The Notorious BIG’s Crack Commandment Number Four – “Never Get High On Your Own Supply”: Innovative Industrial Properties (Ticker: IIPR)

My Moves:

I also own Preferreds of IIPR, the initial yield 9%, currently trading at approx. 8.5% yield. 

Word of caution: preferreds were issued at a par value of $25 per share and currently trade at about $26.50. If IIPR decides to call them back (which they can) you will lose whatever you paid above $25.

Innovative Industries Properties Overview:

This is going to be quick. As I learned, if you want to grow marijuana, you can do it indoors or outdoors, but a product grown indoors in a controlled environment is superior to the one grown outdoors. So to all the suburban readers, as much as seeing high wildlife on your doorstep may be entertaining, go for the basement and attic, not the backyard. However, if you decide to grow it on a more industrial scale, you will need a building to grow it in, as well as some storefronts to distribute to the consumers. Innovative Industries (IIPR) provides the capital needed for the construction of such an establishment and then charges rent. They are the landlord of the Cannabis Industry. Per the table below in the financial section, rents annually are approximately 13% of the amount invested into the construction. I assume there are some escalators built into the contract as that rate is increasing yearly. Cash Flows are approximately 10% of the amount invested in real estate. IIPR is a REIT, so most of the cash flow is paid out in the form of dividends, resulting in a dividend yield of 7.7% at the current price of $94 per share.

Financial Overview: 

Risks to Consider:

Quality of borrowers: There was a short report in 2022 by Blue Orca Capital (I’ll spend more time on it below) about IIPR questioning the quality of the IIPR’s borrower's ability to pay. Since the report, some tenants have defaulted as the report had accurately warned. Listening to the last earnings call, management seemed pretty upbeat; they seem to be getting a healthy amount of interest from potential new tenants of the properties they foreclosed on. It also appears that they had some clients who fell on hard times in 2023 and needed rent deferral, and those clients seemingly paid back what they owed and are now up to date.  

Of approximately $2.4Bn of loans, the company only has $305MM of debt and $15MM of preferred stock, which is a fairly undemanding amount of debt. If IIPR continues to have problematic tenants, obviously profitability will be impacted, but insolvency feels remote at the moment. 

Below is a chart from the company presentation summarizing exposure by the lessee (tenant):

Economics of the business: It appears that lessors (landlords) of the properties are paying 13% on the money they borrow, which feels fairly steep. I suspect it has to do with the Cannabis industry being in a funky position concerning regulation, where it is regulated at the state level differently than at the federal level, which I assume causes all kinds of distortions. I also suspect that the Cannabis industry has expanded very quickly as the states changed their rules and there were relatively few people who were willing and able to provide funds, resulting in good returns for the IIPR which was there early and was able to expand quickly via selling additional shares. According to the presentation on the website, 94% of the leases expire after 2033 – meaning that unless lessors default, there is a lot of visibility for almost a decade.

Valuation Metrics:

I expect the business to trade mainly based on two variables; dividend yield and expected growth of the dividend. Currently IIPR trades at approx. 7.75% dividend yield. The growth prospects are not very clear as the company for the most part deployed almost all of the cash it raised. On the earnings call, management spoke of a new $65MM revolver. For a company with $2Bn of book value, that will hardly move the needle. I have to assume that unless something changes, the dividend amount will be more or less steady. If that’s the case, I think a range of $80-$100 per share, implying approximately 7-9% is probably reasonable (if nothing changes). One also has to take into consideration a fed rate. The share price will be sensitive to that due to different yield expectations.

The Covered Calls I wrote with $80-$85 strike yielding between 13-16% reflect my view on value and I feel ok about the returns vs. downside at those levels.

Musings:

Information asymmetry exists in almost every transaction. Sellers typically know much more about what they are selling than buyers. It is the case when buying a used car and buying a company, even after extensive diligence (ask JP Morgan about its Frank acquisition,) and it is certainly true when investing in public markets.  Management teams of public companies are under tremendous pressure to meet investor expectations every quarter, rain or shine. To accomplish this objective, it is not uncommon for the management teams to use various tools at their disposal. When the job, multi-million dollar compensation, and not the least of all pride are on the line that’s not a complete surprise - nobody wants to lose. These tools will vary depending on the industry - there are of course always accounting gimmicks, accounting after all is not only science but also art. If accounting rules are difficult to bend to your will, one can always present various adjusted metrics. In certain businesses, the company can generate additional revenue and profit in the short term by extending credit to unworthy borrowers (Crack Commandment Number Six). Or if you want to keep things simple you can always rely on “restructuring” - firing people to meet profitability targets today at the expense of slower revenue growth tomorrow is a reliable method to hit target profit numbers in the short term. These maneuvers and many others in my experience are done within the boundaries of the “rules” under the strict supervision of various people whose job it is to enforce and interpret these rules such as internal and external lawyers and accountants and probably some regulatory folks depending on the industry. The conference calls where a CEO admits to not performing are probably as rare as Black Swans, so it is not surprising that there are plenty of examples of management teams being creative. For shareholders - sitting on the outside looking in - using limited information curated by the same management teams - the reality is not always clear.  

Enter “short sellers” - people who generally make a living snuffing out things that don’t always meet the eye. Lately, there seem to be a rise of a particular type of “short sellers” who practice their art publicly by putting out long reports, focusing on a few issues that they repeatedly beat to death.  They are often not wrong and the issues they uncover are often real. In my observations, their findings often bring to light practices of inept management that are playing games with numbers or cutting corners vs. outright fraud.  However, these reports, which often have an air of sensationalism generally have a tone of “the sky is falling” - implying that if there is smoke, perhaps there is also a fire. I know from my own experience, that given the asymmetry level of information - I have often sold shares in question - even though logically I thought these issues were manageable. But when the market reacts wildly on a downside - I ignore logic and assume that there is something I don’t know, that others do, and losing 10-15% is better than losing my full investment.

My hat is off to the people who can make a consistent living shorting stocks - I lost money on every stock I tried to short ☹️. However, I do have mixed feelings about this “fear-mongering” approach to short selling. Instead of being objective, to me, these reports often read as “all is lost, abandon the ship NOW”. As investors, I believe the ethical responsibility of the authors of these reports is to quantify the impact of the issues uncovered and not just scream “fire” in a crowded theater. But generally, I am sympathetic to their approach - they find companies that are not as “righteous” as they appear, and instead of waiting for everyone else to notice, which may take years, they bring these issues to life. At the end of the day, they don’t create problems, they just shine the light on them.

Google a short report on IIPR by Blue ORCA published two years ago - and be your own judge of this approach. You can see what they wrote and what actually happened. To give them credit - the stock is down from about $180 / share at the time of the report and since the report, the company has certainly increased the level of the information provided to shareholders.

Random Observation–Actions and Consequences

One of the criticisms of raising the minimum wage is that companies will be forced to automate, resulting in fewer jobs.

McDonalds in Brooklyn.  See any cashiers?

Happy Investing,

Sam

Behind the Curtain: The Story Behind Endgame Mindset Newsletter

After graduating from NYU’s Stern, I started my adult life as an Investment Banker in Lehman Brothers’ Mergers and Acquisitions group. I have spent the majority of my professional career as an investor, investing on behalf of large institutions such as Morgan Stanley, Merrill Lynch, and Bank of America, as well as a private equity fund and helping companies buy other companies.  In my free time, I spend a lot of hours researching stocks.  A lot. It is hard to save your way to financial freedom without making good investments. 

Recently, I have also started focusing on Covered Calls.  My goal with covered calls in the current rate environment is to generate a 10-12% unlevered return.  In writing this newsletter, I share my analysis and what I own with others, hopefully helping them earn steady and attractive returns as well.

Disclaimer:

Although the information contained in the newsletter is obtained from sources I believe to be reliable, I cannot guarantee its accuracy. Calculations made in this letter are based on my estimates and not only do I make mistakes but actual performance will almost certainly be different from my projections. The opinions expressed in the newsletter are mine and may change without notice. The information in the newsletter may become outdated and I have no obligation to update it. The information in the newsletter is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. It is provided for information purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell, or hold a security. No recommendation or advice is being given as to whether any investment is suitable for a particular investor or a group of investors. It should not be assumed that any investments in securities, companies, sectors, or markets identified and described were or will be profitable. I strongly advise you to discuss your investment options with your financial adviser before making any investments, including whether any investment is suitable for your specific needs.

Do your homework before putting money at risk!