Did This High-Flying Marijuana Stock Just Sell Out Its Shareholders?

Marijuana stocks have never been more popular, and the investors that decided to buy shares of cannabis companies at the beginning of the year despite 2018's largely negative returns have seen some big rewards. Many of the top names in cannabis cultivation and production have seen returns that have more than made up for losses last year, and the prospects look increasingly bright for many major players in the budding industry.

Ancillary companies in marijuana have also done well, with many businesses prospering by supplying cannabis cultivators with the resources they need in order to succeed. Innovative Industrial Properties (NYSE: IIPR) has been a high-profile early mover in the business of facilitating real estate transactions for marijuana companies, with the real estate investment trust focusing on investing in grow facilities for cannabis that meet the legal requirements various states impose on medical marijuana production.

The REIT just got the good news that it will join the S&P SmallCap 600, but Innovative Industrial's need to raise capital in order to finance its growth just resulted in a transaction that some found troubling. Those concerns aren't unreasonable, but in the long run, the impact on shareholders should be a lot smaller than many fear.

What REITs need: cash

The challenge that any small companies faces is how to get the cash they need in order to grow. Most companies have two options: they can borrow money by issuing bonds or taking out loans, or they can sell additional shares of stock. Borrowing has the advantage of not having a direct impact on shareholders' stakes in the company, but it increases the company's leverage, making it more vulnerable to disruptions in cash flow. Issuing stock has the benefit of avoiding a negative impact on the balance sheet, but it comes at the price of reducing the proportional stake that shareholders have in the company.

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Innovative Industrial wants to have capital available to invest in new projects as they come up. Accordingly, it decided to raise $125 million from the capital markets. Rather than picking straight debt or doing a secondary offering of shares, Innovative Industrial decided to split the difference by using exchangeable bonds that under certain circumstances are exchangeable for additional shares of the REIT's stock.

What Innovative Industrial's deal looks like

Under the terms of the private offering, Innovative Industrial's operating subsidiary agreed to issue $125 million in exchangeable senior notes, with a maturity of five years and an interest rate of 3.75%. Those terms look pretty good when you consider that five-year U.S. Treasury notes currently yield about 2.5%. For a small company like Innovative Industrial, you'd normally see much wider spreads.

The reason for the low interest rate is that the notes include an equity kicker. At Innovative Industrial's election, the notes can be exchanged for shares of stock. The initial exchange rate set under the terms of the note was 14.37298 shares per $1,000 in par value, which works out to an equivalent price of about $69.575 per share.

Should you be unhappy with the offering?

Innovative Industrial's stock price initially dropped on the announcement, falling from about $64 to $60 per share. Concerns about dilution were paramount among the criticism that investors had about the deal. However, there are three reasons why Innovative Industrial's offering wasn't a bad move: