use cannabis operators and serves as a source of capital by acquiring and leasing back their real estate assets. The Company now owns 63 properties in 16 states with $126.1 million in annualised revenues, totaling approximately 5 million rentable square feet. Its tenants include major cannabis companies such as Curaleaf Holdings, Trulieve, Cresco Labs, and Green Thumb Industries. Two important factors behind the stunning success of the business model to date are the company’s very much in demand and profitable sale-leaseback programme (which allows cannabis producers with little capital to grow faster) as well as IIPR’s long-term triple net leases (which offer very high and relatively secure long term recurring returns).

IIPR map graphic cannabis sector investing blog Pynk community
Source: Company’s result presentation

Investment Case

The key drivers behind the continued growth of the cannabis sector are easy to identify: continuing deregulation and new applications for cannabis within an ever-growing range of medical ailments. But the sector itself has been extremely volatile as a wall of capital was deployed by a long list of cannabis producers vying to land grab their market share and this led to short term overcapacity, decimating crop prices and growth projections. The pandemic of course exacerbated the downturn.

In line with my minimising risk approach, I typically invest in high growth/high profile trends through ‘picks and shovels’ providers, and in this industry therefore, I have been a long-term holder of IIPR. In my view, the shares offer the best of both worlds: as marijuana deregulation continues apace, their clients need new growing facilities in newly deregulated states while being a REIT, 90% of income is paid to us as shareholders every year. In fact this more robust and lower risk business model meant that IIPR emerged pretty unscathed from the downturn in the sector over the past couple of years, continuing to grow at breakneck speed in fact. It has already established its relatively large market position thanks to its first mover advantage with as yet no direct competitors (though they will inevitably come for sure).

As such, the company continues to be in a great position to benefit from the sector’s attractive long term growth prospects and offers a very attractive recurring earnings profile through its long-term leases (typically 16 years). Although the stock is exposed to the cannabis sector, in my opinion the most important part of their offering is that they provide an attractive source of funding to fast growing cannabis growers. In the current land grab phase of this industry, sale and leaseback is popular as a great many of marijuana producers are unprofitable and cash poor, and thus hungry for a ready source of capital.

Sale & Leaseback Model

(Sale Leaseback Program - Innovative Industrial Properties)

One of the benefits for IIPR’s customers is that they allow cash strapped fast growing cannabis growers to free up capital and grow faster. In a way this company fits with another very strong trend I have seen: the emergence of niche alternative funding providers disrupting existing capital raising models. As banks have retrenched due to low interest rates and anemic growth prospects, a number of very profitable capital provision niches have sprung up where first movers are enjoying very high profitability.

The other attraction of IIPR is that it typically collects rent in triple-net leases, which push most costs – such as taxes, insurance, and utilities – to the renter. There’s stability built into the model, as the average age of the leases is more than 16 years. Meanwhile, the company’s debt-to-total-gross-assets ratio is a solid 12%. IIPR tenants pay eye-wateringly high annual yields - in the region of 10-11% - with service and administration charges taking yields up to 15% for the very smallest customers.

The resilience of the business model was clearly demonstrated by the lack of problems following the ‘perfect storm’ of negative conditions in the cannabis sector over the past year: despite massive overcapacity in the crop, closure of dispensaries due to COVID lockdown as well as some caution entering into the pace of deregulation, IIPR’s results remained nothing short of stunning: in the second quarter (eye of the Covid storm), the company announced revenue of $24.3 million, an increase of 183% year over year. It now boasts 15 consecutive quarters of increased revenue and 13 consecutive quarters of increased earnings. IIPR keeps adding to its portfolio, buying industrial and greenhouse buildings, and has quickly found tenants for its new properties. I feel the company’s resilient performance through this severe short term sector downturn perfectly illustrates why these types of picks and shovels businesses are attractive relatively lower risk investment options.

IIPR FFO and AFFO cannabis sector investing blog Pynk community
Source: Company’s result presentation
Returns may increase or decrease as a result of currency fluctuations.
Past performance is not a true indicator of future results.

The most recent results show continued growth at a “tech-like” pace: revenues for the third quarter of 2020 were up 196% when compared to the same quarter of the previous year. Adjusted funds from operations (AFFO)
increased 192% from the same quarter the previous year. Dividends also increased 10% from the previous quarter and are up 50% from Q3 2019. Innovative Industrial Properties remains also extremely well-positioned financially, with virtually no debt beyond $143.7 million of unsecured debt, making for a 9.4% debt-to-gross-assets ratio. It really highlights their resilience of the business model that rent collection averaged 100% from July to October of 2020, a period of time in which many REITs struggled with occupancy and rental collections. Their average remaining lease term is 16.2 years with a well-established, diverse range of tenants.

IIPR finance stats cannabis sector investing blog Pynk community
Source: Company’s result presentation
Returns may increase or decrease as a result of currency fluctuations.
Past performance is not a true indicator of future results.

Little Competition

State licensing of cannabis operators is creating an opportunity for IIPR. Initially, the risks associated with this regulatory process created a sort of vacuum where many of the traditional large real estate players felt uncomfortable treading. As a result, IIPR had the chance to ramp without substantial competition from larger REITs to achieve its current position of market leader in the space. IIPR gets a long-term lease with regular rent escalation, and the business frees up capital in order to fund further capital development. While competition is inevitable in such a high return business, IIPR has created significant competitive advantages through its size, spread, customer list and sector expertise.

Continuing Deregulation

Recently, two new states, South Dakota and Mississippi, approved the use of medical marijuana, bringing the total number of states having legalized the use of medical marijuana to 36 states and 4 territories. ArcView Market Research estimates that all states will have legalized medical cannabis by 2025 and estimates that sales will reach $34 billion by the same year. There’s clearly a strong and increasing demand for IIPR’s services.

If the company continues to maintain its current growth trends, which have exceeded 143% or more year over year since 2017, we can expect to see revenues around $563 million or more by 2025, assuming an average increase of 75% over the next five years to compensate for increased competition and scale. With that, AFFO and dividends will continue to grow in line with revenues. These projections are rather conservative in the light of the company’s track records so it’s not inconceivable that they surpass these levels.

In terms of dividends, IIPR’s success has allowed them to increase its dividend per share numerous times over their short existence, with future increases appearing reasonably probable. Dividends for the company have increased by $1.02, or 680%, since 2017 with payout ratios ranging from 71% to now around the 90% to 92% range providing a current dividend yield of roughly 3.2% to investors. Based on the company’s strong balance sheet, I expect it to maintain similar ratios and returns for investors as revenues grow.

IIPR dividends cannabis sector investing blog Pynk community
Source: Company’s result presentation
Returns may increase or decrease as a result of currency fluctuations.
Past performance is not a true indicator of future results.

Valuation Upside

Given the company’s robust performance through the downturn, I believe investors will assign a higher rating to the shares, as it is increasingly seen as a defensive and secure business, with growth unrelated to economic activity, enjoying land assets and yield support and the icing on the cake being the recovery now taking place in the cannabis sector as a whole. Management has raised the dividend payout by more than 600% since the first installation in 2017. As a REIT, the company is required to distribute at least 90% of its taxable income through dividends so income as well as profits are very likely to grow.

IIPR is growing rapidly and there is every sign this growth will continue as it buys up further properties. While some of the company’s renters saw business fall because of the pandemic, incredibly, all its tenants paid what they owed in April, May, June, and July, and only one Los Angeles company ended up in receivership. Of the company’s 5 million square feet of space, 99% is currently under a long-term lease (average 16 years).

Near Term Catalysts

IIPR will continue to benefit from cannabis companies looking to expand into newly-deregulated states or simply looking to free up capital through sale and leaseback. Several states remain poised to legalise (medical and or recreational) marijuana for the first time including Maine, New Jersey, Montana, South Dakota, and Arizona, Idaho, Mississippi and Nebraska. IIPR’s impressive list of major cannabis company clients also gives confidence to the business’ growth prospects as they can simply follow their clients from state to state as they expand. The cannabis sector as a whole has been under a cloud and if conditions now slowly improve over the medium term, I believe this recovery too will act as a catalyst to IIPR’s value.

Key Risks

In my view, IIPR represents an exciting larger business with an enviable growth profile, strong market position and medium risk

• New competitors offering land and funding: so far IIPR owns this space and business model. Given the returns on offer, it is very likely that other competitors will enter the space. I see this as the most likely business risk. One factor that has held back larger and more diversified players from entering this market is the lack of standard at the federal government level. Were cannabis to be deregulated at the federal as opposed to the state by state level, this would reduce the complexity and perceived legal risk of the industry in the eyes of the larger property players who may then be more inclined to enter the market. In addition, it is very likely that we see IPOs of other younger businesses emulating IIPR given the returns on offer. Against this, there may well be enough growth on offer in the sector for many players to make attractive returns.

• Secondary Offering: the greatest risk to the new investor appears to be the potential for a secondary equity offering. This is often a risk with growing businesses, as well as REITs, so secondary offerings should be reasonably expected from time to time. This is especially the case with IIPR, which has tried to grow through such capital raises rather than taking on traditional debt. A secondary would dilute existing shareholders, but probably raise capital at a price that is still a very attractive proposition in investment terms.

• Regulatory: any peel back of the deregulation of the cannabis industry - due to a new and unexpected health concern for example - would drastically affect the growth profile of the business. All things being equal however, the Biden/Democratic election win is generally seen as supportive of further deregulation.

• Bankruptcies of cannabis growers: the industry has suffered a mini shakeout as supply grew in excess of demand. It isn’t inconceivable that there will be more severe sector downturns in which some weaker players become insolvent potentially leading to defaults on IIPR’s leases. This risk at least in the short term seems to be receding as we exit the current sector downturn.

• New Taxation: the complexity, confusion, and legal risk has prevented larger companies with a lower cost of capital from entering the market which has given IIPR the opportunity to fully utilise its first mover advantage to gain size and scale such that it has created a large defensive competitive position. But now seemingly friendly jurisdictions could end up changing rules, including the power to tax. It is hard to imagine that these issues are not priced into the sale-leasebacks (the average lease is at 11%), but may result in periods of reduced cash flow.

• Crop disease: I’ve never heard of this with cannabis, but clearly intensive farming of any crop means there is an outside chance of disease/fungi ruining crops.


Growth prospects until at least 2025 looks strong for Innovative Industrial Properties

The cannabis sector is a nascent growth industry, likely to continue to develop over the next several years. IIPR is the largest specialist landlord to the cultivators within states that have legalized medical marijuana. This is very much a pick and shovel play where IIPR is becoming a source of capital for the industry by becoming their landlord. As such IIPR appears capable of continuing to produce superior shareholder returns in 2021 and beyond.
As more and more states legalise medical cannabis, the company will have further opportunity to expand into new markets. While IIPR hasn’t publicly shared a specific growth plan, based on current activity, it appears they will continue to utilise their sale-leaseback structure while expanding their current partnerships with existing tenants to help fuel growth. I personally am a long term holder of IIPR and rate them a strong ‘have your cake and eat it’ long term buy.

Disclaimer: Please bear in mind that this information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Past Performance is not a true indicator of future results. Returns may increase or decrease as a result of currency fluctuations.

When investing, your capital is at risk and you may recover less than the initial investment. Past performance is not a true indicator of future results.

Written by
Pouneh Bligaard
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