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With or without banks, cannabis landlord pushing ahead

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With or without banks, cannabis landlord pushing ahead

Sale-leaseback transactions have fueled the legal cannabis sector's rapid expansion, and the leader of the only publicly traded cannabis landlord thinks the model will endure even if the bill intended to bring banking services to the federally illegal industry is signed into law.

In September, the U.S. House of Representatives passed by a wide margin the Secure and Fair Enforcement Banking Act, which would allow financial companies to serve cannabis businesses in states where consumption is legal. The bill awaits approval in the Senate, but in an email, Innovative Industrial Properties Inc. President and CEO Paul Smithers described the SAFE Banking Act's passage in the House as "very positive" for the company and the industry. Secure and transparent banking services in the space would empower operator-tenants by giving them more flexibility and the resources to pursue growth, and such services would not detract from the company's "key role" as a capital provider in the space, he said.

"The regulated cannabis industry in the United States is rapidly evolving, and this is yet another piece that is getting traction for change," Smithers said of the legislation.

Innovative Industrial has added 1.2 million square feet to its portfolio so far in 2019, largely through sale-leaseback deals, according to S&P Global Market Intelligence data. Recent weeks have seen a handful of acquisitions in Michigan and Illinois, two new recreational markets.

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In the absence of banking services, sale-leaseback transactions have provided a lifeline for fledgling cannabis operators. Smithers said such deals have allowed Innovative Industrial's tenants to pursue higher-yielding growth plays, while avoiding the dilution that comes with equity and convertible securities offerings.

"We believe that the sale-leaseback model will be one that endures as well for the cannabis industry," he said.

And yet three years ago, when Innovative Industrial went public, the model was not widely accepted. It was not clear at the time that operators would flock to sell their real assets, or that they would want to pay rent. The sheer number of such deals executed in the market in 2019 marks its acceptance as the main path to growth for many, according to Tom Catherwood, an analyst at financial services firm BTIG.

In an interview, Catherwood called 2019 the year of the sale-leaseback, when even the largest, most profitable cannabis operators embraced it.

"We've seen these large, multi-state operators, which tend to be well-capitalized, saying, 'Wait, it's not just the little guys that need to do this for capital, this would make a lot of sense to fund our expansion,'" he said. Catherwood added that Innovative Industrial's July transaction in Holyoke, Mass., with Trulieve Cannabis Corp. was emblematic of the shift.

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Merrill Ross, REIT analyst at Compass Point, said sale-leaseback transactions allow young businesses to reap more capital upfront by selling property at high current market values — an advantage in a young and highly capital-intensive business. Grow facilities in 2019 are sophisticated structures whose pumps, fans, and water and climate systems are expensive to maintain. There are so few financing avenues for cannabis companies "that there's no way that a sale-leaseback isn't the right way to go right now," she said.

Ross recently initiated coverage of Innovative Industrial with a "buy" rating. She said she was captivated initially by the company's ability to source good real estate deals at capitalization rates in the teens — a phenomenon she attributed to the still illicit nature of cannabis businesses.

"It's unusual to see a REIT that can buy assets in the high single digits, nevermind double digits, at this point in the cycle," she said.

Innovative Industrial continues to focus on medical cannabis operators but has moved piecemeal into retail dispensaries, alongside its tenants' own expansion in that field. Smithers signaled in his email a willingness to sign retail dispensary deals with "strong, experienced" operators not already on its roster, whether or not the SAFE Banking Act becomes law.

The passage of the SAFE Banking Act is not certain. Some observers say the Republican-controlled Senate, led by staunch marijuana opponent Mitch McConnell, will hesitate on a "yes" vote and not prioritize it amid other year-end legislative priorities. But Compass Point's research team, including Ross, thinks the Senate will pass the legislation eventually. Ross said the event would be game-changing, even if it does not open "floodgates" of capital in a highly regulated industry.

"The more that the cannabis sellers and distributors can participate in the banking system, and you can write a check rather than showing up with a bag of cash, the safer it is for everybody," she said.

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