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Cannabis: Hashing Out a Budding Industry


Cannabis landlord Innovative Industrial's growth is promising, but baked in

Innovative Industrial Properties Inc. has had a vigorous first-quarter run in the market, and while analysts like the legal cannabis landlord's long-term growth prospects, they think its stock price likely has plateaued.

Ladenburg Thalmann's John Massocca and Brandon Travis downgraded the company to a "neutral" rating from "buy" in a March 20 note, judging its "sector leading growth potential" and unique position as the dominant real estate investment trust in the legal cannabis market to be baked into the share price. The company's stock is up 94.7% year-to-date through March 20, against the SNL US REIT Equity index's 14.2% total return and the S&P 500's 13.2% total return.

"If you were judging it as if it were any other REIT, it would seem extremely pricey," Massocca said in an interview.

Innovative Industrial has returned 367.8% since its Dec. 1, 2016, initial public offering at $20 per share. The SNL US REIT Equity index returned 22.8% over that same time frame, and the S&P 500 returned 34.5%.

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Massocca and Travis believe the stock is trading at or near fair value, and they consider its near-doubling year-to-date justified in view of the company's expansion and the impact its acquisitions are likely to have on its net operating income. With cannabis use still illegal at the federal level in the U.S., and with capital sources scarce for operators and prospective buyers in the space, Innovative Industrial has been able to continually source assets at cheap valuations. Massocca gave high marks to the company's management team for rounding up the number of acquisitions it has in the last two-plus years.

"They can invest at these super high cap rates and raise capital at really low cap rates," Massocca said. "So when they invest money and generate NOI, it's accretive to net asset value. You're able to collect that spread between your cost of capital and the yields you can get on investments. ... So much of the value — legitimately so — is [based] on what you think they can do."

Innovative Industrial traded at a 149.6% premium to the S&P Global Market Intelligence consensus NAV estimate of $35.40 per share as of March 20.

On a March 14 earnings call, Paul Smithers, Innovative Industrial's president and CEO, described "tremendous velocity" in the growth of the medical cannabis market. Innovative Industrial targets deals with medical operators, but does not limit its tenants from growing cannabis intended for recreational purposes if they obtain state licenses.

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Innovative Industrial's management team also outlined on the call a nearly $100 million property acquisition pipeline, with about $47 million of transactions under contract, "just under" $40 million of transactions under letter of intent, and another $10 million in final negotiation.

"Our yields remain straight down the middle in all of our transactions, with yield ranging anywhere from 12% to ... up to 15%-plus," Executive Chairman Alan Gold said on the call, according to a transcript.

As of March 20, Innovative Industrial owns 13 properties comprising about 1.1 million square feet, including about 215,000 square feet of development and redevelopment, across 11 states. In 2018 alone, the company acquired six properties in five new states. Gold said on the call that he expects the momentum to continue in 2019, with an "extremely strong" external opportunity set in each of the states in which it currently operates.

"The medical-use cannabis industry is one of the most dynamic growth industries in current times," he said.

Massocca said Innovative Industrial likely will maintain its leading edge in the cannabis real estate market as long as cannabis remains an illegal substance at the federal level, stifling competitors in the capital markets. His team's new "neutral" rating is purely quantitative; he does not expect to see an additional 12.5% increase in the share price this year.

"[E]ven assuming ... significant additional capital deployment beyond current cash on hand ... the REIT's current strong investment spreads remaining largely unchanged, and ... eventual cap rate compression that may occur if cannabis is legalized at the federal level, it is difficult to get to a valuation resulting in a 12.5% total return from yesterday's closing price, which is necessary for us to maintain a BUY rating," Massocca and Travis said in the note.

Innovative Industrial did not respond to a request for comment.