Our previous reporting of Innovative Industrial Properties (NYSE:IIPR) outlined the REIT’s long-term growth attributes, which we believe will carry the security beyond the broader asset class. In this analysis, we reiterate our buy recommendation as we uncovered it a few additional positives related to intrinsic valuation, the REIT’s income statement, asset valuation metrics, and more.
Despite numerous macroeconomic headwinds, we believe that Innovative Industrial Properties could be a blip in the financial markets and thrive.
Business Model Analysis
Let’s start with the basics and look at Innovative Industrial Properties’ operating growth rates.
The cannabis REIT’s growth rates are staggeringly high, and it’s managed to hit those rates at nearly one 100% collector quotawhich is rarely seen.
Innovative Industrial Properties’ Adjusted Funds from Operations over 5 years CAGR of 194% is truly outstanding. Adjusted funds from operations provide an economic explanation for the REIT’s returns as they offset amortization and other non-cash costs.
A key feature of Innovative Industrial Properties is the 100 percent triple net lease agreement with its tenants, eliminating maintenance investments and vouchers. Given the current inflationary environment, this is extremely beneficial; Therefore, it can be said that Innovative Industrial Properties’ strong collection rate and its 100% net rental models give it a competitive advantage.
The figure below shows how quickly Innovative Industrial Properties is scaling. I don’t want to delve too deeply into the chart below as we covered it in detail in our previous article. However, I do want to highlight the speed at which the REIT’s total assets are growing while it has a near 100% collection rate.
Last and probably most important. Innovative Industrial Properties generally accounts for its cash inflows and outflows on a cash basis. In many cases, publicly traded companies manipulate their income statements to smooth profits through economic cycles. However, at face value, Innovative Industrial Properties’ income statement closely follows the cash flow statement (see the relationship of accruals in the chart below).
I had to look at things more holistically to contrast my analysis.
Innovative Industrial Properties recently suffered a credit event when its tenant, Kings Garden, defaulted on its payments $2.2 million a month Rent. Although Innovative Industrial Properties’ portfolio includes credible companies, credit events are typically exogenous and intrinsically linked to the global economy.
According to recent data, the global economy is being plagued by resilient inflation, negative GDP growth and falling core consumption. Cannabis resembles tobacco-like properties, but it has yet to be classified as a consumer product, meaning it’s a cyclical business.
In addition to above. Innovative Industrial Properties’ tenants are part of an industry in its early stages of development, which means residents’ income statements are vulnerable to economic downturns. We see this as a potential red flag regarding counterparty risk.
The two charts below show 1) Innovative Industrial Properties’ top tenants and 2) its listed tenants’ quick ratios and EBIT margins, which are intrinsically linked to counterparty risk.
Source: Search for Alpha; Innovative industrial properties
To provide context about the record above. A company’s quick ratio is its cash and receivables divided by its current liabilities. A fast ratio above 1.00 is generally considered acceptable. As can be seen from the table, Innovative Industrial Properties is exposed to various assets with low quick ratios, which poses a counterparty risk. Additionally, some of its holdings have negative EBIT margins, which triggers numerous red flags.
After all, it probably goes without saying that the REIT faces exposure to an industry that faces constant litigation. The ongoing fight for the “full” legalization of cannabis increases systemic risk to the trading price of the asset.
Dividend discount model
I used a three-tier dividend rebate model to value Innovative Industrial Properties. The three-level dividend discount model discounts future dividends along with a terminal value to synchronize a fair value. Because future dividend growth rates are subjective, the model should be viewed with caution; Still, it’s a useful indicator.
Based on a three-tier model measuring three distinct growth periods, the Innovative Industrial Properties REIT is undervalued by more than 90%.
Here is how I developed the model.
- I pulled the REIT’s cost of capital from YCharts. I then used that number to discount the cash flows.
- I’ve broken down the REIT’s future dividend growth into three phases. I have used retrospective rates as I believe they will be repeatable in the REIT’s next operating cycle (5 years).
- I derived the constant growth rate by using the current dividend per share (fwd) growth rate. I wanted to calculate a sustainable growth rate, but REITs pay high dividend payout ratios, making the calculation impractical.
- I generated a terminal value by dividing the REIT’s fifth-year dividend by the difference between its cost of capital and its sustainable growth rate.
- Finally, I ended up with a fair value by adding the discounted cash flows (and the terminal value).
Relative valuation metrics
A relative valuation framework adds substance to my dividend rebate model. According to Innovative Industrial Properties’ price-performance ratio, the REITs are significantly undervalued at a normalized discount of 12.91%. Additionally, the REIT’s high dividend yield is desirable in today’s market, which is characterized by risk-off investor sentiment and high inflation.
Quantitative risk analysis
The following relates to valuation of assets and not valuation. I was somewhat shocked by Innovative Industrial Properties’ Sharpe Ratio of 1.092, as it exceeds the risk-reward threshold (1.00). A Sharpe ratio measures an asset’s excess return (benchmarked at the risk-free rate) relative to its volatility. Thus, if it exceeds 1.00, the Innovative Industrial Properties REIT can be attested to have a favorable risk-return profile.
However, investors need to note the stock’s value-at-risk, which indicates that Innovative Industrial Properties tends to fall 19.47% or more in 5% of its trading months.
Innovative Industrial Properties is a best-in-class REIT based on advanced valuation and pricing metrics. In addition, the most important operational indicators of the REIT convey long-term growth. We therefore maintain our buy recommendation for the REIT.
If you’re interested in advanced analytics, be sure to keep an eye out for our marketplace program, The Factor Investing Hub, which is launching soon. FIH is an AI-driven “Smart Beta/Factor Investing” portfolio management concept that aims to balance long-term portfolios relative to “factors”.