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Bull of the Day: Innovative Industrial Properties (IIPR)

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The markets have been extremely volatile lately and bad news and reduced expectations regarding the Coronavirus extend o a wide range of companies that wouldn’t appear to have direct exposure.

Investors are increasingly coming to the realization that nearly every industry relies in international trade for the sale of finished products or in its supply chain (or both.)

With stocks broadly down more than 10% over the past two weeks, the Board of the US Federal Reserve took the unusual – but not unexpected – step of lowering the Fed Funds target rate by 50 basis points on Tuesday morning with the intent of cushioning the blow to the US economy from the impact of the virus.

Innovative industrial Properties (IIPR - Free Report) is in the fairly unique position of operating entirely inside the United States and should also get a boost from falling interest rates. After yet another blowout quarterly earnings report, upward analyst revisions have earned the company a Zacks Rank #1 (Strong Buy).

IIPR is a Real Estate Investment Trust that invests exclusively in real property assets that are used for the cultivation and production of cannabis products. The core of their business is that they purchase properties from growers or producers, perform tenant improvements to maximize utility to the operators and execute a leaseback agreement in which the producers continue to operate their businesses while paying rent to IIPR.

IIPR has become the hands-down industry expert in navigating the complex patchwork of state and local regulations pertaining to marijuana facilities.

As a REIT, the company pays out at least 90% of operating income each year in the form of a cash dividend. As IIPR has continued to add assets to its portfolio, that dividend has been rising steadily and the current yield is better than 4% annually.

Marijuana is now legal in some form in 33 states, but remains prohibited at the federal level - which leaves operators significantly underserved by the traditional banking system. With most banks and other financial institutions unwilling to take the risk of lending to marijuana businesses, IIPR essentially fills that lending role, allowing producers to turn their real estate assets into cash for expanding operations.

As the nation’s de facto lender to the cannabis industry, IIPR enjoys very favorable lease terms on the properties it owns. The average term is 15.6 years and the average return on invested capital is 13.3% - both considerably better than industry averages.

In 2019, the US House of Representatives passed the SAFE Banking Act -  a piece of bipartisan legislation that would remove the threat of penalties for financial institutions that do business with cannabis businesses. The Act was heralded as a big step forward for improving the efficiency of transactions in the industry, reducing the incidence of violent crime associated with all-cash businesses, allowing traditional banks to earn banking fees and profits from cannabis businesses and streamlining the collection of taxes and fees by state and local governments.

Unfortunately for the cannabis industry, the SAFE Act appears to be completely stalled in the US Senate and majority leader Mitch McConnell (R, KY) has demonstrated no intention of opening the issue to a vote.

Ironically, that’s actually good news for Innovative Industrial Properties. The fact that traditional lending institutions still can’t provide financing to cannabis companies means that IIPR is effectively the only game in town - and allows them to continue adding property assets on favorable terms.

While most industry observers expect that the rules prohibiting cannabis at the federal level will eventually be eased, it now appears that it’s going to take until at least the end of 2020 – and possibly much longer. In the meantime, IIPR is amassing a huge portfolio of high performing assets. Over the past 14 months, they’ve gone from 11 properties to 51.

Although most of the industry is desperately hoping for an ease in restrictions, these restrictions work in IIPR’s favor, letting them build a seemingly insurmountable head start over the potential competition.

As for the impact of the Coronavirus, not only does IIPR avoid all of the common issues regarding trade and travel, the Fed’s recent emergency rate cut works in their favor as well. Because they are required to pay out a fixed percentage of cash flows, REITs generally exhibit price behavior similar to bonds. As interest rates fall, bond prices and REIT share prices increase to reflect the relativeness attractiveness of their cash distributions in the future.

In simple terms, with the annual yield on 10-year US Treasury notes dipping below 1%, IIPR’s 4% dividend looks more and more attractive. Even if shares were to rally 33%, the current $1/quarter dividend would represent an annual yield of more than three times the rate paid on government bonds.

A lot of attention has been paid lately to ways to avoid losses – or even generate profit opportunities – from the reaction to the spread of the Coronavirus. Because of its naturally defensive nature, Innovative Industrial Properties looks to be able to sidestep most of the problems and even benefit from the trend in interest rates.

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