Here's Why This REIT Could Be the Best Cannabis Stock You've Never Heard Of

Cory Renauer, The Motley Fool - Posted 4 years ago

Over the past 12 months, the amount of search traffic driven by Innovative Industrial Properties (NYSE: IIPR) barely registered when compared to large cannabis producers like Aurora Cannabis (NYSE: ACB). You might be surprised to learn that over the same period, IIP's stock price has soared 252% because it has something all the popular cannabis companies don't: rising profits.

If you're surprised to see shares of a dull landlord business outperforming marijuana stocks that receive heaps more attention, there are a few things about this real estate investment trust (REIT) that you should know.

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Ben Franklin hiding under a pot leaf.

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Business is booming

In the U.S., cannabis cultivators and processors have a hard time finding banks willing to deposit the piles of cash their businesses generate. That's because, at the moment, serving customers engaged in federally illegal activity means risking their license to operate in the country, which would equal a death sentence for nearly any financial institution.

At the beginning of 2017, IIP owned just one property, but banking restrictions have brought a steady stream of cannabis cultivators right to IIP's doorstep. As of May 7, 2019, the REIT owned 19 properties -- and they're all occupied by state-licensed medical marijuana cultivators that have signed long-term leases.

IIP's making money now

Nearly all the cannabis industry giants, Aurora Cannabis included, have been issuing new shares of their stock to continue growing at any cost. For example, Aurora has increased its outstanding share count by a whopping 176% over the past two years, which means it needs to earn that much more in order to provide the same return investors were expecting when they bought the stock.

Assuming IIP's customers continue paying the rent for 15 straight years, this company can look forward to a steadily rising bottom line. Once you adjust for annual rent increases and management fees, IIP's yield on capital invested in its first 19 properties will work out to around 14.8%.

During the first three months of 2019, IIP collected $6.6 million in rent, which was 146% more than a year earlier. Since tenants are responsible for maintenance and other variable costs, a great deal of that money flows to the bottom line. In the first quarter, adjusted funds from operations (FFO) reached $5.3 million.

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A garbage bag full of untrimmed cannabis flower.
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Shareholders get a big cut

As a REIT, IIP doesn't have to pay any corporate taxes as long as it distributes at least 90% of earnings directly to its shareholders in the form of dividends. 

Thanks to surging rental revenue, IIP's quarterly dividend payment is growing by leaps and bounds. Recently, IIP declared a second-quarter dividend that was 33% higher than the first-quarter payout and 140% higher than a year earlier.

This dividend could get huge

At $0.60 per share, IIP's dividend offers a meager 1.9% yield that could grow significantly. The current payout exceeds FFO generated in the first quarter by $0.05 per share, but adjusted FFO during the first quarter rose 275% compared with the previous year.

In the second quarter, IIP acquired and entered long-term leases with tenants in California and Pennsylvania. With rent checks from new tenants that signed leases in April added to the company's reliable revenue stream, the company should have no problem meeting its latest obligation, and committing to further increases.

Reason to tread carefully

Since businesses keep paying the rent until they're done circling the drain, REIT profits can keep growing through temporary bouts of trouble. Unfortunately, one of IIP's larger tenants has a problem that's been developing for an entire decade.

Recently, IIP expanded its investment in Green Peak Innovations (GPI), Michigan's largest purveyor of licensed cannabis, by $18 million, to $31 million. Sadly for GPI, inside Michigan's busiest provisioning centers "licensed cannabis" is a four-letter word because it's generally more expensive, and of much lower quality than what they're used to. 

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Marijuana dispensary sign.

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Ever since Michigan's medical marijuana program began in 2008, patients have been able to buy their medicine from caregivers, and there aren't many hoops to jump through to earn a caregiver license. As a result, there are thousands of small operations growing their products in basements, garages, and pole barns that they already own instead of spending eight-figure sums on giant greenhouses that produce mediocre cannabis.

Provisioning centers in Michigan tend to carry licensed cannabis, but they don't sell very much. That's because they haven't stopped selling products produced by basic caregivers who don't have any overhead. As a result, GPI is sitting on a ton of ready-for-sale product that it can't sell at a profit. 

GPI thinks it can produce a steady profit if given a chance to sell mass-produced cannabis at a price of around $45 for an eighth of an ounce, or 3.5 grams. Different dispensaries take different markups, but those with the best ratings on Weedmaps charge between $25 and $40 for the same amount of carefully curated cannabis that mass-produced marijuana can't compete with at any price.

Play it safe

Most states with new medical marijuana programs have erected huge barriers that will keep big companies from competing with the cottage industry that they're surrounded by. Of course, strict regulations aren't very effective if rarely enforced. In California, licensed dispensaries that play by all the rules at great expense are currently getting squeezed by unlicensed storefronts and delivery services that local authorities have little motivation to shut down.

While IIP has what it takes to deliver huge gains, it's probably best to wait and see if tenants in Michigan and California are still able to pay their bills a year from now. 

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Cory Renauer has no position in any of the stocks mentioned. The Motley Fool recommends Innovative Industrial Properties. The Motley Fool has a disclosure policy.