Innovative Industrial Properties - the financial statements don't tell all

Value Investing Case Study 33-1: In this post, I share my thoughts on how I derived the Investment Thesis for Innovative Industrial Properties Inc. Looking at the numbers from the financial statements are not sufficient. You have to dig deeper.

Innovative Industrial Properties - going behind the scene

In August 2022, I published an article on Innovative Industrial Products Inc (IIPR) on Seeking Alpha. It had the following Investment Thesis.
  • While the company has grown significantly since its 2016 IPO, this was driven by its financing strategy rather than operating or marketing strategies. This depended on the high market price for its shares together with growth in its AFFO (adjusted funds from operations) per share.
  • Given the high-interest rate, the decline in IIPR share price, and the potential recession, this model is no longer tenable. IIPR would find it challenging to grow its lettable areas as well as grow its AFFO per share.
  • Looking at IIPR through a no-growth lens, there is no margin of safety at the current market price.


In this post, I would share with you the thought process that led me to that thesis. It illustrates that looking at the numbers from the financial statements superficially may lead to a wrong conclusion. To get insights, it is not sufficient just to read the Annual Reports/Forms 10k. Being familiar with the industry is also important.

I spent the past 20 years running a property company with both development and investment property activities. At the same time, I have also invested in REITs. These provided me with the necessary background to go beyond the numbers.

Should you go and short it? Well, read my Disclaimer.

Contents

  • IIPR background
  • Growth potential
  • Financial Engineering
  • IIPR competitive advantages
  • Valuation
  • Conclusion
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IIPR Background

Founded in December 2016, IIPR is the first publicly traded company on the New York Stock Exchange to provide real estate capital to the regulated cannabis industry. According to its website:

“We focus on purchasing specialized industrial real estate assets for the regulated cannabis industry. We believe that our sale-leaseback and other real estate solutions offer an attractive alternative to state-licensed cannabis operators who have limited access to traditional financing alternatives.”

The company IPO in 2016 with just one property of 127,000 sq ft of lettable area. As of the end of 2021, it had 103 properties with 7.7 million sq ft of lettable area. The growth had been phenomenal as can be seen from Chart 1. At the same time, there was also a more than 6-fold increase in the AFFO per share. 

IIPR growth metrics
Chart 1: Growth Metrics

The net income and ROE have also shown tremendous growth as can be seen from Chart 2. The first impression is that this is a growth stock. 

IIPR Net Income and ROE trends
Chart 2: Net Income and ROE Trends

According to Investopedia:

“…a growth stock is any share in a company that is anticipated to grow at a rate significantly above the average growth for the market. These are companies that are expected to grow sales and earnings at a faster rate than the market average.”

However, I was a bit worried about classifying IIPR as a growth company. This was because the property sector is a mature one with limited growth. For example, according to Statista, real estate revenue in the US is expected to grow at a 3.71% CAGR from 2022-2025.

While IIPR serves the cannabis sector, it was still a property company. I thus wanted to understand the source of its historical growth. 

Growth potential

IIPR serves the cannabis sector. In the United States, cannabis is often used in the cosmetic, pharmaceutical, and food & beverage industries. This is a new sector with tremendous growth opportunities as illustrated by the following quotes.
  • “The U.S. regulated cannabis sales grew an estimate 52% in 2020 to $20 billion, and are expected to grow to over $45.9 billion by 2025, according to Marijuana Business Daily. Arcview Market Research and BDS Analytics also project that all U.S. states will have authorized cannabis for medical use and nearly 50% of U.S. states will have authorized cannabis for adult-use by 2025.” IIPR website.
  • “The U.S. cannabis market size was valued at USD 10.8 billion in 2021 and is expected to expand at a compound annual growth rate (CAGR) of 14.9% from 2022 to 2030.”  Grand View Research
  • “U.S. cannabis sales are estimated to rack up a whopping $57 billion by 2030, according to a top researcher…That figure could top a whopping $72 billion if the 18 additional states that seem likely to legalize activate their markets…” Forbes

The increasing legalization of cannabis and rising acceptance of its use for medical purposes are the key factors driving the growth of the market. 

The logic is that if the sector is a growth one, then the supplier of products and services to the sector would also be a growth one. The challenge for IIPR is not the source of properties given the industry growth prospects. Rather how do you fund the acquisitions?

Drivers of growth

Unlike normal stocks, REITs are unique in that they pay out their dividends from their free cash flow. As REITs pay out almost all their cash flow as dividends, they retain very little cash flow to carry out growth initiatives, such as purchasing new properties. 

To grow, REITs need to tap the capital markets. You can see this by looking at the balance sheet of a typical REIT.

Assets = Equity + Liabilities

In other words, the managers of the REIT can fund the new purchases or other capital requirements either by adding to the equity or liabilities.

Chart 3 illustrates this situation for IIPR. You can see that the growth in the total real estate cost is matched by the Total Capital Employed. 

The Total Capital Employed = Equity + Debt. You can see that in the case of IIPR, the bulk of the capital was from Equity.

IIPR Real estate funding vs capital structure
Chart 3: Real Estate Funding vs Capital Structure

Financial Engineering

Let me summarize what we know so far:
  • The cannabis companies require funds for their business. IIPR has been able to provide them by buying their facilities on a sale-cum-lease back basis.
  • The cannabis sector is growing and as such IIPR was able to find new properties.
  • IIPR has been able to raise capital to purchase the properties. The majority of the capital was from equity.

What was unique was that IIPR was able to increase its equity while achieving a growing AFFO per share. 

Based on my industry experience, REIT is a business where growth in FFO is tied to growth in the rental. Rental growth comes from either annual rental revision or additional lettable areas.

In the case of IIPR, the annual rental revision was less than 5%. So, the growth has to come from new lettable areas. 

But for the AFFO per share to grow, my working hypothesis was that the growth rate in the lettable area must be higher than the growth rate in the number of shares. I found the following growth rates from 2017 to 2021:
  • The lettable areas grew at 88 %.
  • The number of shares grew at 67 % CAGR.

Think about it. 
  • The capital raised = value of properties. Both are growing.
  • Capital = number of shares X price per share.
  • But the growth in the number of shares is lower than the growth in the capital raised.
  • For this to be true, it must be because the price per share is increasing.

I then looked for the data to verify this conclusion. Chart 4 illustrated what I found. You can see that the new share issuance price increased from 2017 to 2021. 

The conclusion then is that IIPR managed to grow its AFFO per share because it was able to raise capital with increasing share prices. If this is not financial engineering, I am not sure what is.

AFFO growth did not come about because of higher utilization of the lettable areas or other reductions of operating costs. Growth was not driven by improvement in operations. 

I am not making a judgment about how IPPR achieved the AFFO growth. What I was interested in was whether the conditions to enable this financial engineering would continue to be there.

IIPR real estate cost vs new share issuance price
Chart 4: Real Estate Cost vs New Share Issuance Price

IIPR competitive advantages

According to IIPR, its competitive strengths are:
  • Experienced and committed management team.
  • Recurring revenue with contractual escalations. 
  • Demonstrated investment acumen.
  • Positive regulated cannabis industry trends. 

I do not consider these as unique. In the first place, IIPR had only 18 employees as of the end of Dec 2021. This reinforces my point that growth did not come from improvement in operations. 

I would add that squeezing additional lettable areas from existing properties is not something you can do every year. Based on my experience, you need a strong operating team. In the case of IIPR, they depended on the tenants to manage the properties. As such I doubt this avenue was available to IIPR. 

The second and last points are common to all REIT participants in the cannabis sector. 

Only the third point could be something that served IIPR well. You can see from Chart 5 that management took advantage of the market situation to issue new shares at higher prices. 

This reduced the number of shares being issued. The result is that the AFFO per share grew. This growth in AFFO per share attracted interest in the stocks driving share prices up. This in turn enabled new shares to be issued at higher prices. 

Kudos to management for this.

IIPR new share issuance price vs market price
Chart 5: New Share Issuance Price vs Market Price

But this is a musical chair. What happens when the share price starts to decline thereby affecting the ability to issue new shares at higher prices? The tremendous growth in AFFO per share will drop.

Financial model to test the hypothesis

To validate my idea, I developed a financial model as shown in Table 1. The model linked:
  • The additional lettable areas to be acquired (b) and hence the cost (f) to the funds raised (j). 
  • The funds raised are dependent on the number of shares (h) and the share price (i).

I have assumed the following in the model:
  • The rental yield and cost of the property per sq ft are those of 2021.
  • There are no rental expenses ie Rent = AFFO.

Table 1 illustrates one simulation assuming 1 million sq ft of new lettable area. I have assumed that the additional lettable area is at USD 9.00 per share of AFFO. This is so that I can achieve a 5% growth in AFFO per share. 

Note that from 2020 to 201 IIPR achieved a CAGR of 33 %. This 5% is very conservative.

Based on these parameters, the new shares would have to be issued at USD 72.70 per share. Given the IIPR market price of USD 96, this would be a 25% discount on the market price. Compared to the discounts over the past 2 years as per Chart 5, this is not attractive.

I ran another simulation based on a 10% growth in AFFO per share. To meet this, the share issuance price would have to be higher than the current market price of USD 96 per share.

The simulations showed that given the current market price, it is not possible to achieve the historical growth in AFFO per share.

This is of course a back-of-envelop simulation of the share issuance. But it highlights the key parameters that had enabled IIPR to achieve its historical growth - high and increasing market price for its shares.

While there are still opportunities to acquire new properties, funding them with equity on attractive discounts would be a challenge.

IIPR financial model
Table 1: Financial Model
Notes to Table 1
a) This is the actual lettable area as of the end of 2021.
b) This is the new lettable area acquired.
c) Growth rates.
d) The rental yield achieved by the new property.
e) Price of the new property.
f) Total cost = new lettable area X price of new property.
g) Rental = Yield X Total cost of property.
h) No of shares= Rental divided by AFFO per share. I assumed that there is no other expenses.
i) Share price is an input variable. I varied this so that the Cost for property = Funds raised.
j) Funds raised = Share Price X number of shares. 


Case Notes

According to Investopedia, traditional metrics such as EPS and PE ratio do not apply to REITs. A better metric to use funds from operations (FFO), which makes adjustments for depreciation, preferred dividends, and distributions. 

But FFO does not deduct capital expenditures required to maintain the existing portfolio of properties. Therefore, many use a measure called adjusted funds from operations (AFFO) to estimate the REIT’s value. This is better than FFO for two reasons:
  • It is a more precise measure of residual cash flow available to shareholders and therefore a better “base number” for estimating value.
  • It is a true residual cash flow and a better predictor of the REIT’s future capacity to pay dividends.

But AFFO does not have a uniform definition. Most calculations subtract capital expenditures. It is used as an estimate of the cash required to maintain existing properties. 

A useful valuation metric is the reciprocal of the price-to-AFFO multiple - called the AFFO yield. To evaluate the REIT’s price, we can then compare the AFFO yield to: 
  • The market’s going capitalization rate (cap rate). This is a general number that tells investors how much the market is currently paying for real estate.
  • The estimate for the REIT’s growth in FFO or AFFO. The growth that we are expecting should eventually translate into both higher dividends and prices. 

As you can see, there are many ways to value companies. As a newbie, you have to quickly be familiar with all the various valuation methods. One way is to read as much as possible on this. A good site for this is Seeking Alpha.*. Click the link for some free stock valuation examples. If you subscribe to their services, you can tap into their business analysis and valuation.




Valuation

I estimated the value of IIPR as follows:
  • Net asset value = USD 63 per share. IIPR is a REIT and the NAV provides a very strong floor value for a REIT. 
  • AFFO yield of 7.3 %.

I estimated the no-growth AFFO per share at USD 7 per diluted share based on the average 2021 values and the projected 2022 values.

2021 AFFO per diluted share      = USD 6.66

2022 AFFO per diluted share     = USD 7.48 (annualized)

Average AFFO per diluted share = USD 7.07 

At the current market price of USD 96 per share, this is equal to an AFFO to price yield of 7.3 %. One way to gauge whether this is good is to compare it with the market cap rate. 

The difficulty here is that there are no currently available cap rates. These would have taken into account the current interest rate regime and the potential recession.  However, we can have a feel of this from the following 2021 cap rates:
  • “…average capitalization rates (cap rates) have held stable for the last three quarters at 5.8% for industrial facilities…” Q2 2021 Industrial Market Outlook, Colliers.

I would expect the cap rate to be higher in 2022 given the current interest rate situation. As such, I am not sure that the 7.3 % AFFO yield of IIPR can be considered a good margin of safety.

I would hasten to add that you invest in REITs for the dividends and not the capital growth. In this context, the dividend yield of IIPR at the current price assuming the 2021 dividends:

= 5.72 / 96 = 6%.

If you are looking for dividend income without expecting any capital appreciation, IIPR could be an opportunity. But if you are looking for a growth story, then be careful. It is not the cannabis industry growth that drove historical growth. It was financial engineering.

Conclusion

I hope the article has shown that you should not take the financial statements' numbers at face value. You have to understand the drivers of the performance. Only then can you judge whether the numbers make sense.

Based on my analysis, I summarized the IIPR position as follows:
  • IIPR had grown its lettable area and AFFO per share 6 to 7 folds since its IPO in 2016. But this was due to “financial engineering”.
  • Its property acquisitions were funded by equity that benefited from increasing share prices. AFFO per share growth was due to the rents increasing at a faster rate than the number of shares.
  • The current economic situation is different. It will be more challenging to fund its acquisition via equity given the lower share price. The lower share price also meant more shares issuance that will affect the AFFO per share.

In my article for Seeking Alpha, I also commented on some of the risks and shortfalls of my thesis. I suggest that you read the original article for these.  I have left them out here as they are not critical to my thought process on establishing the Investment Thesis. 



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I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

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