Shares of Innovative Industrial Properties (IIPR) plunged over 15% on Thursday following a disclosure from the cannabis-focused REIT that Parallel, its second-largest tenant accounting for 10% of rent last year, has defaulted on its January rent for one of the five properties it leases.
That opening statement reads eerily similar to our last update on IIPR last summer.
Shares of Innovative Industrial Properties (IIPR) plunged nearly 15% on Friday following a disclosure from the cannabis-focused REIT that Kings Garden, its fifth-largest tenant accounting for 8% of rent last year, defaulted on its July rent.
Two additional tenants have reportedly not paid rent this month for at least one rented property, making roughly 6% of IIPR's portfolio in default.
It's also worth noting that IIPR executed lease amendments with another two struggling tenants for properties representing about 3% of its invested capital.
The Kings Garden default last summer has since been resolved, resulting in a "confidential conditional settlement agreement" and the tenant relinquishing two of the six properties it had previously occupied.
One of these relinquished properties has a signed letter of intent from a potential tenant but has yet to be officially leased. At the same time, the other is being evaluated by management for possible non-cannabis use.
This outcome with Kings Garden, which likely involved a mix of rent concessions and reduced rent, inspires little confidence in how the newly announced defaults will play out.
As a refresher, in a way, IIPR acts as a de-facto bank for cannabis growers who have limited banking options because marijuana is still illegal at the federal level.
IIPR provides a cash infusion to marijuana growers needed to grow their businesses by purchasing their facilities and then leasing back those properties to the cannabis operators in a transaction called a sale-leaseback.
Some analysts believe many of these properties were purchased at unwarranted premiums, deemed justified at the time by the industry's high growth prospects.
But as that growth phase keeps getting pushed down the road, the prices paid by IIPR may prove to have been overly ambitious, especially if today's rent rates are unsustainable for many tenants.
Either way, the cannabis industry remains complicated with conflicting state and federal laws, ongoing stigmas from the medical community, the aforementioned banking challenges, and the fact overall legal marijuana sales are declining following a pandemic surge.
Simply put, many cannabis operators are struggling to find their way and remain financially fragile with uncertain growth prospects. And with their uniquely designed facilities, it will take time to repurpose these properties for other industries if needed.
As such, there's pressure to work with existing tenants to maintain occupancy. Doing so, however, is likely to reduce IIPR's income as the outcome likely involves rent concessions and softer leasing terms.
With four of IIPR's 30 tenants defaulting on at least one of the REIT's 108 properties in the past six months, alarm bells are ringing that more could be in store given the industry's challenging environment that doesn't look poised to improve any time soon.
Furthermore, these defaults provide validity to concerns about IIPR's underwriting history and severely cloud the REIT's near-term outlook.
Turning to the dividend, IIPR's payout ratio already sat at the high end of management's target range of 75% to 85% of adjusted funds from operations (AFFO).
While the dividend may remain covered despite the announced defaults, IIPR's payout ratio will push beyond the board's preferred level. And with IIPR's outlook trending in the wrong direction, further cash flow deterioration seems likely.
Source: Simply Safe Dividends
Given the REIT's squeezed dividend coverage and the potential for more tenant defaults as industry headwinds linger, we are downgrading IIPR's Dividend Safety Score from Borderline Safe to Unsafe.
Shareholders should brace for a volatile year or two as budding economic challenges will likely add to the cannabis industry's turbulence.
Conservative investors may want to look elsewhere for more stable income, like industrial-focused Prologis which maintains a much safer payout ratio, or the diversified W.P. Carey which has achieved steady dividend growth for over 20 years.
That said, once these near-term challenges pass, the REIT's low leverage and increasing diversification – including over 100 properties in 19 states, with no facility exceeding 5% of revenue – position IIPR to capitalize on future growth opportunities in this dynamic industry.
We will continue monitoring the latest developments with IIPR's tenants and potential dividend policy and will provide updates as needed.
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