IIPR's Undervaluation: Low Leverage and Cannabis Rescheduling Catalysts - Episode Hero Image

IIPR's Undervaluation: Low Leverage and Cannabis Rescheduling Catalysts

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TL;DR

  • Innovative Industrial Properties (IIPR) trades at a 15% dividend yield and 8x AFFO, significantly cheaper than its MSO tenants, despite facing fewer price compression headwinds and benefiting from rent collection stability.
  • Rescheduling cannabis to Schedule 3 would eliminate 280E taxes for MSOs, potentially converting GAAP losses to profits and removing uncertain tax liabilities, a significant catalyst for tenant credit quality.
  • IIPR's dividend, currently not covered by AFFO, faces a near-term risk of a cut, but even an 85% payout ratio after a cut would still yield 11%, with upside from releasing vacant properties.
  • IIPR's extremely low leverage ratio of 1.3x debt-to-EBITDA provides a substantial margin of safety, making bankruptcy risk virtually nil even with declining AFFO, unlike highly leveraged REIT peers.
  • The preferred stock of IIPR, yielding 9.5%, offers exceptional safety with 48x AFFO coverage and remains secure even under a hypothetical 50% rent reduction scenario, outperforming other high-yield preferreds.
  • Legalization, while a long-term bullish catalyst, could initially lead to price compression for MSOs due to interstate commerce, whereas rescheduling offers more immediate financial benefits by removing 280E taxes.
  • Management's conservative leverage strategy is a critical positive for IIPR, mitigating risks associated with tenant defaults and operational challenges, contrasting with potential issues from external management structures.

Deep Dive

The core insight is that Innovative Industrial Properties (IIPR), a cannabis-focused REIT, is undervalued due to a confluence of factors that obscure its stability and upside potential. Despite significant headwinds faced by its tenants (multi-state operators or MSOs), IIPR's conservative financial management, particularly its low leverage, provides a strong safety net. The impending rescheduling of cannabis from Schedule I to Schedule III, coupled with the removal of Section 280E taxes for MSOs, is poised to fundamentally improve tenant credit quality and unlock substantial value for IIPR.

The primary second-order implication of cannabis rescheduling is the significant improvement in the financial health of IIPR's tenants. The removal of Section 280E taxes, which currently force cannabis operators to pay taxes on gross profits without deducting operating expenses, would allow MSOs to shift from paying exorbitant tax rates (often exceeding 80% and even occurring with negative operating income) to being GAAP profitable. This improved profitability will enhance tenant credit quality, reducing the risk of rent defaults and increasing the likelihood of IIPR releasing currently vacant properties. This potential for increased rental income, even at reduced market rates, presents upside that is not currently reflected in IIPR's valuation.

Furthermore, IIPR's exceptionally low leverage ratio (1.3x debt to EBITDA) contrasts sharply with industry peers (typically 5-6x) and even its own tenants. This conservative capital structure acts as a critical buffer against operational volatility. Even with approximately 20% of its tenants not paying rent, leading to its dividend not being fully covered by current adjusted funds from operations (AFFO) per share ($1.70 AFFO vs. $1.90 dividend), the low leverage ensures financial stability. This means that even a potential dividend cut to a still-attractive yield (e.g., 11% after a cut) would be sustainable, as the company is not burdened by the need to service high levels of debt. This financial prudence positions IIPR to weather tenant distress and capitalize on future opportunities, suggesting a re-rating of its yield towards industry norms (8-9%) is probable as tenant credit quality improves.

The analysis highlights a critical valuation discrepancy: IIPR trades at a significantly cheaper valuation (15% dividend yield, 11x earnings, 8x AFFO) than its MSO tenants, which are valued at 15-25 times earnings even after accounting for the removal of 280E taxes. This is illogical because IIPR's rental income model is inherently more stable and less susceptible to price compression headwinds that plague the operators. The landlord's cash flow is consistent as long as tenants remain operational, whereas operator profitability is directly tied to fluctuating cannabis prices. The preferred stock, yielding around 9.5%, is particularly compelling due to its 48x AFFO coverage and minimal risk even under severe stress scenarios, suggesting an attractive risk-reward profile with both yield and potential capital appreciation.

The key takeaway is that IIPR's exceptionally low leverage and the impending positive impact of cannabis rescheduling on its tenants create a compelling investment case. Investors are overlooking the fundamental stability provided by IIPR's conservative financial management, leading to a mispricing of its common and preferred shares. As the benefits of rescheduling materialize, improving tenant solvency and unlocking vacant properties, IIPR is poised for significant upside as its valuation re-aligns with its inherent safety and growth potential.

Action Items

  • Audit IPR's tenant lease agreements: Identify 20% of non-paying tenants and assess recovery potential post-rescheduling.
  • Analyze IPR's debt structure: Calculate current debt-to-EBITDA ratio and model impact of 50% rent reduction on leverage covenants.
  • Evaluate IPR's preferred stock coverage: Measure AFFO per share against preferred dividend payments for 48x coverage.
  • Assess management's diversification strategy: Review life sciences investment tenant IQHQ for potential conflicts of interest.
  • Track MSO ETF performance: Monitor daily price movements against rescheduling news to identify hype-driven volatility.

Related Episodes

Key Quotes

"Technically, IPR is listed on the major exchanges, so there's no necessarily big issue finding institutional capital that can't buy in. However, it falls itself in the worst of both worlds where cannabis investors just kind of want to focus on the operators directly selling cannabis, so they don't want to focus on the cannabis REITs. Whereas the REIT investors, they see this big 16% or 15% double-digit dividend yield, they see it's cannabis, and the REIT investors try to avoid it."

Julian Lin explains that Innovative Industrial Properties (IIPR) faces a unique challenge because it is overlooked by both cannabis investors, who prefer direct operators, and traditional REIT investors, who are wary of its cannabis association. This dual avoidance creates a situation where IIPR is less scrutinized than it might otherwise be.

"Yes, the rescheduling would mean that the MSOs, which are the multi-state operators, again, these are the tenants of IPR, the landlord which we're focusing on today, it means that they will no longer have to pay so-called 280E taxes. 280E taxes mean that these operators pay taxes based on gross profits, so they can't deduct operating expenses or interest expenses from the calculation of taxable income."

Julian Lin clarifies the significant impact of cannabis rescheduling, specifically the removal of Section 280E of the tax code. Lin highlights that this change would allow multi-state operators (MSOs), who are tenants of IIPR, to deduct operating expenses and interest, thereby reducing their tax burden from gross profits to net profits.

"So you would think that their valuations should be held back lower, whereas the landlord, they have a very consistent, more reliable income stream because they're just collecting rents. So regardless of how prices are going, as long as their tenants are not bankrupt and are still operating, they get the same rent payment. So that cash flow stream should be a higher quality business than that of their tenants, yet somehow this stock is trading cheaper than their tenants, and that's why I think it's quite interesting."

Julian Lin points out a valuation discrepancy where IIPR, the landlord, trades at a cheaper valuation than its tenant MSOs, despite having a more stable income stream from rent collection. Lin argues that the landlord's business model, which relies on consistent rent payments, should be considered higher quality than the operators who are subject to price compression headwinds.

"Prior to all of this rescheduling executive order, IPR has seen a lot of volatility in its tenants, tenant base. For example, PharmaCann, Forefront, and over the last several years, a lot of the California operators have been in default with some of their properties. So in the most recent quarter, they generated $1.70 or so in adjusted funds from operations per share, whereas they pay a $1.90 dividend. So their dividend is not currently covered by AFFO per share."

Julian Lin details the challenges IIPR has faced with its tenant base, including defaults from operators in California. Lin notes that in the most recent quarter, the company's dividend payout exceeded its adjusted funds from operations (AFFO) per share, indicating that the dividend was not fully covered by current earnings.

"With REITs, I would say the single most important and very highly underestimated financial metric that investors should be looking at is leverage. Again, not trying to talk up my own horn so much with IPR, but like having a ton of leverage versus having low leverage is everything for a REIT."

Julian Lin emphasizes that leverage is a critical and often underestimated metric for Real Estate Investment Trusts (REITs). Lin asserts that the level of debt a REIT carries is paramount to its financial stability and long-term survival, suggesting that high leverage is a primary cause of REIT failures.

"But with the leverage at 1.3 times debt to EBITDA, I see the risk of bankruptcy virtually nil. The only chance of bankruptcy is if the entire legal cannabis sector is just unsustainable and impossible, right?"

Julian Lin states that IIPR's extremely low leverage ratio of 1.3 times debt to EBITDA makes the risk of bankruptcy negligible. Lin posits that bankruptcy would only occur if the entire legal cannabis industry itself were to fail, indicating a high degree of financial security for the company due to its conservative debt levels.

Resources

External Resources

Books

  • "Best of Breed Growth Stocks" by Julian Lynn - Mentioned as the name of the investing group Julian Lynn runs on Seeking Alpha.

Articles & Papers

  • "IPR" (Seeking Alpha) - Mentioned as a public report written by Julian Lynn that in-depth covered the preferred stock of Innovative Industrial Properties.

People

  • Julian Lynn - Guest on the podcast, runs the investing group "Best of Breed Growth Stocks" on Seeking Alpha.
  • Jerry - Mentioned as having had a previous podcast conversation regarding rescheduling with the Bengal team.
  • Josh - Mentioned as having had a podcast conversation with Jerry from Bengal Capital.
  • President Trump - Mentioned for issuing an executive order to expedite the rescheduling of cannabis.
  • Biden administration - Mentioned in relation to the rescheduling of cannabis occurring in 2024.
  • Tim Rivers - Mentioned as CEO of Trulieve, instrumental in convincing President Trump to reschedule cannabis.
  • Allen Gold - Mentioned as the adjective chairman of iQ HQ and former executive chairman of IPR.
  • LeBron James - Mentioned as an example of a media influencer discussing cannabis for recovery.
  • Jerry - Mentioned as having discussed rescheduling with the Bengal team.
  • Josh - Mentioned as having discussed rescheduling with Jerry from Bengal Capital.

Organizations & Institutions

  • Seeking Alpha - Platform where Julian Lynn runs his investing group and published a report.
  • Bengal team - Mentioned in relation to a previous podcast conversation about rescheduling.
  • Innovative Industrial Properties (IIPR) - Primary subject of discussion, a cannabis REIT.
  • Multi-State Operators (MSOs) - Tenants of IIPR, companies directly selling cannabis.
  • Trulieve (TCNNF) - Mentioned as an example of an MSO.
  • Verano (VRNO) - Mentioned as an example of an MSO.
  • Newlake Capital (NLC P) - Mentioned as a comparable to IIPR in terms of leverage.
  • Realty Income - Mentioned as a comparable net lease REIT.
  • National Realty - Mentioned as a comparable net lease REIT.
  • Glass House - Mentioned as an SSO that might benefit from legalization.
  • iQ HQ - Mentioned as a tenant in the life sciences sector that IPR invested in.

Websites & Online Resources

  • Best of Breed Growth Stocks - Julian Lynn's investing group on Seeking Alpha.

Other Resources

  • Rescheduling - The process of changing cannabis's legal classification, a key topic of discussion.
  • 280e taxes - Taxes that cannabis operators must pay based on gross profits, preventing deductions for operating and interest expenses.
  • Schedule 1 - The current classification of cannabis, which rescheduling aims to change.
  • Schedule 3 - The proposed classification for cannabis after rescheduling, which would remove 280e taxes.
  • REIT (Real Estate Investment Trust) - A company that owns, operates, or finances income-generating real estate.
  • Adjusted Funds From Operations (AFFO) - A metric used to measure the cash flow of REITs.
  • Debt to EBITDA ratio - A financial metric used to assess a company's leverage.
  • Net lease - A type of commercial real estate lease where the tenant is responsible for property taxes, insurance, and maintenance.
  • Gap operating income - Operating income calculated according to Generally Accepted Accounting Principles (GAAP).
  • Uncertain tax liabilities - Potential tax obligations that are not yet definitively determined.
  • Interstate commerce - The buying and selling of goods and services between states.
  • Leverage - The use of debt to finance assets.
  • Covenants - Conditions or restrictions in loan agreements.
  • Preferred stock - A class of ownership in a corporation that has a higher claim on assets and earnings than common stock.
  • Common stock - A class of ownership in a corporation that carries voting rights and is entitled to receive dividends.
  • Life sciences real estate - Real estate specifically designed for companies in the biotechnology, pharmaceutical, and medical device industries.
  • Internally managed REITs - REITs that have their own management team.
  • Externally managed REITs - REITs that hire an external company to manage their operations.
  • Valuation - The process of determining the current worth of an asset or company.
  • Price to Earnings (P/E) ratio - A valuation ratio of a company's current share price to its per-share earnings.
  • Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) - A measure of a company's overall financial performance.
  • Sales per share - A financial ratio that measures a company's revenue generated per outstanding share of common stock.
  • Net cash balance sheet - A balance sheet where a company has more cash and cash equivalents than its total liabilities.
  • S&P 500 - An index of 500 leading publicly traded companies in the U.S.
  • Google - Mentioned as a benchmark for high-quality company valuation.
  • Meta Platforms - Mentioned as a benchmark for high-quality company valuation.

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