Could legalizing cannabis hurt innovative industrial real estate stocks?


W.When it comes to Real Estate Investment Trusts (REITs) in the cannabis industry, Innovative industrial real estate (NYSE: IIPR) is the first among equals. IIP owns 76 marijuana growing areas, and I like to joke that it’s the landlord for the industry. It is also one of my most convincing stocks.

The prospect of marijuana legalization has profound implications for every player in the industry, and IIP is no exception. I’ve spoken to some skeptics of the stock, and their refrain is always the same: things are great right now, but legalization is going to ruin them, so don’t touch them. As a shareholder, I don’t think this argument is correct – but let’s break the subject down into bite-sized pieces to analyze.

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The bears might be right

To understand how legalization could affect Innovative Industrial stock, it is necessary to understand why it is so successful under the current legal system. One of the persistent problems for US cannabis companies is that it is difficult to raise money to expand as large financial institutions are suspicious of the legality of working with the industry.

That is why IIP is a lifesaver for these companies. In case you’re not familiar, Innovative Industrial’s business model is to conduct sale-leaseback transactions that result in cannabis companies receiving liquid capital.

For the uninitiated, sale leasebacks are a type of real estate business in which a company with a built-up property sells them to a buyer like Innovative Industrial, who then immediately leases them back to the seller. Leasebacks are a win-win situation as the cannabis business receives cash upfront without disrupting its manufacturing space, and IIP receives another piece of land in its portfolio as well as a trickle of rental income. Thanks to the constant signing of new leasebacks, IIP has increased its quarterly revenue by more than 1,000% and increased its dividend by 328.6% over the past three years.

Eventually, if the law changes to allow cannabis companies to gain access to finance through traditional institutions like investment banks, they will not need to raise funds through sale-leaseback transactions with IIP. While the option will remain on the table, it will likely be easier to get into debt without sacrificing ownership of property.

In theory, this means that IIP can no longer expand its holdings as quickly as in the past. But that doesn’t mean a disaster, nor is it a guaranteed result.

Legalization might as well open the door to new customers

The thing about raising money as a business is that having more than one source of funding is extremely helpful.

For example, many companies issue new shares and then also take on debt in order to generate even more capital. The fact that they can issue stocks doesn’t preclude taking on debt, or vice versa. However, if a company’s stock is already diluted or its stocks are not valued at an attractive level, that avenue may be blocked. Likewise, a debt burden can eventually become so great that new creditors are deterred.

In short, even with marijuana fully legalized, IIP is very unlikely to go without new leaseback targets. And if it has to find a niche by working with indebted or severely watered down cannabis growers, there will still be an audience for its services.

Then there is the prospect that the cannabis industry will explode nationwide when the legal floodgates are finally opened. In such a gold rush-like environment, it is entirely possible that more companies than ever will be shouting for IIP funding to move forward with their new activities. While some of these actors would undoubtedly be lured away by banks, it is very hard to believe that IIP would be kicked to the curb with its investment dollars still waiting.

In any case, the existing group of tenants has a weighted average lease term of 16.7 years, so that they can still pay out a longer period of time to the shareholders if it takes a while to get used to a new business model after legalization.

The topic is paused again

At the moment, the prospect of federal legalization of cannabis is not on the national agenda, so shareholders can sit back and relax.

But the SAFE Banking Act was on the table for a short time. If the law is passed, it would prohibit banks that work with marijuana companies from being prosecuted for it. While there has been continued bipartisan support for the bill, attempts to incorporate it as a rider in other laws, such as the recently passed National Defense Authorization Act (NDAA), have failed.

It looks like things will stay the same for now. Cautious investors could probably still argue that IIP stock is worth avoiding. For everyone else, the dividends will continue to pile up, regardless of whether legalization takes place in the next few years or not. The positioning of IIP in the industry offers many advantages.

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Alex Carchidi owns innovative industrial real estate. The Motley Fool owns shares of and recommends Innovative Industrial Properties. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are those of the author and do not necessarily reflect those of Nasdaq, Inc.